Sometimes a Texas non-compete will take the form of forfeiture clause rather than an express prohibition on competing. For example, let’s say a company awards equity ownership to a valued employee, with a clause stating that the employee will forfeit that ownership if he competes. Is that a non-compete? And does it matter whether a court classifies it as a non-compete or something else?
*Disclaimer: This is an issue in some matters I’m currently handling. I said it once before, but it bears repeating: everything in this post is just my personal opinion, not the opinion of my firm or clients. Although in this case, my personal opinion aligns with my clients’ position pretty well, so it’s not a big deal.
In my opinion, the answers should be yes, the agreement is a non-compete and no, it does not ultimately matter because either way, the scope of the clause must be reasonable.
But the issue is open to debate, and there are several plausible answers under current Texas case law:
A. The forfeiture clause functions as a non-compete and therefore must meet the requirements of the non-compete statute.
B. The forfeiture clause is not a non-compete because it doesn’t actually prohibit the employee from competing; it just says the employee will forfeit some benefit if he competes.
C. Whether the forfeiture clause is a non-compete depends on the nature of the incentive plan; if it is a non-contributory profit-sharing plan, it probably isn’t a non-compete, but if the employee owns vested shares in the company, it probably is a non-compete.
D. Regardless of whether the forfeiture clause is a non-compete, it must be reasonable to be enforceable.
The bottom line is that the answer is unclear.
So for Texas lawyers who draft non-competes for employers, there are two things to remember. First, putting the non-compete in the form of a forfeiture clause won’t necessarily avoid the requirements of the non-compete statute. Second, regardless of what you call it, a Texas court probably will not enforce a forfeiture clause that functions as an unreasonably broad non-compete. So you might as well make the scope of the discouraged competition reasonable.
If that’s all you need to know, you can skip the rest. If you want to understand why, keep it tuned right here.
The trouble is that we have two Texas Supreme Court opinions that cut in different directions on this issue.
In Peat Marwick Main & Co. v. Haass, 818 S.W.2d 381, 385 (Tex. 1991), the court held that an agreement that does not expressly prohibit competition but imposes a financial penalty for competition is subject to the requirements of the non-compete statute.
But in Exxon Mobil Corp. v. Drennen, 452 S.W.3d 319, 329 (Tex. 2014), the court said that a forfeiture clause in an employee’s non-contributory profit-sharing plan is not a “covenant not to compete,” reasoning that it does not restrict the employee’s future employment but only makes the employee choose between keeping the profit-sharing and working for a competitor.
There are several plausible ways to interpret these apparently contradictory holdings:
- Drennen implicitly overruled Haass, establishing a broad rule that places form over substance by simply asking whether the agreement expressly prohibits competition.
- Drennen established a narrow exception to Haass for forfeiture of unvested shares that had been awarded but not yet delivered pursuant to a non-contributory profit-sharing plan; it does not apply to forfeiture of vested shares the employee already owns.
- Drennen and Haass can be reconciled based on some other distinguishing factor.
- It ultimately doesn’t matter whether Drennen conflicts with Haass, because regardless of whether you call a forfeiture clause a non-compete or not, it still must be reasonable in scope.
In my opinion, no. 1 is the worst interpretation, nos. 2 and 3 are reasonable, and no. 4 is the simplest and best way to reconcile the cases. To understand why, let’s dig into these two cases and see how Texas courts have applied them.
Haass said a clause that functions as a non-compete should be treated as a non-compete
Haass involved an agreement between an accounting firm and one of its partners, Haass. The agreement had a liquidated damages clause requiring Haass to compensate the firm if he withdrew and took clients with him. Id. at 383. Haass left, opened his own firm, and clients followed. Id. at 384. The firm argued that the damages clause was not a non-compete, while Haass contended it operated as a non-compete and therefore had to be reasonable. Id.
The court agreed with Haass that the damages clause was effectively a non-compete. Writing for a 7-2 majority, Justice Gammage acknowledged that the damages clause did not expressly prohibit Haass from providing accounting services to clients of the firm. Rather, the clause provided that if Haas did compete, he had to pay the liquidated damages. Id. at 385.
Surveying case law from other jurisdictions, the Haass court said:
Most courts have analyzed such provisions as restraints on trade sufficiently similar to covenants not to compete to be governed by the same general reasonableness principles in order to be enforceable. Even those courts that have declined to treat such damages provisions as restraints on trade have required them to be reasonable to be enforced.
Id. (internal citations omitted). Noting that the reasonableness test in either case was essentially the same, the court concluded that “the view adopted by most courts, that such covenants should be subject to the same standards as covenants not to compete, is the correct one.” Id.
Haass cited two additional reasons for treating a damages clause as a non-compete. First, the court reasoned that “[i]f the damages provided are sufficiently severe, then the economic penalty’s deterrent effect functions as a covenant not to compete as surely as if the agreement expressly stated that the departing member will not compete.” Id. at 385. “The practical and economic reality of such a provision,” the court said, “is that it inhibits competition virtually the same as a covenant not to compete.” Id. at 385-86.
Second, Haass said treating the damages provision as a non-compete was consistent with the court’s prior cases. Id. at 386 (citing Henshaw v. Kroenecke, 656 S.W.2d 416 (Tex. 1983), and Frankiewicz v. National Comp Associates, 633 S.W.2d 505 (Tex. 1982)).
Applying the reasonableness standard for non-competes, the Haass court went on to hold that the damages clause was overbroad and unenforceable because it imposed an industry-wide exclusion.
Haass established two broad common-sense principles:
First, a contractual provision that does not expressly prohibit competition can still be a non-compete if it imposes a significant financial penalty for competing. The “practical and economic reality” of the clause is more important than the label.
Second, regardless of whether a contractual penalty is classified as a non-compete, it must meet the same reasonableness requirements as a non-compete to be enforced.
Following Haass, Texas courts treated forfeiture clauses as non-competes regardless of how the clauses were worded or labeled.
For example, in Valley Diagnostic Clinic, P.A. v. Dougherty, 287 S.W.3d 151 (Tex. App.—Corpus Christi 2009, no pet.), the forfeiture clause expressly stated that it was not a covenant not to compete, but the court was not persuaded. “Although the provision at issue here is a forfeiture clause and expressly states that it is not a covenant not to compete,” the court said, “the Texas Supreme Court has analyzed such clauses in the same manner as covenants not to compete because they share the same objective—to restrain a former employee from competing against the employer.” Id. at 155.
Drennen said a forfeiture clause triggered by the employee competing is not a non-compete
But then the Texas Supreme Court muddied the waters in Exxon Mobil v. Drennen, 452 S.W.3d 319 (Tex. 2014).
Drennen was an ExxonMobil VP who received restricted stock subject to the terms of an incentive program. Id. at 322. The agreements included both a New York choice-of-law clause and a forfeiture clause allowing ExxonMobil to terminate outstanding stock awards if the employee engaged in “detrimental activity,” which included becoming employed by a competitor. Id.
When Drennen left ExxonMobil and went to work for Hess, another large energy company, ExxonMobil cancelled Drennen’s outstanding restricted stock awards based on his employment by a competitor. Id. at 323. Drennen sued for a declaratory judgment that (1) the detrimental activity clause was a non-compete, (2) the non-compete was unenforceable because it was not limited in time, geographic area, or scope of activity, and (3) therefore ExxonMobil’s purported cancellation of the restricted shares was invalid. Id.
The Houston Court of Appeals held that the forfeiture provision was an unreasonable and unenforceable non-compete and refused to apply New York law because the result would be against fundamental Texas policy. Id.
The Texas Supreme Court disagreed and reversed. The court viewed the forfeiture clause as similar to the provision at issue in Haass. But the court did not interpret Haass as holding that a forfeiture clause is a non-compete. “While we ultimately determined that the provision in Haass was an unreasonable restraint of trade,” the Drennen court said, “we never concluded that the damage provision was, itself, a covenant not to compete.” Id. at 329.
Let’s pause on that point. Drennen’s interpretation of Haass is strained at best. The Haass opinion expressly stated that a forfeiture clause should be judged by the same reasonableness standard as a non-compete and then applied that standard to the forfeiture clause at issue. Haass, 452 S.W.3d at 385-87. The reasoning of Haass was that a forfeiture clause that functions as a non-compete should be treated as a non-compete. For Drennen to say that Haass never actually held that a forfeiture clause is a non-compete seems like an academic distinction.
But that was not the worst part. Drennen went on to say the following:
There is a distinction between a covenant not to compete and a forfeiture provision in a non-contributory profit-sharing plan because such plans do not restrict the employee’s right to future employment; rather, these plans force the employee to choose between competing with the former employer without restraint from the former employer and accepting benefits of the retirement plan to which the employee contributed nothing. See Dollgener v. Robertson Fleet Servs., Inc., 527 S.W.2d 277, 278–80 (Tex. Civ. App.—Waco 1975, writ ref’d n.r.e.). Whatever it may mean to be a covenant not to compete under Texas law, forfeiture clauses in non-contributory profit-sharing plans, like the detrimental-activity provisions in ExxonMobil’s Incentive Programs, clearly are not covenants not to compete.
Id. at 329 (emphasis added).
This sort of thing bothers me. The court pretends the issue is easy, cites one Waco case from 1975, and then gets the answer wrong.
In my view, a forfeiture clause conditioned on the employee competing is obviously a non-compete and should be treated as such. But even if I’m wrong, the Drennen court at least should have acknowledged there is a reasonable disagreement on the issue. Heck, three justices on the Court of Appeals ruled the other way, citing Haass in support of holding that the forfeiture clause was a non-compete. Is Drennen saying they’re just morons?
My beef is not so much with the result. It’s the way Drennen gets there. The court could have acknowledged that there are two reasonable arguments, discussed both sides of the issue, and then explained which argument it found more persuasive and why.
Instead, Drennen simply made the statement quoted above and then said “we hold that, under Texas law, this provision is not a covenant not to compete.” Id. 329.
But to the court’s credit, it added this important qualification: “Whether such provisions in non-contributory employee incentive programs are unreasonable restraints of trade under Texas law, such that they are unenforceable, is a separate question and one which we reserve for another day.” Id.
That statement is important because it acknowledges that a forfeiture clause, even if it is not a non-compete, may still be an unenforceable restraint of trade. Keep in mind, section 15.05 of the Texas Business and Commerce Code provides that all contracts in restraint of trade or commerce are unlawful. The Texas non-compete statute provides an exception to that rule for non-competes that meet the requirements of the statute.
So, Drennen leaves open the argument that, even if a forfeiture clause is not a non-compete, an unreasonably broad forfeiture clause is an unenforceable restraint of trade.
Buc-ee’s follows Haass and interprets Drennen narrowly
Drennen also leaves open the argument that a clause requiring forfeiture of vested shares the employee already owns is a non-compete subject to the requirements of the non-compete statute.
This distinction finds support in the one case Drennen cited for the distinction between a forfeiture clause and a non-compete, Dollgener v. Robertson Fleet Services, Inc., 527 S.W.2d 277 (Tex. App.—Waco 1975, writ ref’d n.r.e.).
Dollgener, decided long before enactment of the non-compete statute, held that a forfeiture provision in a noncontributory profit-sharing trust was not a covenant not to compete. Id. at 278-80. Thus, like Drennen, Dollgener did not involve forfeiture of vested shares the employee had already earned.
The Houston Court of Appeals recently applied this very distinction in Rieves v. Buc-ee’s, Ltd., 532 S.W.3d 845 (Tex. App.—Houston [14th Dist.] 2017, no pet.), a case I wrote about here. The court held that an agreement that imposes a severe economic penalty on an at-will employee for quitting must meet the reasonableness requirements for non-competes, even if the agreement does not expressly prohibit competition. Id. at 851. Quoting Haass, the Buc-ee’s court reasoned that the “practical and economic reality” of such a contractual penalty is that it inhibits employee mobility in virtually the same manner as a non-compete. Id.
The employer in Buc-ee’s cited Drennen for the proposition that a forfeiture provision is not a non-compete, but the Court of Appeals rejected this argument. Characterizing Drennen as a “choice-of-law case,” the Buc-ee’s court distinguished Drennen as involving “cancellation of future payments of unvested stock options that had been awarded but not delivered to Drennen, an ExxonMobil vice president, under a non-contributory profit-sharing plan.” Buc-ee’s, 532 S.W.3d at 852. One critical distinction was that “Drennen did not involve ExxonMobil seeking the return of Drennen’s salary or any stock options that had already vested.” Id. (emphasis added).
So, Buc-ee’s also supports the argument that Drennen does not apply to a contract requiring forfeiture of vested shares the employee already owns. This is interpretation no. 2 outlined above. It reconciles Haass and Drennen based on whether the forfeiture involves equity ownership interests that have already vested.
Is this the right way to reconcile Haass and Drennen? As a practical matter, we won’t know the answer until the Texas Supreme Court addresses the issue. When it is unclear whether two cases conflict or can be reconciled based on some distinguishing factor, the answer really depends on how the third case treats them. And we don’t have that case yet.
But we don’t need that third case to know that regardless of whether a forfeiture clause is classified as a non-compete or not, it must be reasonable. An unreasonably broad forfeiture clause would be an unenforceable restraint of trade. Haass and Drennen seem to agree on that point.
So, if an employer wants to use a forfeiture clause to discourage employees from competing, the lawyer who drafts the agreements should at least include reasonable limitations on the scope of competition that triggers the forfeiture. The safer course is to assume the clause will be treated like a non-compete, and to include reasonable limitations on time, geographic area, and scope of activity restrained.
Zach Wolfe (firstname.lastname@example.org) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Thomson Reuters named him a 2020 Texas “Super Lawyer”® for Business Litigation.
These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.