“Faithless Servants” Beware – Part I

The Evolution of the Faithless Servant Doctrine

The “Faithless Servant Doctrine” is unusual in that it goes against the general common law principle that the purpose of damages is to make the injured party whole.  It is one of the few examples in our common law in which damages are not measured in this manner.     

The Doctrine provides that when an employee seriously breaches his terms of employment or a fiduciary seriously breaches her fiduciary duties, he or she can be forced to forfeit their compensation – both prospectively and retrospectively. The theory behind the Doctrine is simply that one who has acted unfaithfully in an employment context should not be entitled to his or her compensation. In other words, a condition of payment of compensation is that the employee or fiduciary will faithfully perform his job.

New York is among a minority of states that have developed this Doctrine through judge-made common law.  It serves as a powerful tool for employers and principals to recover compensation paid or due to employees, or fiduciaries who have breached their employment contract or fiduciary duties.

First adopted by New York courts in the 19th century, the  Faithless Servant Doctrine has sometimes been criticized for its potentially ”draconian” results and has been limited and tempered somewhat by New York courts over time.  Originally, an employee or fiduciary that seriously breached his employment agreement or her fiduciary duty could have any outstanding compensation withheld and even the entirety of their prior compensation forcibly returned to the employer or principal. In other states, this protection is sometimes incorporated into employment contracts by a “clawback” provision. However, in New York, Alabama, Michigan, South Carolina, Kansas, Florida, Massachusetts, and Oregon state common law already provides some degree of “clawback” protection to most employer/employee and principal/fiduciary relationships where the compensated party acts wrongfully and in bad faith in the course of their duties.

The U.S. Court of Appeals for the Second Circuit, whose jurisdiction includes New York, has used two different tests in applying the Faithless Servant Doctrine under New York law. The first standard requires that the defendant violate his employment contract through misconduct or “unfaithfulness.” The second requires only that the defendant act adversely to his employer in any part of a transaction, or alternatively, omit to disclose any interest which would naturally influence his conduct in dealing with the subject of his employment. New York state courts have followed the Second Circuit’s lead, but vary which of these tests they apply –since as a common law doctrine, the courts have no concrete statutory text to reference.

The Faithless Servant Doctrine can be applied to a company’s employees and fiduciaries at any level, from the bottom up to board members, executive officers, and general partners. Some of the most common circumstances under which the Faithless Servant Doctrine is applied include when a fiduciary or employee:

  • embezzles or steals money from the company
  • diverts a business opportunity from the company
  • engages the company in a self-dealing transaction
  • commits any kind of fraud in connection with the company, or
  • steals trade secrets or clients from a company – especially in conjunction with a demonstrated decrease in productivity and intentions to launch a competing business.

In New York, the Faithless Servant Doctrine can be applied and enforced even if the plaintiff employer or principal was not actually harmed by the defendant’s wrongdoing.

The Faithless Servant Doctrine is not limited to only direct payments of capital. Rather, any stock options or other investment opportunities offered to the defendant in connection with his employment may also have their profits, plus interest, subject to clawback via the Doctrine. This rule applies even where the defendant used his own capital to invest. Even retirement funds, pensions, and other benefits can be subject to the Faithless Servant Doctrine.

Depending on the severity of the wrongdoing, even a single instance of misconduct or unfaithfulness can be enough to warrant application of the Faithless Servant Doctrine.

The modern trend in the application of the Faithless Servant Doctrine has  limited the clawback power to only the period of employment during which the wrongdoing occurred. In cases where the defendant was paid on a task-by-task or commission basis, the clawback is sometimes limited only to the specific tasks or sales which were directly related to or affected by the wrongdoing. Tasks and sales totally insulated and disconnected from the defendant’s wrongdoing are often out of reach of the modern Faithless Servant Doctrine under New York law.