Federal Court Ruling Points Out Importance of Confidentiality Agreements and Protection of Trade Secrets

Date: 4/27/2012
 Business Group Update 4-27-2012

The use of non-disclosure agreements and confidentiality agreements has become a fact of business life. As a sure sign of their popularity and common usage, these agreements even have managed to gain their own acronym – "NDA's", standing for non-disclosure agreements. To skeptics who wonder where these agreements came from and why they are needed, a recent federal court decision from the 7th Circuit Court of Appeals provides the answer. (Fail-Safe, LLC v. A.O. Smith Corporation No. 11-11354 decided March 29, 2012 7th Circuit Court of Appeals)

Fail-Safe, LLC (FS) manufactures anti-entrapment devices for artificial pool drains. These have become critical due to the number of injuries and deaths of swimmers trapped by pool drain suction. A.O. Smith Corporation (AOS) manufactures motors for pool and spa pumps. In November, 2000, an AOS engineer attended a trade show and saw FS's suction entrapment technology. AOS's marketing director, Mike Metzler, also became aware of FS's products in a trade magazine. Seeing the potential for joint development, AOS's marketing director began discussions with FS's founder, Joseph Cohen, regarding a potential joint development project.

These discussions continued without result for quite a long time. In November, 2002, Cohen wrote to FS expressing an interest in having AOS develop a pump motor for FS with various specific features. The letter did not mention confidentiality. After more correspondence, in March, 2003, Cohen sent another letter to AOS, again failing to mention confidentiality, describing a project in broad terms. The same month, Cohen visited AOS's plant in Milwaukee where he was asked to sign AOS's one-way NDA protecting only the confidential information of AOS. Still, the light failed to come on for Cohen and FS and Cohen completed his visit without mentioning trade secrets or confidentiality at all.

After the visit, Cohen shared test results on a pump with AOS, without mentioning confidentiality. In September, 2003 Cohen wrote to AOS summarizing his view of the relationship between the two companies and offering to work with AOS to market the pump (whose test results Cohen had disclosed to AOS without an NDA) as a life-saving design. Nothing came of the letter.

In January, 2004, Cohen sent a letter to seventeen pump manufacturers. The letter claimed that FS and AOS had worked together to solve the problem of suction entrapment. This was too much for AOS, which sent its own letter to the same manufacturers denying any joint relationship. AOS also sent a letter to FS's Cohen, accusing FS of breaching the NDA that Cohen had signed during his plant visit in March, 2003.

Although subsequent discussions became contentious, the parties continued to correspond, but failed to reach any agreement. In May, 2006, AOS introduced two pump motors that FS claimed incorporated its trade secrets, the "eMod" and the "Guardian." Nearly two years later, in April 2008, FS filed suit for misappropriation of trade secrets and unjust enrichment. The district court granted AOS's motion for summary judgment.

The Court of Appeals showed little sympathy for FS's position. Wisconsin law requires an owner of a trade secret to make "efforts to maintain its secrecy that are reasonable under the circumstances." (Wisconsin Statutes, Sec. 134.90) States which have laws protecting trade secrets have similar requirements.

Far from taking "reasonable steps", the Court of Appeals found that FS had taken no steps to protect any alleged trade secrets. FS's failure is shown by:

· None of the information provided by FS was marked confidential.

· FS did not inform AOS that it expected the information to remain confidential.

· FS signed AOS's one-way NDA but did not obtain, or even request, a similar one-way or a two-way NDA protecting FS's confidential information.

Concluded the Court, "FS failed to make a modicum of effort to protect the confidentiality of its information, a failure that was not reasonable under the circumstances."

FS relied on an earlier 7th Circuit case (Learning Curve Toys, Inc. v. PlayWood Toys, Inc., 342 F.3d 714 (7th Cir. 2003)) to support its case. FS claimed that it reasonably believed that it had entered into a joint venture with AOS, thus creating a mutual duty of confidentiality. Learning Curve supported the notion that parties could have an oral confidentiality agreement that the courts would enforce. The 7th Circuit Court of Appeals distinguished Learning Curve as a relationship between two unsophisticated small companies. Illinois courts have "recognized on several occasions that the expectations for ensuring secrecy are different for small companies than for large companies." But the Court declined to apply this "small company" rule to protect FS from its own failures.

But what about FS's claim that AOS "unjustly enriched" itself by using FS's alleged confidential information? The Court was equally dismissive. "FS willingly volunteered information to AOS, and thus there is nothing unjust about AOS's later use of, and benefit from, that information. . . . Simply put, one cannot steal free advice."

The lessons from the case are clear and stark. FS failed to protect information that it later claimed to be valuable and to give it a competitive advantage. It failed to mark the information as confidential, failed to inform the recipient that it considered the information confidential, and failed to obtain (or even request) an NDA obligating the recipient to protect the information.

Admittedly, not all trade secret cases are as straightforward as this one. Litigants have spent much time and money to dispute what is a trade secret and whether certain steps were "reasonable" under the circumstances to protect the trade secret. But to take no steps and to make certain assumptions about the other party's understanding of its trade secrets was not a difficult case. The Court called this an "extreme" case which left it little choice but to grant to AOS summary judgment. If FS's trade secrets ever had value, FS's failure to take even basic steps to protect them left FS with empty hands and, no doubt after paying its legal fees, thinner wallets.

For more information about this or any other corporate law topic, please contact Stephen Proctor, Chair of the Business Group, at 847.734.8811 or via e-mail at sproctor@masudafunai.com.