Sexual Harassment Legal Settlements: The Rules Have Changed Under the Tax Cuts and Jobs Act

At the risk of stating the obvious, the #MeToo movement, in raising awareness about the traumatic experiences of sexual assault and harassment victims, has already begun to spur changes to our laws. This is readily apparent in Section 162(q) of the Tax Cuts and Jobs Act which disallows employers from deducting settlement payments and legal costs related to sexual harassment or abuse matters if the parties signed a settlement agreement with a confidentiality provision. It would appear that ensuring the confidentiality of a settlement now comes at a higher price to corporations which in the past would have deducted the settlement amount and the attorney’s fees related to that matter. However, as is often the case under the “law” of unintended consequences, this provision may prove detrimental to some claimants by causing companies to (i) challenge allegations and fight lawsuits alleging sexual harassment or sexual abuse rather than settle early if they don’t expect to be able to use the foregoing deductions because any settlement will be confidential and/or (ii) insist on paying lower amounts to settle confidentially, including in instances where claimants desire confidentiality because of the unavailability of these deductions.

What Does Section 162(q) Say?

New Internal Revenue Code Section 162(q) provides that, as of December 22, 2017, no deduction shall be allowed for:

” 1. any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement; or

2. attorney’s fees related to such a settlement or payment.”

This provision applies to payments made on or after December 22, 2017 even if the settlement agreement was signed prior to that date.

How Does It Change Existing Law?

Before Section 162(q) of the Internal Revenue Code was modified, employers could deduct the amounts paid as part of a confidential settlement along with all related legal costs as ordinary and necessary expenses incurred in carrying on their businesses. In forcing employers to choose between non-disclosure of a settlement payment and non-deductibility of the payment and related legal costs, the new section aims to deter settlement agreements containing non-disclosure provisions which have been wildly decried in the media as “hush money” payments that conceal the culpability of employers and thereby do not deter future sexual harassment in the workplace.

IRS Guidance is Needed

Because the IRS has yet to release guidance regarding Section 162(q), there are many unanswered questions, some of which are discussed below.

1. Unintended Consequences for Claimants

Section 162(q) clearly aims to benefit employees who have been the victims of sexual harassment; however, there are aspects of the statute that could end up hurting some of them. First, employees who receive settlements related to sexual harassment or abuse claims may themselves want the settlements to remain confidential out of fear that the publication of the settlement could negatively impact their personal life or future job prospects. Since Section 162(q) provides an incentive for an employer to not settle confidentially, an employee or former employee who desires nondisclosure now has less leverage and may be more likely to accept a lower settlement offer in return for confidentiality. Thus, early settlements may be less common and settlement amounts may be lower than in the past since such amounts and all related legal costs are no longer deductible.

Second, Section 162(q) does not on its face restrict only employers from deducting attorney’s fees. Therefore, it is at least conceivable, however absurd, that claimants could find themselves in a worse position financially than they were in prior to the adoption of the provision. Before Section 162(q) was amended, claimants could take an above-the-line tax deduction on the attorney’s fees they paid; thus, they were only taxed on the net portion of the settlement amount they received. Can claimants possibly be taxed on the entire amount of a settlement, i.e., more than they actually keep after taking into account attorney’s fees and costs which often comprise at least a third of the settlement amount? The far more reasonable position in my view is that, given the stated purpose of the legislation in the Conference Committee Report to disallow any deduction “for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement” (H. Rept. 115-466 at 279), claimants can still deduct attorney’s fees and therefore will only pay taxes on the net amount they receive. However, until the IRS issues clarifying guidelines, some claimants may seek to have employers cover their possible additional tax liability which could present a stumbling block to a settlement.

2. Ambiguity Surrounding the Term “Related To”

Both provisions of 162(q) apply to settlements “related to” sexual harassment or abuse. This is problematic because many plaintiffs allege sexual harassment or abuse in addition to multiple other claims, such as race and gender discrimination claims. In drafting settlement agreements, employers almost always settle all claims simultaneously and do not distinguish between the sexual claims and other allegations. It is now unclear how employers should approach the settlement of multiple claims. Should they insist on separate settlement agreements for the deductible and non-deductible claims? In doing so, can employers offset the tax consequences of a nondeductible settlement by allocating larger amounts to settlements for other, non-sexual related claims? Absent clarifying guidance from the IRS, that seems very likely to occur in my view and, indeed, is probably already being done.

This ambiguity also applies to the provision regarding attorney’s fees. Where there are multiple claims against an employer, its attorneys conduct research and render other legal services vis-a-vis all claims, not only those which relate to sexual harassment or abuse. How should the fees associated with attorney time be allocated under Section 162(q)? Additionally, attorney’s fees are nondeductible only insofar as they relate to “settlement or payment.” Is the investigation of, or response to, a complaint of sexual harassment or abuse sufficiently related to “settlement or payment” to fall within the provision’s purview, or would attorney’s fees related to such legal services be deductible? The answer to these and other questions must await guidance from the IRS and, inevitably in some cases, the United States Tax Court. In the interim, companies confronted with these issues would be well advised to work with counsel who handle these types of matters regularly.

Finally, companies often insist in settlement agreements on general releases of all claims, including those of a sexual nature. Would such a release in a confidential settlement of a matter where there was no allegation of sexual harassment or abuse trigger Section 162(q)? That seems highly unlikely. Nonetheless, companies should give careful consideration before entering into a settlement agreement that contains explicit references to sexual harassment or abuse claims where no such claims were alleged.

Richard B. Friedman
Richard Friedman PLLC

830 Third Avenue, 5th Floor
New York, New York 10022
TEL: 212-600-9539
rfriedman@richardfriedmanlaw.com
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Restrictive Covenants in Franchise Agreements Under New York Law

What Are They?

Restrictive covenants are often found in agreements between franchisors and franchisees. The purpose of such covenants is to prevent franchisees—who are the owners and operators of businesses such as “chain-style” stores and restaurants—from harming franchisors by providing similar goods or services after the franchise agreement expires or is terminated. Restrictive covenants can serve to protect the good will of the franchisor after the franchise is reconveyed. See Jiffy Lube Int’l, Inc. v. Weiss Bros., 834 F. Supp. 683, 691 (D.N.J. 1993). 

A typical restrictive covenant clause in a franchise agreement provides that the franchisee may not own or operate a similar or competing entity in a specified area for a specified period of time after the franchise relationship expires or is terminated. 

When Are They Enforceable? 

In order to be enforceable in New York, restrictive covenants in franchise agreements must be:

1. reasonable in geographical and temporal scope; and

2. necessary to protect a franchisor’s legitimate interest. 

ServiceMaster Residential/Commercial Servs., L.P. v. Westchester Cleaning Servs., Inc., No. 01 CIV. 2229 (JSM), 2001 WL 396520, at *3 (S.D.N.Y. Apr. 19, 2001). 

In determining whether to grant an injunction to enforce a restrictive covenant, New York courts weigh the harm that such an injunction would likely cause to the franchisee and to the general public. Golden Krust Patties, Inc. v. Bullock, 957 F. Supp. 2d 186, 198 (E.D.N.Y. 2013) (citing BDO Seidman v. Hirshberg, 93 N.Y.2d 382, 389, 690 N.Y.S.2d 854, 712 N.E.2d 1220 (N.Y.1999). 

New York courts have held franchise agreements akin to employment agreements. Am. Jur. 2d, Monopolies, Restraints of Trade, and Unfair Trade Practices §§ 511-521. Accordingly, the general rules and policies that govern restrictive covenants in employment agreements also apply in courts’ analyses of such covenants in franchise agreements. Id. We have written recently on the current state of restrictive covenants under New York law. That article can be found here

1) Reasonable in Geographical and Temporal Scope 

Under New York law, a restrictive covenant will be found enforceable where it is reasonable in geographic and temporal scope. Golden Krust Patties, Inc. at 198. Whether geographic and temporal scope is reasonable is acutely fact specific. Courts recognize franchisors’ interests in preventing ex-franchisees selling to customers of the former franchise, thereby profiting from and potentially damaging the franchisor’s good will. See ServiceMaster Residential/Commercial Servs., L.P. v. Westchester Cleaning Servs., Inc., No. 01 CIV. 2229 (JSM), 2001 WL 396520, at *3 (S.D.N.Y. Apr. 19, 2001); Carvel Corp. v. Eisenberg, 692 F.Supp. 182, 185–86 (S.D.N.Y.1988) (restriction against competing stores within two miles for three years was “reasonably related to Carvel’s interest in protecting its know-how and to its ability to install another franchise in the same territory”). However, courts will not enforce restrictions regarding when and where a former franchisee can compete when such restrictions are found to be overbroad and detrimental to the franchisee’s ability to earn a livelihood. 

In Singas Famous Pizza Brands Corp. v. New York Advertising LLC, 468 F. App’x 43 (2d Cir. 2012), the Second Circuit held that a restrictive covenant that prohibited a former pizza store franchisee from engaging in “the Italian food service business” within ten miles of the franchisee’s former location for a two-year period was reasonable. The Court based its conclusion on evidence that it had taken four years for the former franchisee to find a suitable location for the Singas. The Court also stated that the ten-mile geographical restriction was “reasonably calculated towards furthering [the franchisor’s] legitimate interests in protecting its ‘knowledge and reputation’ as well as its ‘customer goodwill.’” See Id. at 46–47. 

However, the court reached a somewhat different result in Golden Krust Patties, Inc. v. Bullock. In that matter, Golden Krust, a Caribbean fast-food chain, sought a preliminary injunction against a former franchisee whose franchise agreement was terminated after the franchisee was discovered to have been selling food products manufactured by Golden Krust’s competitors. The franchise agreement stated that, for two years after expiration or termination of the agreement, Golden Krust franchisees were restricted from opening any restaurant at or within ten miles of the franchise location, or within five miles of any other Golden Krust in operation or under construction.

The Eastern District Court ultimately granted the injunction but modified the geographic constraints of the non-compete provision to reflect “the densely populated nature of the New York Metropolitan area.”  Golden Krust Patties, Inc. at 199 (E.D.N.Y. 2013). Reasoning that “most consumers in that region will not travel ten miles—or even five miles—to a fast-food establishment,” the Court determined that a four-mile restriction from the franchise location was more appropriate than the original ten-mile restriction. Id. Additionally, the Court reduced from five miles to two and a half miles the required minimum distance of restaurants that could be opened by the former franchisee from any Golden Krust location. The Court cited the close proximity between Golden Krust locations (often less than one mile apart) as evidence that a broad non-compete zone was not necessary. Id. 

The Golden Krust Court distinguished the case from Singas, holding that Singas had only restricted franchisees from operating Italian food service businesses, whereas Golden Krust restricted former franchisees from operating any type of restaurant business. Id. It is reasonable to believe that the court would have been less inclined to modify the geographic scope of the non-compete had Golden Krust restricted franchisees only from serving Caribbean-style food. Thus, one major takeaway from these cases is that New York courts are more likely to find temporal and geographic restrictions to be reasonable if a franchise agreement’s non-compete clause is sufficiently narrow in other ways. 

2) Legitimate Business Interests 

New York courts have traditionally required that restrictive covenants in franchise agreements, in addition to being reasonable in time and scope, serve legitimate business interests. ServiceMaster Residential/Commercial Servs., L.P. at *3. As already noted above, courts recognize in franchisors a legitimate interest in guarding against former franchisees’ exploitation of i) the knowledge provided by the franchisor and ii) the franchisor’s customer base. In ServiceMaster Residential, the Court held there to be “a recognized danger that former franchisees will use the knowledge that they have gained from the franchisor to serve its former customers, and that continued operation under a different name may confuse customers and thereby damage the good will of the franchisor.” ServiceMaster Residential/Commercial Servs., L.P at *3 (citing Jiffy Lube Int’l, Inc. v. Weiss Bros., Inc., 834 F.Supp. 683, 691-92 (D .N.J.1993) (upholding ten-month, five-mile restriction on rapid lube operation); Economou v. Physicians Weight Loss Ctrs., 756 F.Supp. 1024, 1032 (N.D.Ohio 1991) (upholding one-year, fifty-mile restriction on diet center). 

Legitimate business interests are strengthened when the franchisor has provided the franchisee with unique access to training and clientele. In finding that ServiceMaster’s restrictive covenant served a legitimate interest, the Court emphasized that the franchisor had provided the franchisee with training and confidential manuals regarding how to launch a restoration cleaning business. ServiceMaster Residential/Commercial Servs., L.P at *3. 

Likewise, in RESCUECOM Corp. v. Mathews, No. 5:05CV1330 (FJS/GJD), 2006 WL 1742073, at *1 (N.D.N.Y. June 20, 2006), the Court found that the franchisor-plaintiff had provided the former franchisee with “training and manuals pertaining to the best methods for operating a successful computer sales and services business . . . [and] extended to the defendant the knowledge and ability to launch and successfully operate a computer sales and services business.” The franchisor had also provided the franchisee with access to clientele, evidenced by the fact that the franchisee successfully diverted at least five of the franchisor’s former customers. Id. at *2. The Court granted a preliminary injunction against the defendant, who had opened a computer sales company in the same location as the franchise he had previously operated. 

3) Weighing the Interests of the Franchisee and the Public 

In determining whether to grant injunctions based upon the restrictive covenants of franchise agreements, recent cases have emphasized the balancing of the franchisor’s interests against the interests of both the public and the franchisee. See Singas Famous Pizza Brands Corp. at *12; Golden Krust Patties, Inc. at 198. 

Singas and Golden Krust—two of the most recent leading New York decisions involving restrictive covenants in franchise agreements—explicitly consider the potential harm of enforcing the non-compete provisions at issue to both the former franchisees and the public interest. Both decisions ultimately found the covenants enforceable and granted injunctions (though the Golden Krust Court, as discussed above, modified the temporal and geographic scope of the provision). 

In Singas, the Court acknowledged that defendants invested significant time and money into restaurants they had hoped would be Singas franchises. However, according to the Court, “any hardship caused by an injunction was caused by the defendants’ own violation of the Agreement” when they opened a restaurant location as a purported franchise without having received permission from Singas. Singas Famous Pizza Brands Corp. at *12. 

In Golden Krust, the Court also found that any harm caused to defendants by an injunction would stem from their own wrongdoing, as the former franchisee had sought to pass off a competitor’s product as a Golden Krust product, and had continued to operate after termination in contravention of the franchise agreement. Golden Krust Patties, Inc, at 199–200. In addition, the Golden Krust Court found that the public would be harmed if the defendants were allowed to continue to use the franchisor’s trademarks and solicit Golden Krust customers. The Court stated as follows: “There is likely a greater harm to the public in the form of consumer confusion if defendants are not enjoined.” Golden Krust Patties, Inc. at 200. 

Conclusion 

The general rules and policies that govern restrictive covenants in employment agreements also apply in New York courts’ analyses of such covenants in franchise agreements. However, courts will give deference to franchisors which have provided unique access to training and other benefits to franchisees. Thus, as with such cases in the employment context, litigations involving the alleged breach of restrictive covenants in franchise agreements are very factually intensive and are best handled by counsel who regularly represent clients in such matters.

Richard B. Friedman
Richard Friedman PLLC

830 Third Avenue, 5th Floor
New York, New York 10022
TEL: 212-600-9539
rfriedman@richardfriedmanlaw.com
www.richardfriedmanlaw.com
www.richardfriedmanlaw.com/blog
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