Geographic Area of a Texas Non-Compete – Part 2

Geographic Area of a Texas Non-Compete – Part 2

If Part 1 was a flashback to the vinyl era, then this Part 2 moves us into the cassette era. That’s more my time. I never actually had a Peter Frampton record, but I can still remember recording The Name of This Band is Talking Heads on to a blank cassette tape.

The theme of Part 1 was the Sales Territory principle, which says that a reasonable geographic area for a Texas non-compete should usually coincide with an employee’s actual sales territory. This principle goes all the way back to the first vinyl era, the Jazz Age, when Texas courts reasoned that an employee is going to develop goodwill only in the area where he has personal contact with customers.

But of course, not every case involves the typical sales employee who is responsible for a certain territory. What about cases where physical territory is not important, or where the employee is a high-level executive?

In such cases, the Sales Territory principle may be less useful, and Texas courts may be more likely to follow what I call the Holistic principle. The Holistic principle considers the reasonableness of the geographic limitation not in isolation, but in combination with other factors, such as the employee’s rank in the company, the employee’s knowledge of high-level confidential information, the nature of the business, and perhaps most important, the scope of activity restrained by the non-compete.

This leads us to General Rule No. 5.

General Rule 5: No geographic limitation or broad geographic limitation + non-compete limited to existing customers = probably reasonable.

The Sales Territory principle was rooted in the idea that customer goodwill is usually tied to a certain geographic territory. This idea goes back at least as far as the City Ice Delivery case in the 1920s. But Texas courts also recognized decades ago that even a non-compete with no geographic limitation at all can be reasonably limited to protecting customer goodwill, if the scope of activity it restrains is narrow.

Consider Stocks v. Banner American Corp., 599 S.W.2d 665 (Tex. Civ. App.—Texarkana 1980, no writ). Stocks sold his stock in Banner and agreed not to compete with Banner for three years. Banner’s business included manufacturing and selling blank cassette tapes, selling blank labels for cassette tapes, and custom duplication of cassette tapes. Banner’s customers included Tandy Corporation and Apple Computers. Id. at 666.

Stocks apparently could not leave the cassette game behind, because he somehow became an owner of Xalon Corporation, which sounds like an evil company from Aliens or Terminator. Despite the lack of any geographic limitation in the non-compete, the trial court enjoined Stocks and Xalon Corporation from doing business with Tandy, Apple, or a list of other Banner customers. Id. at 666-67.

The Court of Appeals found that the lack of a geographic area was not fatal to the non-compete. See id. at 667 (“Failure to include a territorial limitation will not void a covenant to compete”). The court cited Justin Belt Company, Inc. v. Yost, 502 S.W.2d 681 (Tex. 1973), where the court held that a non-compete that was “unlimited both as to time and to space” could be enforced to a reasonable extent. Id. The court also reasoned that non-competes may be construed more broadly in the sale of a business than in an employment relationship. Id. (citing Seline v. Baker, 536 S.W.2d 631 (Tex. Civ. App.—Houston [1st Dist.] 1976, no writ)).

Thus, the non-compete could be enforced to some extent, despite the lack of a geographic limitation. But to what extent? The Stocks court cited two cases approving injunctions limited to prohibiting a former employee from contacting certain listed customers. Id. at 667-68 (citing Toch v. Eric Schuster Corp., 490 S.W.2d 618 (Tex. Civ. App.—Dallas 1972, writ ref’d n.r.e.), and Arrow Chem. Corp. v. Anderson, 386 S.W.2d 309 (Tex. Civ. App.—Dallas 1965, writ ref’d n.r.e.)). The takeaway was that “[t]he use of a customer list as an alternative to setting a specific geographical limit is a reasonable means of enforcing a covenant not to compete.” Id. at 668.

Apple Computers was one of the key customers in the Stocks case decided in 1980

From the Stocks rule we can deduce this common-law principle of Texas non-compete law: a non-compete that is limited to prohibiting a former employee or owner from doing business with the company’s existing customers may be reasonable and enforceable even if it lacks a geographic limitation. See also Investors Diversified Servs., Inc. v. McElroy, 645 S.W.2d 338, 339 (Tex. App.—Corpus Christi 1982, no writ) (non-compete limited to clients securities salesmen contacted or learned about while working for company was enforceable despite lack of defined territory).

The logic of the rule is that the point of requiring a geographic limitation was to protect customer goodwill. If the non-compete is otherwise limited to protecting customer goodwill—because it is limited to the company’s existing customers—then a geographic limitation may not be necessary. This is the most basic formulation of the Holistic principle.

But this was a common-law rule. Did the Stocks rule survive the enactment of the Texas non-compete in 1989? Let’s just say the Stocks rule fared better than cassette tapes at the end of the 80s.

Even though the statute expressly requires a geographical limitation, Texas courts continued to hold that a geographic limitation may be unnecessary if the scope of activity restrained is sufficiently narrow.

In Totino v. Alexander & Associates, Inc., No. 01-97-01204-CV, 1998 WL 552818 (Tex. App.—Dallas Aug. 20, 1998), former employees of an insurance brokerage argued that the their non-competes violated the statute because they contained no geographic limitation, but the court rejected this argument. Id. at *3. The statute’s reasonable geographic restriction parallels a similar common-law requirement, the court reasoned, and Texas courts had held that a geographic limitation was not necessary where the non-compete was limited to clients the former employee had contact with. Id. at *3-4 (citing McElroy and Stocks). The non-compete “implicitly” contained a reasonable geographic restriction because it was limited to clients of the brokerage. Id. at *4.

The First Court of Appeals followed the same approach in Gallagher Healthcare Insurance Services v. Vogelsang, 312 S.W.3d 640 (Tex. App.—Houston [1st Dist.] 2009, pet. denied). The non-compete in Gallagher had no geographic limitation, but it was limited to clients the employee had worked with in her last two years at the company. Id. at 654. “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,” the court said, citing Stocks, Totino, and McElroy. Id. at 654-55. The court held the limitation to clients the employee worked with while employed by the company was a “reasonable alternative to geographical area.” Id. at 655.

As these cases illustrate, the scope of activity restrained is usually a more important factor than geographic area. Even a non-compete that has a reasonable geographic area will be unenforceable if the scope of activity restrained is too broad. See Burning Down the Haas: The Industry-Wide Exclusion Rule in Texas Non-Compete Litigation.

The employee’s position in the company is also an important factor, which leads to the next general rule.

General Rule 6: No geographic limitation or broad geographic limitation + non-compete not limited to specified customers + high-level executive = It depends.

We have seen that a broad geographic area—or even the lack of any geographic area—may be found reasonable if the non-compete is limited to existing clients or customers. But what if the non-compete is not limited to existing clients or customers?

This is where it gets hard. In a case like this, other factors, such as the employee’s rank in the company and knowledge of the company’s confidential information, become more important.

The Stocks rule lasted longer than these bad boys

Judge Ellison considered the issue in detail in M-I LLC v. Stelly, 733 F.Supp.2d 759 (S.D. Tex. 2010). In that case, Knobloch resigned from his position as Manager of Sales for the Americas at M-I, an oilfield services company. He started his own oilfield services company and allegedly started “raiding” employees from M-I. Id. at 769-70.

Knobloch’s non-compete restricted doing business with existing M-I customers, but it did not end there. Like many non-competes, it also prohibited Knobloch from engaging in any business “involving oilfield displacement tools or services or any other businesses then conducted by Employer.” Id. at 794. These restrictions applied “in any geographic area” where the company did business, which effectively meant North America, South America, and the Caribbean. Id. at 797.

Knobloch argued that his non-compete was unenforceable because the geographic area was too broad, but Judge Ellison disagreed, citing his own formulation of the Holistic principle. “[N]on-compete covenants with restrictions covering a wide geographic area may be reasonable if they are limited in scope to a firm’s current or prospective clients such that they do not pose a greater restraint than necessary to protect the firm’s goodwill,” he said, citing his own opinion in TransPerfect Translations (I love that flex). Id. at 797-98.

He also cited a version of the Sales Territory principle: “Covenants with wide geographic areas have been upheld frequently in Texas courts, especially when the area covered constitutes the employee’s actual sales or work territory.” Id. at 798.

Applying these rules, Judge Ellison acknowledged that “a geographic area covering the Western hemisphere is broad, reaching to the outer limits of a restriction.” But he ruled that this broad geographic area was reasonable, even where the non-compete was not limited to existing customers, where:

  • Knobloch had “extensive job responsibilities” and held a position in “upper management” (Manager of Sales for the Americas). He was “much more than a manager and salesman for his former employer.” He oversaw the company’s “relationships with major international clients.”
  • His actual territory did span the Americas.
  • Knobloch knew the company’s technical confidential information: “An engineer by training, Knobloch participated in the design of [the company’s] tools and in facilitating wellbore completions. He delivered technical presentations internationally, formulated company growth strategies, and discussed product development with engineers.”

Id. at 798-99.

In short, in M-I v. Stelly the geographic area covering the entire Western hemisphere was reasonable where the employee was a high-level executive, he was actually responsible for that territory, and he had knowledge of the company’s confidential technical information.

M-I v. Stelly took a “holistic” approach

Texas cases since M-I v. Stelly have tended to find broad geographic areas reasonable when the former employee was a high-level executive.

Consider Daily Instruments Corp. v. Heidt, 998 F.Supp.2d 553 (S.D. Tex. 2014). In that case, the non-compete broadly applied to the United States and any country in which Daily Instruments did business. Id. at 567. Daily Instruments specialized in the narrow field of reactor thermometry, which involved electrical temperature measurement devices used in reactors for the refining, chemical, and petrochemical industries. Id. at 557.

The court found the non-compete reasonable for three reasons. First, the employee was a high-level sales manager with responsibility for a very large territory and with access to the company’s confidential information regarding worldwide clients and sales. Id. at 567-68. Second, the field of reactor thermometry was very narrow, with a narrow customer base, few competitors, and a global scale. Id. at 568. Third, the non-compete had a reasonable limitation on scope because it did not bar the employee from working in the industry, but only from performing the kind of work he had performed in his last two years of employment in the narrow field of reactor thermometry products, and from disclosing confidential information. Id.

Similarly, in Ameripath, Inc. v. Hebert, 447 S.W.3d 319, 335 (Tex. App.—Dallas 2014, pet. denied), the court found a broad geographic area reasonable considering the employee was a member of employer’s “highest level management team.” The employee cited the Sales Territory principle and argued that he only worked in two counties, while the geographic scope of the non-compete was much broader. Id.

But the court said “the breadth of enforceable geographical restrictions in covenants not to compete must depend on the nature and extent of the employer’s business and the degree of the employee’s involvement in that business.” Id. (citing Butler v. Arrow Mirror & Glass, Inc., 51 S.W.3d 787, 793 (Tex. App.—Houston [1st Dist.] 2001, no pet.). The restriction on working anywhere for a company that operated in the Dallas-Fort Worth area was reasonable, the court reasoned, because the employee’s “management knowledge of and experience with [the company’s] Dallas-area operations would be valuable to his new employer.”

And in McKissock, LLC v. Martin, 267 F.Supp.3d 841, 856-57 (W.D. Tex. 2016), the court found a nationwide geographic area reasonable, where the company had a national customer base, the employee taught online courses available to the national customer base, and the employee held an upper-level position as Senior Appraisal Instructor.

Hmm. “Senior Appraisal Instructor.” I’m wondering how “upper-level” that really was. In theory, I don’t have a problem with the Holistic principle applied in M-I v. Stelly and subsequent cases. Courts should remember that the primary rationale for requiring a geographic limitation is to protect a company’s goodwill.

But I fear that in practice, dispensing with the geographic limitation requirement or allowing an extremely broad geographic area can have a real chilling effect on the ability of businesses to hire the best executive talent. I’ve seen this in my practice.

Maybe it’s time to hit rewind.

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Zach 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.

Geographic Area of a Texas Non-Compete – Part 1

Geographic Area of a Texas Non-Compete – Part 1

The reasonable geographic area requirement of Texas non-compete law is delightfully dated. It’s an analog throwback in a digital era. When Texas courts say a non-compete must be limited to a reasonable geographic area, you can just feel the needle dropping into the well-worn grooves of your uncle’s vinyl copy of Frampton Comes Alive!

But some of you will object that requiring a geographic limitation in a non-compete is an obsolete relic of a bygone era, like Microsoft stores. We’re in the WFH era now. The physical location of an employee doesn’t matter. You might argue a sales person with a cell phone and a laptop can do just as much damage to your business from a beach chair in Fiji as a cubicle in Pearland.

Maybe so. But if the non-compete says “within Pearland,” you’re kind of stuck with that. Plus, the Texas non-compete statute still requires a non-compete to have a reasonable limitation as to “geographical area.” Tex. Bus. & Com. Code § 15.50(a).

The traditional connection between physical proximity and customer goodwill

This is perhaps the most old-fashioned part of Texas non-compete law. It hearkens back to a time when physical proximity was the key to a salesman maintaining goodwill with the customer.

Consider Randolph v. Graham, 254 S.W. 402, 403-4 (Tex. App.—San Antonio 1923, writ ref’d), where the court held that a medical practice non-compete was reasonable and enforceable, despite having no time limitation, because it was limited to practicing medicine within a 20-mile radius of Schertz, Texas.

The court didn’t explain why the geographic area was reasonable, but it’s easy to understand. People like to go to a doctor with an office near them. So, if a doctor sells his practice in Schertz and moves to Austin, it is unlikely his patients will follow him. (The drive from Schertz to Austin is 65 miles up I-35, which usually takes 5-7 hours.) A 20-mile radius sounds about right to prevent the doctor from taking advantage of the goodwill he developed with his patients.

Two years later, the geographic limitation requirement took shape in City Ice Delivery Co. v. Evans, 275 S.W. 87 (Tex. Civ. App.—Dallas 1925, no writ). The court said the test for enforceability of a non-compete in an employment contract was whether it imposed “any greater restraint than is reasonably necessary to secure protection of the business of the employer or the good will thereof.” Id. at 90.

Applying this principle to the geographic area of the non-compete, the court held that the employer was entitled to an injunction against the employee competing in the ice delivery business in the territory where he had delivered ice to the company’s customers, but not against competition outside of the territory, where the company had no goodwill based on the employee’s “personal contact” with customers. Id.

Again, we can see why it made sense to limit the non-compete to the employee’s delivery area. In a business that involves physical delivery of the product to the customer, it was unlikely that a salesman was going to develop goodwill with customers outside his delivery area. Especially in 1925, when the ice would melt if you had to go too far.

So there you have it. Two keys to the geographic area requirement: (1) it should be limited to the territory where the employee interacted with customers, because (2) that is the area where the employee developed goodwill with the customers on behalf of the company.

64 years later, the Texas legislature enacted the 1989 non-compete statute. It provides that a non-compete must contain limitations as to time, geographical area, and scope of activity to be restrained that are “reasonable and do not impose a greater restraint than is necessary to protect the goodwill or other business interest of the promisee.” Tex. Bus. & Com. Code § 15.50(a).

How have Texas courts interpreted the statute’s reasonable geographic area requirement? In principle, not much has changed since City Ice Delivery.

The Sales Territory principle

In most cases, where the employee worked in some kind of customer-facing sales role within a defined territory, the reasonableness of the geographic area will turn on whether it matches the employee’s sales territory. Let’s call this the Sales Territory principle.

When the case involves a sales person or other low to mid-level employee, the Sales Territory principle will usually explain why the court found the geographic area reasonable or unreasonable. In other words, the Sales Territory principle usually applies when the case does not involve a high-level executive. That leads to our first general rule.

General Rule 1: Non-executive + no geographic limitation = probably unreasonable

The easiest cases are those involving a non-executive who has a non-compete with no geographic limitation.

One of the first cases to apply the statute’s geographic area requirement was Zep Manufacturing Co. v. Harthcock, 824 S.W.2d 654 (Tex. App.—Dallas 1992, no writ). That case involved a non-compete between Zep, an industrial chemical manufacturer, and Harthcock, an industrial chemist. Id. at 656-57. Harthcock’s non-compete barred him from performing services similar to those he performed for Zep for two years following termination, with no geographic limitation. Id. at 660.

The court cited the general principle that “what constitutes a reasonable area generally is considered to be the territory in which the employee worked while in the employment of his employer.” Id. (citing two pre-statute cases, Justin Belt Co. v. Yost, 502 S.W.2d 681, 685 (Tex. 1973), and Diversified Human Resources Group v. Levinson-Polakoff, 752 S.W.2d 8, 12 (Tex. App.—Dallas 1988, no writ)).

The court then said the non-compete failed to comply with the statute because it contained no limitation as to geographic area. Id. at 661. Thus, the non-compete would prohibit Harthcock from working as an industrial chemist anywhere, regardless of whether it was in an area not serviced by Zep or Harthcock.

“Noncompete covenants with broad geographical scopes have been held unenforceable,” the court said, “particularly when no evidence establishes that the employee actually worked in all areas covered by the covenant.” Because the non-compete contained no geographic restriction, the court held it was unenforceable. Id.

But today, most Texas lawyers are smart enough to include some geographic limitation in the non-compete. What then?

General Rule 2: Non-executive + ill-defined geographic limitation = probably unreasonable

Texas courts have reached similar conclusions when the non-compete has some geographic limitation, but is so broad or vague that it has no connection to protecting the goodwill developed by the employee.

For example, in TENS Rx, Inc. v. Hanis, No. 09-18-00217-CV, 2019 WL 6598174, at *1 (Tex. App.—Beaumont Dec. 5, 2019, no pet.) (mem. op.), the non-compete applied “in any state or geographical territory in which Employer is conducting, has conducted or anticipates conducting its business.”

The employee filed a motion for summary judgment that the non-compete was unenforceable because the geographic limitation and scope of activity restrained were unreasonable. Id. at *2. The employer argued that the employee was bound by the contractual stipulation that the geographic restriction was reasonable, stating it was “disingenuous” for the employee to now assert the contrary. Id. at *3.

This brings up one of my pet peeves: lawyers for the first employer love to argue that the employee is being dishonest or “disingenuous” when the the non-compete recites that its limitations are reasonable and the employee later argues they’re unreasonable. I don’t find this persuasive, and I’m guessing most judges don’t either. Almost every non-compete contains self-serving recitals like this. Even when I’m representing the employer trying to enforce the non-compete, I would rather just demonstrate that the limitation is reasonable than play this game.

In any case, the trial court in TENS Rx didn’t buy the “disingenuous” argument. It granted summary judgment that the non-compete was unreasonable in geographic scope and scope of activity restrained. Id.

Because the non-compete related to provision of personal services, the employer had the burden to prove the non-compete was reasonable. Id. at *4. On appeal, the employer cited no authority that the restrictions were reasonable, instead merely arguing that the employee was bound by the contract’s stipulation that the restrictions were reasonable. Id. at *4. The court appeared to reject this argument, instead looking to Texas case law on reasonableness of a geographic limitation. Id.

The question is “whether the covenant contains limitations that are reasonable as to geographical area and do not ‘impose a greater restraint than is necessary to protect the goodwill or other business interest of the promisee.’” Id. (citing Marsh USA Inc. v. Vook, 354 S.W.3d 764, 777 (Tex. 2011)).

“The territory in which the employee worked for an employer is generally considered to be the benchmark of a reasonable geographic restriction,” the court said. Id. “Noncompete covenants with broad geographical scopes have been held unenforceable, particularly when no evidence establishes that the employee actually worked in all areas covered by the covenant.” Id.

“Here, there is no definite territory stated and no evidence that Hanis worked in all areas covered by the covenant,” the court said. “It is also unreasonable to impose a condition upon Hanis that would require her to know where TENS ‘anticipates doing its business.’” Id.

close-up-photo-of-assorted-color-of-push-pins-on-map-1078850
Sales territory is usually the benchmark for a reasonable geographic area

TENS Rx shows the risk of making the geographic limitation too abstract. Sure, there is some logic to defining the area as “the employee’s sales territory.” What better way to comply with the Sales Territory principle? But the risk of defining the geographic area this way is that the court may say it is too indefinite. How are the employee—and the court—to know what the sales territory is if it’s not spelled out in the contract?

On the other hand, the company may not know in advance what the employee’s sales territory will be. What if the employee works for the company for over a decade and the territory changes? I don’t have any foolproof solution to this problem, other than to say that usually the better practice is to include a specific geographic area that predicts, as well as the company can, what the employee’s likely sales territory will be.

Let’s say the employer tries to do that and limits the non-compete to a specific, concrete geographic area, such as “within Harris County, Texas.” Is that reasonable? It will probably depend on the employee’s actual sales territory, which leads us to the next general rule.

General Rule 3: Non-executive + well-defined geographic area broader than sales territory = probably unreasonable

When the employee is not a high-level executive and the non-compete has a specific geographic area, the question will be whether the geographic area is broader than the employee’s actual sales territory.

This creates an obvious problem. Dozens of Texas cases say that the reasonableness of a non-compete is a question of law. But how can a judge decide the reasonableness of the non-compete’s geographic area without considering extrinsic evidence about the facts?

Suppose the non-compete’s stated geographic area is “within Harris County, Texas and surrounding counties.” On a motion for summary judgment, the Employee signs a sworn affidavit stating “my sales territory was limited to Harris County,” while the Employer’s CEO signs a sworn affidavit stating “Employee’s sales territory included Harris County and all the surrounding counties.” In other words, conflicting evidence. How can the trial court decide that issue as a question of law?

It can’t. And this illustrates why Texas courts are simply wrong when they declare that the reasonableness of a geographic limitation is always a question of law. On the other hand, if the facts regarding the employee’s sales territory are undisputed, then the reasonableness of the geographic area could present a question of law for the court.

Consider Fomine v. Barrett, No. 01-17-00401-CV, 2018 WL 6376500, at *1 (Tex. App.—Houston [1st Dist.] Dec. 6, 2018, no pet.), which prohibited a chiropractic case manager from competing within a 500-mile radius of the clinic’s location. The former case manager, Barrett, moved for summary judgment that the geographic limitation was unreasonable, extending beyond her work responsibilities for the clinic. Id. at *2.

The Court of Appeals affirmed summary judgment for Barrett. The court began by citing the Sales Territory principle, i.e. “[t]he territory in which an employee worked for an employer is generally considered to be the benchmark of a reasonable geographic restriction.” Id. at *3.

The clinic argued that a 500-mile radius was reasonable because Barrett marketed to patients throughout the State of Texas, but the court rejected this argument. Even assuming Barrett’s sales territory included all of Texas, a 500-mile radius would include all of Louisiana and significant portions of Alabama, Arkansas, Mississippi, Oklahoma, and Mexico. Id. at *3. The geographic scope was therefore “significantly broader” than the geographic scope of Barrett’s employment with the clinic, and the non-compete was therefore unenforceable as written. Id. at *4.

Fomine shows the importance of the employer offering evidence that an employee responsible for generating sales actually worked in the entire geographic area stated in the non-compete. Otherwise the area may be found broader than necessary to protect the employer’s goodwill.

The Sales Territory principle can also apply when the defendant is not a sales employee. Ortega v. Abel, 562 S.W.3d 604 (Tex. App.—Houston [1st Dist.] 2018, pet. denied), was a non-compete case involving the sale of a Hispanic-themed grocery store chain. The geographic area was a 10-mile radius from each of the five stores sold, which equated to most of the Greater Houston area. Id. at 611. The defendants’ expert testified that a three-mile radius would be more than sufficient to protect the goodwill of each store, reasoning that people in a city like Houston rarely travel more than 10 to 12 minutes to go to the grocery store. Id. The plaintiff, Ortega, did not present any evidence to contradict this testimony. Id. at 612.

The Court of Appeals held that the evidence was sufficient to support the trial court’s determination that the 10-mile radius in the non-compete was greater  than necessary to protect Ortega’s goodwill. Id. The court reasoned that “[t]he goal of a covenant not to compete is to establish the restraints on trade reasonably necessary to protect the goodwill or other business interest of the promise, not to prevent any competition.” Id. The expert’s testimony supported the trial court’s conclusion that a 3-mile radius was sufficient. Id.

General Rule 4: Non-executive + geographic area basically matching sales territory = probably reasonable

The next application of the Sales Territory principle is where the employee is a sales person or other lower to mid-level employee, and it is undisputed that the geographic area matches the sales territory the employee actually worked (or is at least pretty close).

That presents a fairly easy case for the court to hold that the geographic area is reasonable.

For example, in Gehrke v. Merritt Hawkins & Associates, LLC, No. 05-18-001160-CV, 2020 WL 400175, at *4 (Tex. App.—Dallas Jan. 23, 2020, no pet. h.), the non-compete between a national physician recruiting firm and a salesman prohibited competition in states in which the salesman worked during his last year with the firm. The court held that the multi-state geographic restriction was enforceable because the salesman actually worked within those states. Id.

But of course not every case involves an ordinary sales-level employee. What if the employee was a high-ranking executive who knew everything about the company and was responsible for all of the company’s customers?

I feel like I should save that for Part 2.

Do you feel like I do?

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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.

Recent Case Illustrates Catch-22 for Texas Non-Compete Injunctions

Recent Case Illustrates Catch-22 for Texas Non-Compete Injunctions

They say the early bird gets the worm, but they also say all good things come to those who wait. In Texas non-compete litigation, both things can be true.

Let’s illustrate with a hypothetical. Dawn Davis leaves her sale job at Paula Payne Windows and goes to work for a fierce competitor, Real Cheap Windows. Company president Paula Payne calls her outside counsel and says, “Johnny, you’ve got to do something before Dawn takes her customers with her.”

“Have any of them left yet,” he asks. “No,” Paula says, “but it’s only a matter of time.” (#Hamilton)

“Here’s the problem,” Johnny says. “To get an injunction, I’ve got to show imminent harm, and the mere fact that she joined a competitor may not be enough.”

Paula Payne Windows reluctantly decides to wait. Then, over the next four weeks, half of Dawn’s customers stop ordering from Paula Payne and start buying their windows from Real Cheap.

Desperate to stop the bleeding, Paula Payne assigns a new sales guy, Eric Boonster, to the rest of Dawn’s accounts. But Eric doesn’t have Dawn’s experience, or her personal relationships with the customers. Two more customers jump to Real Cheap.

That’s the last straw. Paula Payne Windows sues Dawn and Real Cheap in Texas state court. Paula Payne asks the judge for a temporary injunction barring Dawn from doing business with any of the customers she serviced while working for Paula Payne.

At the hearing, Paula Payne Windows argues that its new sales guy can service Dawn’s customers, and that the customers will stick with Paula Payne Windows if the court orders Dawn to stop doing business with them. But on cross examination, Paula admits the customers are free to go to any company they want, and that she could quantify the amount of lost profits from any sales the company loses to Real Cheap.

Dawn doesn’t buy it. She gets on the stand and says, “I’ve known most of these customers for years, and there’s no way they will stay with Paula Payne if the court tells them they’re not allowed to keep buying from me.”

So, under Texas law, what is the correct ruling by the trial court judge?

(A) Grant a temporary injunction prohibiting Dawn from doing business with any of her former customers from Paula Payne Windows from that point forward. The loss of sales and customer goodwill establishes irreparable injury.

(B) Grant a temporary injunction prohibiting Dawn from soliciting or doing business with any of her former customers who have not yet left Paula Payne Windows, because there is insufficient evidence the customers who have already left would go back to Paula Payne Windows.

(C) Deny a temporary injunction. There is no evidence the customers at issue will buy from Paula Payne if they can’t buy from Dawn, and any sales Paula Payne loses can be adequately compensated with damages.

Personally, I tend to favor answer C, for reasons I explained in The Problem With Non-Competes. But to be fair, you can make a case for each one of these choices. You can find Texas cases to support any one of them.

In one recent case, the court chose answer B, the intermediate option. There is some logic to that choice, as we will see, but it results in a dilemma for the employer who is trying to enforce the non-compete and hold on to customers.

The Gallagher Case

In Gallagher Benefit Services v. Richardson, No. 6:19-cv-00427, 2020 WL 1435111 (E.D. Tex. March 24, 2020), Richardson admitted she was servicing over 60 former Gallagher insurance clients, despite her two-year non-compete. Gallagher sued Richardson for breach of non-compete and sought a preliminary injunction in federal court.

A preliminary injunction requires proof of a substantial threat of irreparable harm. The judge’s ruling on this element was mixed.

As to clients who were still doing business with Gallagher, the court found that Richardson’s admitted possession of a Gallagher producer report and servicing of former Gallagher clients established a threat of irreparable harm. Id. at *6.

But why would this harm be irreparable if Gallagher could obtain lost profits damages for the loss of client business?

“As to the violation of the noncompete clause,” the court said, “irreparable harm may be shown where future damages would require quantification estimates that can be avoided by an injunction that prevents the damages in the first place.” That harm could be avoided, and the status quo preserved, by enjoining Richardson from recruiting or working for any current Gallagher clients. Id.

If those clients leave Gallagher as a result of Richardon’s competition, the court acknowledged, Gallagher could attempt to quantify its damages. “But that quantification will involve estimates and thus potential undercompensation,” the court said. That irreparable harm can be avoided by an injunction against competition for current Gallagher clients, the court reasoned, noting that courts “routinely” enjoin prohibited competition in these circumstances. Id. (citing federal district court cases).

On the other hand, the court rejected Gallagher’s irreparable harm argument as to clients Richardson was already servicing. The court had specifically asked what evidence supported Gallagher’s argument that Richardson’s current clients would have stayed with Gallagher, id. at *2, and Gallagher argued that the court could “infer” that some of the clients would return to Gallagher if the court enjoined Richardson. Id. at *6. But the court said Gallagher did not prove sufficient facts to support that inference, including its capacity to service those clients.

Therefore, as to clients who had already left Gallagher for Richardson, the court found there was not enough risk to warrant disrupting the status quo with an injunction. Id. at *7.

“Without evidence of how many additional competitors Gallagher faces in the marketplace, or of Gallagher’s ability and realistic prospects of regaining any of the clients now with Richardson,” the court said, “Gallagher has not met its burden of showing more than this minimal extent [of] irreparable injury.” Id. at *8.

The court noted that “other courts have also been hesitant to eliminate a defendant’s book of business where the plaintiff has not offered sufficient evidence that the clients in question would return to the plaintiff.” Id. (citing First W. Capital Mgmt. Co. v. Malmed, No. 16-cv-1961-WJM-MJW, 2016 WL 8358549, at *11-12 (D. Colo. Sep. 30, 2016)).

Based on this reasoning, the court entered a preliminary injunction that prohibited Richardson from doing business with any Gallagher clients she serviced during her last two years at Gallagher, except for accounts she was already servicing as of the date of the injunction. Id. at *7.

The Gallagher Dilemma

Gallagher v. Richardson illustrates a Catch-22 facing an employer who wants to get an injunction to stop a former employee from taking customers with her. If the employer files suit and asks for an injunction before customers have left, it may be difficult to prove imminent harm, because the employee hasn’t violated the non-compete yet. But if the employer waits until after customers have left, the judge may take the Gallagher v. Richardson approach and say it’s too late to get an injunction to stop the employee from doing business with those customers.

So what is the employer with the non-compete to do?

Ideally, the employer would offer testimony that it has the ability to service the customers even without the ex-employee and that the customers are likely to continue doing business with it.

If the employer can get some of the customers to vouch for this, even better, but that’s usually hard to pull off. The last thing you want to do when you’re trying to hold on to customers is drag them into a lawsuit, especially when you’re asking them to testify against the sales person they like. And if the customer already wants to stay with you, why would you need an injunction?

So the employer may have trouble persuading the trial judge the customers will come back, and it may get stuck with the intermediate result of Gallagher v. Richardson. For that reason, some might say the lesson of the Gallagher case is that the employer should immediately file suit when the employee leaves to join a competitor.

That’s a plausible position, but it strikes me as too simplistic. What if you go to the temporary injunction hearing before any customer has left, and the employee testifies that she only plans to go after new customers? How are you going to show imminent harm? This approach strikes me as too hot.

Perhaps the “just right” approach is to monitor the situation closely and file suit as soon as two or three customers jump ship. Then you can point to those defections as evidence of imminent harm, but you can try to get an injunction to stop the employee from taking any other customers.

This still leaves the question of why damages would be inadequate.  But the employer at least has cases it can cite on that issue—as the Gallagher opinion illustrates.

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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.

 

Can a Non-Compete Grant an Injunction by Stipulation?

Can a Non-Compete Grant an Injunction by Stipulation?

Listen. Do you want to know a secret? It doesn’t really matter whether a contractual stipulation to an injunction is binding on a court.

Still, most non-competes contain some kind of stipulation that a breach will cause the company irreparable injury, and the company is therefore entitled to an injunction in the event of a breach. Let’s call this an “ipso facto” clause.

There are essentially four ways courts can approach an ipso facto clause:

  1. Find it enforceable and dispositive.
  2. Consider it as a factor favoring an injunction.
  3. Cite it as a factor, but without really giving it any weight.
  4. Disregard it entirely.

In my personal opinion, no. 4 is the correct approach. I don’t think a judge should give this kind of stipulation any weight. We wouldn’t let private parties stipulate to their own rules of evidence or procedure. And it seems especially inappropriate for a temporary injunction, which is both an “extraordinary” remedy and, traditionally, an “equitable” remedy left to the discretion of the judge.

You might cite “freedom of contract.” Ok, but how much weight would you give a clause that says “in the event of any litigation between Company and Employee, the court shall declare Company the winner”?

No, I don’t think this is the kind of decision we let private parties dictate in advance, and that may explain why you won’t find many Texas cases saying an ipso facto clause is dispositive and binding on the court.

In Wright v. Sport Supply Group, Inc., 137 S.W.3d 289, 293-94 (Tex. App.—Beaumont 2004, no pet.), the court said it was unaware of any Texas case holding that an ipso facto clause alone establishes, for injunction purposes, that remedies at law will be inadequate. And in Shoreline Gas, Inc. v. McGaughey, No. 13-07-364-CV, 2008 WL 1747624, *11 (Tex. App.—Corpus Christi 2008, no pet.) (mem. op.), the court, citing Wright, said the employer cited no Texas case holding that an ipso facto clause proves there is irreparable injury or no adequate remedy at law.

Addressing an analogous issue, the court in Forum US, Inc. v. Musselwhite, No. 14-17-00708-CV, 2020 WL 4331442 (Tex. App.–Houston [14th Dist.] July 28, 2020, no pet. h.) (mem. op.), rejected the employer’s argument that the non-compete was reasonable because the agreement recited it was reasonable. “If the rule was otherwise,” the court explained, “every employer could require employees to sign an acknowledgement or reasonableness as a condition of employment and courts would be powerless to hold unreasonable covenants not to compete unenforceable as a violation of Texas public policy.” Id. at *10.

But Texas courts have sometimes cited ipso facto clauses as a factor to consider. In Wright, the court held that an ipso facto clause provided some “substantive and probative evidence” to support the trial court’s temporary injunction, citing the strong public policy of Texas favoring freedom of contract. Wright, 137 S.W.3d at 294.

This kind of “punting” seems to be the most common approach. See South Plains Sno, Inc. v. Eskimo Hut Worldwide, Ltd., No. 07-19-00003-CV, 2019 WL 1591994, at *6 (Tex. App.—Amarillo April 12, 2019, no pet.) (mem. op.) (citing ipso facto clause, in addition to evidence of irreparable injury, in support of affirming trial court’s temporary injunction); Poole v. U.S. Money Reserve, Inc., No. 09-08-137CV, 2008 WL 4735602, at *8 (Tex. App.—Beaumont Oct. 30, 2008, no pet.) (mem. op.) (citing ipso facto clause as “but one consideration in our analysis”).

Citing the ipso facto clause as a non-dispositive factor is kind of an easy way out, so I get why courts would do it. But I wonder. In these cases where courts cited an ipso facto clause as a factor, did the clause actually make a difference? In other words, would the case have come out the same way if the agreement had no such clause?

I suspect the answer is yes, but of course there is no way to be sure.

I do know of at least one Texas case that seemed to find an ipso facto clause conclusive. In Henderson v. KRTS, Inc., 822 S.W.2d 769 (Tex. App.—Houston [1st Dist.] 1992, no writ), the buyer of a radio station obtained a temporary injunction prohibiting the seller from interfering with the buyer’s efforts to move the station. Id. at 771-73. On appeal, the seller argued the temporary injunction was improper because damages would be an adequate remedy. The Court of Appeals disagreed, citing the ipso facto clause. The court held that the seller, “by agreement, stipulated that [the buyer] could seek injunctive relief without the necessity of proof of actual damages.” Id. at 776. But the opinion simply decreed this without any analysis.

In a more recent case, the First Court of Appeals reached the opposite conclusion, without citing Henderson. In Malone v. PLH Group, Inc., No. 01-19-00016-CV, 2020 WL 1680058 (Tex. App.—Houston [1st Dist.] Apr. 7, 2020, no pet. h.) (mem. op.), the court said an ipso clause had no effect.

The employment agreement in Malone contained restrictive covenants prohibiting the employee from competing against the company, soliciting the company’s employees, and using or disclosing the company’s confidential information. Id. at *1. The agreement also contained an ipso facto clause, stating any breach of the restrictive covenants would cause “irreparable damage” to the company, and the company “will be entitled as a matter of right to equitable relief, including temporary or permanent injunction, to restrain such breach.” Id.

After a bench trial, the trial court found that the employee breached the confidentiality clause by forwarding a bid log report to his private email account, but the trial court also found the company failed to prove a “continuing violation” of the confidentiality provision, and it therefore denied equitable relief. Id. at *6.

On appeal, the company argued that it was entitled to an injunction under the ipso facto clause based on the breach of the confidentiality requirement. The Court of Appeals disagreed, for two reasons. First, there was sufficient evidence to support the trial court’s finding that there was no continuing violation. Second, the court said “a contracting party’s acknowledgment that the other contracting party has a right to equitable relief does not bind judicial actors or require a court to grant the equitable relief ultimately requested.” “Trial courts are afforded discretion in granting equitable relief,” the court explained, and the company “cannot remove that discretion by eliciting a contractual term from Malone authorizing injunctive relief.” Id. at *6 (citing Shoreline Gas).

So the same Court of Appeals has reached the opposite conclusion on this issue? What gives?

Here’s a hint. In both cases, the Court of Appeals affirmed the trial court’s ruling. In Henderson, the trial court granted an injunction, and the Court of Appeals affirmed. In Malone, the trial court denied an injunction, and the Court of Appeals affirmed.

Similarly, in Shoreline Gas, the case cited in Malone, the trial court denied a temporary injunction, and the Court of Appeals affirmed.

You might deduce (or is it induce?) that the rule in non-compete injunction cases is that the party who wins in the trial court wins.

That would be pretty close to accurate, but the truth is a little more complicated. Here’s what I think the “real” rules are:

1. If the trial court grants a temporary injunction to enforce a non-compete, and there is some evidence to support it, the Court of Appeals will usually affirm the injunction and might cite the ipso facto clause as a factor supporting it (although it wouldn’t be necessary, because there would be some evidence to support it anyway).

2. If the trial court denies a temporary injunction, and had some reasonable basis to do so, the Court of Appeals will usually affirm the denial and either say the ipso facto clause had no effect (as in Malone), or say that it was just one factor to consider (as in Wright).

These two rules will apply in the vast majority of cases. And in both scenarios, the Court of Appeals can punt because it doesn’t really have to decide whether the ipso facto clause is dispositive.

In the rare case where the trial court grants an injunction and there is really zero evidence of irreparable injury, then the Court of Appeals might have to bite the bullet and decide whether the ipso facto clause establishes irreparable injury, despite the lack of any evidence. But that will be rare.

So should employers continue to include ipso facto clauses in their non-competes? Well, as much as I hate to include language that I personally think should have no effect, I do include an ipso facto clause in my form non-compete. See The Plain-Language Non-Compete.

For one thing, there’s no real harm in including it. And some judges might consider the clause as a factor, or even find it dispositive, although that would be a mistake.

There’s one more reason I like to include an ipso facto clause in my form non-compete. If I later have to go to court to try to get an injunction enforcing that non-compete, the employee’s stipulation to an injunction can be useful. Why?

Sorry, you can’t expect me to give away all my secrets.

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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.

 

Can They Lay Me Off *And* Enforce My Non-Compete?

Can They Lay Me Off *And* Enforce My Non-Compete?

Can a Texas employer lay off an employee and then enforce the employee’s non-compete? As with so many legal issues, I’d bet all my chips there’s a short, simple answer, a longer more complicated answer, and a practical answer.

The short answer is yes, an employer can fire an at-will employee—for a good reason, an unfair reason, or for no reason at all—and then enforce the employee’s non-compete. There is nothing in the Texas non-compete statute that expressly ties enforceability to whether the employee quit, got fired, or got laid off.

You can see this harsh reality in the recent case Amend v. J.C. Penney Corp., No. 05-19-00723-CV, 2020 WL 1528497 (Tex. App.–Dallas Mar. 31, 2020, no pet. h.) (mem. op.). In that case, J.C. Penney eliminated Amend’s position and terminated him. He later found a job at Lowe’s as President of Online. J.C. Penney’s sued Amend for breaching his non-compete, the trial court judge refused to dismiss the suit, and the Court of Appeals upheld the trial court’s decision. The fact that J.C. Penney laid off Amend didn’t stop it from suing to enforce his non-compete.

But the longer answer is that the reason for termination of employment can be a factor that affects how the judge evaluates the reasonableness of the non-compete and whether to grant a temporary injunction enforcing the non-compete. I’ll walk through that answer momentarily.

The practical answer is that if the employer cares enough to spend the time and money to sue the employee to enforce the non-compete, then it’s going to cost the employee around $10,000 in legal fees to fight back, at least initially. If the employee doesn’t have that kind of money, it’s going to be tough sledding. I’ll cover that too.

But first, let’s put these questions in context by understanding some basic principles of Texas non-compete law.

Background on Basics of Texas Non-Compete Law

For about a century, Texas law on non-competes was common law, i.e. law made by judges. I covered some of this history in Jurassic Non-Competes. In 1989, the Texas legislature passed the Covenants Not to Compete Act, found at sections 15.50-52 of the Texas Business and Commerce Code. I just call it the non-compete statute for short. For the most part, it codified the common law principles the courts had developed (with two important exceptions I’ll get to later).

The statute has two basic requirements. First, a non-compete must be “ancillary to an otherwise enforceable agreement.” Second, a non-compete must be reasonably limited in time, geographic area, and scope of activity restrained. We now have three decades of case law applying those requirements.

Bear in mind that even if the non-compete as written fails the reasonableness test, the statute says the court shall reform the non-compete, i.e. rewrite it, to the extent necessary to make it reasonable.

But as a practical matter, true reformation hardly ever happens, because the parties almost never get that far. And strangely enough, the Texas non-compete statute says nothing about the event that is usually most important in a Texas non-compete lawsuit: the temporary injunction hearing.

The statute does talk about “injunctive relief,” but not specifically about a temporary injunction (or preliminary injunction, in federal court). Courts have developed common-law requirements for a temporary injunction, including “imminent harm” and “irreparable injury,” and the statute does not preempt those common-law requirements. 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 non-compete case).

A temporary injunction hearing usually takes place a few weeks after the lawsuit is filed. At that hearing the judge will decide whether to order the employee to comply with the non-compete while the lawsuit is pending. If the judge thinks the non-compete is overbroad, the judge can enter a temporary injunction that only enforces the non-compete to a reasonable extent.

The losing party can appeal that decision to the Court of Appeals, but the chance of winning the appeal is low. The main reason for that is the standard of review: abuse of discretion. Even if the Court of Appeals thinks the judge got it wrong, it is supposed to uphold the decision as long as the trial court judge didn’t do anything too crazy.

The end result is that non-compete cases often settle after the temporary injunction hearing. If the judge orders the employee to stop competing, in most cases that might as well be a permanent injunction, because usually the employee is going to have to look for some other job. If the judge denies the request for a temporary injunction, the employer may decide to cut a deal with its former employee rather than spending more money on what may be losing lawsuit.

With this background information you are now equipped to understand what I’m going to say about companies laying off employees and then enforcing their non-competes.

Explanation of the Short Answer

You can now see why I say that, in theory, the way employment ended does not impact whether the non-compete is enforceable. As I said, the non-compete has two requirements, “ancillary” and “reasonable.” There’s nothing in the statute that says the employer can’t fire or lay off an at-will employee and then enforce the employee’s non-compete.

Of course, this doesn’t seem fair. It strikes most people as wrong that a company could fire an employee without good cause and then prevent the employee from working for a competitor. That’s probably why there is a common misconception that the employer can only enforce the non-compete if the employee quit, or if the employee was fired for good cause.

Our intuitive sense of fairness also tells us that a company shouldn’t be able to use a non-compete to prevent a former employee from making a living. And for many decades, Texas courts shared this sentiment. This led Texas courts to say that a non-compete must not be “oppressive” to the employee and must not restrain the employee from engaging in a “common calling.” See Hill v. Mobile Auto Trim, Inc., 725 S.W.2d 168, 171-72 (Tex. 1987).

But the 1989 statute did not include those two requirements. And the statute says its criteria for enforceability are “exclusive” and preempt any other criteria “under common law or otherwise.” Tex. Bus. & Com. Code § 15.52.

So, arguably, the Texas non-compete statute eliminates the burden on the employee as a factor in deciding enforceability of the non-compete. That means the employee cannot argue it is unfair or oppressive for the company to lay off the employee and then enforce the non-compete, right?

Well that’s the short answer, at least.

The Longer Answer

There are still some ways for the employee to argue it is unfair to enforce the non-compete against an employee who was laid off.

First, remember the reasonableness requirement. The non-compete must be reasonably limited and “not impose a greater restraint than is necessary to protect the goodwill or other business interest” of the employer. Tex. Bus. & Com. Code § 15.50(a).

In deciding what is reasonably necessary to protect the employer’s goodwill, the judge can take into account the circumstances of the employee’s departure. The scope may be more or less reasonable depending on whether the employee had a premeditated plan to quit and take customers to a competitor, as opposed to the employee getting laid off.

Second, keep in mind both the common-law requirements for a temporary injunction and the standard of review that applies to an appeal of a trial court’s decision on a temporary injunction. Put those together, and the result is that the trial court judge has a lot of wiggle room to grant or deny a temporary injunction.

For example, if the judge doesn’t think it would be fair to enforce a non-compete against an employee who got laid off, it’s pretty easy for the judge to say, “sorry, you may have a case for breach of the non-compete, but damages would be adequate to compensate for that, so I don’t see any irreparable injury.” The facts will almost always provide some support for that conclusion. And because of the “abuse of discretion” standard, it is very unlikely that the trial court judge’s denial of a temporary injunction will get reversed by the Court of Appeals.

Third, if the lawsuit is in federal court, then the company trying to enforce the non-compete has the burden to show that “the threatened injury outweighs any prejudice the injunction might cause the defendant.” BMC Software, Inc. v. Int’l Bus. Machines Corp., No. H-17-2254, 2018 WL 4530020, at *2 (S.D. Tex. Sept. 21, 2018) (citing Bluefield Water Ass’n, Inc. v. City of Starkville, 577 F.3d 250, 252-53 (5th Cir. 2009)). That opens the door to the employee arguing that the burden of getting laid off and then prevented from working for a competitor outweighs any loss of revenue to the company.

Fourth, the laid-off employee’s best friend may be the “industry-wide exclusion” rule, which I explain in Burning Down the Haass: The Industry-Wide Exclusion Rule in Texas Non-Compete Law.

That rule is really a subset of the first question of reasonableness, but it’s important enough to deserve its own category. Texas law says a non-compete that prohibits working for a competitor in the industry in any capacity is too broad. Usually, the non-compete must be tied to preventing the employee from taking the company’s customers with her. This is where I get Wolfe’s First Law of Texas Non-Compete Litigation: you can’t take your customers with you.

If you get laid off and want to go to work for a competitor, in most cases Texas law should allow you to do it, as long as you’re not trying to take your customers with you. That means you may have to start from scratch at a new company, at least until the non-compete expires, but at least you can get a job in the same industry.

The Practical Answer

But what if you want to take your customers with you? What if you’ve had those customers for years, even before you joined the company that laid you off? What if you’re mad as hell and you’re just not going to take it anymore?

You can fight, and you may have a shot at winning, but it’s going to cost you. If you have a non-compete, get laid off, and try to take your customers with you to a new company, chances are your former employer is going to file a lawsuit (assuming the dollar amount of lost business is worth fighting over). If you can’t afford to hire a lawyer to defend you, your chance of winning is not good.

So what’s it going to cost to defend yourself? I tackled this question in How Much Does a Texas Non-Compete Lawsuit Cost? at my YouTube channel, That Non-Compete Lawyer. As a rule of thumb, the first stage of the lawsuit through the temporary injunction hearing is going to cost you $10,000.

Of course, it’s just a rule of thumb. As I say in the video, it may be more, it may be less. But that number should give you some sense of what it’s going to take. If $10,000 is a huge amount of money to you, then maybe you shouldn’t be gambling at this table.

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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. This post is dedicated to Kenny Rogers.

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.

 

 

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.

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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.

 

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.

(A recent Texas Supreme Court case provides some additional support for the strict view; see Irreparable Injury, I presume?)

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 one 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.

While an industry-wide exclusion is generally unenforceable in Texas, that does not necessarily mean that the scope is reasonable just because it is not an industry-wide exclusion. In Forum US, Inc. v. Musselwhite, No. 14-17-00708-CV, 2020 WL 4331442 (Tex. App.–Houston [14th Dist.] July 28, 2020, no pet. h.) (mem. op.), the court rejected this argument. “While it is true that an industry-wide exclusion is almost always going to be unreasonable because it restrains more activity than necessary to protect the business interest of a former employer,” the court said, “the inverse of that statement will not always be true.” Id. at *6. The court held that the non-compete and non-solicitation provisions in a sales manager’s employment agreement were overbroad and unenforceable where not tailored to the manager’s activities while an employee. Id. at *7-11. In other words, the court applied the janitor corollary.

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D’Onofrio applied the industry-wide exclusion rule to the travel industry

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.

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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

Does the industry-wide exclusion rule 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.

But in Forum US, Inc. v. Musselwhite, No. 14-17-00708-CV, 2020 WL 4331442, at *11 (Tex. App.–Houston [14th Dist.] July 28, 2020, no pet. h.) (mem. op.), the court held that a provision prohibiting solicitation of employees was overbroad and therefore unenforceable, where it lacked “any limitation as to the employee’s type of position or whether they had any interaction with Musselwhite,” the defendant employee.

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.