In a recent post, I addressed the applicable framework under Texas law when employees not subject to non-compete agreements leave a job to compete with a former employer. This article addresses Texas law on non-compete covenants and its impact on potential disputes when covered employees exit and work in competitive roles.
Employers and employees alike have legitimate interests in these circumstances. Employers have an interest in protecting their investment in competitive information and knowledge held by the employee. On the flipside, exiting employees have a legitimate interest in earning a livelihood—and sometimes their only viable alternative might require a competitive role.
Recent Regulatory Scrutiny of Non-Compete Agreements
Because non-compete agreements can be used abusively to negatively impact employees and burden the free market, legislators and regulators have widely acted to restrain freedom of contract in connection with their use. Prospective federal regulatory changes may drastically alter the current legal framework nationwide.[i] But for the time being, Texas employers and employees would do well to familiarize themselves with the framework described below.
How Can Non-Compete Agreements Restrain Competition from Employees?
The “teeth” that compel compliance with covenants not to compete are (1) damage awards and (2) injunctive relief. Additionally, requests for injunctive relief to enforce non-compete covenants benefit from a special rule: the proponent need only show a substantial breach of a covenant for entitlement to a permanent injunction. See Butler v. Arrow Mirror & Glass, Inc., 51 S.W.3d 787, 795 (Tex. App.–Houston [1st Dist.] 2001, no pet.) (holding that a showing of irreparable harm was not necessary to support the lower court’s issuance of a permanent injunction); but see Argo Grp. US, Inc. v. Levinson, 468 S.W.3d 698, 702 (Tex. App.—San Antonio 2015, no pet.) (holding that a plaintiff seeking a temporary injunction under Tex. Bus. Com. Code § 15.51 must show a probable, imminent, and irreparable injury in the interim before trial); Primary Health Physicians, P.A. v. Sarver, 390 S.W.3d 662, 664–65 (Tex. App.–Dallas 2012, no pet.) (same). This significantly relaxes the proof required to support a permanent injunction.[ii]
These enforcement mechanisms drastically alter the legal framework governing relationships between employees and their former employers. Unless they are restrained voluntarily by agreement, former employees have a common law right to compete. Consequently, unless a non-compete agreement applies, in typical cases courts will not issue an injunction to restrain competitive conduct by a former employee post-exit. For the same reason, damage awards are not available in these circumstances unless the competing former employee’s pre-exit conduct breached a fiduciary duty or misappropriated a trade secret.
The specters of injunctions and damage awards, which can include attorney fees, dramatically raise the stakes for employees keen to compete with former employers. But not all non-compete agreements meet the enforceability requirements established in the Texas Covenants Not to Compete Act (the “Act”), set forth in Sections 15.50 through 15.52 of the Texas Business & Commerce Code. Accordingly, parties to a non-compete agreement should consider whether a non-compete covenant may be overbroad or unreasonable and any resulting consequences.
What if a Non-Compete Covenant is Unenforceable as Written? Can it be Reformed?
A Texas court cannot enforce a covenant not to compete that fails to comply with the Act’s requirements. This means that courts cannot award damages or issue injunctions in connection with breaches of overbroad or unreasonable non-compete agreements. Employers have the burden of establishing that the restrictions of a non-compete covenant are reasonable. TEX. BUS. & COM. CODE § 15.51(b). Further, if an employee is successful in defending a non-compete action and shows that the employer knew that the restrictions of an agreement were unreasonable when entered, a court may award the employee attorney fees. Tex. Bus. & Com. Code § 15.51(c). These are good reasons for narrowly tailoring non-compete agreements to protect competitive information or other legitimate interests with reasonable restrictions that expire when the relevant information becomes stale.
Luckily for employers, however, in non-compete disputes, courts must reform covenants that contain unreasonable restrictions but are otherwise enforceable. Nonetheless, parties can waive their right to reformation and a court can only reform non-compete covenants that are necessary to protect legitimate business interests. Daytona Grp. of Texas, Inc. v. Smith, 800 S.W.2d 285, 290 (Tex. App.—Corpus Christi 1990, writ denied) (citing DeSantis v. Wackenhut, 793 S.W.2d 670, at 685 (Tex.1990)). After reformation, a court can award damages and issue injunctive relief—but relief can only apply prospectively to post-reformation conduct. Even if a contract stipulates that a prevailing party shall obtain attorney fees and the employer prevails on a request for reformation, attorney fees cannot be awarded. See, e.g., Perez v. Texas Disposal Sys., Inc., 103 S.W.3d 591, 591–92 (Tex. App. 2003).
Consequently, the mechanisms appropriate to seek enforcement of a non-compete covenant, and when to use them, can imply tough choices. If a court reforms the relevant covenants, the employer loses the ability to recover damages and attorney fees for past conduct, along with the leverage that accompanies the threat of those possibilities. Similarly, a departing employee subject to an unreasonable non-compete covenant can file suit for a judicial declaration that the agreement is unreasonable, but doing so risks losing the potential benefit of the employer’s inability to obtain an injunction and damages for pre-reformation conduct.
Enforceability Criteria: What Barriers Exist to Enforcement of Non-Competes?
Because non-compete covenants can harm employees and unreasonably restrain commerce, over several decades Texas courts developed criteria for their enforcement based on “reasonableness.” See Peat Marwick Main & Co. v. Haass, 818 S.W.2d 381, 388 (Tex. 1991) Later, the Texas legislature established similar statutory requirements in the Act but provided the reformation remedy to protect legitimate business interests. Id.
First, a non-compete covenant cannot be enforced or reformed unless it is “ancillary to an otherwise enforceable agreement” between the parties. Tex. Bus. & Com. Code § 15.50(a). In the context of an employment relationship (which is an otherwise enforceable agreement), this requires a finding that there is additional consideration (i.e., a benefit to the employee) supporting the covenant that is “reasonably related to an interest worthy of protection, such as trade secrets, confidential information or goodwill.” Marsh USA Inc. v. Cook, 354 S.W.3d 764, 775 (Tex. 2011). Generally, conferring benefits on employees like specialized training or information will be sufficient to meet this requirement. Id.
Secondly, the Act directs courts to evaluate the reasonableness of non-compete covenants on three factors. Tex. Bus. & Com. Code § 15.50(a). These include the reasonableness of their limitations as to:
- the scope of activity restrained;
- the geographic scope of the restrictions; and
- the time period of the restrictions.
Texas courts determine the reasonableness of a covenant’s restrictions on a case-by-case basis. At one end of a continuum, courts will tolerate only minimal restrictions on low level employees, or none at all. On the other end of that continuum, courts will tolerate relatively more stringent restrictions on executive or high-level employees that possess competitive knowledge or secret proprietary information.
Finally, there is a “catch-all” requirement: non-competes must be no more restrictive than necessary to protect “the goodwill or other business interest” of the employer. A restraint is unnecessary if it is broader than necessary to protect the legitimate interests of the employer. Gallagher Healthcare Ins. Servs. v. Vogelsang, 312 S.W.3d 640, 654 (Tex. App.—Houston [1st Dist.] 2009, pet. denied) (citing DeSantis v. Wackenhut Corp., 793 S.W.2d 670, 682 (Tex.1990)). Accordingly, even if a non-compete covenant’s limitations do not contain unreasonable restrictions relevant to the former employee’s scope of activity, their geographic application, and their duration, they can be deemed overly restrictive if they are not necessary to protect the former employer’s goodwill or other legitimate business interest.
In conclusion, as a practical matter, the legal framework established by the Texas Covenants Not to Compete Act and case law interpreting the Act favors employers. Even when non-compete agreements are clearly unreasonable, the threat of litigation can be sufficient to intimidate employees into compliance. But well-funded or clever former employees can take advantage of the Act’s enforceability requirements and other protections to avoid liability for competitive conduct. Additionally, large-scale employers that abuse non-compete agreements have exposure to anti-trust liability under Texas and federal law. See DeSantis v. Wackenhut Corp., 793 S.W.2d 670, 686-688 (Tex. 1990). As a result, especially when the stakes are high, employers have good reasons to prepare non-compete agreements that are narrowly tailored to protect legitimate business interest that are enforceable without judicial reformation.
[i] Out of this concern, the Federal Trade Commission recently proposed a rule that would enact broad prohibitions on non-compete agreements with few exceptions. The rule would broadly alter the existing legal framework. Nonetheless, if the FTC passes the proposed rule, it will doubtlessly confront significant legal challenges.
[ii] A successful applicant for permanent injunctive relief must demonstrate the following four grounds for relief: 1) the existence of a wrongful act; 2) the existence of imminent harm; 3) the existence of irreparable injury; and 4) the absence of an adequate remedy at law. Priest v. Texas Animal Health Comm’n, 780 S.W.2d 874, 875 (Tex. App.—Dallas 1989, no writ) (citing Frey v. DeCordova Bend Estates Owners Ass’n, 632 S.W.2d 877, 881 (Tex.App.—Fort Worth 1982), aff’d, 647 S.W.2d 246 (Tex.1983)).