Let’s Roll: Do’s and Don’ts for Texas Trade Secrets Injunctions

Let’s Roll: Do’s and Don’ts for Texas Trade Secrets Injunctions

Recent case offers lessons on how to get (or avoid) a trade secrets injunction in Texas

When I say “drywall installation,” I’m guessing “trade secrets” is not the first thing that pops into your mind. Personally, I think of John Goodman’s character Dan Conner from the TV show Roseanne.

But a recent opinion from a federal district court in Dallas may change that. See Marek Brother Systems, Inc. v. Enriquez, No. 3:19-CV-01082, 2019 WL 3322162 (N.D. Tex. July 24, 2019).

Marek Brother Systems offered commercial and residential construction services, including ceilings, “acoustical solutions,” flooring, and paint. Juan Enriquez was a Marek project manager. Id. at *1. It does not appear that Enriquez signed any non-compete.

Enriquez did two typical things before resigning from Marek to run his own business. First, he formed an LLC, JP Acoustics and Drywall. Second, he sent a Marek customer list to his personal email address.

Let’s pause here for just a moment. Neither one of these things is necessarily wrongful, but both are a bad idea.

Under Texas law, it is not a breach of an employee’s limited fiduciary duty to make plans to compete with his employer. This can even include forming the entity the employee plans to use to compete. See Fiduciary Duty Lite: What Employees Can and Can’t Do Before Leaving.

But employees, why would you want to do this? Forming an LLC is relatively quick and easy. You can do it the day after you resign, and that’s one less thing for the employer to complain about.

Likewise, sending a company customer list to your personal email address is not necessarily wrong. In most businesses, it’s not unusual for employees to email or transfer company documents to their personal devices or accounts for work at home or on the road. This often happens, even when the company prohibits such personal use on paper. So, if a salesman emails himself an open orders list every week, it’s less suspicious if he does so the week before leaving, and if everybody at the company knows employees sometimes do this.

But again, unless you’re certain you will stay with the company until retirement, why would you do this? You should keep in mind Wolfe’s First Law of Trade Secrets Litigation: whatever company information the employee takes on the way out the door will be the alleged “trade secrets” in the company’s subsequent lawsuit.

Enriquez’s third mistake was naming the company “JP Acoustics and Drywall.” I would have called it “JP Drywall . . .” An “acoustics” company sounds like it has trade secrets; a “drywall” company doesn’t.

But let’s get back to the legal issues. Marek claimed that Enriquez’s email included confidential contact information for Marek’s customers and “proprietary notes” about the customers. Id. at *1. One of Marek’s customers was Muckleroy and Falls, id. at *1, which sounds like a business in a Frank Capra movie. Both Marek and JP Acoustics did work for Muckleroy and Falls after Enriquez left Marek. Id. at *4.

Marek claimed that Enriquez was using Marek’s confidential information to advance his business. Id. at *1. Marek sued Enriquez and JP Acoustics, claiming misappropriation of trade secrets, as well as breach of fiduciary duty, tortious interference with contract, and violation of the Computer Fraud and Abuse Act. Marek asked for an injunction to stop the defendants from doing business with any company that was a customer of Marek during the 12 months before Enriquez resigned. Id. at *2.

Marek claimed it spent years accumulating the customer information, and that it made diligent efforts to ensure the secrecy of its customer information, including restricted access to facilities, computer passwords, and disclosure to employees only on a “need to know” basis. Id. at *4.

The defendants responded that the customer information was readily available online or in the Yellow Pages. Id.

So was Marek entitled to a trade secrets injunction?

Let’s pause again to note that this is about as plain-vanilla a soft trade secrets case as you are going to find. You could have said to me “drywall manager leaves company, company files trade secrets suit,” and I could have guessed the essential facts (except maybe the name of the customer). So the outcome of the case may tell us something about how courts deal with typical customer list cases.

The federal district court judge said no, Marek was not entitled to an injunction.[1] First, the court said that the claims for breach of fiduciary duty and violation of the Computer Fraud and Abuse Act were based on conduct that occurred before termination of employment, any resulting damage was “readily quantifiable,” and therefore there was no threatened irreparable harm. Id. at *3. For the authoritative explanation of these concepts, see Injunction Junction, What’s Your Function?

Then the court turned to the claims of trade secrets misappropriation and tortious interference with contract. Illustrating Wolfe’s First Law, Marek claimed that its trade secrets were the customer information Enriquez emailed to himself.

But the court was not persuaded. It started by quoting the Trilogy Software case:

“[I]nformation that a firm compiles regarding its customers may enjoy trade secret status under Texas law.” Trilogy Software, Inc. v. Callidus Software, Inc., 143 S.W.3d 452, 466 (Tex. App.—Austin 2004, pet. denied) (citations omitted). “But this does not mean that trade secret status automatically attaches to any information that a company acquires regarding its customers; if it did, it would amount to a de facto common law non-compete prohibition.” Id. at 467. “Before any information can be a trade secret, there must be a substantial element of secrecy.” Id. (citation omitted). Secrecy requires that the information “is not generally known or readily ascertainable by independent investigation.” Id. (citations and quotation marks omitted). “It is the burden of the party claiming secrecy status to prove secrecy.” Id. (citations omitted).

If this sounds familiar, it might be because I discussed this case in my post When is a Customer List a Trade Secret?

Marek failed to persuade the court that the customer information was not “readily ascertainable.” The court cited several things missing from Marek’s case:

  • Marek did not provide the court with the email attachments containing the alleged trade secrets.
  • Marek did not describe the nature of the “proprietary notes” or why they should be considered proprietary information.
  • Marek did not offer specific facts to support its allegation that it “spent years accumulating” the customer contact information.

Id. at *4.

Maybe Marek should have seen it coming. The same judge had denied a TRO two months earlier in Computer Sciences Corp. v. Tata Consultancy Servs. Ltd., No. 3:19-cv-970-L, 2019 WL 2058772, at *3-4 (N.D. Tex. May 9, 2019), finding there was no evidence the emailed confidential software source code was actually shared with software developers.

But let’s not be too quick to fault Marek’s counsel. The deficiencies in Marek’s evidence seem obvious, but maybe the email attachments were not that helpful to Marek’s case. Perhaps the proprietary notes were not that proprietary. Perchance there were no more specific facts to be offered. Or maybe there was just not enough time to get the evidence needed.

And even if Marek had proven the customer information was a trade secret, there was another big hole in Marek’s evidence: proof of some nexus between the use of the alleged trade secrets and loss of sales to customers. (Picture Marek saying “Causation!” the way Jerry Seinfeld says “Newman!”)

The court said Marek did not allege that Defendants outbid Marek for any particular job or otherwise took Muckleroy and Falls business from Marek. Rather, both parties were servicing Muckleroy and Falls “to neither’s detriment and without direct competition.” In the absence of evidence that the defendants were injuring Marek’s business relationship with the customer, the court said, it could not find that Marek was substantially likely to suffer an irreparable injury due to the defendants’ contact with the customer. Id. at *4.

Injunction denied.

Nevertheless, the story had a happy ending. The parties later signed this Agreed Injunction that barred Enriquez and JP Acoustics from initiating new business with a list of specified customers.

And the Marek case provides lessons for both employees and employers in trade secrets cases.

Employees:

  • DON’T form an LLC for your future competing business any sooner than you really need to.
  • DON’T send company documents to personal devices or email accounts, even for valid reasons.
  • DON’T take customer lists when you leave. Is it really that hard to find the customers? (If so, the list might actually be a trade secret.)
  • If you take a customer list, DO show that the information in it is readily ascertainable.
  • If you do something you shouldn’t have before leaving, DO argue that it can be compensated with damages, so no injunction is warranted.
  • DO watch my video Dumb Things Employees Do Before Leaving a Company for similar tips in convenient audiovisual form.

Employers:

  • DO offer the misappropriated confidential documents as evidence, under seal if necessary.
  • DO specifically explain why the customer information is valuable and not readily ascertainable.
  • DO try to offer evidence that the employee has actually used the confidential information to take specific customer business from you (I know, this is often easier said than done).
  • DON’T expect to get an injunction merely because an employee has taken confidential company documents.
  • DO watch my video Smart Things Companies Can Do to Protect Confidential Information.

Finally, whether you’re an employee or employer, do get advice from a lawyer as early as possible, preferably one with experience handling departing employee disputes. That might help you avoid the common mistakes above. In the words of another John Goodman character, “Donny you’re out of your element!”

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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.

[1] To be precise, the court construed the motion for preliminary injunction as a motion for temporary restraining order, denied a TRO, and set a hearing on a preliminary injunction.

Does the Amended TCPA Still Apply to Departing Employee Lawsuits?

Does the Amended TCPA Still Apply to Departing Employee Lawsuits?

I know what you did last summer

They say that breaking up is like knocking over a coke machine. It’s just not going to happen on the first push. This is also true of my attempt to break up with the Texas Citizens Participation Act, or “TCPA.”

A quick recap: I fell in love with the TCPA when Texas courts started applying its broad definitions so broadly that you could file a motion to dismiss in just about any kind of lawsuit, as long as the claims had something to do with a “product or service in the marketplace.” That included departing employee lawsuits, the focus of my practice.

I’ll admit, it was a toxic relationship, one the Texas legislature probably never intended.

Then the backlash came. The Texas legislature, the Fifth Circuit Court of Appeals, and the Dallas Court of Appeals conspired to sabotage our relationship. See Turn Out the Lights, the Party’s Over: Texas Legislature Takes All the Fun Out of the TCPA.

The legislature dealt the cruelest blow. Last summer it amended the TCPA to carve out most claims based on non-competes and trade secrets. See Tex. Bus. & Com. Code § 27.010(a)(5).

Like a meddling parent, the legislature was determined to keep me and the TCPA apart. How am I supposed to file a TCPA motion to dismiss a departing employee lawsuit if the statute doesn’t apply to non-compete and trade secrets claims anymore? That’s my bread and butter.

Keep hope alive

But wait. There is hope. Breach of non-compete and misappropriation of trade secrets are not the only claims made in departing employee lawsuits. As I explained in my viral YouTube video What Are the Key Legal Issues in a Departing Employee Lawsuit?, breach of fiduciary duty is another common claim when an employee leaves a company to work for a competitor.

Does an employee really owe an employer a fiduciary duty, the highest common-law duty known to man? Well, sort of. For a brief explanation, see Fiduciary Duty Lite: What Employees Can and Can’t Do Before Leaving.

The typical theory in a departing employee lawsuit is that the employee, while still on the company’s payroll, schemed with others to compete with the company. If the employee crosses the line into actually competing with her employer, that can be a breach of the employee’s limited “fiduciary” duty to the employer.

There’s no exemption in the amended TCPA for claims of breach of fiduciary duty, and Texas courts have applied the statute to such claims. See, e.g., O’Hern v. Mughrabi, 579 S.W.3d 594, 603-4 (Tex. App.–Houston [14th Dist.] 2019, no pet. h.) (TCPA applied to suit making single claim of breach of fiduciary duty); Elite Auto Body LLC v. Autocraft Bodywerks, Inc., 520 S.W.3d 191, 194, 205 (Tex. App.–Austin 2017, pet. dism’d) (TCPA applied to claims against former employees including breach of fiduciary duty).

So if you’re on the defense side of a departing employee lawsuit, you may not be able to file a TCPA motion to dismiss the non-compete and trade secret claims, but you could still file a TCPA motion to dismiss the breach of fiduciary duty claim. And even if that motion is denied, you get an interlocutory appeal.

This is especially important when the employee doesn’t have a non-compete. Proving that the employer’s information was a trade secret can be difficult, so in cases without a non-compete, breach of fiduciary duty is sometimes the employer’s strongest theory.

Hey, I just met you

Still, my loyal Fivers know that carving out non-compete and trade secrets claims was not the only change the legislature made to the TCPA last summer. The legislature also changed the definition of “matter of public concern.”

The previous definition of “matter of public concern” was the match that lit the prairie fire that swept across Texas litigation. That definition covered communications about a product or service in the marketplace, which meant just about any kind of lawsuit.

But House Bill 2730 reigned in that broad definition, making these changes:

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Is this new definition of “matter of public concern” broader or narrower?

Before, the definition included an issue related to a product or service in the marketplace. That prong of the definition covered a potentially wide range of lawsuits, but its language was fairly specific.

The new definition, in contrast, is vague to the point of being tautological. The statute now effectively defines “matter of public concern” to include “a subject of concern to the public.” Wow, thanks for that clarification, Texas legislature.

So does a claim for breach of a former employee’s breach of fiduciary fall under the new definition of matter of public concern?

And this is crazy

Here’s the argument that it applies. Let’s say a salesman decides he’s not happy with his job. He starts talking with some co-workers, or maybe with a competitor, about leaving the company and forming a new venture that will compete for the company’s customers. Then he starts talking to his customers about it. Maybe he even tells his customers to delay their orders until after he leaves.

Arguably, those communications are about competition in the salesman’s industry, which is a matter of interest to the community and a subject of concern to the public. So if the employer claims breach of fiduciary duty based on these communications, you could argue the TCPA applies.

The counter-argument says this is just too much. If “matter of public concern” is construed to include competition between two private companies, one could argue, then the TCPA would still apply to almost everything. That can’t be what the legislature intended.

That’s essentially what the Dallas Court of Appeals said about the previous version of the TCPA. In a series of decisions, the Dallas court reigned in the scope of the TCPA by holding that communications between private parties about doing business are not matters of public concern, despite the broad “product or service in the marketplace” language that was in the statute. The Fort Worth Court of Appeals took a similar view. See Metroplex Courts Push Back on Broad Application of TCPA.

It’s a safe bet those courts will take the same approach to the TCPA’s new definition of a matter of public concern. They are likely to reject the argument that an employee’s communications about competing with his private employer are a subject of concern to the public just because there is a general public interest in free competition.

But other courts may be more receptive to the argument. The Austin Court of Appeals and the Houston Court of Appeals took more of a “plain meaning” approach to the earlier version of the TCPA. That’s how the TCPA got applied to non-compete and trade secrets claims in the first place. See A SLAPP in the Face to Texas Trade Secrets Lawsuits.

So call me maybe

If you take a similar plain meaning approach to the new definition of matter of public concern, there is at least a reasonable argument that the definition applies to communications about competing with an employer. So, if an employer sues a former employee for breach of fiduciary duty based on the employee’s alleged scheme to compete with the employer, the employee should at least consider filing a motion to dismiss the claim under the TCPA.

I’ve prepared a sample motion that does just that.

*MASSIVE LAWYER DISCLAIMER: Every case is different, and this sample motion is just an idea for Texas litigators to consider; I’m not necessarily endorsing it, and non-lawyers should consult with qualified counsel about these issues.

Keep in mind, the plaintiff can defeat the TCPA motion by offering evidence that the employee owed a fiduciary duty, the employee breached the duty, and the breached caused damages.

But that can be a real hurdle for the employer. Whether the alleged conduct of the employee constitutes a breach may present a legal question for the judge. And even when there is evidence of a breach, it is sometimes difficult for the employer to show the breach caused actual compensable damages. (Another lurking issue is that the fiduciary duty claim may be preempted by the trade secrets statute, but I’ll save that for the “advanced” course.)

Bottom line: filing a TCPA motion to dismiss a breach of fiduciary duty claim in a departing employee lawsuit will sometimes be a good strategy for the defense.

Some will think it crazy to apply the TCPA to a claim against an employee for breach of fiduciary duty. But is it any crazier than the cases that applied the earlier version of the TCPA to departing employee litigation? As discussed above, the new definition of matter of public concern is arguably just as broad as the old definition.

Plus, this may shock you, but sometimes employers use contrived claims of breach of fiduciary duty to try to punish or bully employees who exercise their right to leave the company and compete freely. Isn’t that the kind of claim the TCPA is supposed to prevent?

If so, maybe I’m not so crazy to consider getting back together with the TCPA. The statute promised me it has changed its ways, so maybe I’ll give it one more chance before I finally tip over that coke machine.

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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.

________________________

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.

What is “Hearsay” Anyway? Tips for Lawyers and Non-Lawyers

What is “Hearsay” Anyway? Tips for Lawyers and Non-Lawyers

Early in my legal career, I worked on a couple big embezzlement cases. In both cases my firm represented the embezzle-ee, not the embezzle-or (are those real words?). And in both cases, the core evidence of the embezzlement was hearsay.

“Hearsay” has been in the news a lot lately. It’s kind of the evil twin of another term getting a lot of play: “direct knowledge.” Hearsay and direct knowledge are not exactly opposites, but you could say they are two sides of a coin.

As a trial lawyer with at least a basic understanding of the hearsay rule, I cringe when people use terms like “hearsay” and “direct knowledge” without really understanding what they mean.

But we lawyers mustn’t carp too much. “Hearsay” has an ordinary meaning in popular discourse that doesn’t pretend to match the legal definition of hearsay. When an ordinary person says that information is hearsay, they just mean it’s secondhand knowledge. There’s nothing wrong with using the word “hearsay” in that ordinary sense—in theory.

Plus, even lawyers have a hard time with the legal definition of hearsay. I doubt the average non-litigator lawyer could give you a good definition. Even some litigators might struggle to explain it. And in my experience, even the average trial court judge doesn’t have a firm grasp of the hearsay rule.[1]

So what is hearsay? The legal definition is simple: an out of court statement offered for the truth of the matter asserted.[2]

But there’s a lot wrapped up in that definition. Plus, as any Law and Order fan knows, there are exceptions to the hearsay rule. More about that later.

The “out of court statement” part is not too difficult. Let’s say I’m trying to prove that Dawn Davis embezzled money from her former employer, Paula Payne Windows. I call Paula Payne, the owner of the company, to the stand. “Ms. Payne,” I ask, “how do you know Ms. Davis forged those checks?” “Because my bookkeeper told me she saw Ms. Davis do it,” she answers.

In this case, it’s an “out of court” statement, meaning the bookkeeper is not there testifying to the statement she made. Instead, it’s Payne testifying about the bookkeeper’s statement.

And notice something else: Payne does not have direct knowledge, i.e. “personal knowledge,” that Davis forged the checks. She only has “secondhand” knowledge. That’s the connection between hearsay and direct knowledge.

In this case, it is clear that the statement—“I saw Davis forge the checks”—is offered for the truth of the matter asserted. Payne is trying to prove that Davis forged the checks. The statement is that Davis forged the checks. So, the statement is offered to prove the truth of the matter asserted.

But trust me, the “truth of the matter asserted” is where the hearsay rule gets hard. It’s the part that even some judges and lawyers struggle to understand. And that’s before we even get to the exceptions.

Let’s start with a relatively easy example where a statement is not offered for the truth of the matter asserted.

“Ms. Payne,” I say, “please take a look at Plaintiff’s Exhibit 10, is that an email from Ms. Davis to your bookkeeper?” “Yes,” Payne says. “What did Ms. Davis say in the email?” I ask. “She said can you please take care of getting the attached invoice paid,” Payne answers.

Here, the statement in the email is clearly an out of court statement. But is it offered for the truth of the matter asserted?

It depends on what I’m trying to prove. Let’s say that the point is to prove a scheme to submit fraudulent vendor invoices on behalf of a company that Davis secretly owned. In that case, I am not offering the email for the truth of the matter asserted. If anything, I’m offering Davis’s statement in the email to prove the opposite of what it asserts.

So in this case, if opposing counsel says “objection, hearsay,” the judge should say “overruled.”

Harder Cases

But it’s not always this easy. Sometimes, a statement is offered both for the truth of the matter asserted and for another purpose.

Let’s say I’m trying to prove that Davis secretly accepted a job offer from Paula Payne’s fierce competitor, Real Cheap Windows. “Mr. President of Real Cheap Windows,” I say, “what did Ms. Davis say to you when you offered her a job at your company?” His response: “she said yes I would like the job.”

“Yes I would like the job.” That’s an out of court statement. But is it offered for the truth of the matter asserted? Well, yes. And no.

On the one hand, I am trying to prove that Davis wanted the job and accepted the job offer. So the statement is hearsay, right?

No, not really. Here’s the thing. It’s not a question of whether the statement “I would like the job” is true or not. The relevant fact is that Davis accepted the job offer.

As my law school Evidence professor used to say, it’s a case where the “saying of the words” itself, not the truth of the words said, is significant. You could also call this a “verbal act.” Some older court opinions tend to call this sort of statement res gestae (“things done”).

Another way to put it: the statement is not hearsay because the probative value of the statement does not flow from the speaker’s belief in the truth or falsity of the statement.

Confused yet? That’s ok. It’s a subtle distinction.

And, frankly, it’s one that a lot of judges may struggle to grasp. Picture this:

Me: What did Ms. Davis say when you offered her the job?

Opposing Counsel: Objection, hearsay.

Me: Your Honor, it’s not hearsay, it’s a verbal act. 

Judge: Verbal act? What exception is that?  

Me: Uh, that’s not really an exception per se. It’s just that the statement is not hearsay because, well I’m not so much offering it to prove the truth of the matter asserted. 

Judge: You’re not offering it to prove she accepted the job?

Me: Well yes, your Honor, I am trying to prove she accepted the job, but . . .

You get the idea. It’s hard enough to explain this subtle distinction. It’s even harder in the heat of a courtroom battle, especially when opposing counsel is happy to contribute to the judge’s confusion.

Luckily, in this case there is an easier way out of the problem. I could simply say “it’s an admission by a party opponent, your Honor, an exception to the hearsay rule.”

This leads me to my Hearsay Practice Tip for lawyers: If a hearsay exception clearly applies and is easy to explain, argue the exception first, rather than trying to make a subtle argument about the “truth of the matter asserted.”

Hearsay Exceptions 

I promised we would get to the exceptions.

But first, there is a slight complication. There are two different types of hearsay exceptions. First, there are exceptions that are defined as “not hearsay.” If they are not hearsay in the first place, then you might say they are not “exceptions” at all, but let’s not be pedantic. Second, there are exceptions for certain types of statements that are admissible, even though they are hearsay.

For simplicity, let’s just call both types hearsay “exceptions.”

I once made it a goal to memorize all of the hearsay exceptions. I count 31 of them in the Federal Rules of Evidence and 30 in the Texas Rules of Evidence (they are largely the same).

My heart was in the right place, but this was not an efficient exercise. I mean, it’s great to know that there is an “ancient documents” exception to hearsay, but over 90% of the time there are only a handful of hearsay exceptions a litigator needs to know.

You can probably get by with a thorough understanding of just three of the hearsay exceptions:

  1. Impeachment with prior testimony (like a deposition)
  2. Admission by party opponent
  3. The “business records” exception

You can look up the other exceptions when needed, or memorize them if you are really nerdy. But these three should be second nature to any litigator.

The first one, impeaching the witness with prior testimony, is a trial lawyer’s bread and butter. I probably don’t need to say much about it, although the rule has some little twists and turns that are worth checking.

Admission by Party Opponent

I shouldn’t have to say much about the second exception either, but maybe I need to anyway. I once had a trial where I offered an email from the opposing party’s president to an agent of my client. Opposing counsel jumped up and objected, “hearsay!”

“You’ve got to be kidding me,” I thought to myself. “Your Honor, this is an email from Mr. X as a representative of the company,” I said, “it’s an admission by a party opponent.”

“What exception is that?” the judge said. And this was not a new judge.

It took some discipline for me not to roll my eyes. Instead, I flipped open my Texas Rules of Court to Rule of Evidence 801. “Here it is, Rule 801(e)(2)(A), the statement is offered against an opposing party and was made by the party in an individual or representative capacity.”

Lawyers with trial experience know that exception should have been obvious to the judge. Maybe I was just being tested. And to the judge’s credit, the objection was overruled.

The Business Records Exception

Then there is the business records exception. The actual words are “records of a regularly conducted activity,” but everyone calls it the business records exception. It has a four-part definition they made us memorize in trial advocacy class, but the definition is pretty abstract. It’s easier to give examples: monthly bills, bank statements, receipts, invoices, etc.

Documents like these are admissible “business records” when they are “kept in the course of a regularly conducted business activity” and making the record was a “regular practice.”[3] Documents like these are routinely admitted in evidence even though they are hearsay. (But remember, just because they are admitted doesn’t mean they have to be accepted as true.)

In practice, the business records exception is the most formulaic hearsay exception. It leads to two rituals. First, the lawyer going through the four-part definition with a witness on the stand to “prove up” the business records. Second, the pretrial “business records affidavit,” a signed and notarized statement from a records custodian reciting the four elements of the definition and swearing that the 8,000 pages of attached records meet all those elements.

In both cases it is rare that the witness really has personal knowledge of how each record was generated. But everybody kind of “looks the other way.” Opposing counsel usually doesn’t want to be a jerk and object, knowing you could pull the same move when she offers her business records. And most judges don’t require proof of the business records exception that is truly based on personal knowledge.

That’s probably the way it should be, especially when it is obvious that the documents at issue meet the exception. If it’s the type of document that is clearly a business record—like a monthly bank statement—no time should be wasted going through the elements of the exception. It’s not the time to pull a “gotcha” and suddenly become a stickler for “personal knowledge.”

Direct Knowledge

Personal knowledge, which is essentially what people mean by “direct knowledge,” is important, but sometimes you have to rely on hearsay.

Imagine the owner of Paula Payne Windows gets a call from an anonymous tipster. “Paula, you don’t know me, but I’ve got some important information I feel I need to share with you. I have a friend who heard from someone who has reason to know, and that person said that Dawn Davis has been embezzling thousands of dollars from your business every month. You should probably look into it.”

What is Payne going to say? “I appreciate your call, Mr. Tipster, but I can’t rely on this information, because it is clearly hearsay. I’m not going to accuse someone of stealing based on secondhand information.”

No, obviously, that is not what Payne is going to do. She’s going to investigate this serious allegation to find out if it’s true.

So Payne calls Davis into her office the next day. “Dawn, I hate to ask you this, but I received an anonymous tip that you’ve been stealing money from the company. What do you have to say for yourself?”

“That’s hearsay!” Davis says. “That person doesn’t have any direct knowledge that I embezzled money from you.”

This response does not exactly inspire confidence. Wouldn’t you expect Davis to deny the tipster’s allegation, if it wasn’t true?

Which leads me to my Practical Tip for lawyers and non-lawyers alike: Don’t confuse courtroom rules of evidence with practical rules of life. People reasonably rely on “hearsay”—or secondhand knowledge—to make important judgments about business, politics, and life in general all the time.

Of course, testimony based on personal knowledge is generally more reliable than hearsay or other secondhand information. But it’s not everything.

________________________

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.

[1] This is not really a problem, because of course most trial court judges are above average.

[2] More precisely, hearsay is “a statement that: (1) the declarant does not make while testifying at the current trial or hearing; and (2) a party offers in evidence to prove the truth of the matter asserted in the statement.” Fed. R. Evid. 801(c); Tex. R. Evid. 801(c).

[3] Rule 803(6).

The “Inevitable Disclosure” Doctrine in Texas Trade Secrets Litigation

The “Inevitable Disclosure” Doctrine in Texas Trade Secrets Litigation

Does Texas law recognize the “inevitable disclosure” doctrine? Should it?

This strikes me as the wrong question. The right question is not “should Texas follow the inevitable disclosure doctrine?” but rather “what evidence is sufficient to establish imminent harm from the threatened use of trade secrets?” I propose the following dichotomy:

  1. In a “soft” trade secrets case, the mere fact that a former employee knows a company’s trade secrets and has gone to work for a competitor should usually be insufficient to establish the “imminent harm” necessary to support a temporary injunction barring the employee from working for the competitor. There must be something more, such as evidence of a plan to use the trade secrets, or evidence that the employee has already used or disclosed the trade secrets.
  2. But in a “hard” trade secrets case, “something more” should not be required if the trade secret is so secret and so valuable the employee’s mere knowledge of the trade secret creates an imminent risk that the employee will disclose it to her new employer.

I admit that no. 2 is a little circular, but there’s really no getting around that. At least my test puts the emphasis on the degree of the threat, where it should be.

But what is a “soft” trade secret? Or a “hard” trade secret? And what is the inevitable disclosure doctrine in the first place? Let’s back up a bit.

The Inevitable Disclosure Doctrine

The inevitable disclosure doctrine is a concept in trade secrets law. It is the idea that a person who knows a company’s trade secrets can be enjoined from working for a competitor on the theory that the person will inevitably use that knowledge.[1] For example, in T-N-T Motorsports, Inc. v. Hennessey Motorsports, Inc.,[2] the court held that evidence that the defendants possessed the plaintiff’s confidential information and were “in a position to use it to compete” showed an “inherent threat” sufficient to support an injunction.

The Texas Uniform Trade Secrets Act (TUTSA) and the federal Defend Trade Secrets Act (DTSA) do not expressly refer to the inevitable disclosure doctrine. The doctrine can be seen as an application of the common-law “imminent harm” requirement for an injunction. The question is whether harm is imminent when a person with knowledge of the company’s trade secrets is working for a competitor.

The DTSA indirectly rejects—or at least constrains—application of the inevitable disclosure doctrine in two ways. First, it authorizes the court to grant an injunction “to prevent any actual or threatened misappropriation,” but with the important limitation that the court cannot “prevent a person from entering into an employment relationship.” The court can place conditions on such employment, provided the conditions are based on “evidence of threatened misappropriation and not merely on the information the person knows.” In other words, the court cannot limit a former employee’s work for a competitor based merely on the idea that the employee will inevitably disclose the employer’s trade secrets. Second, the injunction cannot conflict with an applicable state law “prohibiting restraints on the practice of a lawful profession, trade, or business.”[3]

Similarly, TUTSA codifies the common-law principle that an injunction may not prohibit a person from using “general knowledge, skill, and experience” acquired during employment.[4] This limitation emphasizes that injunctions should be narrowly tailored to prevent disclosure of trade secrets, not to unreasonably restrict employee mobility. Still, TUTSA at least leaves open the possibility that a risk of “inevitable disclosure” of trade secrets could establish the “imminent harm” needed to support a temporary injunction.

Texas law is unsettled on whether and to what extent the inevitable disclosure doctrine applies.[5] But we can draw some preliminary conclusions from the case law.

First, if there is evidence that the employee has already disclosed the alleged trade secrets to the competitor, or used the alleged trade secrets while working for the competitor, then resort to the inevitable disclosure doctrine is unnecessary. The doctrine really only becomes a real issue when the evidence is that the employee possesses or knows the trade secrets but has not done anything wrong with them—yet.

Second, inevitable disclosure really goes to the question of an injunction, not damages.

Global Supply v. Riverwood

Both principles were apparent in Global Supply Chain Solutions, LLC v. Riverwood Solutions, Inc., No. 05-18-00188-CV, 2019 WL 3852661 (Tex. App.—Dallas Aug. 16, 2019, no pet. h.), a recent case showing the limits of the “inevitable disclosure” argument.

In that case, Global Supply and Riverwood were competitors in the supply chain management industry, including product data management (PDM) services. Id. at *1. They had merger discussions in which Global Supply provided a seven-page PowerPoint presentation containing financial information about Global Supply. Id. at *2. After these discussions were abandoned, Riverwood unsuccessfully solicited two customers of Global Supply and recruited Lori Austin, a consultant for Global Supply, to be Riverwood’s director of PDM services. Id. at *2-3.

Global Supply sued Riverwood and Austin in Collin County District Court, claiming misappropriation of trade secrets, but Global Supply never set a hearing on a temporary injunction. Id. at *4. After some discovery and designation of experts, the parties filed motions for summary judgment, including Riverwood’s motion for summary judgment on Global Supply’s trade secrets claim. Id.

The problem for Global Supply was that there was no “direct evidence” that Austin disclosed any trade secret to Riverwood. Id. at *7. So Global Supply argued that it was “inevitable” that Austin would disclose its trade secrets in the course of her employment at Riverwood. Id. In other words, the inevitable disclosure doctrine.

In support of its argument, Global Supply cited the Seventh Circuit’s statement that “a plaintiff may prove a claim of trade secret misappropriation by demonstrating that defendant’s new employment will inevitably lead him to rely on the plaintiff’s trade secrets.” Id. (citing PepsiCo, Inc. v. Redmond, 54 F.3d 1262, 1269 (7th Cir. 1995)).

But Collin County ain’t in the Seventh Circuit, and the trial court granted summary judgment for Riverwood and Austin.

The Dallas Court of Appeals affirmed, rejecting Global Supply’s inevitable disclosure argument. The court cited Cardinal Health Staffing Network, Inc. v. Bowen, 106 S.W.3d 230, 241-42 (Tex. App.—Houston [1st Dist.] April 3, 2003, no pet.), which said “[w]e have found no Texas case expressly adopting the inevitable disclosure doctrine, and it is unclear to what extent Texas courts might adopt it or might view it as relieving an injunction applicant of showing irreparable injury.” Id.

Global Supply argued that the adoption of TUTSA brought the inevitable disclosure doctrine to Texas, but the court disagreed. The court reasoned that the “ultimate merits” are not at issue in a temporary injunction hearing in a trade secret misappropriation case. Thus, whatever merit the inevitable disclosure argument may have in support of a temporary injunction, the court said the argument is insufficient to raise a fact issue on damages in response to a motion for summary judgment. Id. at *8.

The court then turned to whether Global Supply had offered sufficient evidence on the elements of its TUTSA claim. Global Supply offered the following:

  • The idea that building supply sourcing could be operated as a standalone business was the trade secret misappropriated by Riverwood.
  • Riverwood contacted a Global Supply customer about using Riverwood for sourcing building supplies, knowing he was a Global Supply customer.
  • Austin was doing the same work at Riverwood that she did for Global Supply.
  • Peck, Global Supply’s president, testified that Austin “must have” disclosed Global Supply’s confidential information in order to do her job at Riverwood.
  • Peck also testified that building supply sourcing “was unlike anything Riverwood was doing at the time.”

Id. at *14-15.

So, the evidence of misappropriation was pretty thin, especially in light of controverting evidence:

  • Global Supply did not share any information about its building supply sourcing business model with Riverwood.
  • The seven-slide PowerPoint presentation did not include this information, and Global Supply conceded that the merger discussions did not involve delivery of trade secrets other than that delivered in writing.
  • Riverwood had sourced building supplies before the merger discussions.
  • Peck conceded Riverwood could have provided building supply sourcing without his being aware of it.
  • Global Supply did not lose any business from the customer Riverwood contacted.
  • Austin testified she returned all company property to Global Supply, did not retain Global Supply documents, complied with her confidentiality agreement, never disclosed Global Supply’s confidential information or trade secrets to Riverwood, and only used generally known information.
  • Peck conceded he had no knowledge of the work Austin was actually doing at Riverwood.
  • Austin testified about how she performed her job responsibilities at Riverwood without using Global Supply’s confidential information.

Id. at *14-15.

Based on the evidence, the Court of Appeals held that the trial court properly granted summary judgment against Global Supply’s trade secrets claim. Id. at *15-16. Thus, the “inevitable disclosure” argument could not fill the gaps in Global Supply’s evidence of misappropriation of trade secrets.

So did Global Supply reject the inevitable disclosure doctrine? Not really. Two significant factors limit the reach of Global Supply. First, it was not a temporary injunction case. Trying to use the inevitable disclosure doctrine as a substitute for direct evidence of damages was a stretch.

Second, the court seemed skeptical of Global Supply’s theory that its business model was a trade secret in the first place. This was apparent in the court’s statement that “Global supply does not point to any summary judgment evidence that it shared with Riverwood any information about its ‘business model’ that ‘took extensive effort to develop.’” Id. at *15.

A Harder Case

Imagine instead a temporary injunction case with evidence that the alleged trade secret is really secret and really valuable. Let’s say an oilfield services company develops a secret drilling technology that a competitor would pay millions for. The engineer who developed the technology for the company gets hired by a direct competitor as Director of Engineering. There’s no evidence that the engineer has disclosed the technology to the competitor, or even evidence that he plans to do so, but the trial court enters a temporary injunction barring the engineer from working for the competitor, citing the imminent risk that the engineer will disclose the technology.

That’s a stronger case for application of the inevitable disclosure doctrine, first because it involves an injunction and second because it involves a “hard” trade secret.

The two quintessential types of hard trade secrets are “secret sauce,” like the Colonel’s herbs and spices or the formula for Coke, and secret cutting-edge technology, like say, laser guidance for self-driving cars. When an employee runs off to a competitor with that kind of secret, it does seem a little unfair to require proof that employee has already given the secret to the competitor.

“Soft” trade secrets are different. Soft trade secrets are things like customer lists, customer information, and pricing information. Virtually every business has this kind of information. That doesn’t mean the information can’t be a trade secret. It can, as I explained in When Is a Customer List a Trade Secret?

But there’s a danger here. If courts grant injunctions too freely in soft trade secret cases, they risk turning trade secret law into a “de facto” non-compete for all employees who have customer information. And Texas courts have recognized we don’t want to do that. See Trilogy Software, Inc. v. Callidus Software, Inc., 143 S.W.3d 452, 466-67 (Tex. App.—Austin 2004, pet. denied) (“this does not mean that trade secret status automatically attaches to any information that a company acquires regarding its customers; if it did, it would amount to a de facto common law non-compete prohibition”).

That’s why I say in a soft trade secrets case, there should be some evidence that the employee has used or disclosed the trade secrets—or plans to do so—before the court grants a temporary injunction. If Texas courts are going to embrace the notion of “inevitable disclosure” at all, it should be limited to cases involving hard trade secrets.

Of course, the distinction between hard and soft trade secrets is not in the statutes; it’s just my terminology. And you could always have borderline cases (“semi-soft” trade secrets?) But the underlying concept—that the degree of secrecy and value of the alleged trade secrets is a factor in determining whether a temporary injunction should be granted—is sound. At least it focuses on the right question.

________________________

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.

[1] See The Inevitable Disclosure Doctrine: A Necessary and Precise Tool for Trade Secret Law.

[2] 965 S.W.2d 18, 24 (Tex. App.—Houston [1st Dist.] 1998, pet. dism’d).

[3] 18 U.S.C. § 1836(b)(3).

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

[5] Cardinal Health Staffing Network, Inc. v. Bowen, 106 S.W.3d 230, 241-42 (Tex. App.—Houston [1st Dist.] April 3, 2003, no pet.); DGM Services, Inc. v. Figueroa, No. 01-16-00186-CV, 2016 WL 7473947, at *5 (Tex. App.—Houston [1st Dist.] Dec. 29, 2016, no pet.) (mem. op.).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Obviously, dermatopathology is narrower than anatomic pathology. Duh.

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

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

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

Thus, the industry-wide exclusion rule appears to be alive and well in Texas today—in several forms. 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

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

PRACTICE TIPS

The cases above suggest some tips for practitioners:

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

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

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

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

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

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

 

 

Oh Lord, Won’t You Buy Me a Mercedes-Benz Dealership?

Oh Lord, Won’t You Buy Me a Mercedes-Benz Dealership?

The scene: Cameron County Courthouse, Brownsville, Texas. Plaintiff’s closing argument in Carduco, Inc. v. Mercedes-Benz USA.

Ladies and gentlemen of the jury, there was a time when a handshake and a man’s word meant something here in the Rio Grande valley. If you made a deal and shook on it, you could take that to the bank.

My client Renato Carduco grew up in that era. He built his successful car dealerships on principles of honesty and hard work. If he told a customer he was going to do something, he did it. If he promised his employees something, he kept the promise. And he expected other people to keep their word too.

He certainly expected that when he made a deal with Mercedes-Benz USA. You heard the testimony. When Mr. Carduco’s son was having trouble with his Mercedes dealership in Harlingen, Mr. Carduco agreed to buy it. But he knew Harlingen wasn’t the best place for it, so he wanted the option to move the dealership to McAllen.

So Mr. Carduco did what any experienced businessman would do. He asked Mr. Oswald, the Mercedes representative, if it would be possible to move the dealership, and Mr. Oswald said “that won’t be a problem, we don’t have any other plans for McAllen.” So Mr. Carduco went into the deal believing he would have the option to move.

But then when Mr. Carduco saw the proposed contract, something was wrong. You may remember Plaintiff’s Exhibit 9, the Purchase Agreement. It had this part saying that Mr. Carduco was, and I quote, “only purchasing the right to conduct a Mercedes-Benz retail sales dealership at Purchaser’s present location in Harlingen, Cameron County, Texas.” And it prohibited Mr. Carduco from changing locations without written consent from Mercedes-Benz USA.

Well that was a red flag for Mr. Carduco. So he called up Mr. Oswald and said, “Frank, I’m concerned about this part of the contract that says I’m only getting the right to have a dealership in Harlingen, what if I want to move it to McAllen?” And you remember what Mr. Oswald said. “Renato, don’t worry about that stuff in the contract, if you decide to move, we’ll take care of you.”

Trouble is, Mr. Oswald didn’t tell Mr. Carduco the whole story. You heard the testimony and saw the emails. At the same time, Mercedes-Benz USA was talking to another Mercedes dealer about building a new dealership in McAllen. But they didn’t disclose that to Mr. Carduco until after he had signed the contract.

So, when Mr. Carduco signed that Purchase Agreement, he believed two things. One, that there were no plans for some other dealer to set up shop in McAllen, and two, that he could relocate his dealership to McAllen if he wanted to.

Ladies and gentlemen, that’s fraud. So I hope that after you consider the evidence, you will write “Yes” in response to Question No. 1.

The Real Case

If you like to keep up with recent Texas Supreme Court opinions—and who doesn’t?—you know this hypothetical closing argument is based on a real case, Mercedes-Benz USA, LLC v. Carduco, Inc. (Tex. Feb. 22, 2019). The jury in that case answered “yes” Mercedes-Benz committed fraud, and found actual damages of $15.3 million and punitive damages of over $100 million.

Let’s pause right there. A jury in the Valley enters a $100 million verdict for a local businessman against a big multinational corporation. Already, you know that verdict is not likely to survive a trip to the Texas Supreme Court.

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My friends all have Porsche dealerships . . .

And yes, the Texas Supreme Court later threw out the verdict, holding there was no evidence of fraud. The court said Carduco could not have justifiably relied on alleged statements by Mercedes-Benz USA that the written contract directly contradicted.

 

But what about the facts in bold in the closing argument above? Mercedes-Benz specifically told Carduco he could move and not to worry about what the contract said. How is that not fraud?

Well, here’s the thing. I made up those facts (the ones in bold). I made them up to make the case harder. To me, the key question raised by Mercedes-Benz is whether those additional facts would have made a difference to the outcome.

Let me explain.

Texas Law on Fraud, Omissions, and Justifiable Reliance

First let’s put the Mercedes-Benz case in context by laying out some basic principles of fraud law:

  1. Fraudulent inducement is a type of fraud. It’s the claim that one party fraudulently induced another party to sign a contract. It allows the defrauded party to avoid the obligations of the contract and, potentially, to recover damages caused by the fraud.
  2. The most basic element of fraud is a misrepresentation. There has to be a material misrepresentation made with some kind of intent. (Let’s set aside the intent and materiality elements for now.)
  3. An affirmative misrepresentation is easy. If you make a statement that is not true, that’s a misrepresentation.
  4. Omissions are harder. Generally, an omission is not fraud, unless there is a duty to disclose.
  5. If one of the parties owes a fiduciary duty to the other, there would be a duty to disclose. But in most “arms-length” transactions between two businesses, there is no fiduciary duty relationship and no general duty to disclose.
  6. A duty to disclose can arise if you make a representation that, while technically true, is rendered misleading by your omission.
  7. The next most basic element of fraud is reliance. The person you make the representation to must decide to sign the contract in reliance on the representation.
  8. It has to be a certain kind of reliance. Some courts say “reasonable” reliance. Recent Texas cases use “justifiable” reliance. In any case, unreasonable reliance is not going to be justifiable reliance.
  9. There is often conflicting evidence regarding whether the alleged misrepresentation is made. But as long as there’s at least a smidgen of evidence, most appellate court decisions addressing fraud will assume the misrepresentation was made.

As you can gather from this summary, there are a lot of “general” rules and a lot of exceptions. But this outline will hold true most of the time.

Here’s where it gets more difficult: the contract. In almost any business transaction, there will be a written contract that contains statements that conflict with the claim of fraud. That’s because the lawyer who drafted the contract (or the form the contract is based on) wanted to avoid claims of fraud.

The most common contractual terms that conflict with a claim of fraud are:

  • A merger clause, e.g. “This Agreement replaces and supersedes all prior agreements and understandings between the parties regarding the subject matter of this Agreement.”
  • A disclaimer of reliance, e.g. “No party to this Agreement is relying on a representation or agreement not contained within the four corners of this Agreement.”
  • A specific substantive contract term that conflicts with the alleged misrepresentation. For example, a clause that says “you cannot move your dealership” when the alleged misrepresentation is “we will let you move your dealership.”

What is the effect of such terms? Do they defeat a subsequent claim of fraudulent inducement?

There is no easy answer. Texas courts—like courts everywhere in the Anglo-American common-law tradition—have struggled with this question for decades, if not centuries. (Courts in other traditions probably struggle with it too, but I have no familiarity with that.)

There are three basic alternatives courts have to choose from:

  1. The contractual terms defeat any conflicting claim of fraudulent inducement.
  2. The contractual terms have no effect on a claim of fraudulent inducement.
  3. It depends on the circumstances.

You can make a reasonable case for each of these, but no. 3 is the most common. Even when courts appear to endorse no. 1 or no. 2, they are probably following no. 3, because they would rule differently if presented with different facts.

The Texas Trend

Texas courts generally follow no. 3, but the pronounced trend in the Texas Supreme Court in the last 30 years has been towards holding that contractual terms negate a claim of fraudulent inducement.

The traditional rule is that “fraud vitiates a contract.” For example, in Dallas Farm Machinery Co. v. Reaves, 307 S.W.2d 233, 239 (Tex. 1957), the court held that a merger clause does not bar a claim that the contract was induced by fraud. Part of the rationale is that you shouldn’t enforce a contractual disclaimer when the disclaimer itself—as part of the contract—was induced by fraud.

The Texas Supreme Court reaffirmed the traditional principle in Williams v. Glash, 789 S.W.2d 261 (Tex. 1990). Writing for the majority, Justice Doggett said “a release is a contract and is subject to avoidance, on grounds such as fraud or mistake, just like any other contract.” Id. at 264.

But in the 1990s the Texas Supreme Court started whittling away the traditional rule. This trend coincided with complete Republican control of the court. This is not surprising, because generally conservatives favor enforcing contractual disclaimers, while liberals favor letting fraud verdicts stand. I’m generalizing, of course, but let’s not ignore the elephant in the room.

The trend began with Prudential Ins. Co. v. Jefferson Associates, Ltd., 896 S.W.2d 156, 161-62 (Tex. 1995), where the court held that an “as is” clause in a real estate purchase contract conclusively negated the reliance element of a fraudulent inducement claim.

Then in Schlumberger Technology Corp. v. Swanson, 959 S.W.2d 171, 180-81 (Tex. 1997), the court held that a disclaimer of reliance negated a claim of fraudulent inducement, where the release at issue was intended to resolve a dispute, it was an “arms-length” transaction, the parties had highly competent legal counsel, and the parties were “knowledgeable and sophisticated business players.”

After that, defense counsel in any fraud case with a disclaimer of reliance would rely heavily on Schlumberger. And in Forest Oil Corp. v. McAllen, 268 S.W.3d 51, 58 (Tex. 2008), the court extended Schlumberger to a settlement agreement intended to resolve past and future claims.

The Texas Supreme Court slightly bucked the trend in Italian Cowboy Partners, Ltd. v. Prudential Ins. Co. of Am., 341 S.W.3d 323 (Tex. 2011). The contract in that case had a merger clause, but not a disclaimer of reliance. The court distinguished a mere merger clause from a disclaimer of reliance and held that the merger clause did not negate a claim of fraudulent inducement. Id. at 336.

But the court returned to form in JPMorgan Chase Bank, N.A. v. Orca Assets G.P., L.L.C., 546 S.W.3d 648 (Tex. 2018). This time the issue was not so much the effectiveness of the contractual disclaimer, but the justifiable reliance element of the fraud claim. The court held that an experienced oil and gas business could not justifiably rely on a lessor’s statement that certain acreage was “open,” i.e. not already leased, where the contract contained an unusual negation-of-warranty clause and there were other “red flags” indicating that maybe the acreage was already leased. Id. at 660.

The court in Orca Assets approvingly cited case law holding that in an arms-length transaction, the defrauded party must exercise “ordinary care for the protection of his own interests” and “cannot blindly rely on a representation by a defendant where the plaintiff’s knowledge, experience, and background warrant investigation into any representations before the plaintiff acts in reliance upon those representations.” Id. at 654.

In February 2019, the court addressed justifiable reliance again in Mercedes- Benz (more about that later).

Then the Texas Supreme Court returned to disclaimers of reliance in IBM Corp. v. Lufkin Industries, LLC (Tex. March 15, 2019). In contrast to Schlumberger, Lufkin Industries addressed a contract signed at the beginning of the business relationship, not an agreement to resolve a dispute. But the court held that the customer’s fraudulent inducement claim against IBM was barred, where the parties were sophisticated, both sides had lawyers, and two contract clauses expressly and clearly disclaimed reliance. I wrote about this case in Can Your Business Avoid a Fraud Claim by Putting Magic Words in the Contract?

Most recently, it was justifiable reliance again in Barrow-Shaver Resources Co. v. Carrizo Oil & Gas, Inc. (Tex. June 28, 2019). The court held that a driller could not have justifiably relied on a production company’s oral statement that the company would not unreasonably withhold consent for the driller to assign its interest in a “farmout” agreement.

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Truckin’ . . . got the ways and means

As these cases illustrate, the Texas Supreme Court has used both contractual disclaimers and the justifiable reliance element to steadily carve back the fraudulent inducement theory in business transactions.

Back to Mercedes-Benz 

Mercedes-Benz was part of this trend. It held that Mr. Carduco’s reliance on the alleged misrepresentation about the dealership was not justifiable, where Mr. Carduco was a sophisticated businessman, both sides had lawyers in the transaction, and the alleged misrepresentation directly conflicted with specific statements in the contract. The court also held that, even crediting Mr. Carduco’s testimony, there was no evidence that Mercedes-Benz made any affirmative misrepresentation to Mr. Carduco.

The part of Mercedes-Benz I don’t fully grasp is why it was necessary to reach the issue of justifiable reliance in the first place. Why didn’t the court just say there was no evidence of a misrepresentation and stop there? The court seemed awfully eager to write about justifiable reliance.

In any case, the result in Mercedes-Benz is not surprising. The plaintiff’s most fundamental problem was the absence of a clear, affirmative misrepresentation.

But what if the facts had been better for Mr. Carduco? What if, as hypothesized in my fictional closing argument above, the Mercedes-Benz representative had specifically told Mr. Carduco something like “don’t worry about what the contract says, we’ll let you move to another location”?

You could argue that the same reasoning in the Mercedes-Benz opinion would still apply and it wouldn’t make a difference. The rationale of Mercedes-Benz was that a sophisticated business can’t justifiably rely on a representation that is directly counter to what the contract says.

And you could cite the Texas Supreme Court’s subsequent decision in Barrow-Shaver. In that case the sophisticated and experienced parties deleted “shall not be unreasonably withheld” language from a consent-to-assign clause in the contract; thus the provision was “specifically negotiated through a back-and-forth process.” Under those circumstances, the court held that the plaintiff could not justifiably rely on the defendant’s oral promises that “it won’t be a problem,” “don’t worry about,” and “we will work with you.”

On the other hand, in Mercedes-Benz there was no back-and-forth negotiation of the term requiring consent to move the dealership. And under my hypothetical facts, you could make a case that Mr. Carduco’s reliance would have been more justifiable. It’s one thing to say that an experienced business person should not rely on his own vague “belief” that he is going to be allowed to do something the contract says he cannot do. It’s quite another to say he can’t rely on a man’s word.

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IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who focuses on 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.