INSIGHT: ‘Readily Ascertainable’ Tax Planning Strategies Are Not a ‘Trade Secret’

A tax planning strategy marketed by a Puerto Rican firm wasn’t a trade secret, a U.S. appeals court recently ruled, and the firm that devised the strategy could not prevent a former subcontractor and employee from using the strategy for his own clients.

See TLS Management and Marketing Services, LLC v. Rodriquez-Toledo, No. 19-1104 (1st Cir. 7/21/2020).

TLS Management and Marketing Services LLC (TLS) was a tax planning and consulting firm based in Puerto Rico. TLS alleged that it generated two trade secrets, the “Capital Preservation Report” (CPR), and the “U.S. Possession Strategy” (USPS). The trade secret was alleged to be the portion of the CPR not specific to any individual client.

The USPS involved the provision of tax advice and tax avoidance strategies. In essence, the USPS was a “tax arbitrage” strategy based on the fact that Puerto Rico tax rates were lower than U.S. federal tax rates. Under the USPS, a participating client became a member of a TLS “division,” and purchased shares of TLS. Through a “services agreement,” the client’s company outsourced some business activities to TLS. TLS and its affiliate had tax exemption grants under the Export Services Act and the Economic Incentives Act.

A business that held a grant under these Acts was generally subject to a fixed corporate tax rate of 4%. TLS paid a 4% Puerto Rico tax rate on the outsourcing fees paid to TLS while the same fees were deductible to the mainland client’s company as a business expense. If the client wished to access the earnings the client and TLS entered into a “promissory note” and “security agreement,” effectively allowing the client to withdraw the earnings as a tax-free loan.

Ricky Rodriguez-Toledo (Rodriguez) was the founder and sole owner of ASG Accounting Solutions Group, a company that also offered services in tax planning and accounting. In March 2012, ASG signed a subcontractor agreement with TLS that included a non-disclosure provision. On Sept. 1, 2012, Rodriguez began working for TLS and signed a confidentiality and non-disclosure agreement.

After his departure from TLS, in early 2015, Rodriguez provided tax services in competition with TLS. TLS alleged that Rodriguez and ASG misappropriated trade secrets by utilizing the USPS trade secret in providing tax services to two former clients of TLS. These clients sought advice on how to exit their “membership” with TLS.

On Aug. 17, 2015, TLS sued Rodriguez and ASG. Rodriguez was alleged to have misappropriated the CPR trade secret by downloading copies of particular CPRs without authorization before he left TLS. Rodriguez and ASG were also alleged to have violated the non-disclosure agreements. The district court granted summary judgment to TLS on the breach of contract claims. The district court also held that TLS’s CPR and USPS were trade secrets. It concluded that Rodriguez and ASG misappropriated the trade secrets. The defendants appealed.

Common Knowledge or Readily Accessible?

The defendants argued that TLS failed to establish that it had trade secrets. Most forms of intellectual property, such as patents and copyrights, “have boundaries that are defined before the commencement of litigation.” Trade secrets are different. There is no requirement of registration and, by definition, there is no public knowledge of the trade secret in advance of litigation.

Puerto Rico’s Trade Secret Act defines “trade secrets” to be any information: (a) That has a present or a potential independent financial value or that provides a business advantage, insofar as such information is not common knowledge or readily accessible through proper means by persons who could make a monetary profit from the use or disclosure of such information, and (b) for which reasonable security measures have been taken, as circumstances dictate, to maintain its confidentiality. See Puerto Rico Laws Title 10, Section 4132. This is similar to the definition in the Uniform Trade Secrets Act (USTA) on which the Trade Secrets Act is based. We consider, the court said, court cases from other jurisdictions that have adopted the USTA in determining whether TLS proved its trade secret claims. The district court, the appellate court found, “did not apply the appropriate trade secret definition,” and concluded that “TLS did not establish that the two CPRs constituted trade secrets.“

A CPR was a report that TLS customized for the particular client. It describes public and general information, such as the meaning of tax terms, case law, IRS regulations and statutes, and public trade articles. A CPR also contained client information. The district court correctly stated that “individual client information and public information contained in the CPR were not trade secrets.” TLS was required to establish that the CPRs contained information that was not public or client information. The court found “no evidence that could support a holding that TLS established the existence of a trade secret in the CPRs.” Any trade secrets in the CPRs were not identifiable because TLS did not “separate the purported trade secrets from other information that was known to the trade.” TLS made no showing as to what aspects of the CPRs were public knowledge and which were not. TLS did not establish that the CPRs contained a trade secret.

The district court held that the USPS was a trade secret because “it was a process and method building on the knowledge and experience of employees that was used to give TLS a business advantage.” Again, the appellate court said, “we conclude that the district court applied an incorrect definition and that, under the correct definition, TLS failed to show that the USPS was a trade secret.”

To a large extent, the court observed, the USPS, like the CPRs, consisted of public knowledge. The general concept of “tax arbitrage” based on Puerto Rico tax exemption laws “was hardly secret.” It is undisputed that most of the individual steps implemented in the USPS were well known. Rodriguez testified that “outsourcing business to a lower tax jurisdiction…had been done for a long time,” for example, by “companies such as Microsoft, Apple,” and that such methods were “highly publicized.” The district court correctly found that the documents and templates underlying the USPS were all commonly used in the tax planning industry.

TLS appears to claim that one aspect of the USPS—the use of promissory notes and security agreements to enable clients to access distributed profits—was not publicly known. In contrast, Rodriguez testified that outsourcing and then “taking income as loans over to the United States” had been done for a long time. TLS could not claim trade secret protection simply because its loan strategy was not publicly known. TLS also had to establish that this aspect of the USPS was not readily ascertainable from public sources. TLS failed to show that the USPS was not so readily ascertainable. Accordingly, the court concluded that “TLS failed to establish that the USPS was a trade secret.”

Non-Disclosure Agreement Is ‘Overly Broad’

TLS’s second claim is that the defendants breached their non-disclosure agreements by using knowledge gained from TLS to provide tax services to former clients of TLS. The defendants argue that these agreements are unenforceable. The district court held that the defendants waived this argument, but the appellate court held that the district court’s finding of waiver is unsupported.

The parties agreed that the enforceability of the contracts here is governed by Puerto Rico law. In Arthur Young & Co. v. Vega III, 136 D.P.R. 157 (P.R. 1994), the Puerto Rico Supreme Court addressed the enforceability of non-compete agreements. The court held that the employer was not justified in barring the employee from offering services for two years. The court relied on authorities from mainland U.S. jurisdictions in conducting its analysis.

TLS argued that a “confidentiality clause” is not a “non-compete clause” and thus Arthur Young was inapplicable. The court disagreed. “Overly broad non-disclosure agreements raise the same policy concerns about restraining competition as non-compete clauses where, as here, they have the effect of preventing the defendant from competing with the plaintiff.” Mainland U.S. cases concerning non-compete clauses hold that overly broad confidentiality agreements constitute unreasonable restraints on trade and are thus unenforceable. A non-disclosure agreement is overly broad if the restriction is “unnecessary to the protection of the employer’s business,” “unreasonably restrictive of the employee’s rights,” and “prejudicial to the public interests.”

An employer’s interest, the court noted, does not extend to prohibiting the employee from using general knowledge acquired by the employee. “An employee is free to take with him or her general skills and knowledge acquired during his or her tenure with his or her former employer.”

A non-disclosure agreement is overly broad, and therefore invalid, when the agreement prohibits disclosure of information that “is not in fact confidential,” because it is public knowledge. Further, a non-disclosure agreement is overly broad when it extends to information properly provided to the defendants by third-party sources.

All of these factors exist here. The non-disclosure agreement’s broad scope extended on its face to public information and general knowledge not particular to TLS. The Rodriguez Agreement’s astounding breadth and lack of any meaningful limitation restricted Rodriguez’s freedom to compete. Similar broad agreements have been uniformly held invalid. The court concluded that the Puerto Rico Supreme Court would apply the principles articulated in Arthur Young to the non-disclosure agreement here and that “it is so broad as to be unenforceable.” The district erred and “we reverse the district court’s decisions.”

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.