The most recent installment of the Restricting Covenant Series was inspired by the Jeopardy! tournament “The Greatest of All Time,” where champion Ken Jennings edged out two other competitors to win the million-dollar prize. So, for the crossword and quiz show enthusiasts, here is the clue in the form of an answer (and the subject of this article): This 17-letter word means to cut out the middleman in connection with a transaction. Correct response: What is “disintermediation”? What does disintermediation have to do with noncompete agreements? Read on.
The First Appearance of Disintermediation in Noncompete Cases
Disintermediation appears most often in staffing industry cases involving the enforcement of noncompete agreements where one of the staffing agency’s employees has been solicited or hired directly by the staffing agency’s client. The first substantive discussion of disintermediation in a restrictive covenant case appears to have arrived on the scene in 1983 around the same time as “Star Wars: Episode VI Return of the Jedi,” and my personal favorite, “A Christmas Story,” were in movie theaters. The case was Consultants & Designers, Inc. v. Butler Service Group, Inc. (11th Cir. 1983), which involved two competing technical services staffing firms that served as middlemen or intermediaries between clients and highly skilled workers (referred to in the case as “job shoppers”). The crux of the case centered on the enforceability of Butler’s post-employment 90-day noncompete agreements with its job shoppers. Butler also had a corresponding 90-day “no-hire” clause in its staffing services contracts with its clients.
The court explained that Butler’s primary business function was to gather, distill and provide its clients with information on available and suitable people for open positions, and simultaneously to provide prospective job shoppers with information about the client’s available positions. Butler earned its income by charging the client a price per employee per pay period that exceeded what Butler paid the employee, and Butler did not receive a finder’s fee from either the job shopper or the client for the initial placement of the employee with the client. Thus, in the market for the information in which Butler operated, Butler competed with other technical service firms and conventional employment agencies, and “disintermediation” from its clients.
In determining whether Butler had a protectable business interest to enforce its noncompetes, the Court of Appeals for the Eleventh Circuit explained that “disintermediation” ─ which it defined as “the actualization of the ever-present cry to eliminate the middleman, i.e., direct solicitation, negotiation and contracting between the firm and the worker” ─ was a legitimate business interest. The court reasoned that if Butler “is to receive a reward for the services of the job shopper proportional to the latter’s contribution to the client firm,” then Butler “must find some contractual means to protect its future income stream from the ravages of opportunistic disintermediation.” Therefore, the court concluded that “Butler had a legitimate interest in protecting from opportunistic appropriation its investment in acquiring the information necessary to carry on its business, and that the [noncompete] covenant was reasonably well crafted to carry out that task.” In plain terms, the Circuit court found that Butler had a legitimate business interest in preventing its clients from cutting Butler out of the placement transaction. Interestingly, in dicta, the court conjectured, however, that if Butler should persist in offering this covenant while its competitors do not, the market will have the opportunity to choose between them, and “[u]ltimately it is the market which will be the final arbiter of the efficiency, or lack thereof, of this covenant.”
The Disintermediation Argument Has Not Been Universally Endorsed
At least one appellate court in Michigan has declined to endorse disintermediation as a competitive business interest for limiting competition of former contingent worker-employees. In Teachout Security Services, Inc. v. Thomas (Mich. Ct. App. 2010), which involved security guards and one-year noncompete agreements with their staffing agency employer, the evidence showed that the guards had received only two days of training from their employer about the client’s site, and otherwise learned everything about the client on the job. The court concluded that “under the circumstances of this case, where the knowledge acquired by defendants in providing security at the [client site] is merely general knowledge accumulated in their day to day positions, recognizing plaintiff’s claim of disintermediation as a reasonable interest would come into conflict” with Michigan common law precedent, which states that an employer may not unreasonably prohibit a defendant from using the general knowledge acquired on the job.
Subsequently, a federal trial judge in Michigan found that there was a “genuine dispute as to whether disintermediation is considered a reasonable competitive business interest” in the Sixth Circuit, and declined to adopt or reject this theory in its analysis of the enforceability of a two-year noncompete agreement between a staffing firm and one of its employees. See Integrated Management Systems, Inc. v. Basavegowda (E.D. Mich. 2019).
What Staffing Companies Should Know About Disintermediation
Since the Eleventh Circuit’s 1983 decision in Consultants, other courts have looked favorably on the disintermediation theory in noncompete cases. For example, in HR Staffing Consultants LLC v. Butts (3rd Cir. 2015), the Third Circuit found that a health care staffing company had a protectable business interest in “preventing disintermediation (the ability of customers or employees to cut out HR Staffing as a middleman).” Citing to Consultants, the Third Circuit observed that “[w]ithout noncompetes, employees searching for placements and clients seeking specialized personnel ‘could get the benefit of [a staffing company’s] services without paying the full price of those services’ by entering into a direct relationship with each other as soon as employees had been placed.” The court concluded that “[p]rotecting HR Staffing’s role in the placement process and thereby ensuring it receives the fees for the only service it provides, is a ‘legitimate interest,’ and, because the noncompete helps prevent disintermediation, enforcing it is reasonable.” In finding that HR Staffing had presented sufficient evidence of irreparable harm in support of its application for a preliminary injunction against its employee, the Third Circuit noted that “HR Staffing’s ability to protect its role as an intermediary through the noncompete is essential to its very existence, and money will not remediate the injury if its business model is destroyed.”
Other courts have agreed with the findings of the Eleventh Circuit and Third Circuit that disintermediation can constitute a protectable business interest to support reasonable restrictive covenants. See, e.g., Volt Services Group v. Adecco Employment Services, Inc. (Or. Ct. App. 2001) (“In the absence of an enforceable restrictive covenant, plaintiff’s employees simply could have agreed with [the client] to eliminate the middleman, thereby diverting all of plaintiff’s business ─ a process known as disintermediation.”); Borg-Warner Protective Services Corp. v. Guardsmark, Inc. (E.D. Ky. 1996) (explaining “the interest of the much maligned but time-honored middleman is a legitimate one that deserves protection against disintermediation”); Aerotek, Inc. v. Burton (Ala. Civ. App. 2000) (finding that plaintiff had a legitimate interest in preventing disintermediation); Columbus Medical Services, LLC v. Thomas (Tenn. Ct. App. 2009) (agreeing with the trial court that plaintiff employment agency had a legitimate business interest in protecting its investment in finding and securing qualified therapists through use of noncompete covenants, but concluding that the public interest of not disrupting the continuity of care for patients and the loss to the State of its investment in the therapists’ specialized training provided by the State rendered the noncompete agreements unenforceable).
In addition to well-established legitimate protectable business interests such as the protection of trade secrets or proprietary information, customer relationships, and goodwill, staffing agencies also should be mindful of “disintermediation” as an additional basis for enforcing reasonable restrictive covenants. That, and you never know when disintermediation might come up in your next crossword puzzle or trivia game.
The goal of this Series is to provide a brief overview and some interesting insights and practical pointers when dealing with unique issues that might arise in the context of restrictive covenants. It is not intended to provide and should not be construed as providing legal advice. Each situation is different, including the governing state law. If legal advice is needed, you should seek the services of a qualified attorney who is knowledgeable and experienced in this area of the law to address your specific issues or needs.