Top 15 Drafting Considerations for Texas Non-Competes

Top 15 Drafting Considerations for Texas Non-Competes

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When I think about drafting a Texas non-compete, I think about these words to a song I liked in the 80s:

Freedom of choice, is what you got. Freedom from choice, is what you want.

It would be so much easier if we didn’t have so many choices, especially when drafting non-competes.

You’ve got two basic choices at the start. You can just cut and paste from a form, like my Plain-Language Non-Compete, or you can take the time to consider the client’s particular needs, the legal issues raised, and the practical considerations, and then draft accordingly. If you do the latter, here are my top 15 things to think about.

1. Does your client really want or need a non-compete?

This is not really a “drafting” tip. But before you start drafting a non-compete, you might want to ask the client “are you sure you really want a non-compete?” I explain why in The Most Effective Form of Non-Compete in Texas (or Anywhere). Spoiler alert: the answer is that you are better off with a happy employee than with an unhappy employee who was required to sign an airtight non-compete (if such a thing existed).

2. Should you include a choice of law clause?

If you’re drafting a non-compete for an employee working in Texas, can you improve the chance of enforcing the non-compete by including a choice of law clause selecting some other state’s law?

Probably not. There are two reasons for this.

First, you are probably not going to find a state that is significantly more favorable to non-competes than Texas. There are some things about Texas law that are favorable to the employee, such as the fact that you can’t get damages for breach of an overbroad non-compete (see no. 6) and the prohibition of industry-wide exclusions (see no. 9) But overall, Texas law is relatively friendly to non-competes.

So if you’re going to select some other state’s law (Delaware is a likely contender), you should at least take the time to understand whether that state’s law is actually better for your client.

But even then, there’s a second reason choosing another state’s law won’t work: Texas law on choice of law.

If the employee is working in Texas, a choice of law clause selecting some other state’s law is probably not going to be enforceable in a Texas court. I cover this in “This Stuff’s Made in New York City!” How Texas Courts Decide Which State’s Law Applies to a Non-Compete.

I say “probably” because there is some wiggle room in the three-part test for enforcing a choice of law clause. But in most cases you’re better off just avoiding this complication and selecting Texas law.

3. Which state’s law will apply?

We’ve been assuming the employee is going to work in Texas. But what if the employee is going to work outside of Texas? Will your Texas choice-of-law clause be enforceable? If not, what requirements of the other state’s law do you need to comply with?

This can get complicated. And your client probably doesn’t want to pay for you to spend hours researching the nuances of Oklahoma’s choice-of-law jurisprudence.

But here’s what I suggest. Assume there is a good chance the other state’s law will apply, and spend an hour researching the basic requirements of that state’s non-compete law. You might be surprised what you find. For example, Louisiana requires a non-compete to expressly state which parishes it covers.

Second, make the non-compete as narrow as reasonably possible (see nos. 6-9). That will tend to enhance its enforceability no matter which state’s law applies.

4. How do you meet the “ancillary” requirement?

Texas law requires a non-compete to be “ancillary to an otherwise enforceable agreement.” There is a lot of case law on what this means, some of it now obsolete. It boils down to two categories: (1) a non-compete tied to a confidentiality agreement and (2) everything else.

The most common way to meet the “ancillary” requirement for an at-will employee is to tie the non-compete to a confidentiality agreement. The Texas Supreme Court simplified this in the Alex Sheshunoff case. The court said the employer can meet the “ancillary” requirement by doing two things: agree to provide the employee confidential information and then actually provide the promised confidential information.

A corollary to this rule is that the employer can do the same thing by agreeing to provide specialized training and then actually providing such training.

Given this clear guidance from SCOTX, you’d be surprised how many Texas non-competes don’t expressly state that the employer will provide the employee with confidential information (or specialized training).

Not to worry. The Texas Supreme Court said in the Mann Frankfort case that the agreement to provide confidential information can be implied, if the nature of the employee’s work necessarily requires access to confidential information.

But why chance it? It’s so easy to include an express agreement to provide confidential information. Same for specialized training. And it helps if the training is actually “specialized.”

A harder question is how to make sure your client actually provides confidential information to the employee. I have one form of non-compete that includes a form for the employee to fill out 60 days later acknowledging that the employee has received confidential information.

Of course, after signing this acknowledgment the employee could still claim later that the information was not really confidential, but the signed form at least gives the employer’s litigation counsel good impeachment material.

On the other hand, what if the employer forgets to have the employee sign the acknowledgment? Now the evidence is messier, possibly creating a fact issue. For that reason, I stopped including the acknowledgment in my standard form of non-compete.

But it’s still an option to consider.

The next most common way to meet the “ancillary” requirement is to tie the non-compete to the sale of a business. I addressed this in Non-Competes in the Sale of a Texas Business. Generally, Texas law is friendlier to non-competes in this scenario.

My main drafting tip for a non-compete tied to the sale of a business is to make sure that the asset purchase agreement expressly states the buyer is obtaining the goodwill of the business. Protecting the goodwill is the rationale for allowing the non-compete, so you don’t want any ambiguity about whether the goodwill is being sold.

5. As to customers, should you include both a non-solicit and a non-compete?

It is very common for a Texas non-compete to have both a “non-solicitation” section and a separate non-compete section. The non-solicitation section will say, for example, that for two years the employee agrees not to solicit any person who was a customer or prospect of the employer during the last year of employment. The non-compete will more broadly prohibit competing with the employer. This means the non-solicit is really just a subset of the non-compete.

Why do lawyers draft it this way? And is it a good idea?

In my opinion, it’s generally a bad idea, although I admit this is more art than science.

First, let’s get one thing out of the way. A non-solicitation agreement is a form of a “covenant not to compete” and is therefore subject to the requirements of the Texas non-compete. See Is a Non-Solicitation Agreement a Non-Compete? This is one area of non-compete law where the Texas Supreme Court has not put form over substance.

That means including a separate non-solicitation section isn’t going to do anything to avoid the requirements of the statute.

So what’s the benefit? I think the idea is that the non-solicit is a sort of insurance policy. If a court finds the non-compete too broad, the employer can still fall back on the non-solicit, which is narrower and more likely to be found reasonable.

But tying the non-compete to “solicitation” creates practical problems of its own.

Here’s a familiar scenario that will illustrate what I mean:

Chris Customer: [answers phone] Hello? 

Dawn Davis: Hey, Chris. It’s Dawn. How have you been? 

Chris: Oh pretty good, Dawn. You know, just trying to keep up with all my construction projects.

Dawn: I hear you. I guess that’s a good problem to have.

Chris: Yeah, I can’t complain. So how are things going at Paula Payne Windows?

Dawn: Fine, I guess. But I’m not working there anymore. I’m the sales manager at Real Cheap Windows now.

Chris: Oh, cool. I didn’t know that. How do you like it so far?

Dawn: So far it’s great. We’ve got an excellent team here. We’re really doing good things for our customers. 

Chris: Glad to hear it. Well it’s nice hearing from you. Will I see you at the kids’ soccer game Saturday?

Dawn: Yup, I’ll see you there.

Question: did “solicitation” just happen in this phone call? The problem is that there will almost always be a factual dispute about whether the communication at issue was solicitation. And the particular problem for the employer is that the customer will tend to back up the employee’s assertion that there was no solicitation.

Perhaps you could solve this problem by including a definition of “solicit” in the agreement. But now you’re creating more opportunities for argument and interpretation.

And there’s an additional, more subtle problem with solicitation: causation. Even if the employer proves the employee solicited the customer and the customer left, that doesn’t necessarily prove the solicitation caused the customer to leave. What if Chris testifies under oath, “I’ve gone to church with Dawn and her husband for over ten years, and I would have taken my business to Dawn regardless of whether she solicited my business or not.” Wouldn’t that evidence negate causation?

For all these reasons, I tend to favor tying the non-compete to doing business with the company’s customers, not solicitation of the company’s customers. Whether the employee has done business with the customer, i.e. providing goods or services to the customer for money, is usually a more objective fact.

6. In general, should you make the non-compete broad or narrow?

I think you know what I’m going to say. But it’s worth taking a moment to explain why.

The employer’s instinct is to make the non-compete as broad as possible. If you represent the employer, part of your job is to explain why that’s not in the client’s best interest. There are two main reasons for this.

First, it will be easier to get a temporary injunction enforcing the non-compete if the non-compete is enforceable as written. True, the trial court judge can enter a temporary injunction that only partially enforces the non-compete, but as a non-compete litigator I would much rather go into the courtroom defending a non-compete I know is already reasonable in scope.

Second, if a court finds that the non-compete was not reasonable as written, the court can reform the agreement, but the employer cannot recover damages that occur before reformation. See Tex. Bus. & Com. Code § 15.51(c). In practical terms, that means drafting an overbroad non-compete is going to cost your client a significant bargaining chip.

When you explain those two facts to your employer client, the client may start to understand the need to resist the instinct to make the non-compete as broad as possible. Instead, a good rule of thumb is to “narrow the non-compete until it hurts.” When your client’s reaction is “ouch, only one year, that’s going to hurt,” you know you’re on the right track.

7. How do you meet the reasonable time period requirement?

Like I said, shorten the time period until it hurts. Texas courts have enforced non-competes as long as 3-5 years, but why chance it? The time period must be no longer than necessary to protect the employer’s legitimate interest, which usually means goodwill and confidential information. That usually means no more than two years. And one year is even better.

8. How do you meet the reasonable geographic area requirement?

There are Texas cases that, despite the command of the statute, you don’t need to have an express geographic limitation if there is a reasonable limitation on the scope, but again, why risk it? Put some geographic limitation in, even if it’s broad. Better yet, make the geographic scope as narrow as possible. The rule of thumb is that it should match the territory the employee is actually going to be responsible for.

9. How do you meet the reasonable scope requirement?

This is where I see the most mistakes in Texas non-competes. It seems many lawyers who draft agreements with non-competes are not aware that Texas law generally prohibits an “industry-wide exclusion.” I explained this in Burning Down the Haass: The Industry-Wide Exclusion Rule in Texas Non-Compete Law. (Again with the 80s songs.)

There are exceptions to the industry-wide exclusion rule, but again, why chance it? It’s best to limit the non-compete to customers the employee deals with or learns confidential information about while working for the company.

10. Should you include stipulations that the non-compete is enforceable, that a breach will cause irreparable injury, etc.?

You see clauses like this all the time. Essentially, these are just attempts to have the employee waive objections to enforceability.

Do clauses like this have any legal effect? Texas law is unsettled. Usually the court will cite a clause like this as an additional reason for enforcement, without saying the clause is dispositive. I don’t think I’ve seen any case that says, for example, that a stipulation that a breach will cause irreparable injury is conclusive.

My personal opinion is that these clauses should be given exactly zero weight. You can’t waive a public policy issue. And I don’t think private parties can change the requirements for obtaining an injunction any more than they could stipulate to different rules of evidence or procedure.

Despite my personal view, do I still include clauses like this when I draft a non-compete for an employer? Yes, of course. It doesn’t hurt. And it can help in cross examination of the employee.

How? You can’t expect me to give away all my secrets.

11. Should you include a tolling clause?

A tolling clause says that the time period of the non-compete will be extended by the amount of time that the employee is in breach. I’m starting to see more of these.

These clauses strike me as introducing more potential uncertainty than they are worth. A time period of one year from termination is objective and usually easy to apply. Figuring out the period of time the employee has been in breach can present a factual dispute. If you’re the employer, the last thing you want is to add yet another potential fact issue.

The court might even say the tolling clause renders the time period too indefinite to be enforced. I haven’t seen a case on this, but if I represent the employee I might at least make the argument.

12. Should you include a liquidated damages clause?

A liquidated damages clause specifies a specific amount of damages for a breach. I covered the requirements of a liquidated damages clause generally in Liquidated Damages Lessons from the Stormy Daniels Settlement.

I don’t like liquidated damages clauses in non-competes. It’s usually not that hard to calculate actual damages after the fact; in most cases it’s lost profits. But coming up with a dollar amount in advance that reasonably estimates what the actual damages are likely to be is difficult. For these reasons, you’re likely to have an argument over whether the liquidated damages clause is enforceable. That’s one more argument the employer doesn’t need.

If you do include a liquidated damages clause, be sure you also include a clause expressly stating that the employer can still obtain injunctive relief in addition to the liquidated damages. Otherwise, a court might say the liquidated damages are the employer’s exclusive remedy.

13. Can you avoid enforceability problems by structuring the non-compete as a forfeiture clause?

The short answer is no. If the agreement says the employee is free to compete but will forfeit his equity ownership in the company if he does so, the reasonableness requirements for Texas non-competes could still apply. And even if the court doesn’t consider the agreement a non-compete, it would still have to be reasonable.

For the longer answer, see my post When Is a Forfeiture Clause a Non-Compete?

The bottom line is that structuring the non-compete as a forfeiture clause—as opposed to an express prohibition on competition—won’t necessarily avoid enforceability issues, and if you do go the forfeiture route, you should still include reasonable limitations on time period, geographic area, and scope.

14. Can you improve the effectiveness of the non-compete by including severance pay? Garden leave?

When employees consult with me about non-competes, I sometimes suggest that if the employer is going to require a one-year non-compete, for example, then maybe the employee should ask for one year of severance pay. The rationale is that if the employee is going to sit out of the industry for a year, she should at least get paid for that year.

There is a certain logic to this, but of course that doesn’t mean employers will like it. Companies don’t usually like paying people to do nothing.

Still, there could be a benefit to the employer. This is why you sometimes see “garden leave” provisions. Under garden leave, the employee technically remains employed by the company for some period of time but is no longer actively doing anything for the company. The idea is that it’s easier to enforce a non-compete against a current employee than a former employee. Plus, competing with the employer while still employed would usually violate the employee’s limited “fiduciary” duty. See Fiduciary Duty Lite: What Employees Can and Can’t Do Before Leaving.

I don’t have as much experience with non-competes tied to garden leave, but it’s an idea employers should at least consider.

15. Can you draft an effective non-compete in the middle of employment? When the employee is on the way out the door?

The short answer? It’s hard, but not impossible. And it’s easier to do it in the middle than at the end.

The problem, in a word, is consideration. If the employee is already working for the company and has already received confidential information, what’s the new consideration for the non-compete?

Typically, the agreement in this situation will recite continued employment as consideration. But to improve the argument for enforceability, the employer should try to tie the new non-compete to a promotion, a higher level of responsibility, and/or increased access to confidential information.

Having the employee sign a non-compete after notice of termination is usually not going to work, even if the employer agrees to pay severance for it. Traditionally, a mere agreement to pay money has not satisfied the “ancillary to an otherwise enforceable agreement” requirement. But you can try. And feel free to be creative.

Like another song says, freedom’s just another word for nothin’ left to lose.

________________________________________

IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Follow @zachwolfelaw on Instagram to keep up with his latest shenanigans.

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.

 

When Is a Forfeiture Clause a Non-Compete?

When Is a Forfeiture Clause a Non-Compete?

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 a case I’m currently litigating. 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 client’s 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.

Conflicting Cases?

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:

  1. Drennen implicitly overruled Haass, establishing a broad rule that places form over substance by simply asking whether the agreement expressly prohibits competition.
  2. 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.
  3. Drennen and Haass can be reconciled based on some other distinguishing factor.
  4. 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.

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IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Follow @zachwolfelaw on Instagram to keep up with his latest shenanigans.

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.

 

 

The Problem With Non-Competes

The Problem With Non-Competes

A Texas non-compete litigator points out the biggest problems with the way non-competes work in practice

There are too many non-competes, the non-competes are too broad, and judges are too willing to enforce them with injunctions.

That’s it. That’s the tweet.

But this is a blog, not Twitter, so I’ll elaborate.

I’m not the only one worried about non-competes. The American Constitution Society (ACS) recently released an Issue Brief titled “No Exit: Understanding Employee Non-Competes and Identifying Best Practices to Limit Their Overuse” (November 2019). It covers the traditional legal framework governing non-competes, explores why an increasing number of workers are subject to them, summarizes recent legislative responses, and explores non-legislative approaches to combating the overuse of non-competes.

The ACS takes a dim view of the widespread use of non-competes, especially for lower-level employees like janitors and sandwich makers. “Taken in the aggregate,” the brief argues, “such widespread limitations on employee mobility have demonstrable, negative consequences for wages and innovation.”

At the federal level, the ACS brief reports, the proposed Workforce Mobility Act of 2019 would ban the use of non-competes, with some limited exceptions permitting non-competes for owners or senior executives in the sale of a business or dissolution of a partnership. The bill has some bipartisan support, but passage “seems far from assured.” The issue brief concludes that policymakers in most states “should consider adopting stronger measures to discourage employer overuse of non-competes.”

The ACS brief approaches non-compete reform with an obvious pro-worker orientation. As a lawyer who represents both employers and employees in non-compete disputes and litigation, I have more of a practitioner’s perspective. And as a Texas non-compete lawyer, I don’t expect any significant change in the law soon.

But my experience handling non-compete cases tells me that some common-sense reforms are overdue in the Lone Star State.

Here are the five biggest practical problems with non-competes that I’ve learned from handling Texas non-compete cases.

Disclaimer: This is, like, just my opinion, man. So you’re not allowed to cite this post against me if I’m trying to get an injunction against your client.

1. In the vast majority of cases an employee non-compete is not really bargained for.

Imagine this scenario. Dawn Davis is a single mom and a legal assistant at a big law firm in Dallas. She makes good money, but the hours are long, and her bosses are jerks. She finds an opportunity for a new career in sales: Paula Payne Windows offers her a job selling windows in the construction industry. There are only two problems: it’s for less money, initially, and she has to move to another city. Still, Dawn is ready for a change, so she accepts the offer.

Dawn scrapes together enough money to pay a deposit on a new apartment in a decent school district, packs everything in a U-Haul, and moves her two kids, a cat, and a turtle to Cedar Park. The next Monday, she shows up for work. “We’re so excited that you’re joining us,” her boss Paula Payne says, “I’ll just need you to sign a few documents, and then we can get you started on this prospect list.”

You see where this going.

We all know Dawn’s non-compete is not bargained-for in any meaningful way. What’s she going to do, say “I’m sorry I can’t sign this,” decline the job, and start looking for some other way she’s going to pay next month’s bills? She could do that in theory, but in practice she’s going to do what countless other Texas employees do in similar situations: sign the documents.

Unfortunately for Dawn, there won’t be any getting out of the non-compete. It may be unenforceable for other reasons, but not because it wasn’t bargained for. “Did anyone put a gun to your head and say you have to sign this agreement,” the lawyer for Paula Payne Windows will ask Dawn in her deposition years later. Unless Dawn can testify to some extreme circumstance like that, a Texas judge is not going to rule that the non-compete is void based on duress, unconscionability, or some similar defense.

This scenario is typical. I’ve handled a lot of non-compete matters, and it’s common for the employee not to see the non-compete until it’s practically too late. And even when the employee gets the non-compete agreement before accepting the job, it’s rare that there is actually any bargaining over the non-compete. See, e.g., TENS Rx, Inc. v. Hanis, No. 09-18-00217-CV, 2019 WL 6598174 (Tex. App.—Beaumont Dec. 5, 2019, no pet. h.) (mem. op.) (employee claimed she had reservations about the non-compete but signed it because the employer said it was just a formality).

Ok, but so what? Doesn’t the “no bargaining” objection prove too much? Yes, employees sign non-competes agreements that are not really bargained for, one could argue, but that’s true of all kinds of things at-will employees agree to, like binding arbitration. Yet we generally enforce those things. Why should non-competes be different?

Well, for one thing, it’s not just the interests of the employee at stake. It’s also the interests of customers and the public. Generally, employee mobility is a good thing for the economy. It’s a big reason we have the at-will employment rule in the first place.

One way you could fix the “no bargaining” problem is to require employers to give advance written notice that a job offer includes a non-compete. The ACS brief reports that some states have already enacted rules like this. But I can see this kind of rule leading to all kinds of complications.

There’s a simpler way to fix this problem: prohibit non-competes for at-will employees. You could still allow non-competes in the sale of a business, where the non-compete is actually bargained for, and it makes economic sense to give the buyer a way to acquire the goodwill of the business. The proposed federal legislation has an exception for this.

But this solution does not seem politically feasible in Texas at the moment. More about that later.

2. Employee non-competes hurt the employer by shifting its focus to the wrong thing.

The second problem with employee non-competes in practice is a little counter-intuitive: they hurt the employer.

The best form of non-compete is a happy employee who doesn’t want to leave. Successful entrepreneurs cite keeping employees happy as a key reason for success. If you require employees to sign non-competes, you’re feeding a mindset that focuses on the wrong thing, restricting employees, instead of the right thing, keeping your high performers happy.

Business owners will say I’m being naïve, but as I said in The Most Effective Form of Non-Compete in Texas, if you think a non-compete is going to keep your best people from leaving, who is being naïve?

Still, I get it. I represent employers too, and I understand why they want employees to sign non-competes. It is frustrating to pour time, effort, and money into developing your employees, their skills and knowledge, and their goodwill with customers or clients, only to see them leave as soon as they get a better offer. Sometimes there is even a strong sense of personal betrayal, which is only natural.

So I’m not saying employers should never require non-competes, nor am I saying non-competes should never be enforced (under current law). Confession: I have drafted non-competes for employees to sign and have even sued employees for breaking non-competes. [audience gasp]

On balance, though, an employer is better off focusing on employee retention than drafting an impenetrable non-compete.

Similarly, I’m not sure enforcement of non-competes is the “pro-business” position. When people say enforcing non-competes is pro-business, keep in mind there are usually two businesses in a non-compete dispute: the first employer and the second employer. The employee is usually going from one business to the other. Is it really “pro-business” to tell the second business it can’t hire the employee?

This is before we even get to the problem of the non-compete’s effect on the employee.

3. The cost of litigation has a chilling effect on employees challenging unreasonable non-competes.

Here’s how it usually goes down. Dawn Davis quits her job at Paula Payne Windows and starts up her own windows company. Paula Payne gets worried that Dawn is going to take customers and cut into Paula’s profits, so she has her lawyer send Dawn a nastygram. The letter demands that Dawn refrain from competing with Paula Payne for three years, as her non-compete requires.

What is Dawn to do? Her best option is to work something out in a settlement. Maybe the compromise is that Dawn agrees not to do business with certain customers. Or maybe she agrees to pay Paula Payne 25% of her profits from those customers for a year.

But what if Paula Payne plays hardball and says no, comply with your non-compete or we’re going to sue you and get an injunction to stop you from selling windows?

“What should I do?” Dawn asks her lawyer, Maria Reynolds. “Well this non-compete is clearly overbroad,” Reynolds tells her, “but if we have to go to court it’s going to be expensive.” “How expensive?” Dawn says. “I’m going to need a deposit of $10,000,” Reynolds says, “and that might be enough to get through the temporary injunction hearing in the first month.”

Variations on this scenario happen all the time. The cost of litigating a non-compete case is usually as much, or more, of a settlement factor than the substantive issues.

The cost of litigating tends to give the employer an advantage over the employee in a non-compete dispute. The employer usually has more money, and the employee more to lose. If the employer loses the temporary injunction round, it loses some attorneys’ fees and probably some profits from customers that follow the employee. If the employee loses, she pays attorneys’ fees and has to look for a new job. In the words of Private Hudson, “game over, man.”

The ACS report calls this the “in terrorem” effect of an overbroad non-compete (quoting venerable law professor Harlan Blake). I call it leverage.

Of course, the cost of litigation is also a factor for the company trying to enforce the non-compete, and the problem of litigation expense driving settlement is not exclusive to non-compete cases.

But there is something different about a non-compete lawsuit: it affects the rights of third parties. Namely, the customers.

4. Judges don’t give enough weight to the interests of the customers, who never signed any non-compete.

You know, the customers? They are the ones who pay for the goods or services. Without them, there would be no sales for the parties to the non-compete to fight over.

Well, what if I told you that Texas law allows a judge to enter an injunction against a customer, who never agreed to any non-compete, prohibiting the customer from doing business with an employee who did sign a non-compete?

No way, you would say. This is a free country. A judge can’t just order someone to comply with an agreement they never signed.

Of course, this is precisely the effect of an injunction that enforces an employee’s non-compete. Let’s say you’re Biff Henderson, a residential builder who has bought windows from Dawn Davis for seven years. The judge signs a temporary injunction against Dawn—and “all others acting in concert” with her—prohibiting her from doing business with any of the customers she served at Paula Payne Windows. That is effectively the same as the judge ordering Biff not to do business with Dawn.

I’ve seen a lot of non-compete cases, and I can tell you three things that are usually true about customers.

First, they didn’t sign any non-compete.

Second, customers usually want to keep buying stuff from the person they’ve been buying stuff from. They certainly don’t want a judge telling them they can’t buy from that person anymore.

Third, customers don’t want to get entangled in a lawsuit and spend money on legal fees. In theory, a customer could intervene in a non-compete lawsuit to protect its right to do business with who it wants. But who’s going to do that? Biff may love Dawn, but probably not enough to spend thousands of dollars on legal fees so he can keep buying windows from her.

The net result is that the system has to rely on the employee to speak for the customer in the non-compete lawsuit. And the employee’s lawyer will usually try to do so.

But in my experience, judges don’t give the interests of the customers enough weight. It even seems like some judges consider it routine to grant an injunction to enforce a non-compete.

They forget that an injunction is supposed to be an “extraordinary” remedy.

5. Judges don’t take the “irreparable injury” requirement seriously enough.

One of the traditional common-law requirements for a temporary injunction is irreparable injury. Irreparable means harm that cannot be adequately compensated by damages. In theory, this requirement applies to a temporary injunction enforcing a Texas non-compete. See Cardinal Health Staffing Network, Inc. v. Bowen, 106 S.W.3d 230, 241 (Tex. App.—Houston [1st Dist.] 2003, no pet.) (rejecting argument that proof of irreparable injury is not required in a non-compete case).

But the irreparable injury rule is quite elastic, and the Texas Courts of Appeals review temporary injunctions on an “abuse of discretion” standard. The end result is that trial courts can apply the rule as strictly or loosely as they want, and they will rarely be reversed.

So you get two basic views of applying the irreparable injury rule. The “loose” view starts from the general proposition—stated in many Texas cases—that damages are only “adequate” when they would be as convenient and efficient as an injunction. Then it adds the proposition that the loss of customer goodwill is inherently difficult to measure by a dollar amount. The result is that judges with this view will almost routinely grant a temporary injunction if there is evidence that the employee is taking the employer’s customers.

The “strict” view calls BS on the “no adequate remedy” argument. In your garden variety non-compete case, the financial harm to the employer is the loss of sales. It’s not that hard to measure the employer’s lost profits resulting from the loss of sales. Lost profits damages can compensate for that. You’ve got to have something more than that, the strict view says, to establish that the harm is irreparable.

Both views can find support in the case law. But as should be obvious by now, I personally find the strict view more persuasive. I’ve already covered one reason above: the loose view doesn’t give enough weight to the interests of the customers.

But there’s an even more fundamental problem with the loose interpretation of irreparable injury: it ignores the irreparable injury resulting to the employee if the judge gets is wrong.

Keep in mind, a temporary injunction is not a final ruling on the merits. The parties are entitled to obtain discovery and present their best evidence at a full-blown trial. So at the temporary injunction hearing, the judge is sort of “guessing” at the employer’s likelihood of success at trial.

The problem is that the risks of guessing wrong are asymmetrical.

Here’s what I mean. If the trial court guesses wrong and denies a temporary injunction, the employer still has a remedy. Even if a bunch of customers run off with Dawn Davis while the lawsuit against her is pending, Paula Payne Windows can have the last laugh by seeking lost profits damages at trial.

But if the trial court guesses wrong and grants a temporary injunction, Dawn is out of luck. Worst case, her new employer Real Cheap Windows may decide it just has to let her go. Then she’s going to be looking for another job. It won’t matter if it turns out she was right that the non-compete was unenforceable; Dawn won’t get compensated for missing out on the sales she could have made absent the injunction.

Here’s another way to look at it. Even if the employer turns out to be right, the employee’s violation of the non-compete could be considered an “efficient breach.” The law should allow parties to breach a contract, the efficient breach theory says, as long as the non-breaching party can be compensated by damages.

That’s kind of the point of the irreparable injury rule in the first place, isn’t it?

Conclusion

I come out generally on the same side as the ACS issue brief. We need to reign in non-competes more in Texas. But it does not appear politically feasible that this will happen in the current Texas legislature. That means it’s up to Texas judges to give more weight to the interest of customers and to take the irreparable injury rule more seriously. This can be done without changing the Texas non-compete statute. It only requires applying the statute with common sense and some awareness of the way non-competes actually work in practice.

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IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Follow @zachwolfelaw on Instagram to keep up with his latest shenanigans.

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.

Jurassic Non-Competes

Jurassic Non-Competes

Do Ancient Cases Hold the Secrets to Understanding Present-Day Texas Non-Compete Law?

“Non-compete abuse” is a hot topic. The press says some employers now require even rank-and-file employees to sign non-competes. The Jimmy Johns case was perhaps the low point. You’re going to make sandwich makers sign non-competes. Really? Are they going to run off with the secret bread-slicing techniques? Misappropriate goodwill from Jimmy Johns and take it to Quiznos?

Here’s another case I recently read about that just goes too far. The Patterson Institute, a small music school in Hillsboro, Texas, hired young Bill Crabb to teach piano, organ, violin, mandolin, and banjo, as well as music theory, harmony, and history. Crabb signed a 10-month employment contract, which included a non-compete barring him from teaching music in Hillsboro if he quit the job.

Then tension developed between Crabb and the Institute’s senior music teacher, Mary Rice. Crabb quit and opened a small music school of his own in Hillsboro. The Patterson Institute filed suit and obtained a temporary injunction, but the trial court dissolved the injunction after a trial.

The Court of Appeals reversed, holding that the statute prohibiting restraints of trade did not apply. The court reasoned that it would be inequitable for Crabb to teach at an independent school in Hillsboro, that the statute did not bar the restrictive covenant, and that the Institute was entitled to an injunction. The court cited Gates v. Hooper, in which the Texas Supreme Court held that a non-compete in the sale of a business was not an illegal restraint of trade.

But enforcing a non-compete against a small-town music teacher? This is just too much. The Texas legislature should do something about this kind of non-compete abuse.

Unfortunately, it’s too late for Mr. Crabb. You see, his case was decided in 1899. See Patterson v. Crabb, 51 S.W. 870, 871-72 (Tex. Civ. App. 1899).

But his case is a good reminder that non-competes have been around for a long time. By comparison, the Texas non-compete statute is relatively young. It just celebrated its 30th birthday in September.

I’ll confess that, even as a lawyer who has read a lot of Texas non-compete cases, I usually don’t pay attention to case law that predates the 1989 statute. But the statute was largely intended to codify Texas common law on non-competes (or at least parts of it). So, many of the issues found in older cases are still relevant.

Here’s a chronological sampling of some principles in older Texas non-compete cases that still apply today.

1. Texas courts generally favor non-competes in the sale of a business.

Gates v. Hooper, 39 S.W. 1079, 1080 (Tex. 1897), was the case cited in Patterson v. Crabb. It’s the oldest Texas non-compete case I have found so far. (If you find an older one please email me.) You can tell it’s an old case because the opinion is short but the paragraphs long.

This was the Gilded Age when monopolistic “trusts” were a major concern. But the court in Gates upheld a one-year non-compete in a contract for the sale of a mercantile business in Batesville. The court held that the non-compete was not a prohibited “trust” or “combination” because the transaction did not combine the capital, skill, or acts of the parties into any kind of “union, association, or co-operative action.” Id. at 1080-81.

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That was it. Nothing about reasonableness. But it set a precedent favoring non-competes in the sale of a business.

2. Non-competes are uniquely and primarily about protecting goodwill.

The two most common justifications for non-competes are (1) protecting a company’s goodwill and (2) protecting a company’s confidential information.

Reading between the lines, we can imagine both issues were present in Patterson v. Crabb. The opinion is pretty thin on reasoning, but we can assume the Patterson Institute established goodwill with its customers, i.e. its students. We can also assume that Mr. Crabb knew the students, knew the tuition they were paying, and could use that knowledge to set his own school’s tuition just low enough to “undercut” the Institute.

But there’s a fundamental difference between these two interests. There are multiple areas of law that protect an employer’s confidential information. See The Matrix: Making Sense of the Patchwork of Employee Confidentiality Duties.

In contrast, there is really only one legal mechanism to protect goodwill: a non-compete.

And a non-compete always has two fundamental problems. First, it hurts customers. If Mr. Crabb can’t teach music in Hillsboro, the students in Hillsboro may have only one place to go. Second, a non-compete can prevent someone from making a living doing the thing they do best. It doesn’t seem right to force Mr. Crabb to either move out of Hillsboro or change careers.

3. Non-competes should not restrain the right to earn a living.

These problems are not new. Over a hundred years ago, in Miller v. Chicago Portrait Co., 195 S.W. 619 (Tex. Civ. App.—San Antonio 1917, writ ref’d), Mr. Miller signed an employment contract with Chicago Portrait Company, which was in the business of enlarging photographs into portraits. The contract contained a one-year non-compete. Id. at 619.

The Court of Appeals reversed an injunction issued by the trial court. As to confidentiality, the court noted there was “no evidence of trade secrets connected with inducing people to have their photographs magnified into portraits and placed in expensive frames.” Id. at 620.

As to goodwill, the court distinguished between a contract for the purchase of a business and an employment contract, citing an employee’s interest in earning a living:

Courts will not favor contracts that would drive a man out of Texas to seek occupation in a business, with which he is perhaps better acquainted than any other, or put him in another business for which he is not trained or suited. This is a different case from the sale of a business induced by a contract not to engage in a similar business in a named locality in a specified time. The contract in this case is aimed at the right to obtain employment in a similar business. It is an attempt to restrain the right to earn a living.

Id. at 621.

So yes, there is a legitimate interest in protecting goodwill, but that interest must be weighed against an employee’s right to earn a living (and to stay in Texas), especially where no real trade secrets are involved.

Today, the Texas non-compete statute does not expressly refer to the employee’s interest in making a living, but that interest is embedded in the statute’s key concept: reasonableness.

4. Reasonableness is the key to non-compete law.

Given the competing interests at stake in any non-compete dispute, the fuzzy standard of “reasonableness” is critical.

The idea of measuring the enforceability of a non-compete by its reasonableness made an early appearance in Texas law in Randolph v. Graham, 254 S.W. 402 (Tex. App.—San Antonio 1923, writ ref’d). In that case, Dr. Randolph sold his medical practice to Dr. Graham, who agreed not to practice medicine within a 20-mile radius of Schertz, Texas. Id. at 402.

The Court of Appeals affirmed the trial court’s temporary restraining order enforcing the non-compete. The court first cited the policy in favor of enforcing non-competes tied to the sale of a business, reasoning that “professional men” or “skilled artisans” ought to be able to sell the goodwill of their businesses, and invoking “liberty and freedom of contract.” Id. at 402-3.

But the court implicitly recognized the limits of freedom to contract by then addressing the reasonableness of the restriction. The court cited cases from other jurisdictions holding that a contract in restraint of trade is unreasonable and void when it is unlimited in time and space. While the non-compete at issue was unlimited in time, it was limited to the Schertz area, and the court found that limitation sufficient to make the non-compete reasonable and enforceable. Id. at 403-4.

This would not be the last time that parties argued about whether the scope of a Texas non-compete was reasonable.

5. Reasonableness means a non-compete injunction should do no more than necessary to protect the goodwill the employee developed for the company.

By 1925, the essential elements of early Texas non-compete law came into focus, as illustrated by City Ice Delivery Co. v. Evans, 275 S.W. 87 (Tex. Civ. App.—Dallas 1925, no writ).

That case involved an employment contract between a driver and an ice delivery business in Dallas. The business divided its territory into districts, assigning each district to an employee. The contract prohibited the driver, Mr. Evans, from engaging in the ice business within the territory covered by his route, or within five squares of his route. Id. at 88-89.

By this time, the court said it was the “settled law” of Texas that a contract for the sale of a business may include a non-compete reasonably necessary to protect the purchaser’s interest in the goodwill of the business. Id. at 89.

But did the same principle apply to an employment contract? Looking to authorities outside Texas, the court found that non-competes in employment contracts should be governed by the same principles:

The test generally applied to determine the validity of such a covenant in a contract of employment depends upon whether or not restraint placed upon the employé after employment has ceased is necessary for the protection of the business or good will of the employer, and whether it imposes on the employé any greater restraint than is reasonably necessary to secure protection to the business of the employer or the good will thereof. If the covenant in question goes no farther than to accomplish this purpose, it is generally held to be valid.

Id. at 90. (NB: An “employé” is an employee who speaks French.)

In short, like a non-compete in the sale of a business, a non-compete in an employment contract is governed by the related principles of reasonableness and necessity to protect goodwill.

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Thus, the court said, the burden is on the employer to establish both the “necessity for” and the “reasonableness of” the non-compete. Applying this principle to the employer’s claim for an injunction, the court said that the evidence clearly established the necessity of the non-compete as to the immediate territory where Evans delivered ice to the company’s customers. Id.

But there was no such necessity for the five squares outside of his territory, the court reasoned, because the company had no goodwill outside of the employee’s territory that was due to the employee’s “personal contact” with the trade while in service of the employer. Id.

This critical principle is sometimes ignored but still applies today. An injunction should extend no further than necessary to protect the goodwill that the employee developed on behalf of the employer.

Seven years later, the Dallas Court of Appeals would cite City Ice Delivery and other cases and distill the essential requirements of Texas non-compete law as follows:

(1) Is the restraint placed upon the employee, after the employment had ceased, necessary for the protection of the business or good will of the employer?

(2) Does it impose upon the employee any greater restraint than is reasonably necessary to procure protection to the business of the employer or the good will thereof.

Martin v. Hawley, 50 S.W.2d 1105, 1108 (Tex. App.—Dallas 1932, no writ).

This language is strikingly similar to the language the legislature would use over 50 years later in the 1989 non-compete statute. The court also cited the general principle that “contracts restricting the liberty of employment are not viewed by the courts with favor.” Id. at 1108.

Thus, even back in 1932, we can clearly see the two competing considerations: protect the employer’s goodwill to the extent necessary, but without unduly restricting employee mobility. The dividing line is what is reasonably necessary to protect the employer’s goodwill.

6. Generally Texas courts will enforce an unreasonable non-compete to a reasonable extent.

While the basic reasonableness concept took shape in Texas cases as early as the 1930s, it was not entirely clear what a Texas court was to do if a non-compete was unreasonably broad.

This issue was implicit in City Ice Delivery, where the court enforced the non-compete only in part, to the extent of prohibiting competition in the driver’s immediate territory. Later the Texas Supreme Court addressed the issue more directly in Lewis v. Krueger, Hutchinson & Overton Clinic, 269 S.W.2d 798 (Tex. 1954).

In that case, young Dr. Lewis signed an employment contract with a clinic that barred him from practicing medicine in Lubbock County if his employment ceased. The trial court found the non-compete entirely unenforceable because it had no time limitation. The Court of Appeals disagreed but reduced the limitation to three years. Id. at 798-99.

Dr. Lewis argued the court could not make a new and different contract for the parties, but the Texas Supreme Court rejected this argument. Even though the non-compete could be interpreted as applying for life, “it would hardly be doing violence to the established principles to hold that the restriction is merely void or unenforceable with respect to that portion of the time beyond what the court considers reasonable.” Id. at 799-800.

This “blue pencil” rule allows the court to effectively rewrite the non-compete, and it still applies today. Enforcement of a non-compete is not all or nothing in Texas. Generally, if the non-compete is unreasonably broad, it can still be enforced, but only to a reasonable extent.

7. You can’t get damages for breach of an unreasonably broad non-compete.

But what about damages? Can the employer get damages for the employee’s breach of a non-compete that’s unenforceable as written?

The Texas Supreme Court addressed this issue in Weatherford Oil Tool Co. v. Campbell, 340 S.W.2d 950 (Tex. 1960). Citing Martin v. Hawley, the court said the non-compete as written was unreasonable because it had no territorial limitation. Then, citing Lewis, the court said an injunction could still be granted to restrain the employee from competing within a reasonable area. Id. at 952.

But the court said a claim for damages was not available prior to reformation. “We hold that an action for damages resulting from competition occurring before a reasonable territory and period have been prescribed by a court of competent jurisdiction must stand or fall on the contract as written.” Id. at 953. In other words, if the employer drafts a non-compete that is too broad, the employer can still seek an injunction, but it can’t get damages that occur before the court narrows the scope of the non-compete.

The Texas Supreme Court later clarified that the court’s power to reform the non-compete applies to both time and area. Justin Belt Co. v. Yost, 502 S.W.2d 681, 685 (Tex. 1974).

The Weatherford rule concerning damages was later codified in the 1989 statute. Five years later, Jimmy John’s started franchising. And the rest is history.

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IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Be sure to follow the Five Minute Law Facebook account, if anybody still uses Facebook.

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.

Burning Down the Haass: The Industry-Wide Exclusion Rule in Texas Non-Compete Law

Burning Down the Haass: The Industry-Wide Exclusion Rule in Texas Non-Compete Law

WARNING: This week’s post is heavy on case law. Non-lawyers should turn back immediately. You might like one of my lighter posts about Seinfeld, my Morning Routine, or Choice of Law in Texas Non-Compete Litigation.

If you know anything about Texas non-compete law, you know that the Texas non-compete statute requires reasonable limitations as to “time, geographical area, and scope of activity to be restrained.” Tex. Bus. & Com. Code § 15.50(a).

Yet in my practice, I often see non-competes drafted without a reasonable limit on the scope of activity restrained. Scope of activity is probably the most neglected element of Texas non-compete law. Often, the non-compete will bar an employee from having anything to do with any company in the employer’s industry.

When you read one of these, you can almost feel the drafter’s pride in writing a non-compete that is so comprehensive and ensnaring. But guess what? Writing it that way makes it an “industry-wide exclusion,” which Texas courts have said is unenforceable.

The industry-wide exclusion rule has two halves (plus a corollary I’ll get to later).

The first half says that a non-compete that prevents a company’s employee from working in any capacity in the company’s industry is unreasonably broad and therefore unenforceable.

The second half says that a non-compete must be limited to preventing the employee from doing business with customers the employee had dealings with while working for the employer.

The second half of the rule is found in Peat Marwick Main & Co. v. Haass, 818 S.W.2d 381 (Tex. 1991), which arose from a suit that was already being litigated when the 1989 statute was adopted.

In Haass the Texas Supreme Court cited the Texas common-law rule that the scope of a non-compete must not be greater than necessary to protect the employer’s legitimate interests such as goodwill and confidential information. Id. at 386. The court reasoned that the “fundamental legitimate business interest” protected by a non-compete is “preventing employees or departing partners from using the business contacts and rapport established during the relationship . . . to take the firm’s customers with him.” Id. The court also approvingly cited a Wisconsin case stating that “the restrictive covenant must bear some relation to the activities of the employee.” Id. at 387.

I love that Haass uses the French rapport instead of the Anglo-Saxon “goodwill.” It was a more civilized time.

Anyway, the Haass court held that the non-compete was overbroad because it inhibited departing partners from providing accounting services to clients acquired after the partner left, or with whom the accountant had no contact while associated with the firm, which was not reasonably necessary to protect the firm’s goodwill. Id. at 388.

Haass did not use the term “industry-wide exclusion,” but the Fourteenth Court of Appeals later cited Haass for the proposition that “[t]he Texas Supreme Court has held that an industry-wide exclusion is unreasonable.” John R. Ray & Sons, Inc. v. Stroman, 923 S.W.2d 80, 85 (Tex. App.—Houston [14th Dist.] 1996, writ denied) “In the case of covenants applied to a personal services occupation, such as that of a salesman,” the court said, “a restraint on client solicitation is overbroad and unreasonable when it extends to clients with whom the employee had no dealings during his employment.” Id.

Applying both parts of the rule, the Stroman court held that the non-compete was unenforceable because it imposed an industry-wide exclusion on the employee’s ability to work in the insurance business in and around Harris County and extended to customers the employee had no association with while working for the employer. Id.

The First Court of Appeals applied Haass and Stroman to the oilfield services industry in Brown Services, Inc. v. Brown, No. 01-98-00304-CV, 1999 WL 681964 (Tex. App.—Houston [1st Dist.] Sept. 2, 1999, pet. denied) (mem. op.). Rapport is important in oilfield services, because everybody knows who the customers are.

Brown Services held that a first clause barring the employee from being connected to any oilfield services business was an overbroad industry-wide exclusion. Id. at *6. The court held that a second clause barring the employee from soliciting or selling products or services to anyone who was a customer of the employer during his employment was overbroad, because it was not limited to customers he had contact with. Id. at *7. So you see both halves of the rule.

Same for Wright v. Sport Supply Group, Inc., 137 S.W.3d 289, 298 (Tex. App.—Beaumont 2004, no pet.), where the court cited Haas and Stroman for the propositions that “[a] covenant not to compete that contains an industry-wide exclusion from subsequent employment is unenforceable,” and “a covenant not to compete that extends to clients with whom a salesman had no dealings during his employment is unenforceable.” The court held that the agreement at issue was overbroad and unenforceable because it was not limited to customers the employee had dealings with while employed by the company. Id.

Wright also cited Haass for the principle that “[a] restrictive covenant is unreasonable unless it bears some relation to the activities of the employee.” Id. You might call this the “janitor corollary” of the industry-wide exclusion rule. The idea is that a non-compete that would bar a salesman from working for a competitor as a janitor would be unreasonably broad.

Four years later, the Beaumont Court of Appeals considered whether the Texas Supreme Court’s intervening decision in Sheshunoff changed the industry-wide exclusion rule applied in Wright. See Pool v. U.S. Money Reserve, Inc., No. 09-08-137 CV, 2008 WL 4735602, at *8 (Tex. App.—Beaumont 2008, no pet.) (mem. op.) (addressing Alex Sheshunoff Mgmt. Servs., L.P. v. Johnson, 209 S.W.3d 644 (Tex. 2006)).

The Poole court said that Sheshunoff was distinguishable because it involved a non-compete that only prevented the employee from soliciting prior clients with whom he had personal contact or any previously identified prospective client. Thus, the court reasoned, Sheshunoff did not change the industry-wide exclusion rule. Id. at *8.

(Sheshunoff was the case that cleared up confusion about whether a non-compete is “ancillary to an otherwise enforceable agreement,” an issue I explain in convenient video form here.)

In another post-Sheshunoff case, EMS USA, Inc. v. Shary, 309 S.W.3d 653, 660 (Tex. App.—Houston [14th Dist.] 2010, no pet.), the court said enforceability of a non-compete would turn on whether it extended to customers that employee had no dealings with. And in CDX Holdings, Inc. v. Heddon, No. 3:12-CV-126-N, 2012 WL 11019355, at *10 (N.D. Tex. March 2, 2012), the court held that the scope of activity restrained was overbroad, where the non-compete applied to all anatomic pathology work performed by the employer, even though the employee’s work exclusively involved dermatopathology.

Obviously, dermatopathology is narrower than anatomic pathology. Duh.

The janitor corollary appeared again in Weber Aircraft, L.L.C. v. Krishnamurthy, No. 4:12-CV-666, 2014 WL 12521297 (E.D. Tex. Jan. 27, 2014). In that case the non-compete barred the employees from working for a company providing the same products (seating products and components) as the employer or working for five specific competitors in any capacity. Citing Wright, the court held that a restriction barring the employees from working for five competitors, “even in a position that would not require [the employees] to use any of [the employer’s] confidential information, such as a janitor position,” was unreasonably broad. Id. at *8.

cruise-ship-615116_1280
D’Onofrio applied the industry-wide exclusion rule to the travel industry

More recently, the Fifth Circuit weighed in on the industry-wide exclusion rule in D’Onofrio v. Vacation Publications, Inc., 888 F.3d 197, 211-12 (5th Cir. 2018), where it applied Haass and Stroman to a non-compete involving the travel industry. The court held that the non-compete as written was unenforceable because the covenants “amount to an industry-wide restriction—preventing former employees from working in any job related to the sales or marketing of not just cruises, but also a host of other travel products—and are not limited as to either geography or clients with whom former employees actually worked during their employment.” Id. at 212.

Thus, the industry-wide exclusion rule appears to be alive and well in Texas today—in several forms. See, e.g., TENS Rx, Inc. v. Hanis, No. 09-18-00217-CV, 2019 WL 6598174, at *4-6 (Tex. App.–Beaumont Dec. 5, 2019, no pet. h.) (affirming summary judgment against non-compete based on industry-wide exclusion rule). But the rule has its limits.

1. When the non-compete does not prohibit working in the industry

Of course, a non-compete that is limited to customers the employee did business with does not run afoul of the industry-wide exclusion rule. In Gallagher Healthcare Insurance Services v. Vogelsang, 312 S.W.3d 640 (Tex. App.—Houston [1st Dist.] 2009, pet. denied), the court approvingly cited the industry-wide exclusion rule of Haas and Stroman, id. at 654, but the court held that the non-compete at issue did not violate the rule, because “[u]nlike some covenants not to compete that preclude the employee from working in the same industry, the agreement here does not limit [the employee] from working in the insurance business.” Id. at 655.

Similarly, in Stone v. Griffin Commc’ns & Security Sys., Inc., 53 S.W.3d 687, 694 (Tex. App.—Tyler 2001, no writ), the court held that a non-solicitation clause limited to customers the employees had contact with while employed by the employer was not an impermissible industry-wide exclusion.

2. When the “industry” is broader than the company’s niche

What exactly is the “industry” for purposes of the industry-wide exclusion rule? In M-I LLC v. Stelly, 733 F.Supp.2d 759, 794 (S.D. Tex. 2010), the non-compete applied to any customer or potential customer of the employer in the business of oilfield displacement tools or services. The employee argued this was an impermissible industry-wide exclusion. Id. The employer argued the non-compete only applied to well completion services, not the oil and gas industry generally, and therefore was not an “industry-wide” ban. Id. at 796.

pump-jack-848300_1920
Texas courts have applied the industry-wide exclusion rule to oilfield services

The court sided with the employer. The court distinguished Stroman as involving a bar on the insurance business generally, while the non-compete in Stelly did not apply to the entire oil and gas industry. Id. at 796. Considering the “industry” to be oil and gas, not the “niche” services offered by the employer, the court held that the non-compete did not impose an impermissible industry-wide exclusion, but instead limited its scope to a reasonably narrow business area that correlated to the employee’s work for the company. Id. at 797.

In Salas v. Chris Christensen Systems, Inc., No. 10-11-00107-CV, 2011 WL 4089999, at *20 (Tex. App.—Waco Sept. 14, 2011, no pet.) (mem. op.), the court held that a non-compete that applied to the “pet supply manufacturing and distribution industry” did not apply to “the entire industry pertaining to pets or pet products,” where the employee was free to return to his previous work as a dog handler and groomer.

Similarly, in Merritt Hawkins & Assocs., LLC v. Gresham, 79 F.Supp.3d 625, 641 (N.D. Tex. 2015), the court held that a non-compete applying to permanent and temporary medical staffing was not an industry-wide exclusion, where it did not prohibit the employee from working in “other sections of the staffing industry or the medical industry.”

3. When the evidence does not show the restriction amounts to an industry-wide exclusion

The industry-wide exclusion rule may not apply if the employee fails to offer evidence that a prohibition of being associated with any “competitor” of the company amounts to an industry-wide exclusion.

In Republic Services, Inc. v. Rodriguez, No. 14-12-01054-CV, 2014 WL 2936172 (Tex. App.—Houston [14th Dist.] 2014, no pet.) (mem. op.), the court held that Stroman did not apply absent evidence that the “competitor” scope of the non-compete was “tantamount to an industry-wide prohibition.” Id. at *8. The employee offered no evidence about the industry at issue, the court said, and the employer offered evidence that there were companies in the legal services or legal support services industry that were not competitors of the employer. “On this record, we cannot determine as a matter of law that the covenant imposed an unreasonable industry-wide exclusion.” Id.

“On this record” is a signal courts use to emphasize that the result could be different in a case with different facts.

For example, in McKissock, LLC v. Martin, 267 F.Supp.3d 841, 855-56 (W.D. Tex. 2016), a non-compete barring the employee from being “connected in any manner with any business or practice which is in competition with [employer]” was overbroad as written.

4. When the employer’s interest is not just its goodwill, but also protecting confidential information

The industry-wide exclusion rule as stated in Haas and Stroman is incomplete because it does not address confidential information. Limiting the non-compete to customers the employee had dealings with may not be required when there is a danger of the employee using knowledge of the company’s confidential information to compete for other customers.

For example, in Accruent v. Short, 1:17-CV-858-RP, 2018 WL 297614, at *1 (W.D. Tex. Jan. 4, 2018), the employee served as a director of client services and a senior engineer for a software services company and had access to a wide range of confidential proprietary information. The non-compete prohibited competing with the portions of the employer’s business in which the employee actively participated or received confidential company information. Id.

The employee in Accruent argued that the non-compete violated the Haass rule because it was not limited to customers and prospects the employee worked with at the company, but the court did not read Haass so broadly. Id. at *5. The court said that Haass applies more narrowly to cases where the employer’s interest “derives from the employee’s relationship with his or her clients.” Id.

In Accruent, the court explained, the employee’s role gave him access to confidential proprietary information concerning the company’s product functionality, development plans, sales pipeline, sales process, customer preferences, and market research. Thus, the concern animating the non-compete was not just that the employee would “use his rapport with his customers to take them with him to a competitor,” but principally the concern that the employee would use the confidential information he learned at the company to help another company compete. Thus, the court found that Haass did not compel finding the non-compete’s scope unreasonable. Id. at *6.

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Accruent v. Short applied the Haas rule more narrowly where a software company’s confidential information was at stake

But there was another problem with the non-compete in Accruent. Recall the janitor corollary from Haass and Wright, i.e. the principle that a non-compete must bear some relation to the activities of the employee. The non-compete in Accruent arguably prohibited the employee for working for a competitor regardless of his role, i.e. even if he was “emptying trash cans” for a competitor. The court agreed that a non-compete barring an employee for working for a competitor in any capacity is invalid. To address this defect, the court reformed the non-compete such that it would only prohibit the employee from working for a competitor in the same or substantially similar role that he performed for his previous employer. Id. at *6-7.

5. When the restriction applies to solicitation of employees, not customers

The industry-wide exclusion rule may not apply to solicitation of employees, as opposed to customers. In Smith v. Nerium Int’l, LLC, No. 05-18-00617-CV, 2019 WL 3543583, at *8-9 (Tex. App.—Dallas Aug. 5, 2019, no pet. h.) (mem. op.), the court held that the industry-wide exclusion rule did not apply to a clause barring a former employee from soliciting the company’s other employees, reasoning that the clause did not bar the former employee from working for the company’s competitors. Id. at *9.

PRACTICE TIPS

The cases above suggest some tips for practitioners:

1. Don’t draft your non-compete with an industry-wide exclusion. That should be obvious by now, but you’d be surprised how many non-competes still have this.

2. When drafting the non-compete, consider limiting it to customers the employee had contact with while employed by the company. Alternatively, you can also include customers that the employee received confidential information about. (Check out my Plain-Language Non-Compete for some ideas.)

3. The practice tip suggested by Republic Services is that if the non-compete is not an industry-wide exclusion on its face, the employee should offer evidence that the scope of the non-compete would effectively prevent the employee from working in any capacity in the industry at issue.

4. Finally, remember that determining whether a Texas non-compete is enforceable as written is just the first step. Even if the scope violates the industry-wide exclusion rule, the court can enter a temporary injunction that enforces the non-compete in part, or reform the non-compete to make the scope reasonable. For more on the practical results of Texas non-compete law, see Wolfe’s First Law of Texas Non-Compete Litigation.

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IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Follow @zachwolfelaw on Instagram to keep up with his latest shenanigans.

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.

 

 

Mysteries of Texas Non-Compete Law, Part 3: Irreparable Injury

Mysteries of Texas Non-Compete Law, Part 3: Irreparable Injury

The celebration of the 30th anniversary of the Texas non-compete statute continues with this week’s unanswered question of Texas non-compete law: does the loss of sales caused by a breach of a non-compete establish “irreparable injury”?

Paper Rules vs. Real Rules

I confess this is actually an answered question. It’s just that the answer is not obvious. That’s because the court opinions aren’t necessarily going to tell you the answer, at least not explicitly.

You see, in law there are the Paper Rules, and there are the Real Rules.

The Paper Rules are the reasons courts put on paper for ruling the way they do. The Real Rules are the actual reasons the courts decide cases the way they do.

If that sounds sinister, don’t worry. The Paper Rules and the Real Rules overlap. If you drew a Venn diagram it would show two overlapping circles. And the circles constantly shift, because sometimes the courts incorporate some of the Real Rules into the Paper Rules.

That’s kind of what the smart people at the American Law Institute do when they write a “Restatement” of a certain area of law. They look at dozens of court decisions and say “here’s how courts actually decide this issue,” and then they make that principle one of the Paper Rules.

That’s why it’s the Restatement (Second) of the Law of Contracts and not the Statement (Second) of the Law of Contracts. The whole project has a certain aroma of legal realism.

Of course, you can always “out-realist” the realists. You can say, “Ha! you think judges are deciding these cases based on what they think is reasonable, I say it’s based on who contributed to their campaigns!” Or based on what will keep the proletariat in his place, or increase economic efficiency, or maintain the patriarchy, etc.

That’s a deeper part of the ocean. Here I’m focusing on the surface level of the Real Rules, the legitimate “legal” reasons courts decide cases a certain way.

If you’re a practicing litigator, you need to understand both the Paper Rules and the Real Rules. You have to be fluent in the Paper Rules to brief and argue your case. But you also need to understand the Real Rules, because then you will know what you really need to prove to win your case, and you will increase your chances of accurately predicting what’s going to happen.

This is especially true in non-compete litigation. Even if you read a lot of non-compete injunction opinions, you might miss the answer to the irreparable injury question if you only pay attention to the Paper Rules.

What the Real Rule is

The Real Rule is that loss of customers establishes “irreparable injury” if the trial court judge wants it to. Otherwise, it doesn’t. You can sum up the reason for this answer in three words: standard of review.

Let’s break it down in ten simple steps:

1. The Texas non-compete statute authorizes judges to award “injunctive relief” for the breach of a non-compete.[1]

2. Injunctive relief includes a temporary injunction (in federal court it’s called a preliminary injunction).

3. A temporary injunction is an order from the trial court judge that says, for example, “Salesman may not do business with Former Employer’s Customers until this court renders a final judgment after trial.”

4. A temporary injunction is a common-law remedy. That means that judges, through case law, have established the requirements for a temporary injunction through decades, even centuries, of case law.

5. The common-law requirements for obtaining a temporary injunction include “irreparable injury,” or irreparable harm, and “no adequate remedy at law.” These requirements apply to non-compete cases.[2]

6. Irreparable injury and no adequate remedy at law mean essentially the same thing: money damages would be inadequate to compensate for the lost sales.

7. If the trial court rules against you on a temporary injunction, you get an interlocutory appeal, which is an appeal taken before the trial court has rendered a final judgment.[3]

8. The “standard of review” for an interlocutory appeal of a temporary injunction ruling is “abuse of discretion.”[4]

9. Abuse of discretion means even if the Court of Appeals thinks the trial court judge got it wrong, it will affirm the ruling as long as there was a reasonable basis for it.

10. There are cases saying that the loss of customer sales establishes irreparable injury.[5] There are other cases saying it doesn’t.[6]

Maybe this difference can be reconciled based on the different facts of the cases. Maybe it can’t. But either way, you can see where this is headed.

Here is the practical result:

A. In a non-compete case, the trial court judge will usually decide the temporary injunction based on what the judge thinks is fair.

B. If the trial court judge grants a temporary injunction, the Court of Appeals will almost always say the judge could have reasonably found that the loss of customers established irreparable injury.

C. If the trial court judge denies a temporary injunction, the Court of Appeals will almost always say the judge could have reasonably found that the loss of customers did not establish irreparable injury, because the loss could be adequately compensated by damages.

The bottom line is that the irreparable injury requirement is effectively a variable that the trial court judge can use to justify whatever decision the judge thinks is fair. This is the Real Rule in non-compete litigation.

Mind you, it’s only a general rule. It is possible to persuade an appellate court that the trial court abused its discretion, but it is rare. And even when an appellate court reverses a trial court’s ruling on a temporary injunction, it’s usually based on some other issue, not the irreparable injury requirement.

So now you know the Paper Rules and the Real Rule on irreparable injury in non-compete cases. Mystery solved.

What the Real Rule should be

But what should the rule be? Should the loss of sales establish irreparable injury?

I say generally, no, for two main reasons. First is the almost-forgotten principle of “efficient breach.” Second is the almost-forgotten constituency in non-compete cases: the customers.

Efficient breach is a concept you learn in law school and then never hear about, unless you go into academia or clerk for the Seventh Circuit. Black’s Law Dictionary defines efficient breach as the “modern contract theory which [sic] holds that it may be economically efficient to breach a contract and pay damages.”

The idea of efficient breach reflects the amoral bent of modern contract law. 1Ls learn that contract law is about commerce and efficiency. It’s not about right and wrong. There’s nothing inherently immoral about breaking a contract. Efficient breach says it’s fine to break a deal as long as you compensate the other party for its damages and still come out ahead.

Of course, most people, including judges, don’t really think like this. Courts even refer to contractual promises as covenants. Talk about a word with some moral baggage! Truth is, there is always a tension between the moral and amoral strands of contract law.

So when the Law and Economics movement started promoting the concept of efficient breach in the 1970s, it was only partly descriptive, and retroactively so.

It was descriptive in the sense that it provided a rationale for certain timeworn principles of contract law. You might recognize one of those principles: the irreparable injury requirement.

The efficient breach theory provided an economic explanation for the irreparable injury requirement: courts will refrain from enjoining a party from breaching a contract, as long as the injured party can be made whole with damages, because that’s more economically efficient.

That’s the descriptive part. The prescriptive part is the idea that courts should refrain from granting an injunction when damages would be adequate to compensate the injured party.

This doesn’t mean you have to be a Law and Economics type to appreciate the efficient breach theory. For me, the value of the theory is that it helps us discern when we are deciding cases based on moral considerations as opposed to the amoral rules of the marketplace.

You see this a lot in non-compete cases. In most cases, when a sale person breaks a non-compete and her employer loses sales, damages are not that hard to calculate and would adequately compensate the employer.

So what explains why a judge would grant an injunction in such a case?

I think it’s the moral element. Specifically, it’s the notion of loyalty. Breaking a non-compete is not just some antiseptic breach of contract, the judge thinks, it’s a breach of loyalty. It’s a betrayal.

And I get that. But the problem, in practice, is that loyalty tends to be a one-way street in employment relationships. We expect loyalty from the employee, but where is the loyalty when the employer fires the at-will employee for an unfair reason, or for no reason?

I say non-compete litigation could use a little more of the efficient breach theory, and a little less of the moralizing. That means don’t grant an injunction to prevent the loss of sales unless the damage is truly irreparable, e.g. if the loss of sales would put the company entirely out of business.

Unless I represent the employer trying to enforce the non-compete. Then let the moralizing flow.

Who will speak for the customers?

The second reason I think it’s wrong to grant an injunction to prevent an ordinary loss of sales is that it unfairly restricts the rights of non-parties. Specifically, the customers. Or if it’s a professional service, the clients.

Yes, customers and clients. Remember them? They pay the bills.

When a judge orders a sales person to stop doing business with certain customers, that is effectively the same as ordering the customers not to do business with the sales person.

Let that sink in. A temporary injunction tells a customer you can’t get your lumber, or insurance policy, or oilfield services—or whatever it is—from the person you like. And in many cases, that’s the person you’ve bought that thing from for years.

Think about it. The customer never signed any non-compete. The customer is not a party to the lawsuit. And in most cases, the customer hasn’t done anything wrong. But a judge is going to tell the customer what to do?

Now I may be just a small-time Texas litigator, but that don’t seem right. This is just my personal opinion, but I say protecting the interests of customers is a compelling reason for strictly enforcing the irreparable injury requirement in non-compete litigation.

Don’t get me wrong. If the non-compete is reasonable and enforceable, the employer can still get damages. Specifically, the employer can recover lost profits damages, if proven with reasonable certainty.

But wait a minute, you say. What about the cost of pursuing damages in a lawsuit? The attorneys’ fees, the expert witness fees, the time and uncertainty of the litigation process. You don’t get those things back.

Ah, transaction costs. The bane of the efficient breach theory.

All I can say is, transaction costs are an inherent problem in any litigation. That’s why cases settle.

That’s another one of the Real Rules.

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IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC.

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.

[1] Tex. Bus. & Com. Code § 15.51(a).

[2] Some Texas courts have held that irreparable injury and the other common-law requirements do not apply to a claim for a permanent injunction to enforce a non-compete. See the discussion in Tranter, Inc. v. Liss, No. 02-13-00167-CV, 2014 WL 1257278, at *6-7 (Tex. App.—Fort Worth Mar. 27, 2014, no pet.) (mem. op.).

[3] Tex. Civ. Prac. & Rem. Code § 51.014(a)(4) (state court); 28 U.S.C. § 1292(a)(1) (federal court).

[4] See, e.g., Argo Group US, Inc. v. Levinson, 468 S.W.3d 698, 700 (Tex. App.—San Antonio 2015, no pet.) (“In this interlocutory appeal, our review is limited to determining whether the trial court abused its discretion in denying Argo’s request for a temporary injunction”); Cardoni v. Prosperity Bank, 805 F.3d 573, 579 (5th Cir. 2015) (“We review a district court’s assessment of these factors [that a party seeking an injunction must show] for abuse of discretion. Conclusions of fact that affect that analysis are left undisturbed unless clearly erroneous, whereas conclusions of law are reviewed de novo.”)

[5] See, e.g., Cardinal Health Staffing Network, Inc. v. Bowen, 106 S.W.3d 230, 236 (Tex. App.—Houston [1st Dist.] 2003, no pet.) (“proof that a highly trained employee is continuing to breach a non-competition covenant gives rise to a rebuttable presumption that the applicant is suffering irreparable injury”); Tranter, 2014 WL 1257278, at *7 (“A highly trained employee’s continued breach of a noncompete agreement creates a rebuttable presumption that the employer is suffering an irreparable injury”).

[6] See, e.g., Argo Group US, Inc. v. Levinson, 468 S.W.3d 698, 704-5 (Tex. App.—San Antonio 2015, no pet.) (affirming trial court’s denial of temporary injunction where trial court could have reasonably found no threat of irreparable injury); Midstate Environmental Services LP v. Atkinson, No. 13-17-00190-CV, 2017 WL 6379796, at *4 (Tex. App.—Corpus Christi 2017, no pet.) (mem. op.) (affirming trial court’s denial of a temporary injunction to enforce a non-compete based on lack of irreparable injury, where damages could be calculated based on the proceeds plaintiff would have received for customers that switched to the competitor); Am. Mortgage & Equity Consultants, Inc. v. Bowersock, No. 1:19-CV-492-RP, 2019 WL 2250170, at *5 (W.D. Tex. May 24, 2019) (denying TRO for misappropriation of customer information where the court would be able to calculate damages for resulting from the “converted” customers); BMC Software, Inc. v. Int’l Business Machines Corp., No. H-17-2254, 2018 WL 4520020, at *4-5 (S.D. Tex. Sept. 21, 2018) (denying preliminary injunction where alleged loss of customer could be compensated by money damages).

Mysteries of Texas Non-Compete Law, Part 2: Reformation

Mysteries of Texas Non-Compete Law, Part 2: Reformation

We’re celebrating the 30th anniversary of the Texas non-compete statute by examining some of the great unanswered questions of Texas non-compete law. Part 1 asked whether it matters if the information provided by the employer is really confidential. This Part 2 asks whether reformation is available when the non-compete is missing a key limitation.

Are you studying for the California bar exam? If so, you probably know that the California Bar announced that it “inadvertently” leaked this year’s bar exam topics to a group of law school deans. To be fair to all test takers, the bar examiners decided to release the list of topics publicly.

I’m sure everyone studying for the California bar feels much better now.

In light of this disturbing news, I must come clean and disclose a phone call I recently received:

[ring tone: guitar intro to Sweet Child of Mine]

“Wolfe here.”

“Yes, hi, this is the Texas Board of Law Examiners. For the first time ever, we’re including a question about non-compete litigation on the bar exam this year. We were hoping we could run it by you.”

“Oh, cool, and you’re calling me because you saw my blog Five Minute Law and my YouTube channel That Non-Compete Lawyer?”

“Uh . . . well, actually you’re the ninth person we’ve tried. Everyone else is on vacation.”

“Ok, cool. Send it over.”*

The problem is that I know a few Texas law students through my local Inn of Court, so I could be accused of leaking the question to them. To avoid any appearance of impropriety, I am now making the question available to my readers—all thirteen of them (hi, Mom!).

Ok, Fivers, here’s the question:

W&O Supply Company sells supplies like the Garbarino centrifugal and positive displacement pump to the marine industry. Four of W&O’s employees—a branch manager, outside salesman, warehouse manager, and inside salesman—left W&O to start a competing business.

Each employee had signed W&O’s standard non-compete. The non-compete prohibits diverting, or assisting in diverting, any customer from W&O to a competitor. The non-compete is limited to any area within 100 miles of any W&O branch but contains no time limitation.

While working for W&O, the employees received confidential information regarding W&O’s supplier costs, customer purchasing history, and pricing. After leaving W&O and forming the competing business, the employees solicited sales from W&O customers.

W&O filed suit against the former employees in U.S. District Court in Houston, Texas, alleging breach of the non-competes and seeking a preliminary injunction. The employees filed a motion to dismiss for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6), arguing the non-compete is unenforceable on its face because it contains no time limitation.

W&O filed a response arguing that the non-compete statute requires the court to reform the non-compete to include a reasonable time limitation and that, even without reformation, the court could still grant a preliminary injunction enforcing the non-compete for a reasonable time period.

The correct ruling on the motion is:

A. Denied. W&O’s allegations are sufficient to state a plausible claim for relief. W&O could prove some set of facts showing that a time limitation of a year is reasonable.

B. Denied. Reformation of an overbroad non-compete is mandatory under the Texas non-compete statute, Tex. Bus. & Com. Code § 15.51(c).

C. Denied. The court can enter a preliminary injunction enforcing the non-compete to a limited extent. Whether the non-compete should be reformed is an issue for final judgment.

D. Granted. While the non-compete statute requires the court to reform a time limitation that is too long, the court cannot reform a non-compete that contains no time limitation whatsoever.

So what’s the best answer? No peeking.

Ha! It’s a trick question! You could make a reasonable case for each one of these answers. That’s why it’s an unanswered question of Texas non-compete law. No question like this should ever appear on the bar exam.

But if you ask U.S. District Judge Kenneth Hoyt, he would say D is the best answer. I know that because I’ve read his opinion in W&O Supply, Inc. v. Pitre, No. 4:19-CV-00153, 2019 WL 15592090 (S.D. Tex. Apr. 10, 2019).

The facts of the case were fairly close to the simplified version I outlined above. The key fact: the non-competes had no time limitation. The legal question was whether W&O was entitled to reformation. Specifically, should the judge effectively “rewrite” the agreement to add a reasonable time limitation?

Because we are all textualists now, let us start with the text of the statute. It says, in pertinent part:

If the covenant . . . contains limitations as to time, geographical area, or scope of activity to be restrained that are not reasonable and impose a greater restraint than is necessary to protect the goodwill or other business interest of the promisee, the court shall reform the covenant to the extent necessary to cause the limitations contained in the covenant as to time, geographical area, and scope of activity to be restrained to be reasonable . . .

Tex. Bus. & Com. Code § 15.51(c).

The “shall reform” language indicates the legislature intended reformation to be mandatory. But the clause starts with a significant “if.” Reformation is only mandatory if the non-compete “contains limitations as to time, geographical area, or scope of activity to be restrained . . .”

That “if” clause is what we call a “condition precedent” (which, to complicate matters further, is pronounced pree-see-dent, not preh-suh-dent). That means the rest of the clause only applies if the condition is met.

So, if a non-compete has limitations that are unreasonably broad, the condition precedent is satisfied, and reformation is mandatory. But if the non-compete has no time limitation whatsoever, then the condition precedent is not met, and reformation is not required.

That’s effectively what the employees in W&O Supply argued, and the judge agreed:

It is the Court’s view that it is empowered only to reform existing terms. Where the Agreement lacks a critical term, such as a time limitation, placing a time limitation in the Agreement is to rewrite the Agreement. The Agreement lacks an unenforceable provision that the Court can revise; therefore, reformation is impermissible.

W&O Supply, 2019 WL 15592090, at *3.

The unavailability of reformation was not academic. Because the non-competes were unenforceable and could not be reformed, the court not only denied a preliminary injunction, it dismissed the lawsuit. Id.

So why is the availability of reformation an unanswered question?

Well, W&O Supply is just one case, and there are other arguments that could be made.

First, you could argue that the court in W&O Supply read the non-compete statute too literally. The purpose of the statute is to provide for reformation of overbroad non-competes. One might argue this purpose should be served as much when the agreement lacks a limitation as when the limitation is too broad.

Second, there are cases saying the court can enter a preliminary or temporary injunction enforcing an overbroad non-compete to a limited extent. See, e.g., Transperfect Translations, Inc. v. Leslie, 594 F.Supp.2d 742, 756 (S.D. Tex. 2009) (noting uncertainty in Texas cases and holding that the non-compete would be temporarily reformed for the purpose of entering a preliminary injunction).

Third, the statute also requires a geographic limitation. See Tranter Inc. v. Liss, No. 02-13-00167-CV, 2014 WL 1257278, at *5 (Tex. App.—Fort Worth Mar. 27, 2014) (non-compete that contained no geographic restriction at all was unreasonable and unenforceable as written). Yet there are cases enforcing non-competes that contain no geographic limitation whatsoever. See Gallagher Healthcare Ins. Servs. v. Vogelsang, 312 S.W.3d 640, 654-55 (Tex. App.—Houston [1st Dist.] 2009, pet. denied) (“A number of courts have held that a non-compete covenant that is limited to the employee’s clients is a reasonable alternative to a geographical limit”).

If the absence of a geographic limitation is not fatal to a non-compete, why should the absence of a time limitation be any different?

They’re going to put that one in the essay section.

__________________________________

IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. He doesn’t really have that ring tone, but it would be cooler if he did.

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.

*It should be obvious that all the stuff above about the Texas bar exam is made up. Then again, the news about the California bar exam sounded fake too.