Texas Supreme Court Decision Facilitates Covenants Not To Compete

October 18, 2011

This summer the Supreme Court of Texas (the “Court”) re-shaped the landscape for enforcing covenants not to compete, or not to solicit customers[1], by relaxing its requirements for such covenants to be “ancillary to or part of an otherwise enforceable contract.”  In Marsh USA Inc. et al v. Cook (June 24, 2011, No. 09-0558). The Court held that a covenant not to compete could be “ancillary to or part of an otherwise enforceable agreement” if the agreement protects or enhances the employer’s good will.

Previously, the Court had held that a covenant not to compete had to be ancillary to or part of an agreement in which the employer promised to provide trade secrets, confidential information, specialized training, or other similar asset to the employee to make the covenant something other than a purchased, “naked” restraint of trade, which is against long-established Texas public policy. In other words, the courts had required that the employee receive something that it could use to injure its employer—but for the covenant. The reasoning was that, for a covenant not to compete to be “ancillary to or part of” an agreement, the consideration provided by the employer under the agreement had to “give rise” to the need for the protective covenant by the employee.

Prior to 1987, reasonable noncompetition clauses in contracts pertaining to employment were not considered to be contrary to Texas public policy as an invalid restraint of trade. However, in Hill v. Mobile Auto Trim,[2] the Court declared that covenants not to compete are unenforceable if they prohibit employees from obtaining jobs that share a “common calling” with current employment, effectively destroying an employer’s ability to obtain an enforceable covenant not to compete.

In 1989, the Texas legislature reacted to Hill by enacting Section 15.50(a) of the Texas Business and Commerce Code (the “Act”):

“…[A] covenant not to compete is enforceable if it is ancillary to or part of an otherwise enforceable agreement at the time the agreement is made to the extent that it contains limitations as to time, geographical area, and scope of activity to be restrained that are reasonable and do not impose a greater restraint than is necessary to protect the goodwill or other business interest of the promisee.”  (Italics added.)

It was widely recognized, even by the Court, that the legislature had acted “to reverse the Court’s apparent antipathy to covenants not to compete . . .. ”[3]

Nonetheless, in 1994, in Light v. Centel Cellular Co. of Texas,[4] the Court held that, for a covenant to be “ancillary to or part of an otherwise enforceable contract,” the consideration provided by the employer had to “give rise” to an interest worthy of protection (e.g., trade secrets, confidential information or specialized training) and had to be provided to the employee at or after the signing of the covenant.

In Marsh, the Court did not consider whether trade secrets, confidential information or specialized training had been or would be delivered in connection with Cook’s covenants.[5]  Instead, the “otherwise enforceable agreement” was the grant of an option to Cook in 1996 to purchase stock of Marsh USA’s parent and Cook’s exercise of that option.  A condition to exercise of Cook’s option was his execution of a Non-Solicitation Agreement (“Agreement”).[6]  In 2005, Cook exercised the option and executed and delivered the Agreement.  Thus, the Court assessed whether the non-solicitation covenants were “ancillary to or part of an otherwise enforceable agreement” where the employer’s consideration was selling its parent company’s stock to the employee at a price that was below market value on the date of purchase.   Marsh USA claimed that providing stock options gave Cook an incentive to stay with Marsh USA and build its value.  An affidavit by a Marsh USA executive stated, “The Incentive Plan also serves to enhance the relationships between Marsh and its customers by helping the company retain highly motivated employees with an interest in the long-term success of the company, which, in turn, enhances the goodwill of Marsh.”

In Marsh, the Court rejected the “give rise” requirement that had been layered atop the statute in its decision in Light.  Instead, the Court focused on a different part of the Act to ascertain the types of agreement that a covenant not to compete could be “ancillary to or part of.” It concluded that the covenant could be ancillary to or part of an agreement protecting or enhancing the employer’s goodwill.  The employer no longer has to deliver anything to the employee that gives rise to the need for the protective covenant.

The Court concluded that, by awarding Cook stock options,[7] Marsh linked the interests of a key employee[8] with its own long-term business interests.  It stated that stockholders’ interests are furthered by fostering goodwill between an employer and its customers. Thus, the Court ruled, the stock options were reasonably related to the protection of the business’ goodwill and are “ancillary to or part of an otherwise enforceable agreement.” In effect, the Court held that the business interest being protected or enhanced was goodwill and that the consideration given (stock options) had a sufficient nexus to goodwill for purposes of the Act.  It did not say that any payment to the employer would have sufficient nexus with protection of goodwill.[9]

Significantly, the Court also addressed the question of whether the employer’s interest in restraining the employee can exist before the employer’s consideration is given—the Court of Appeals had held that it may not. The Court rejected the lower court’s view, holding that, even if the employer had an interest in restraining the employee’s conduct before the covenant was obtained, it nonetheless could enter into a binding covenant not to compete at a later date with other consideration for the covenant.

Another point that may or may not prove significant is the Court’s statement that a covenant not to solicit employment of other employees of the employer is covered by the Act. This was not the law before this decision, and, because the issue was not before the Court for decision, may not be binding precedent. Nonetheless, when the Supreme Court speaks, even in dicta, the lower courts are apt to listen.

The Court did not address the reasonableness of the restraints imposed by the Agreement, and remanded that issue for further proceedings in the trial court.[10]

Implications of Marsh USA v. Cook

1.  Under Marsh, an enforceable covenant not to compete may be created at any time during employment. 

2.  To meet the “ancillary to or part of an otherwise enforceable agreement” test, the consideration for the other agreement cannot be just cash or another form of outright payment to the employee; it should somehow tie the interests of the employee to the interests of the employer.  A purchase of stock (at a discount, through an option) is now sufficient.  It is likely that the mere granting of an option will be sufficient consideration.[11]  An agreement to which a covenant not to compete is ancillary should now recite that it is related to and intended to protect or enhance the employer’s goodwill.  Employers should continue including a recital of Light consideration (provision of trade secrets, other confidential information and specialized training) whenever possible.

3.  Existing covenants not to compete complying with the Light standard for the “otherwise enforceable agreement” will continue to be enforceable to the extent that they were enforceable before this decision. 

4.  There will be new opportunities to enter into covenants not to compete with persons who in the course of their work do not receive trade secrets, other confidential information or specialized training.  These could be employees with or without access to highly sensitive information but who have contact with customers and thus pose a threat to the employer if they leave to work for a competitor. 

5.  Covenants not to solicit employment of other employees of the former employer may be subject to the same analysis.  A broader universe of agreements, such as non-disclosure agreements executed in the merger and acquisition context, should contain the same recitals as to protection of goodwill (if they do not already contain them).