Everything You Need to Know (and Probably Don’t) About Covenants Not to Compete - Texas

A key employee just left. He was intimately involved in a major transaction. He knows all the secrets of a $40 million deal. To make matters worse, he is going to a competitor. You have a non-compete – what can you do?

Or, you just hired a new employee. She “forgot” to tell you about the non-compete she signed. You are asked by the head of her division to review it. You are being asked “can we just ignore it?” You know the answer is “no!” The question is: How bad is the situation?

These are the most common scenarios with a non-compete. After a few decades of practicing law in this area I thought it would be nice to have a brief resource to quickly scan and get a general sense of “what can we do?” or “how bad is the situation?”

I have been fortunate to have litigated to judgment or arbitration award both sides. These cases are never easy. They run “hot” in that they are emotionally fueled. The “emotional fuel” tends to burn out after a few months. These cases can be absolutely devastating if ignored. There are situations where entire divisions of companies are gutted if a non-compete is not enforced. However, on the other side, there are overly aggressive bullies who overreach in the form of competing in the courtroom instead of the market.

This series of articles will explore several states where I have litigated or analyzed non-compete agreements. The first article is on Texas – my home state. Texas is interesting in that it believes in free commerce (the Texas Covenant Not to Compete Act literally outlaws non-competes) but it also believes in business (so the act provides a giant safe harbor for such an agreement).

Each article will address some of the “vital stats” of a non-compete: consideration, limitations (geography, time, scope), specific statutes (such as physicians), and the interplay with the cousins of a non-compete – non-solicitation of employees and non-solicitation of customers.

I am fortunate to have a strong team that works with me both in Houston and in cities in other states. We will jointly write these articles together.

We also encourage our readers to download our Texas Non-Compete Checklist. This handy resource will help you navigate the nuances of covenants not to compete in Texas and future featured states.

Use this checklist to determine whether your covenant not to compete is enforceable under Texas law.

Texas cherishes smoked brisket, live music - and employee mobility. Any non-compete agreement attempting to overly restrict the free market will not be enforced or will be modified by a court to restrict no more than what is reasonable to protect an employer’s business interests.

In Texas, a non-compete agreement is enforceable if it:

1. Is ancillary to or part of an otherwise enforceable agreement (e.g. an employment or non-disclosure agreement) and
2. Has sufficient consideration and
3. Contains limitations that are reasonable and do not impose a greater restraint than is necessary to protect the goodwill or other business interest of the employer as to:
   1. Geographical area and
   2. Time and
   3. Scope of activity.

The burden of proof lies with the employer to demonstrate that the covenant meets the statutory criteria.

Statutory Authority

Texas’ Covenants Not to Compete Act can be found at Texas Business & Commerce Code §§ 15.50 - 15.52.

1. Ancillary to Enforceable Agreement- The first requirement – that there be an “otherwise enforceable agreement” – is satisfied where the covenant is “part of an agreement that contained mutual nonillusory promises.”[1] For a covenant not to compete to be “ancillary to or part of” an otherwise enforceable agreement, the employer must establish both that (a) the consideration given by the employer in the agreement is reasonably related to an interest worthy of protection and (b) the covenant not to compete was designed to enforce the employee's consideration or return promise in the agreement.[2] In other words, the court must find the traditional components of an enforceable contract — offer, acceptance, and consideration — before testing the covenant against the remaining strictures of § 15.50 of the act.
2. Consideration - Business goodwill, confidential or proprietary information, trade secrets, customer information, and specialized training are examples of interests that can be, in appropriate circumstances, worthy of protection by a covenant not to compete.[3] The classic examples of consideration to meet this requirement are the protection of trade secrets and the award of stock options. It is also of note that “[t]here is no requirement under Texas law that the employee receive consideration for the non-compete agreement prior to the time the employer's interest in protecting its goodwill arises.”[4]
3. Limitations in General - The guiding principle in an analysis of limitations is that the restriction must be reasonable, not imposing a greater restraint than is necessary to protect the goodwill or other business interest of the employer.[5] Whether a covenant is a reasonable restraint on trade is a question of law for the court.[6]
   1. Geographic Limitations - A covenant not to compete with a broad geographic scope is unenforceable, particularly when no evidence establishes the employee actually worked in all areas covered by the covenant.[7] Generally, a reasonable area for purposes of a covenant not to compete is considered to be the territory in which the employee worked during his or her employment. However, the breadth of enforceable geographical restrictions must depend on the nature and extent of the employer’s business and the degree of the employee’s investment in that business.[8] Courts have also held that a non-compete limited to the employee’s clients is a reasonable alternative to a geographical limit.[9] Below are some specific examples from Texas case law:
      • Magazine publisher - Contract silent on geographic location, which had effect of imposing global restriction, modified to county where employee actually worked.[10]
      • Operations manager of glass installation company - Employee’s covenant not to compete in seven counties where employer did business modified to two counties where employee did majority of his work.[11]
      • Travel agent - Employee’s covenant not to compete within two Texas counties or any state where employer conducting/has conducted business during employee’s employment modified to county where employee worked or had clients during employment.[12]
      • Insurance agent - Industry-wide exclusion of employee’s ability to work in insurance business in and around county and ban on customers with whom employee had no association while employed by employer held unreasonable; employer did not show what reformation would be reasonable to protect its business interests.[13]
      • Tax consultant - Employee excluded from employer’s existing or any future marketing area modified to county of employer’s base of operations.[14]
      • Executive - Limitation of 50-mile radius of employer’s principal place of business upheld as reasonable.[15]
      • Pathologist/Executive - Geographical limitation in covenant not to compete that prohibited former employee from becoming employed by or otherwise substantively involved with a pathology practice operating in any county within 50 miles of where employee worked was not overly broad, where former employee was not only employed as a pathologist, but also as managing director and officer of nine entities owned by former employer's parent and on highest level management team. [16]
   2. Restricted Period - In determining the reasonableness of the duration of a covenant not to compete, the trial court has considerable discretion.[17] Again the inquiry is whether the duration is reasonable in comparison to the person it is being enforced against. This would take into account the importance of the person to the enterprise and the breadth of confidential or trade secret information (if that is the basis of consideration) that person received. Courts have repeatedly held up to two years as a reasonable time in a non-competition agreement.[18]
   3. Restricted Scope of Activity - A restrictive covenant is unreasonable unless it bears some relation to the activities of the employee.[19] A covenant not to compete that contains an industry-wide exclusion from subsequent employment is unenforceable.[20] Here are a few examples:
      • Agreement purporting to prohibit employee from working “in any capacity … whatsoever … in any business activities … competitive with those of [employer]” held too broad given significant differences between new and former job.[21]
      • Covenant restricting employee from the employment agency business “as an employer … or otherwise” held unreasonable because it restrained employee from placing personnel in any other non-related field and, therefore, prohibits a larger scope of activity than is reasonably necessary to protect employer and is unenforceable without reformation.[22]
      • Covenant failing to limit prohibited conduct to customers with whom the employee had dealings with while employed by employer held overbroad.[23]

Exempt Professions – Physicians

Section 15.50(b) of the act outlines the situations in which a covenant not to compete is enforceable against a physician[24] – such as a buy-out clause.[25] “This buy-out clause requirement provides physicians with the unique opportunity to buy out their covenants that is not available to any other employee subject to a covenant.”[26] Under Section 15.50 of the act, if the physician elects to compete despite signing a valid non-compete covenant with a buy-out clause, the physician must pay the agreed amount or elect to have a reasonable price determined by an arbitrator.[27] Only an arbitrator can determine a reasonable price.[28] A trial court has no authority to determine a reasonable price and cannot render a covenant unenforceable on the basis of an unreasonable stipulated buyout price.[29] Note that while an arbitrator can determine a reasonable price, neither an arbitrator nor a trial court has the authority to reform the non-compete covenant to create a buy-out clause.[30] If the covenant does not a contain a buy-out clause, it is simply unenforceable.[31]

Notably, the statute does not define “reasonable price.” One Texas appellate court has addressed an employer’s argument that a buyout clause is unenforceable because the agreed-upon value has no relationship to the damages the employer would incur if a physician violated the non-compete covenant (i.e., lost profits).[32] The court, in distinguishing the ordinary meaning of “price,” “damages,” and “lost profits,” reasoned that while a valid liquidated damages amount may represent a reasonable buyout price in a particular case, the “Legislature’s choice of words – ‘price,’ rather than ‘damages’ or ‘lost profits’ – may make a difference in determining a reasonable buyout amount under the circumstances.”[33] While acknowledging that parties agree to an amount or formula at the time they sign the contract and that intervening circumstances may make the amount seem unreasonable at the time the buyout provision is sought to be enforced, the trial court (as mentioned above) still has no authority to reform the price.[34]

Reformation/Blue Penciling

Instead of invalidating a covenant not to compete with broad geographical, time, or scope limitations, the court generally must reform the agreement and revise the provisions to those that are reasonable under the circumstances.[35] However, absent a showing by the employer about what, if any, reformation of the covenant would be reasonable and necessary to protect its goodwill or other business interests, the covenant cannot be reformed.[36] CAUTION: When a court reforms the agreement to make it reasonable, an employer will be limited to injunctive relief (i.e., no damages for breach of the agreement).[37]

Remedies in Action to Enforce Covenant Not to Compete

• Damages and Injunctive Relief - Except in the event of a reformation (no damages), a court may award an employer damages and injunctive relief under a covenant not to compete.[38] There are three types of injunctive orders: (1) temporary restraining orders, (2) temporary injunctions, and (3) permanent injunctions.

• Attorneys’ Fees - Generally, an employer may not recover its attorneys’ fees in an action to enforce a covenant not to compete. Section 15.51(c) of the act provides only for the recovery of attorneys’ fees when an employee satisfies certain evidentiary requirements in defending against enforcement of an unreasonable covenant.[39]

Statute of Limitations

The limitations period for a non-compete action is four (4) years.[40]

Interplay Between Non-Compete Agreements and Other Restrictive Covenants

Prohibitions against post-employment solicitation of employees and customers are commonly included in employment agreements. The fundamental question is whether these provisions are subject to the act. Prior to 2011 the law in Texas was clear that a non-solicitation of customer provision was subject to the act. However, in the landmark decision of Marsh USA Inc. v. Cook, 354 S.W.3d 764 (Tex. 2011), the Texas Supreme Court analyzed whether stock options were sufficient consideration/ancillary to an enforceable agreement. In dicta the court stated “Covenants that place limits on former employees' professional mobility or restrict their solicitation of the former employers' customers and employees are restraints on trade and are governed by the Act.”[41] The problem is that no decision had ever held that a non-solicitation of employees was under the act. Further, the Texas Supreme Court’s holding did not turn on the employee non-solicitation covenant, making the court’s statement regarding restraints on trade dictum and lacking precedential value.

The Quandary

Thus, this is the quandary: Do you need to analyze a non-solicitation provision under the act? For me, the answer for a non-solicitation of customers is yes and for non-solicitation of employees is no. The key to the act is to prevent the reduction of employee mobility. Restricting a former employee from soliciting current employees does not restrict employee mobility. Therefore, I would urge caution before enforcing or defending a non-solicitation of employee provisions. I currently have a case that addresses this issue on appeal. I hope one day to have a definitive answer.

We encourage our readers to download our Texas Non-Compete Checklist. This handy resource will help you navigate the nuances of covenants not to compete in Texas.

Footnotes

[1] See Marsh USA Inc. v. Cook, 354 S.W.3d 764, 773 (Tex. 2011); Alex Sheshunoff Mgmt. Servs., L.P. v. Johnson, 209 S.W.3d 644, 648-49 (Tex. 2006).

[2] Mann Frankfort Stein & Lipp Advisors, Inc. v. Fielding, 289 S.W.3d 844, 849 (Tex. 2009).

[3] See Marsh USA Inc. at 775 (“Consideration for a non-compete that is reasonably related to an interest worthy of protection, such as trade secrets, confidential information or goodwill, satisfies the statutory nexus between the covenant not to compete and the interests being protected.”); see also Alex Sheshunoff Mgmt. Servs., L.P. at 651; see also Lazer Spot, Inc. v. Hiring Partners, 387 S.W.3d 40, 46 (Tex. App. – Texarkana 2012, pet. denied); see also Gallagher Healthcare Ins. v. Vogelsang, 312 S.W.3d 640, 652 (Tex. App. – Houston [1st Dist.] 2009, pet. denied).

[4] Marsh, 354 S.W.3d at 778.

[5] TEX. BUS. & COM. CODE ANN. § 15.50(a).

[6] Gallagher Healthcare Ins. Servs. v. Vogelsang, 312 S.W.3d 640, 654 (Tex. App. 2009)

[7] Butler v. Arrow Mirror & Glass, Inc., 51 S.W.3d 787, 793-94 (Tex. App. – Houston [1st Dist.] 2001, no pet.).

[8] AmeriPath, Inc. v. Hebert, 447 S.W.3d 319, 335 (Tex. App. – Dallas 2014, pet. denied).

[9] See Gallagher Healthcare Ins. v. Vogelsang, 312 S.W.3d 640, 654-55 (Tex. App. – Houston [1st Dist.] 2009, pet. denied)

[10] Cobb v. Caye Publishing Group, Inc., 322 S.W.3d 780, 783-86 (Tex. App. – Fort Worth, 2019, no pet.).

[11] Butler, 51 S.W.3d at 793-94.

[12] Evan’s World Travel v. Adams, 978 S.W.2d 225, 232-33 (Tex. App. – Texarkana 1998, no pet.).

[13] John R. Ray & Sons v. Stroman, 923 S.W.2d 80, 85-86 (Tex. App. – Houston [14th Dist.] 1996, nowrit).

[14] Property Tax Assocs., Inc. v. Staffeldt, 800 S.W.2d 349, 350-51 (Tex. App. – El Paso 1990, writ denied).

[15] Integrated Interiors, Inc. v. Snyder, 565 S.W.2d 350, 351-52 (Tex. App. – Fort Worth 1978, writ ref'd n.r.e.).

[16] Hebert, 447 S.W.3d at 335.

[17] Chandler v. Mastercraft Dental Corp. of Texas Inc., 739 S.W.2d 460 (Tex. App. – Fort Worth 1987, writ denied).

[18] See Vogelsang, 312 S.W.3d 640, 654-55

[19] Wright v. Sport Sup. Grp., 137 S.W.3d 289, 298 (Tex. App. – Beaumont 2004, no pet.) (citations omitted).

[20] Id.

[21] See McNeilus Cos. v. Sams, 971 S.W.2d 507, 510 (Tex. App. – Dallas 1997, no pet.).

[22] See Diversified Human Res. Grp. v. Levinson-Polakoff, 752 S.W.2d 8, 11 (Tex. App. – Dallas 1988, no writ).

[23] See Wright, 137 S.W.3d at 298.

[24] The requirements in subsection (b), however, do not apply to a physician’s business ownership interest in a licensed hospital or licensed ambulatory surgical center. Tex. Bus. & Comm. Code Ann. § 15.50(c).

[25] Tex. Bus. & Comm. Code Ann. § 15.50(b)-(c); see LasikPlus of Tex., P.C. v. Mattioli, 418 S.W.3d 210, 220 (Tex. App. – Houston [14th Dist.] 2013, no pet.); see also Greenville Surgery Ctr., Ltd. v. Beebe, 320 S.W.3d 850, 853 (Tex. App. – Dallas 2010, no pet.).

[26] Beebe, 320 S.W.3d at 853.

[27] It is not fatal to the agreement if the covenant does not include reference to the arbitration option and does not preclude arbitration of the issue of reasonable price. See id. at 897. The court “presume[s] that the parties contracted with knowledge of the statute's arbitration provision concerning the price, and that the parties intended the statute's application in determining a reasonable price.” Id.

[28] See Tex. Bus. & Comm. Code Ann. §§ 15.50, 15.51; see Sadler Clinic Ass’n v. Hart, 403 S.W.3d 891, 896-97 (Tex. App. – Beaumont 2013, pet. denied).

[29] See Hart, 403 S.W.3d at 898 (trial court erred declaring entire covenant not to compete unenforceable because the court believed the stipulated buyout price was unreasonable; proper remedy was binding arbitration to determine reasonable price).

[30] Mattioli, 418 S.W.3d at 220.

[31] See id.; see Tex. Bus. & Comm. Code Ann. § 15.50(b); see also Beebe, 320 S.W.3d at 853 (covenant held unenforceable because no buyout clause).

[32] See Sadler Clinic Ass’n v. Hart, 403 S.W.3d 891, 896-97 (Tex. App. – Beaumont 2013, pet. denied)

[33] See, e.g., id. (questioning how physician's annual gross income would relate directly to employer’s lost profits).

[34] See id.

[35] Tex. Bus. & Comm. Code Ann. § 15.51(c).

[36] Stroman, 923 S.W.2d at 85.

[37] See id.

[38] Tex. Bus. & Comm. Code Ann. § 15.51(a)-(c).

[39] See Franklink, Inc. v. GJMS Unlimited, Inc., 401 S.W.3d 705, 709-12 (Tex. App. – Houston [14th Dist.] 2013, pet. denied) (affirming trial court’s denial of employer’s request for attorneys' fees because the Act preempts Civ. Prac. & Rem. Code Chapter 38); Perez v. Texas Disposal Sys., Inc., 103 S.W.3d 591, 594 (Tex. App. – San Antonio 2003, pet. denied) (holding the Act controls award of attorney’s fees and preempts award of fees under any other law); Ginn v. NCI Bldg. Sys., Inc., 472 S.W.3d 802, 827 (Tex. App. – Houston [1st Dist.] 2015, no pet.) (affirming trial court’s denial of employer’s request for attorneys' fees because the Act does not authorize award of attorneys' fees to employers).

[40] Tex. Civ. Prac. & Rem. Code § 16.051.

[41] See Marsh,354 S.W.3d at 768.