Texas Trade Secrets 101 2.0

Texas Trade Secrets 101 2.0

Ready for an early Christmas present?

I originally published my “Trade Secrets 101” memo in Trade Secrets 101: What Texas Businesses and Lawyers Need to Know. I designed it to give Texas businesses and their lawyers a helpful overview of Texas and federal trade secrets law.

With generous help from lawyer Paul T. Freeman, I have now updated that memo. You can download the new version here.

Regrettably, the new version is longer. But it has significant improvements, including:

  • More case cites
  • A new section on TCPA motions to dismiss
  • Less of my unsupported editorializing

Finally, despite my general preference, the case cites have been moved to footnotes. Don’t @ me.

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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.

These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.

 

 

 

It’s Alive, It’s ALIVE! How to Kill a TCPA Motion in a Trade Secrets Lawsuit

It’s Alive, It’s ALIVE! How to Kill a TCPA Motion in a Trade Secrets Lawsuit

It’s Franken-steen

First let’s get something out of the way. The Texas Citizens Participation Act (TCPA) is a Frankenstein’s monster that the legislature created and now needs to reign in (not that they listen to me).

As I explained in a three-part series back in the summer of 2017, the TCPA grants defendants in certain cases the unusual right to require the plaintiff to prove its case before taking any discovery. In litigator jargon, it effectively lets the defendant file a “no-evidence” motion for summary judgment without first requiring an adequate time for discovery.

The statute was intended to curtail “SLAPP” lawsuits, e.g. where a big company sues a “little guy” in retaliation for exercising his right to publicly criticize the company. The idea was to stop litigation bullies from using groundless lawsuits to grind ordinary people into submission under the weight of crushing legal fees.

But the legislature in its wisdom used broad language in the TCPA, and the Texas Supreme Court applies the plain meaning of statutes (in theory). So the TCPA has taken on a bizarre life of its own. It can apply to just about any kind of lawsuit, including “departing employee” lawsuits where a company claims its former employees misappropriated trade secrets or other confidential information.

This really makes no sense. There is no compelling public policy reason why some defendants should have a right to file a motion to dismiss before any discovery takes place and others should not, depending on whether the lawsuit falls under the byzantine definitions in the TCPA.

Might this have been avoided by construing the statute “liberally”–rather than literally–as the statute itself tells courts to do?[1]

Maybe. But that ship has sailed. As Justice Pemberton wrote in a recent dissent, Texas courts now apply the TCPA as written, even when the implications “sound crazy.” As he noted, unintended consequences are likely when courts interpret statutes “superficially in a mistaken perception of plain-meaning textualism.”[2] So here we are.

The bottom line is that the TCPA will apply to most trade secrets lawsuits in Texas state court. And maybe in federal court too.

This raises several strategic questions in a Texas trade secrets lawsuit:

1. Can the plaintiff avoid the TCPA by filing the trade secrets lawsuit in federal court under the federal trade secrets statute?

2. Can the plaintiff in a trade secrets suit avoid the TCPA by “pleading around” it?

3. When should the defendant in a trade secrets case file a TCPA motion to dismiss?

4. What evidence does a trade secrets plaintiff need to offer to defeat a TCPA motion to dismiss?

In the words of MC Hammer, let’s “break it down.”

Some trade secrets strategery

First, it’s possible that the plaintiff may be able to avoid the TCPA by filing the trade secrets lawsuit in federal court rather than state court. The federal Defend Trade Secrets Act (DTSA) allows a plaintiff to file a trade secrets lawsuit in federal court as long as the case has some connection to interstate or foreign commerce, which means virtually every case.

Courts are divided about whether the TCPA applies in a federal case, and the Fifth Circuit has not yet resolved the issue.[3] It turns on whether the TCPA is considered “procedural” or “substantive,”[4] which is kind of like asking whether the Beatles were a rock band or a pop band.

Law professors and people who were on law review love this kind of question. Personally, I’m less intrigued. I initially assumed the TCPA was procedural and would not apply in federal court, but there are people smarter than me who argue it is substantive, and I’ll concede you can make a reasonable case for that. (If you want more details on this issue see the good summary in this Law360 article by April Farris and Matthew Zorn.)

If I had to predict, I’d say the Fifth Circuit will hold that the TCPA does not apply in federal court. But for now it remains an open question.

That means that filing your trade secrets lawsuit in federal court won’t necessarily get you out of the TCPA woods. Your choice of state or federal court will likely depend on other considerations, i.e. whether you prefer a judge appointed for life who can do whatever the *#$% he wants, or a judge with no experience who got swept into office because he picked the right political party.

Regardless of where you file your trade secrets suit, you can try to avoid a TCPA motion by pleading around the TCPA. Without getting too much into the weeds, the TCPA applies to claims that relate to “communications” about a matter of public concern. So one theory is that the plaintiff in a departing employee case can avoid the TCPA by pleading only use of the trade secrets rather than disclosure of the trade secrets. Disclosing a trade secret to the new employer is obviously “communicating” the information, so just don’t say anything about disclosure.

That’s what I mean by “pleading around” the TCPA. But this may be easier said than done. Even if the plaintiff does not expressly plead that the employee disclosed the trade secrets to the new employer, that allegation will often be implied.

Plus, the mere allegation that the employee has joined another company and used the plaintiff’s trade secrets may be enough to ensnare the plaintiff in the TCPA’s definitional web. The TCPA covers “a communication between individuals who join together to collectively express, promote, pursue, or defend common interests.”[5] Arguably, any time an employee goes to work for a competitor, there is necessarily going to be communication between employee and employer to “collectively . . . pursue . . . common interests.”

So, omitting allegations of trade secrets disclosure from your pleadings may not be sufficient to avoid the TCPA.

Defense wins championships

Now let’s look at it from the other side. If you represent the defendant in a trade secrets case, should you file a motion to dismiss under the TCPA? I see three potential benefits:

(1) obviously, the potential early dismissal of the lawsuit;

(2) smoking out the plaintiff and making him put his cards on the table (talk about mixed metaphors); and

(3) slowing down the plaintiff’s momentum.

Also, if you win the motion you have the right to recover legal expenses “as justice and equity may require.”[6]

The potential downside of filing a TCPA motion in a trade secrets case is that, if the court finds your motion was “frivolous or solely intended to delay,” you will lose the motion and be ordered to pay the plaintiff’s attorneys’ fees for responding to the motion.[7] That’s a momentum shift like throwing a pick-six in the first quarter.

So, deciding whether to file a motion to dismiss a trade secrets case will likely come down to whether you think the plaintiff has enough evidence to prove the claim.

This gets us to the last question: if the defendant files a motion to dismiss, what evidence does the plaintiff need to offer to defeat the motion?

As a threshold matter, the plaintiff can try to prove the TCPA does not apply to the lawsuit. But if the TCPA applies, the plaintiff will need to offer evidence of three essential elements:

(1) the information at issue is a “trade secret”;

(2) the defendant “misappropriated” the trade secret; and

(3) the misappropriation caused some injury to the plaintiff.

I cover the key points of these elements in my Trade Secrets 101 memo (soon to be updated and published in the Texas Journal of Business Law). And a recent opinion from the Tyler Court of Appeals provides a roadmap for offering evidence to support these elements.

But if that salt has lost its flavor . . .

In Morgan v. Clements Fluids South Texas, three employees left Clements, an oil and gas services company, to work for two competitors. Clements claimed it trained the employees on its proprietary system for well completion and production called “salt systems.” It sued the former employees in state court for breach of their NDAs and misappropriation of trade secrets, and the employees filed a motion to dismiss under the TCPA.[8]

The defendant employees met their initial burden to show that the trade secrets claim was factually predicated on conduct that falls within either the “exercise of the right of association” or the “exercise of free speech,” as defined by the TCPA. The court reasoned that the claim was “based on, relates to, or is in response to,” at least in part, the employees’ communications among themselves and within the competitors through which they allegedly “shared or utilized” the alleged trade secrets.[9]

The court then turned to the plaintiff’s burden to establish by “clear and specific” evidence a prima facie case for each element of its trade secrets claim. The TCPA “does not impose an elevated evidentiary standard,” the court said, “and circumstantial evidence and rational inferences may be considered.”[10]

To prove the information at issue was a trade secrets, Clements claimed it had a confidential method for salt systems that gave it a competitive advantage. Its vice president signed an affidavit stating that Clements invested millions of dollars for almost 33 years on research, development, training, and testing of its salt systems, that its system was not available through any outside source, that the system was not available outside the company, and that the system had made Clements the industry leader. The Court of Appeals concluded this was sufficient “clear and specific” evidence of a trade secret.[11]

Whether the employees misappropriated the trade secrets was a closer call. The defendants argued that Clements failed to prove misappropriation because it did not show the employees actually used the trade secrets. The employees signed affidavits denying that Clements provided them with any training they did not have before working for Clements, and denying they shared any Clements information with any third party.[12]

But the court found that Clements offered sufficient evidence of misappropriation to avoid dismissal. Specifically, Clements established:

(1) The employees had no experience in salt systems before working for Clements.

(2) Clements trained the employees to perform salt systems and disclosed its proprietary formula to them.

(3) The employees left Clements to go to a company, Greenwall, that was not doing salt systems.

(4) Shortly after that, Greenwell launched a salt systems business, announcing it in a website post authored by one of the employees.

(5) Greenwell then performed a salt systems job for Pioneer, one of Clements’ customers.

“Given Clements’ description of the time, money, and effort dedicated to the development of its salt systems,” the court said, “it is reasonable to conclude from the totality of the circumstantial evidence that [the employees] used Clements’ proprietary and confidential information in concert with Greenwell to launch its salt systems business.”[13]

Finally, Clements had to offer evidence it was injured by the trade secrets misappropriation. “The burden of proof on damages for misappropriation of trade secrets is liberal,” the court said, “and is satisfied by showing the misappropriation, the defendant’s subsequent commercial use, and evidence by which the jury can value the rights the defendant obtained.” The Texas Supreme Court does not require the plaintiff to establish a specific amount of damages in response to a TCPA motion. Clements was only required to offer evidence supporting a “rational inference as the existence of damages, not their amount or constituent parts.”[14]

The defendants argued that Clements failed to link its loss of the Pioneer job to the alleged misappropriation of trade secrets, but the court disagreed. Greenwell did not previously do salt systems jobs, it performed a salt systems job for Pioneer shortly after the Clements employees joined, and Clements had previously performed all of Pioneer’s salt systems jobs. This was sufficient circumstantial evidence to link the alleged misappropriation to Clements’ loss of Pioneer’s business, establishing an injury to Clements.[15]

The Morgan case teaches us that, while speculation and assumption are not evidence of trade secret misappropriation, you don’t need surveillance camera footage of the employee handing over the secret formula either. It’s enough to offer circumstantial evidence creating a reasonable inference that an employee has used the information to help a competitor take business from the plaintiff.

But Morgan was somewhat unusual. The plaintiff had actual evidence of a secret method that other competitors (allegedly) did not know or practice.

Most trade secrets cases don’t have this. The typical case involves “soft” trade secrets like customer lists, prices, and customer information. And usually the two competitors both do the same kind of non-confidential business before and after the employee changes jobs. In these cases, the fact that a customer follows an employee from one company to another doesn’t necessarily prove the employee used any confidential information. It could just mean the employee has a good relationship with the customer.

So plaintiffs in soft trade secrets cases beware. You will probably need “something more” than losing a customer to defeat a TCPA motion. At least until the legislature fixes the monster it created.

*Update: The TCPA has arrived in the oilfield. See McDonald Oilfield Operations, LLC v. 3B Inspection, LLC, No. 01-18-00118-CV, 2018 WL 6377432 (Tex. App.–Houston [1st Dist.] Dec. 6, 2018) (reversing trial court’s denial of TCPA motion to dismiss in departing employee case involving competitors in the pipeline monitoring business). 

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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. Most of his posts don’t have so many footnotes.

These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.

[1] Tex. Civ. Prac. & Rem. Code § 27.011(b) (“This chapter shall be construed liberally to effectuate its purpose and intent fully”).

[2] Hawxhurst v. Austin’s Boat Tours, 550 S.W.3d 220, 233-35 (Tex. App.—Austin 2018, no pet.).

[3] Thoroughbred Ventures, LLC v. Disman, No. 4:18-CV-00318, 2018 WL 3472717, at *3 (E.D. Tex. July 19, 2018).

[4] Even if the TCPA is substantive, it may not apply in federal court because it conflicts with Federal Rules of Civil Procedure 12 and 56. Id. at *3.

[5] Tex. Civ. Prac. & Rem. Code § 27.001(2).

[6] See Tex. Civ. Prac. & Rem. Code § 27.009(a)(1). A successful movant also has the right to recover sanctions sufficient to deter the plaintiff from filing similar lawsuits, see § 27.009(a)(2), but it will probably be a rare trade secrets case where the court finds such sanctions are needed in addition to attorneys’ fees.

[7] See Tex. Civ. Prac. & Rem. Code § 27.009(b) (“If the court finds that a motion to dismiss filed under this chapter is frivolous or solely intended to delay, the court may award court costs and reasonable attorney’s fees to the responding party”).

[8] Morgan v. Clements Fluids South Texas, Ltd., No. 12-18-00055-CV, 2018 WL 5796994, at *1 (Tex. App.—Tyler Nov. 5, 2018, no pet. h.).

[9] Id. at *3.

[10] Id. at *4 (citing In re Lipsky, 460 S.W.3d 579, 586 (Tex. 2015)).

[11] Id. at *5-6.

[12] Id. at *7.

[13] Id. at *8. However, as to a third employee, Laney, the court held that Clements did not meet its burden. Unlike the evidence concerning the first two employees, Clements offered no evidence, circumstantial or otherwise, that Laney disclosed or used the trade secrets at his subsequent employer, ChemCo. And there was no evidence of whether Chemco had performed salt systems before, or that Laney performed any salt systems jobs with ChemCo. Id.

[14] Id.

[15] Id. at *8-9.

Essentials of Texas Non-Compete Litigation (the Viral YouTube Sensation)

Essentials of Texas Non-Compete Litigation (the Viral YouTube Sensation)

Fivers, did you know I have a YouTube channel? It’s called That Non-Compete Lawyer. I named it that because I’m a lawyer, and . . . ok, you get it.

I thought about naming it That Houston Lawyer Who Does a Lot of Different Kinds of Business Litigation but in Recent Years Mainly Litigation Involving Departing Employee Issues Like Non-Competes and Trade Secrets*. But that just didn’t have the same ring to it.

Anyway, I’ve had this YouTube channel for a while. It’s the home for my series of videos explaining non-compete issues in a way that lawyers and other humans can both easily understand.

It’s also the hub for my series of “Top 5 Tuesday” videos. I consider them both insightful and hilarious, providing useful legal information in an entertaining way, while critics have expressed amazement at how they manage to be dull and frivolous at the same time.

But now I’ve launched something even more amazing: Essentials of Texas Non-Compete Litigation. It’s a 30-minute video course in 15 installments. As you math majors will deduce, that’s an average of two minutes per installment.

And I would venture to say there has never been a better 30-minute YouTube course on Texas non-compete litigation. I mean, it’s no Dude Perfect, but I think you’ll like it. And when you watch, be sure to follow along with my free Study Guide. It has helpful case cites and tips on additional reading. (Spoiler: there’s a heavy dose of Five Minute Law posts in the “Additional Reading.”)

Love it? Hate it? Is there something essential I left out? Did I get anything wrong? Was there anything I could have cut? If so, I’m pretty sure there is a way to communicate that to me through YouTube’s popular platform. Or if you’re not that tech-savvy, you can just text me on your flip phone.

FAQ

Is Essentials of Non-Compete Litigation approved for CLE credit in Texas? No, but I’ll look into that.

Is it better to watch one episode at a time, or to binge-watch the whole series in one weekend? I leave this to your discretion.

Can one Texas trial lawyer cover the essentials of Texas non-compete litigation in just 30 minutes? There’s only one way to find out.

Is there a GoFundMe campaign to get you better lighting and sound? Not yet, but I like the way you think.

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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. He hopes to continue litigating even after becoming a viral YouTube sensation. 

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.

*Not certified by the Texas Board of Legal Specialization

Wolfe’s First Law of Texas Non-Compete Litigation

Wolfe’s First Law of Texas Non-Compete Litigation

It’s my anniversary. Two years ago today I launched this blog with What a Litigator Looks For in the Typical Texas Non-Compete. I thought it best to start with a topic I know. I outlined the five things I look for to determine if a non-compete is enforceable under Texas law.

That post has held up pretty well. Since then, I’ve seen plenty more non-competes. Texas non-compete law hasn’t fundamentally changed, and I still look for those five things. So, if you want an intro to Texas non-compete law, that post is still a good place to start. Or you can watch a video version here.

But two more years have taught me there is a simpler question to ask when a client brings me a non-compete. As a general rule, you can boil down the practical effect of Texas non-compete law to just seven words: you can’t take your customers with you.

What do I mean? If you’re a sales person who has a non-compete and relationships with customers—the most common situation—it is likely a judge will order you not to do business with your customers from your previous company. But the judge shouldn’t completely bar you from working for a competitor.

In other words, you can compete for new customers, but you can’t take your old customers with you. I call this Wolfe’s First Law of Texas Non-Compete Litigation.*

It’s really more of a general rule, but I like the sound of “First Law” more than “First General Rule.”

It’s just a rule of thumb because like most legal rules, it has exceptions, and the whole truth is more complicated. Still, experience has taught me that nine times out of ten, my First Law will hold true.

This means if you’re an employer trying to stop an employee from violating a non-compete, you can probably prevent the employee from taking her customers with her, but you probably can’t do more than that.

If that’s all you need to know, you can stop here. If you want to understand why, read on.

The reasoning behind Wolfe’s First Law of Texas Non-Compete Litigation

Here’s how I get there. The Texas non-compete statute has two requirements: (1) a non-compete must be “ancillary to an otherwise enforceable agreement,” and (2) it must be reasonable.

Employers usually meet the first requirement by (a) expressly stating in the non-compete that they will give the employee confidential information, and (b) actually giving the employee confidential information. A Texas Supreme Court case called Sheshunoff clarified that this will do the trick.

This is where the first big exception comes in. You will sometimes run across a non-compete that does not expressly promise to give the employee confidential information. Usually when you see that it’s either a really old non-compete, or a non-compete drafted for a multi-state company without Texas in mind.

If there is no express promise, you have to look at whether there was an implied promise to provide confidential information. A case called Mann Frankfort said the promise is implied if the nature of the employee’s work necessarily involves providing confidential information. That can be a fact-intensive issue.

Most employers avoid this detour by including an express promise to provide confidential information in the non-compete. Then the second big exception comes into play: did the employer actually provide confidential information to the employee?

I have had cases where there was a genuine dispute about whether the information was really confidential. You are more likely to see this in situations where an employee already had a book of business when he joined the company, or where sales people are entirely responsible for generating their own leads and customers. If the employer didn’t provide confidential information, the non-compete is unenforceable.

But most of the time, it’s pretty easy for the company to show that it provided some confidential information to the employee.

Now that we’ve cleared those possible exceptions out of the way, it’s time to turn to reasonableness.

Let’s be reasonable

Like most states, Texas requires a non-compete to be reasonable in time period, geographic area, and scope of activity restrained.

The good news for employees is that there is almost always at least a decent argument that some aspect of the non-compete is unreasonably broad. Especially the “scope of activity” part. While most Texas lawyers are pretty good about including a reasonable time period and geographic limitation, Texas non-competes are often too broad in the scope of activity they restrict.

Maybe this is because the scope of activity limitation is largely defined by the case law, so a lawyer who only reads the statute won’t get the whole picture. The case law says that an “industry-wide exclusion”—a restriction that prevents the employee for working in the same industry in any way—is too broad.

That’s because a non-compete should be limited to protecting the employer’s goodwill, i.e. its relationships with existing customers. The simplest way to do this is to say–usually in one really long sentence with fancier words–that the employee can’t take her customers with her. That’s a reasonable scope (generally). On the other hand, a non-compete that bars the employee from working for a competitor in any way is usually too broad and therefore unenforceable as written.

But employees shouldn’t get too excited. There is also good news for the employer.

First, note I said unenforceable “as written.” The non-compete statute says that if the non-compete is too broad, the judge must reform it—i.e., rewrite it—to the extent necessary to make it reasonable.

Second, even if the non-compete is too broad, as a practical matter a judge can still issue a temporary injunction to enforce the non-compete to a reasonable extent.[1] (A temporary injunction is an order that applies while the lawsuit is pending.)

Now you can see Wolfe’s First Law coming into focus. When you put all this together, you get two likely scenarios. If the non-compete is reasonable in scope because it is limited to preventing the employee from taking her customers with her, then the judge is likely to grant a temporary injunction that enforces the non-compete as written. If the non-compete is unreasonable in scope because it is not so limited, the judge is likely to limit the injunction to a reasonable scope, i.e. preventing the employee from taking her customers with her.

In either case, the effect is the same. And Wolfe’s First Law of Texas Non-Compete Litigation holds true.

Caveat Five-or

Again, there are exceptions. For example, some judges take the “irreparable injury” rule seriously. That rule says that a court should not grant an injunction if damages would be adequate to compensate the company for the employee’s violation of the non-compete.

My personal view—perhaps a post for another day—is that courts should apply this requirement more strictly. In most cases damages would be adequate to compensate the employer for any lost customers.

But most judges are not so fastidious about the irreparable injury rule. If the judge thinks the employee is violating the non-compete by steering competitors to the employee’s new company, a temporary injunction is likely.

Of course, a temporary injunction is not the end of the story. It is temporary, after all.

Still, in most cases a temporary injunction enforcing the non-compete might as well be a permanent injunction. Why? Remember that a non-compete must be reasonably limited in time. Time periods of three years or longer have sometimes been held reasonable, but most non-competes are limited to one or two years.

How long do you think it usually takes for a case to get to trial? (Hint: at least one or two years.) That means that in many cases, the non-compete will expire before the case goes to trial, or around that time. That’s why I say a temporary injunction might as well be a permanent injunction.

So maybe we should modify Wolfe’s First Law to say this: you can’t take your customers with you, until a year or two after you leave.

But that just doesn’t have the same ring to it.

*Update: There is an important exception: cases where I represent the defendants. But seriously, what if the employee isn’t “taking” the customers, but the customers want to follow the employee without any solicitation by the employee? That’s a different question.

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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. Someday he will come up with a “Wolfe’s Second Law” for something.

These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.

[1] Reformation is a remedy that typically would not be granted until a final judgment after trial. There is some legal question about whether the judge at a temporary injunction hearing should (1) reform the non-compete as a temporary remedy and enter a temporary injunction enforcing the reformed non-compete, or (2) simply enter a temporary injunction that only partially enforces the non-compete to a reasonable extent. The distinction seems largely academic.

Blown Call: The Thing Texas Courts Get Wrong About Non-Competes

Blown Call: The Thing Texas Courts Get Wrong About Non-Competes

Is the reasonableness of a Texas non-compete a question of law or a question of fact?

I was once defending a Texas non-compete lawsuit and taking the deposition of the business owner who was trying to enforce the non-compete. I asked if he had any view of what a reasonable length of time for the non-compete would be. His answer: “when hell freezes over.”

That’s why I love litigation.

Recalling that answer got me thinking about an important issue in non-compete law: Is the reasonableness of a non-compete a question of law or a question of fact? If you’ve read a few Texas non-compete cases, you may already know the answer. There are dozens of cases reciting that the reasonableness of a non-compete is a question of law.

And all of those cases are wrong.

Or at least they are only partially correct. Why?

Before we can answer that question, we need to tackle a deeper jurisprudential question, the kind that law professors love: what is the difference between a question of law and a question of fact?

Deep thoughts on questions of law and fact

Let’s start with the easy part. A pure question of law is a legal issue that can be stated entirely in the abstract, without any reference to the particular facts of a case. Let’s say you’re in a car crash and the question is “what is the statute of limitations for a negligence claim?” That’s a pure question of law.

That doesn’t necessarily mean the question has a simple answer. It just means you can answer the question without knowing anything about any facts. For example, the general rule in Texas would be that you have to file a negligence lawsuit within two years of the car accident.

A pure question of fact, on the other hand, has nothing to do with law. “Did the defendant run a red light?” is a pure question of fact. (There are also “mixed” questions of law and fact, the classic example being whether a defendant was negligent, but let’s put that aside for the moment.)

It gets more complicated when the question applies an abstract legal principle to a particular scenario. Let’s take the question “does the statute of limitations start running at the time of the accident, or when the plaintiff discovered the extent of his injuries?” That sounds more factual, but it’s still a question of law, because it simply applies an abstract principle to a given factual situation.

Now let’s make it harder. My lawyer readers will know the “discovery rule.” The discovery rule is an exception that keeps the limitations clock from starting until the plaintiff discovered, or reasonably should have discovered, the injury. Is applying the discovery rule in a particular case a question of law or a question of fact?

This is where judges tend to go wrong. Perhaps nothing provides a better opportunity for superficial judicial analysis than whether an issue is a question of law or fact.

For example, if the judge thinks it’s a question of fact, she will typically write “the discovery rule is a question of fact for the jury,” cite some cases that said it was a question of fact, and be done with it. Similarly, if the judge thinks it’s a question of law, the judge will write “the discovery rule is a question of law,” cite some cases that said that, and move on.

This is superficial, and wrong. If judges would only remember what their law school professors said, they would say the answer is “it depends.”

It depends. Of course, it depends! It depends on what the evidence is. For example, if the undisputed evidence shows that the plaintiff discovered his injury more than two years before filing suit, then it’s a question of law. You’re just applying a legal principle to an undisputed set of facts. But if there is conflicting evidence about when the plaintiff discovered his injury (or should have discovered it), it’s a question of fact.

Pretty simple, right? But trust me, courts mess this up all the time. Sometimes it may just be intellectual laziness. But often it’s more than that.

Does it matter whether it’s a question of law or fact?

You may be wondering why it matters. What difference does it make whether we call an issue a question of law or a question of fact? Isn’t this just philosophical musing?

No. It matters whether an issue is a question of law or fact because that determines who gets to decide the issue. If it’s a question of law, the judge decides. But if it’s a question of fact, that means the factfinder gets to answer the question. Depending on the type of proceeding, the factfinder could be the judge, the jury, or an arbitrator.

Now, I know a lot of my Fivers are stone-cold realists. You may question whether there is any principled distinction between a question of law and a question of fact. You might say that asking “is it a question of law or fact?” is nothing more than asking “does the judge or the jury get to decide the question?”

That would be going too far. The distinction between a question of law and a question of fact is real, even if it is sometimes difficult to draw that line. But it is important to understand that the practical effect of the answer is to determine whether the judge or the jury gets to decide.

Whether the issue is a question of law or question of fact also determines who gets to decide the issue on appeal. Generally, the appellate court will defer to the factfinder on questions of fact but will decide questions of law de novo. “De novo” is a Latin phrase that means “I don’t care what a lowly trial court judge thinks.”[1]

Is the picture coming into focus now? If I’m the judge and I have a certain view of what a fair outcome would be, might that have some effect on whether I characterize an issue as a question of law or question of fact?

Let’s take our statute of limitations example. If I think the case should go to trial, I might be inclined to simply proclaim that the discovery rule is a question of fact for the jury and leave it at that. Conversely, if I think the case has no merit, I might be inclined to say it’s a question of law and grant summary judgment for the defendant.

I’m not necessarily suggesting there is anything sinister about this. Even the most impartial judges will tend to characterize the issue in a way that favors an outcome they sincerely believe is fair and just. That’s true even before you add external forces to the mix—say, campaign contributions from “tort reform” groups or plaintiff’s lawyers.

But there is a better way: it depends. It depends on the evidence. If the relevant evidence is undisputed, it’s a question of law. If the relevant evidence is conflicting, it’s a question of fact.

This proposition, though often ignored, shouldn’t be controversial. If you think it’s wrong, please tell me why.

Let’s apply what we’ve learned 

Now let’s apply this not-so-controversial principle to a typical Texas non-compete.

Texas, like most states, requires a non-compete to be reasonable in time period, geographic area, and scope of activity restrained. So, is the reasonableness of a Texas non-compete a question of law or a question of fact?

You already know where this is headed, but let’s break it down.

What do we mean by “reasonable,” as applied to a non-compete? Fortunately, the Texas non-compete statute gives us a clue. It says the non-compete must have “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.”[2] For the typical Texas non-compete, which is tied to a confidentiality agreement, reasonableness comes down to whether the limitations are no greater than necessary to protect the company’s goodwill and confidential information.

So how about a three-year time period? Is that reasonably necessary to protect the employer’s goodwill and confidential information? And what about a geographic area of the State of Texas? Is that reasonable?

You’re probably having trouble answering these questions in the abstract. That’s because you don’t know anything about the facts of the case. It would make a difference whether it takes three months or three years for the confidential information to become outdated and useless. It matters whether the company sells products to customers throughout the State of Texas or in just one city.

If you don’t know the answers to these questions, there is no way you can know if the time period and geographic area are reasonable. You simply cannot determine the reasonableness of the non-compete in the abstract.

And yet, many Texas cases recite that the reasonableness of the non-compete is a question of law. As I said earlier, that is either wrong or only partially correct. Reasonableness could only be a question of law if the facts concerning reasonableness are not in dispute. If there is conflicting evidence material to reasonableness, it’s a question of fact.

And I can prove it. My witness is the Texas legislature, and my Exhibit 1 is Section 15.51 of the Texas Business and Commerce Code. It says:

If the primary purpose of the agreement to which the covenant is ancillary is to obligate the promisor to render personal services, for a term or at will, the promisee has the burden of establishing that the covenant meets the criteria specified by Section 15.50 of this code. . . . For the purposes of this subsection, the “burden of establishing” a fact means the burden of persuading the triers of fact that the existence of the fact is more probable than its nonexistence

Let me translate. This means that for a non-compete in a typical employment agreement, the employer has the burden of proving the non-compete is reasonable.

This proves my point that the reasonableness of a non-compete can be a question of fact, provided there is conflicting evidence. How else could there be a burden of proof on the issue? Questions of law don’t have a burden of proof.

Why this matters in non-compete litigation

This explains why I was asking that deposition question about a reasonable time period for the non-compete. I knew it was the employer’s burden to prove that the time period in the contract was reasonable. I wanted to nail down whether the employer had any evidence to offer that the time period was reasonable. He didn’t.

Wait a minute, you say. Even if you’re technically correct, isn’t this just a case of sloppy language? Opinions that say it’s a question of law may still be getting the result right, if the undisputed facts of the case establish that the non-compete was either reasonable or unreasonable.

True. But the issue is not academic. For one thing, treating reasonableness of a non-compete as a question of law tends to favor enforcement of the non-compete. In theory, the judge could just as easily find a non-compete unenforceable as a matter of law. But in practice, the vast majority of cases that say reasonableness is a question of law also say the non-compete was reasonable, and therefore enforceable. So, the outcome of this philosophical issue can make a real practical difference.

Now that I’ve cleared this up, when can we expect Texas appellate courts to stop proclaiming without qualification that the reasonableness of a non-compete is a question of law for the court?

I’d say probably when hell freezes over.

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

These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.

[1] Appellate lawyers call this the “standard of review.” Standard of review is one of those issues that is really, really exciting for appellate lawyers and boring for just about everyone else.

[2] Tex. Bus. & Com. Code § 15.50(a).

Nothing But Net: Fifth Circuit Reverses Gross Profits Award

Nothing But Net: Fifth Circuit Reverses Gross Profits Award

There’s a joke about a CEO who gets a quarterly profit and loss statement showing his company is losing money. “That’s impossible,” he says to the CFO, “all five divisions reported they were profitable this quarter.”

CPA humor. There’s nothing like it.

How could all five divisions make a profit while the company shows a loss? In a word: overhead. Each division is probably calculating its profits without deducting an appropriate share of the company’s overhead expenses.

This is not just a problem for accountants and CEOs. Litigators have to deal with this issue when there is a claim for lost profits damages. Any time a plaintiff tries to calculate lost profits—with or without help from an expert—there is the thorny issue of overhead.

A recent decision from the Fifth Circuit Court of Appeals shows how important this issue can be.  In Motion Medical Technologies v. Thermotek, the Fifth Circuit reversed a jury’s award of over $1.5 million in fraud damages because the award was based on evidence of gross profits, not net profits.[1]

Why? Gross profits don’t account for the company’s overhead, while net profits do. The plaintiff had only offered evidence of gross profits, and Texas law requires evidence of net profits.

Simple in theory, but not so simple in practice. Let’s take a closer look.

An accounting lesson from a litigator

To illustrate, let’s take my favorite hypothetical company, Paula Payne Windows. Paula Payne buys windows from manufacturers and sells them to its customers.

*WARNING* I have no background in accounting, other than litigating cases with accounting issues, so you could say I know just enough accounting to be dangerous. But here we go.

Paula Payne’s revenue is what the customer pays Paula Payne for the windows. Paula Payne’s cost of goods sold (COGS) is what it pays the manufacturer plus the cost of shipping. Revenue minus COGS is gross margin, or gross profit. Gross profit minus overhead is net profit.

So, Paula Payne’s oversimplified P&L for a big window sale looks like this:

Screen Shot 2017-11-18 at 9.34.00 PM

Yeah, I know, there’s also stuff like interest, taxes, depreciation, etc. That’s why I say oversimplified.

Plus, there’s usually some wiggle room in each line. For example, it’s clear that the money Paula Payne pays the trucking company to deliver the windows is part of COGS, but what about the lady in the office who talks to the trucking companies on the phone all day? Is her salary part of overhead or COGS?

Then there is the question of allocation. What share of Paula Payne’s total overhead should it allocate to one particular sale, or group of sales?

You may be thinking that’s what an accounting expert is for. We’ll just ask a CPA how to allocate overhead based on Generally Accepted Accounting Principles (GAAP), right?

The problem, I’ve learned, is that GAAP doesn’t really care how you allocate expenses for any particular transaction. GAAP deals with “financial accounting,” which is how you get to the P&L statement the company provides to the outside world. GAAP wants to make sure that all expenses are deducted before you get to the bottom line. It doesn’t really care how the company slices and dices those expenses internally.

That’s “management accounting,” which is not governed by GAAP. If a company wants to figure out internally how much net profit it makes on a particular transaction, it can use pretty much any reasonable method it wants.

*Update: Some accountants tell me the right way to allocate overhead expenses is to distinguish between variable and fixed. To determine net profit, you deduct the variable expenses, i.e. the ones that rise and fall with changes in sales volume, not the fixed ones. You can look historically at the company’s P&Ls to see which are variable vs. fixed.

But my accountant readers (I have at least two) are probably cringing at my explanation by now, so let’s get to something I know better: litigation.

How not to calculate lost profits in litigation

In Motion Medical, ThermoTek sold a medical device called the “VascuTherm” system. Orthoflex, a rival company, allegedly misappropriated information about Thermotek’s device and started selling its own knockoff device. ThermoTek sued Orthoflex for unfair competition and fraud.

The unfair competition claim was preempted by federal copyright and patent law.[2] That’s an important issue in its own right, but I’ll leave it to a smarter IP lawyer to blog about that. Let’s focus on the damages for the fraud claim.

ThermoTek’s expert witness testified that he used ThermoTek’s gross profit margin, meaning gross sales minus cost of goods sold, to calculate lost profits. He determined total lost profits for lost sales of the VascuTherm system by multiplying average monthly sales by unit sales price and relevant time period, and then deducting cost of goods sold.

“But that is the very definition of gross profits,” the Fifth Circuit scolded. “Indeed,” the court said, “the expert himself conceded on cross-examination that his numbers reflected ‘gross profits rather than net profits.'” The expert also acknowledged “his margins were high because they did not account for ThermoTek’s other business expenses.”[3]

The problem for the plaintiff was that Texas law requires the plaintiff to prove net profits, measured by the plaintiff’s total receipts minus all expenses incurred in carrying on the business. So, in the words of Willie Wonka, “You get nothing! You lose! Good day, sir!”

But surely it wasn’t that simple, right?

Well, it turns out there are some exceptions. First, for certain intellectual property claims, the plaintiff can seek an “accounting” of lost profits, where the plaintiff only has to offer evidence of its gross profits, and the burden is on the defendant to prove any costs that should be deducted to get to net profits. But ThermoTek’s common-law fraud claim was not such a claim.

Second, the court acknowledged that a plaintiff’s failure to include overhead expenses in the calculation of lost profits is “not fatal” if, for example, there is evidence the plaintiff was already profitable when the damages began and could have made the lost sales using only its existing resources.[4] But that argument, Judge Higginson wrote for the court, was not made by ThermoTek or supported by the trial record.

Perhaps this part of the opinion points to a solution for plaintiffs. Imagine ThermoTek’s expert had simply testified, “I didn’t deduct any overhead because ThermoTek was already profitable when the lost sales started, and my investigation satisfied me that ThermoTek could have made those additional sales without any increase in its overhead.” Would the gross profits award then be affirmed?

Lessons for litigators from Motion Medical

That last question points to some lessons litigators—and their hired experts—can learn about lost profits damages from Motion Medical.

If you represent the plaintiff, work with your damages expert early on to decide whether to calculate lost profits based on gross profits or net profits. The safer course, of course, is to go with net profits. In that case, the tricky part is figuring out what percentage of the plaintiff’s overhead to allocate to the lost sales. But as long as the expert uses some reasonable method of allocation, you should be ok.

On the other hand, safer isn’t always better. Net profits may undercompensate your client. If the plaintiff company was already profitable, and if you can make a credible argument that the company would have made the additional sales without any increase in its overhead, you may want to be more aggressive and go for gross profits, relying on the second exception cited in Motion Medical. But be careful. Make sure you offer evidence to support those assumptions, and prepare your expert to explain why overhead was not deducted.

If you represent the defendant, you have some strategic choices to make if the plaintiff presents a damage theory based on gross profits.

First, for the defense there is always the dilemma of whether to designate a damages expert at all. You worry that presenting an expert to calculate the plaintiff’s damages implies that your client did something wrong and that the plaintiff was, in fact, damaged. Often you would rather just attack flaws in the plaintiff’s calculation.

On the other hand, if the plaintiff’s expert offers an inflated lost profits calculation, and you offer nothing, you may get stuck with the plaintiff’s number.

The second decision is when to attack a calculation of gross profits that you think is defective. If you’re working hard to settle the case, you may want to press the issue earlier, e.g. hammering on it at mediation.

But generally I prefer to wait until trial, when it is too usually late for the plaintiff to fix a defective damage calculation. If I represent the defendant, it’s not my job to tell the plaintiff how to do a proper lost profits calculation.

Or is it?

Is it unprofessional to wait until trial to attack a gross profits calculation?

On at least two occasions I waited until trial to argue that the plaintiff’s damage calculation was defective because it didn’t deduct all the necessary expenses. It did not make me popular with opposing counsel.

In one case, I sent interrogatories to the plaintiff asking about its calculation of damages. The plaintiff responded with a calculation that was obviously based on lost revenues, not lost profits. I sat back and waited.

Then, less than 30 days before trial, plaintiff’s lawyers realized they had a problem and tried to cure it with a new calculation that included expenses. I objected. Strenuously. The judge said sorry plaintiff, you don’t get to offer any evidence of damages. Opposing counsel was livid.

In another case, the plaintiff offered evidence of the profits my client made from its alleged wrongdoing, without deducting any overhead. When the president of my client took the stand, I asked “what is your monthly overhead?” You’d think I had kicked an anthill. The defense lawyers practically jumped up and down complaining “he didn’t produce any documents showing overhead!”

My response: “you didn’t ask for them.” Objection overruled.

In both cases, the plaintiff’s lawyers kind of took it personally. They were pretty angry with me. Now, when someone gets really angry with you, there’s a part of you that instinctively feels a little guilty, like maybe you did something wrong (unless you are a sociopath).

So it made me wonder, was it unprofessional of me not to warn them that I was going to attack their defective damage theories? In the first case, should I have relented and said, “ok, it’s no big deal, you can offer your revised calculation”? In the second case, should I have provided information on my client’s overhead in advance?

Tell me what you think.

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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. Most of his accounting knowledge comes from watching “Shark Tank” with his son. 

These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.

[1] Motion Med. Tech., LLC v. Thermotek, Inc., 875 F.3d 765, 779-80 (5th Cir. 2017). The jury’s award of $6 million for unfair competition was reversed on other grounds.

[2] Id. at .

[3] Id. at 776-78.

[4] Id. at 780 (citing ERI Consulting Eng’rs, Inc. v. Swinnea, 318 S.W.3d 867, 879 (Tex. 2010)).

First Western: A Court of Appeals Decision on the Defend Trade Secrets Act

First Western: A Court of Appeals Decision on the Defend Trade Secrets Act

TexasBarToday_TopTen_Badge_VectorGraphicAh, the fall season, it’s finally here. When the Astros win the World Series, the Cowboys win as many games as they can while Ezekiel Elliott can still play, and the sweet smell of pumpkin pie and indictments wafts through the nation’s capital. The only thing that could make fall better would be a real Court of Appeals decision applying the relatively new Defend Trade Secrets Act.

And then it appeared like the Great Pumpkin, the day before Halloween.

In one of the first Court of Appeals decisions applying the federal Defend Trade Secrets Act, the Tenth Circuit Court of Appeals recently held in First Western Capital Management Co. v. Malamed that a plaintiff must prove irreparable harm to get a preliminary injunction under the Act.

If you know anything about injunctions, that probably doesn’t surprise you. “Irreparable harm” is one of the traditional requirements for obtaining an injunction.

But it wasn’t that simple. The plaintiff made the plausible argument that, because the statute authorizes an injunction and does not expressly require proof of irreparable harm, then evidence of irreparable harm is not required. In other words, there is a presumption of irreparable harm when the plaintiff proves the statute was violated.

The Tenth Circuit rejected this argument. The Court of Appeals reconciled its prior decisions by drawing a distinction between a statute that mandates injunctive relief and a statute that merely authorizes injunctive relief. When a statute only authorizes an injunction—as the DTSA does—then the plaintiff still has to prove the “traditional” requirements for an injunction, including irreparable harm.

The district court had already found that the plaintiff did not prove irreparable harm, so the Court of Appeals reversed the preliminary injunction. (You can read more about the district court opinion here.)

So what does this case from Colorado mean for lawyers who handle trade secrets litigation in my home state of Texas?

Lessons from First Western: Plaintiffs should offer evidence of irreparable injury

As I said here, if you represent a plaintiff asking for a preliminary injunction in a Defend Trade Secrets Act case, you should offer evidence of irreparable harm. Then you can make two arguments. First, we’ve proven irreparable harm. Second, even if we haven’t proven irreparable harm, we don’t have to.

Unless and until the Fifth Circuit Court of Appeals holds that the Tenth Circuit got it wrong in First Western, you don’t want the second argument to be your only argument; you want it to be your fallback position. So come prepared with evidence of irreparable harm.

But what evidence is that?

There is no single way to show irreparable harm, but here are a few typical arguments that damages would be inadequate to compensate your client for the defendant’s use of your client’s trade secrets:

  • It will be difficult to quantify the amount of damages.
  • Loss of the trade secrets at issue will be irreversible.
  • It’s unlikely the defendant has sufficient assets to satisfy a judgment for damages.

These arguments don’t always hold up to scrutiny, but you want to have something to argue. The judge will feel more comfortable granting an injunction if you at least offer some evidence to try to show irreparable harm.

Of course, if you represent the plaintiff you can still argue that proving a violation of the statute is sufficient. There is some authority in the Fifth Circuit for the proposition that “where a statute expressly provides for injunctive relief, irreparable harm is presumed and need not be established.”[1]

You can also cite pre-DTSA case law holding that the threatened disclosure of trade secrets is presumed to cause irreparable injury.[2]

But you don’t want to put all your eggs in one basket.

Should the First Western principle apply to Texas statutes?

If you represent the defendant in a Texas trade secrets lawsuit, First Western can help you in two ways. First, and more obvious, you can cite First Western for the argument that the plaintiff still has to prove irreparable harm to get an injunction under the Defend Trade Secrets Act.

First Western isn’t binding in the Fifth Circuit, you can concede, but its reasoning is sound. When Congress passed the DTSA, it was well aware (in theory) of the long-established principle that courts require proof of irreparable injury to get an injunction. If Congress had wanted to excuse plaintiffs from that requirement, it could have expressly said so.

Second, and perhaps less obvious, defendants can argue that the principle applied in First Western should also apply to the Texas trade secrets statute and the Texas non-compete statute.

Like the Defend Trade Secrets Act, these statutes expressly authorize but do not require injunctions.

Just as the DTSA says a court “may grant” an injunction, the Texas non-compete statute says that a court “may award” injunctive relief.[3] Similarly, the Texas Uniform Trade Secrets Act says that actual or threatened misappropriation of trade secrets “may be enjoined.”[4]

The fact that these statutes do not mandate an injunction for violating the statute means that the plaintiff still has to prove the traditional equitable requirements for obtaining an injunction—including irreparable harm.

At least that’s the argument, applying the distinction from First Western.

Just keep in mind there have been some Texas cases going the other way, suggesting that proof of irreparable injury is not required because the non-compete statute preempts other law and expressly authorizes injunctions.[5]

Personally, I think that’s wrong, but until the Texas Supreme Court definitively decides the issue, if I represent the plaintiff I may at least make the argument that proof of irreparable injury isn’t required.

Now if only I could convince the Second Circuit to let Zeke play.

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

These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.

[1] See, e.g., U.S. v. McMillan, 946 F. Supp. 1254, 1266 (S.D. Miss. 1995) (citing  EEOC v. Cosmair, Inc., 821 F.2d 1085, 1090 (5th Cir. 1987), and U.S. v. Hayes Int’l Corp., 415 F.2d 1038, 1045 (5th Cir. 1969)).

[2] See Heil Trailer Int’l Co. v. Kula, 542 Fed. Appx. 329, 335 (5th Cir. 2013) (citing Texas cases). Courts are a little imprecise about this. You could read the cases to say that the disclosure of trade secrets is irreparable injury, or that disclosure of trade secrets excuses the plaintiff from proving irreparable injury, but the distinction may be academic.

[3] Tex. Bus. & Com. Code § 15.51(a).

[4] Tex. Civ. Prac. & Rem. Code § 134A.003(a).

[5] Compare Sanders v. Future Com, Ltd., No. 02-15-00077-CV, 2017 WL 2180706, at *10 (Tex. App.—Fort Worth May 18, 2017, no pet.) (mem. op.) (plaintiff that proves violation of non-compete statute is entitled to permanent injunction without showing of traditional injunction elements), with Argo Group US, Inc. v. Levinson, 468 S.W.3d 698, 701-2 (Tex. App.—San Antonio 2015, no pet.) (joining courts holding that a plaintiff seeking a temporary injunction for violation of the non-compete statute still must show irreparable injury).