Can Your Business Avoid a Fraud Claim by Putting Magic Words in the Contract?

Can Your Business Avoid a Fraud Claim by Putting Magic Words in the Contract?

If you run a business and use contracts drafted by a lawyer, there’s a good chance you’ve seen a clause like this:

This Contract contains the complete agreement between Buyer and Seller concerning the sale of the Products and Services and replaces any prior oral or written communications between them. In entering into this Contract, Buyer is not relying on any representation made by Seller that is not stated in this Contract.

The first part is called a “Merger Clause.” The idea is that it “merges” all prior representations, understandings, and agreements into the written Contract. The second part is called a “Disclaimer of Reliance.”

The main point of the Disclaimer of Reliance is to prevent Buyer from making a fraud claim if the deal goes south. The word “fraud” sometimes intimidates non-lawyers, but the basic concept is simple: if you lie to someone in a business deal and they take action in reliance on the lie, that’s fraud.

One special flavor of fraud is “fraudulent inducement.” It sounds legalistic, but the idea is simple: if I lie to you to get you to sign a contract, that’s fraudulent inducement.

When a business deal goes bad, fraudulent inducement is a popular theory, for two reasons. First, if you prove fraudulent inducement you may be able to avoid all the self-serving terms the other guy’s lawyer put in the contract. Second, you may be able to recover actual damages and even punitive damages.

But once upon a time, a smart lawyer figured this out and put the Merger Clause and the Disclaimer of Reliance in the contract he drafted for his client. The hope was that these clauses would prevent the other party from later claiming fraudulent inducement. The idea caught on, and soon his form went viral.

So today, any time a client needs a contract, a lawyer is going to pull up some form that likely includes both a Merger Clause and a Disclaimer of Reliance. For simplicity, let’s focus on the Disclaimer of Reliance.

If a party to the contract tries to claim fraudulent inducement—either to get out of the contract or to try to get damages—the smart litigator representing the other party is going to say, “sorry, Disclaimer of Reliance.”

Not so fast. The equally smart litigator representing the party claiming fraudulent inducement has an ace up her sleeve too. The Disclaimer of Reliance is ineffective, she’s going to argue, because the entire contract—including the Disclaimer of Reliance—was induced by fraud.

Expecto patronum!

Of course, whether the seller actually lied to the buyer to induce him to sign the contract is almost always in dispute. But let’s assume for the sake of argument that the seller made material misrepresentations to the buyer that caused the buyer to sign the contract.

I know, this is Texas. Like Robert Earl Keen says, “nobody steals, nobody cheats.” But just as a hypothetical, what are courts to do with this common situation?

What Rule Should Apply to a Disclaimer of Reliance?

Let’s consider four different rules courts could choose:

A. A Disclaimer of Reliance has no effect on a fraudulent inducement claim.

B. A Disclaimer of Reliance defeats a fraudulent inducement claim.

C. A Disclaimer of Reliance is effective if, when signing the contract, the parties lit incense, struck a ceremonial gong, and recited the Latin phrase caveat emptor in unison.

D. It depends on the circumstances.

I know, choice C sounds silly, but stay with me.

Choices A through C have one clear benefit: they are what lawyers call “bright-line” rules.

Of course, there could always be a factual dispute about whether the incense was actually lit, or a legal dispute about whether the original public understanding of “gong” included a cymbal. But let’s put those quibbles aside. Choices A through C draw clear, bright legal lines that judges can apply with certainty.

But which outcome is more just? The case for Choice A is that “fraud vitiates everything.” The idea is that when one party fraudulently induces the other party to sign the contract, the whole contract is tainted. There is also a certain “realist” case to make for Choice A: the Disclaimer of Reliance is almost always standard “boilerplate” that was not specifically negotiated by the parties. So it should have no effect.

The problem with Choice A is that it tends to encourage more litigation and less certainty. Any party who regrets doing the deal can claim fraudulent inducement, even if the claim has no merit, and it can take months—or years—and thousands of dollars in legal fees to resolve that claim.

That’s why many lawyers—especially transactional lawyers—would pick Choice B: the Disclaimer of Reliance defeats the fraud claim. The rationale for B is that it may mean less justice in a handful of cases where there is real fraud, but overall it’s better for business if companies don’t have to spend time and money litigating fraud claims. Better to stick to what’s in black and white in the contract.

But there’s an obvious counter-argument to Choice B, too. If courts adopt a bright line rule that a Disclaimer of Reliance bars a fraudulent inducement claim, then everybody is going to put a Disclaimer of Reliance in their contracts (as almost everybody already does). Then you have effectively abolished the fraudulent inducement theory.

And what about Choice C, the incense ritual? No one would seriously pick Choice C, and the reason is obvious. Why should the parties’ legal rights depend on whether incense was lit and the gong was struck? Modern judicial decisions should not turn on such ritualistic formalism.

Ok, but isn’t Choice B effectively the same as Choice C? If we say that a business can avoid a fraudulent inducement claim simply by reciting the magic words “disclaimer of reliance” in the contract, is that really any different from the “gong” rule, in principle?

I think this very point—the reluctance to attach too much significance to “magic words”—is why most courts are going to pick Choice D: It depends. Courts recognize that, while a bright-line rule can provide certainty, reality is just too messy to pick one result that should apply in all cases.

That’s a less satisfying answer—especially for non-lawyers—but it’s an answer that allows courts to enforce contract terms generally, while recognizing that justice may require exceptions in some cases.

At least that’s the theory. Let’s look at a case study to see how it applies.

Big Trouble for Big Blue?

Lufkin Industries manufactures machinery and equipment for the energy industry. It needed to upgrade its business operations software, so it called a little company called International Business Machines, which I call “IBM” for short. IBM recommended its “Express Solution for SAP.”

Before the contract was signed, IBM represented to Lufkin that the Express Solution was a preconfigured system that could be implemented within four to six months and meet 80% of Lufkin’s requirements without any enhancements. Oh, and IBM knew this was false (allegedly).

Would you believe the implementation of the software system did not go well? On the day of the “go-live-ugly” (what a great term), Lufkin followed IBM’s instruction to deactivate its old system. But the IBM system didn’t work. Lufkin was unable to use the Express Solution to invoice customers, manage inventory, track orders, calculate payroll, or pay employees and vendors. In short, the system failure crippled Lufkin’s business.

A jury later found that IBM fraudulently induced Lufkin to sign the contract and awarded over $20 million in damages.

But guess what was tucked away in the IBM-Lufkin contract? That’s right, a Disclaimer of Reliance and a Merger Clause. Section 2 of the Statement of Work said:

In entering into this SOW, Lufkin Industries is not relying upon any representation made by or on behalf of IBM that is not specified in the Agreement or this SOW, including, without limitation, the actual or estimated completion date, amount of hours to provide any of the Services, charges to be paid, or the results of any of the Services to be provided under this SOW. This SOW, its Appendices, and the Agreement represent the entire agreement between the parties regarding the subject matter and replace any prior oral or written communications.

These were the facts of IBM v. Lufkin Industries, decided by the Texas Supreme on March 15, 2019.[1]

So what rule did the Texas Supreme Court apply to determine if this clause was effective?

In theory, the court applied a version of Choice D: It depends.

The court started by noting its decision in Italian Cowboy Partners that said a merger clause, standing alone, does not bar a fraudulent inducement claim. But a disclaimer of reliance, in contrast, can be effective: “a clause that clearly and unequivocally expresses the party’s intent to disclaim reliance on the specific misrepresentations at issue can preclude a fraudulent-inducement claim.”

gong-701647_1920
Bang a Gong

On the other hand, “[n]ot every such disclaimer is effective,” and courts “must always examine the contract itself and the totality of the surrounding circumstances when determining if a waiver-of-reliance provision is binding.” In other words, the court must look to both extrinsic and intrinsic facts concerning the contract.

The most important fact is whether the contract was a settlement agreement that resolved a lawsuit or other dispute. Under the Schlumberger case, a disclaimer of reliance in a settlement agreement will usually be effective to bar a later fraud claim. The idea is that there has to be a way for parties to sign an agreement that ends litigation with certainty.

But most business contracts are signed at the beginning of the relationship, before any dispute. In that case, the relevant factors include whether:

(1) the terms of the contract were negotiated, rather than boilerplate, and during negotiations the parties specifically discussed the issue which has become the topic of the subsequent dispute;

(2) the complaining party was represented by counsel;

(3) the parties dealt with each other at “arm’s length”;

(4) the parties were knowledgeable in business matters; and

(5) the release language was clear.

When two businesses negotiate a contract and lawyers are involved, factors (2)-(5) will almost always apply. And in most cases the second part of (1) will be true. It’s hard to see how there could be a genuine fraudulent inducement claim if the issue in dispute was not discussed before the contract was signed.

All of those factors were present in the IBM case. With at most one factor weighing against enforcement, the court said it had “no trouble” concluding that the factors supported a finding that the disclaimer of reliance was effective. “The parties negotiated the Statement of Work at arm’s length,” the court said, “they were both knowledgeable in business matters and represented by counsel, and the two clauses expressly and clearly disclaim reliance.”

The court didn’t say much about the first half of the first factor: whether the merger clause and disclaimer of reliance were negotiated terms or mere boilerplate. I think we can assume the latter. And I think the court’s silence on that factor tells us the court doesn’t care too much about it.

So, despite the IBM opinion’s touchy-feely language about multiple factors and “totality of the surrounding circumstances,” it comes pretty close to this “bright-line” rule: when two businesses represented by lawyers negotiate a contract that contains a clear disclaimer of reliance, there is no fraudulent inducement claim, even if the disclaimer is boilerplate.

I think the “factors” and “circumstances” language is intended to give the court some wiggle room to allow a fraudulent inducement claim in a truly egregious case, e.g. where the party duped into signing the contract is an unsophisticated consumer not represented by a lawyer. But in most business cases, fraudulent inducement is out in Texas.

As long as you said the magic words.

____________________________________

IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. This post is dedicated to 80s supergroup The Power Station. 

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] Int’l Bus. Machines Corp. v. Lufkin Indus., LLC, No. 17-0666, 2019 WL 1232879, __ S.W.3d __ (Tex. Mar. 15, 2019).

I Can’t Drive 25 (Requests for Production)

I Can’t Drive 25 (Requests for Production)

Senior Texas lawyers despair, the last vestiges of the “trial by ambush” era are being swept away like the Imperial Senate.

It looks like changes to the discovery rules are coming to Texas in 2019. Some of the changes will be significant improvements, while others will be less consequential tweaks. But there is one proposed change that is just a bad idea: limiting each side to only 25 requests for production of documents. More about that later.

The Discovery Subcommittee of the Texas Supreme Court Advisory Committee has been working on changes to the discovery rules for a few years now. I wrote about this two years ago in Proposed Changes to Texas Discovery Rules Threaten Law Firm Revenue. As I wrote then, the two biggest changes are requiring Federal-style initial disclosures and making communications with testifying experts undiscoverable.

These changes struck me as basically a good idea, with the potential to reduce gamesmanship and litigation expense. I say “reduce” because you’re never going to eliminate gamesmanship from discovery. This is litigation, after all. Plus, one man’s “gamesmanship” is another man’s proper use of the rules to protect his client’s interests.

In any case, the changes I wrote about—and others—may be coming soon. On February 11, 2019, the Discovery Subcommittee transmitted its recommended rewrite of the Texas discovery rules to the Supreme Court Advisory Committee.

I’ve only got five minutes, so I won’t try to cover all the changes, but here are some highlights:

  • Rule 190.4 would require a Federal-style initial conference followed by a discovery control plan and docket control order. I often find the initial conference a waste of time—it’s too early to address all those issues—but it’s relatively harmless.
  • Rule 192.4(b) would change “the burden or expense of the proposed discovery outweighs its likely benefit” to “the discovery sought is not proportional to the needs of the case.” In other words, the proposal writes proportionality into the rule, although proportionality is already implicit.
  • Rule 193.2(a) targets “prophylactic” objections: “An objection must state whether any responsive materials are being withheld on the basis of the objection.” This sounds like a good rule, but expect it to be routinely ignored.
  • Rule 194 would now require Federal-style initial disclosures. Unless otherwise agreed or ordered, both sides would have to serve them within 30 days after the defendant’s answer. For Texas practice, this completes the decades-long shift in philosophy from “trial by ambush” to putting your cards on the table from the start. Also, like the federal rule, the new rule would allow “a description by category and location” in lieu of actually producing the documents—I’ve never understood the point of this.
  • Rule 195.5(a)(4) would expand the scope of expert disclosures to be closer to Federal Rule 26.
  • Rule 195.5(c) would generally exempt communications with testifying experts from discovery (like the Federal rules–notice a pattern?). Overall, this is a good change for reasons I explained in my “Proposed Changes” post.
  • Rule 199.1(b) would add total hour limits for depositions (50 hours for a typical case).
  • Proposals for addressing ESI and spoliation are still being discussed.
  • Rule 196.1(c) would provide: “Unless otherwise stipulated or ordered by the court, a party may serve on any other party no more than 15 requests for production or for inspection in a Level 1 case or 25 requests for production or for inspection in Level 2 or Level 3 cases, including discrete subparts.” [record scratch]

Wait, what?! You’re telling me in a typical case I only get to serve 25 requests for production?

If you’re not a lawyer, or if you’re a lawyer who doesn’t litigate, that probably doesn’t sound unreasonable. But trust me, 25 requests for production is not a lot.

I’ve been practicing business litigation in Texas for over 20 years. That’s not as long as most of the people on the Supreme Court Advisory Committee, but it’s still a pretty good run. I don’t think I’ve ever had a case of even the slightest complexity where each side served fewer than 25 requests for production.

My fellow litigators understand that you don’t know what you’re going to get when you serve that first broad set of requests for production. And you usually don’t know what the real factual disputes are until you get some substantive documents from the other side and take one or two depositions.

That’s not all. It’s hard enough to get the documents to prove your claim or defense when the other guy is cooperating. When opposing counsel is actively trying to obstruct your efforts to get the documents you need, it’s even harder. For example, I had a fairly simple non-compete case where I had to serve about a dozen sets of requests for production because the opposing party was so slippery.

Surely I’m not alone. I’m a little surprised that the highly experienced litigators on the Supreme Court Advisory Committee would endorse a 25-request limit. I’d be curious to know how many of them have ever had a business lawsuit where 25 requests for production were adequate.

IMG_7223
Take my license, all that jive

Maybe they’ve seen too many cases with an excessive number of requests for production. But there is already an inherent reasonableness limit. Let’s say a party has already served 75 requests for production in three separate sets and then serves a fourth set of 25 more requests. If those requests are unreasonable or duplicative of prior requests, then the responding party can file a motion for protective order asking the judge to limit the number of requests. I don’t think anyone doubts the trial court judge’s discretion to grant a motion like that.

If, on the other hand, those new requests are relevant to issues in the case, reasonably tailored, and not duplicative of prior requests, I say they should be allowed.

But we must reduce the cost of discovery, right?

I’m all for trying to contain the cost of discovery. But it’s not the number of requests for production that is driving up the cost of discovery. In my experience, it’s really two things: (1) emails, and (2) fighting over discovery.

The impact of emails on the cost of litigation is well known. That ship has sailed.

The other factor that makes discovery so expensive is when the lawyers can’t get along. It’s really the discovery battles that drive up the cost. These skirmishes are usually the result of requesting lawyers serving unreasonably broad requests and/or responding lawyers making a litany of unreasonable objections. The problem is then compounded when trial court judges don’t want to get their hands dirty.

These are the main factors that make discovery expensive, not the number of requests for production.

I don’t know how to fix these problems. But I do know that limiting parties to 25 requests for production isn’t going to make lawyers more cooperative, and it isn’t going to change the fact that reviewing and producing thousands of emails is expensive.

If anything, this new speed limit is likely to increase gamesmanship and battles over discovery. If you only get 25 requests, your incentive is to make them broad. That’s going to lead to more objections and more discovery motions. And don’t get me started on arguing about “discrete subparts”; we already know from interrogatories how much time lawyers can waste on that.

Proponents of the limit will point out that you won’t need as many requests for production because the other party has to produce their evidence as part of the new initial disclosures. That’s a fair point, but it doesn’t help me with getting the documents I need to prove my case.

In fairness to the proposal, I also have to point out the preamble: “Unless otherwise stipulated or ordered by the court . . .”

That’s a good safety valve. It leaves the parties free to agree on a greater number of requests for production, and I expect a lot of litigants—especially in complex cases—will avail themselves of that option. And even if the parties don’t agree, the judge can order a greater number of requests if a party offers a good reason.

So the proponents of this revision would say, listen dude (that’s what they call me), you’re overreacting.

But I still don’t think we should start with the presumption that 25 is a reasonable number of requests for production. When the parties can’t agree, some judges are likely to fall back on the number in the rules. So if we’re going to have a number, it should be a good number. Even better, let’s have no presumptive limit and just rely on an inherent limitation of reasonableness.

That was the decision the Texas Supreme Court effectively made when it adopted the “new” discovery rules back in 1999, when I was a new lawyer and Gary Cherone was singing for Van Halen. Those rules limited the number of interrogatories a party could serve but left the number of requests for production open-ended.

The Supreme Court Advisory Committee should do the same thing now. Most of the proposed changes look good. Just take out that 25-request limit.

And May the Force be With You.

___________________________________________________________________

IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. He likes both David Lee Roth and Sammy Hagar. 

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.

Is a Non-Solicitation Agreement a Non-Compete?

Is a Non-Solicitation Agreement a Non-Compete?

The short answer is yes. A non-solicitation agreement is a form of non-compete.

But why does this issue come up? And what difference does it make?

To understand why, let’s back up a bit. It is common for an employment agreement to contain both a “non-solicitation” section and a “non-compete” section. A non-solicitation clause places restrictions on the employee soliciting company customers after leaving the company. A non-compete clause is broader: it places restrictions on the employee working for a competitor after leaving the company.

Every state limits the enforceability of non-competes in some way. In Texas, where I practice, we have a statute declaring that every contract in restraint of trade or commerce is unlawful.[1] But the statute has a large exception for a “covenant not to compete.”

So what about a covenant not to “solicit”? How does that fit into the statutory scheme?

There are really only two options. A contractual covenant not to solicit is either a “restraint of trade or commerce,” which is illegal, or a form of “covenant not to compete,” which is enforceable if it meets the requirements of the non-compete statute.

It’s pretty easy to see why a non-solicitation agreement is a restraint of trade or commerce. Think about it. Imagine if Apple and Samsung signed a contract saying that Apple will not solicit smartphone customers in Asia, and Samsung will not solicit smartphone customers in North America. The Justice Department would be all over that.

It should be no different if the non-solicitation agreement is part of an employment contract.[2]

You can see where this is headed. It shouldn’t help the company to argue that the non-solicitation agreement is not a “non-compete.” If that’s true, it’s an illegal restraint of trade. I’ve made this point before. See When is a Non-Compete Not a Non-Compete in Texas?

But even aside from this dilemma for the employer, there are two reasons why a non-solicitation agreement should be treated as a “non-compete” that is subject to the restrictions in the non-compete statute.

First, common sense. Let’s say I draft a contract that says the employee shall not “cheat” for a period of one year after leaving the employer, with “cheat” defined as “to work for a company that provides similar goods or services as those provided by Employer.”

Hey, it doesn’t use the word “compete,” so it’s not a “covenant not to compete” subject to the statute, is it?

Of course it is. The law isn’t going to let a company get around the requirements of the non-compete statute merely by using some label other than “compete.” The question is whether the function of the clause is to restrict competition. An agreement not to solicit the employer’s customers obviously restricts competition with the employer and therefore should be treated as a “covenant not to compete.”

blank-business-card-697059
Whether an agreement is a “non-compete” shouldn’t depend on the label

The second reason that a non-solicitation agreement is a “covenant not to compete” is that the Texas Supreme Court has said so. This is more important than the first reason.

In Marsh USA Inc. v. Cook, 354 S.W.3d 764, 768 (Tex. 2011), the Texas Supreme Court clarified Texas law on enforceability of non-competes. The agreement in Marsh prohibited the employee from soliciting a certain type of business from people who were clients or prospective clients of his employer within two years of his termination.

Under the heading “Enforceability of the Covenant Not to Compete,” the Texas Supreme Court began its analysis by stating:

Covenants that place limits on former employees’ professional mobility or restrict their  solicitation of the former employers’ customers and employees are restraints of trade and are governed by the Act [meaning the Texas Covenants Not to Compete Act].

In support, the court cited two state court cases and two federal court cases treating non-solicitation agreements as non-competes.

So that should settle it. A non-solicitation covenant is a kind of “covenant not to compete.”

But what difference does it make?

It matters because a covenant not to compete must meet the two requirements of the statute. First, it must be “ancillary to an otherwise enforceable agreement.” Second, it must be reasonable in time, scope, and geographic area. You can watch a brilliant five-minute video on these requirements here.

The geographic area requirement is often a sticking point. Despite the unambiguous requirement in the statute, it is not unusual to find a non-solicitation clause, or even a broader non-competition clause, that contains no geographic limitation. When that happens, the employee can argue that absence of a geographic limitation renders the clause unenforceable as written.

That’s exactly one of the arguments the employee made in the recent case White v. Impact Floors of Texas, LP, No. 05-18-00384-CV, 2018 WL 6616973, at *3 (Tex. App.—Dallas Dec. 18, 2018, no pet. h.).

In Impact Floors, the trial court granted a temporary injunction enforcing the non-solicitation and non-disclosure provisions of an employment agreement. Id. at *1-2. On appeal, the employee argued the trial court was wrong to enter the injunction because the employment agreement contained no geographic limitation. Id. at *3.

That should have been a pretty easy issue for the Court of Appeals, right? As we’ve seen the Texas non-compete statute applies to a non-solicitation agreement, and the statute expressly requires a reasonable geographic limitation.

But the Court of Appeals rejected the employee’s argument on the ground that the injunction only enforced the non-solicitation and non-disclosure provisions of the agreement, not the non-compete provision. Id. at *3.

I’ll leave it to the appellate specialists to argue whether the Court of Appeals got this right on narrow procedural grounds.[3] But as discussed above, the Texas Supreme Court has specifically said the requirements of the non-compete statute apply to a non-solicitation agreement. So, to the extent that Impact Floors says otherwise, it is wrong.

But there is another way to get to the same result. Despite the plain language of the statute requiring reasonable limitations as to “geographical area,” some Texas courts have said that a limitation on the scope of a non-compete—such as limiting it to the employee’s clients—can be used in lieu of a geographic limitation.[4]

So if you’re the lawyer representing the employee, don’t get too excited if the non-solicitation clause has no geographic limitation. It might still be enforceable as written. And even if it’s unenforceable as written, the trial court judge could still grant a temporary injunction enforcing it to a more limited extent.

But don’t let the employer’s lawyer get away with arguing that a non-solicitation clause isn’t a non-compete. That’s just incorrect.

In my opinion.*

___________________________________________________________________

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

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

[1] Tex. Bus. & Com. Code § 15.05.

[2] See, e.g., Rimkus Consulting Group, Inc. v. Cammarata, 255 F.R.D. 417, 438-39 (S.D. Tex. 2008) (stating that a “nonsolicitation covenant is also a restraint on trade and competition and must meet the criteria of section 15.50 of the Texas Business and Commerce Code to be enforceable”).

[3] The Court of Appeals reasoned that the employee complained on appeal only about the non-compete provision, but that the temporary injunction did not enforce the non-compete provision, so therefore the employee’s complaint presented nothing for appellate review. Id.

[4] See Gallagher Healthcare Ins. Servs. v. Vogelsang, 312 S.W.3d 640, 654-55 (Tex. App.—Houston [1st Dist.] 2009, pet. denied) (“A number of courts have held that a non-compete covenant that is limited to the employee’s clients is a reasonable alternative to a geographical limit”); M-I LLC v. Stelly, 733 F.Supp.2d 759, 799-800 (S.D. Tex. 2010) (taking “holistic” approach and holding that absence of geographic restriction did not render non-compete unenforceable where time period was only six months, employee held upper management position, and employee had access to company’s trade secrets).

Texas Trade Secrets 101 2.0

Texas Trade Secrets 101 2.0

Ready for an early Christmas present?

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

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

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

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

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

___________________________________________________________________

IMG_4571

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

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

 

 

 

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

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

It’s Franken-steen

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Some trade secrets strategery

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

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

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

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

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

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

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

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

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

Defense wins championships

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

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

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

(3) slowing down the plaintiff’s momentum.

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

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

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

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

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

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

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

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

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

But if that salt has lost its flavor . . .

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

___________________________________________________________________

IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Most of his posts don’t have so many footnotes.

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

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

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

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

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

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

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

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

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

[9] Id. at *3.

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

[11] Id. at *5-6.

[12] Id. at *7.

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

[14] Id.

[15] Id. at *8-9.

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

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

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

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

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

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

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

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

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

FAQ

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

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

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

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

___________________________________________________________________

IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. He hopes to continue litigating even after becoming a viral YouTube sensation. 

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

*Not certified by the Texas Board of Legal Specialization

Wolfe’s First Law of Texas Non-Compete Litigation

Wolfe’s First Law of Texas Non-Compete Litigation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Let’s be reasonable

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

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

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

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

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

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

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

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

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

Caveat Five-or

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

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

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

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

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

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

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

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

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

___________________________________________________________________

IMG_4571Zach Wolfe (zwolfe@fleckman.com) is a Texas trial lawyer who handles non-compete and trade secret litigation at his firm Fleckman & McGlynn, PLLC. Someday he will come up with a “Wolfe’s Second Law” for something.

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

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