| Covenants Not to Compete vs. Non-Disclosure Agreements Manufacturing businesses rely on fixed assets to produce revenues. These assets don’t leave business’s premises. In contrast, services-based businesses rely on the intellect of their employees. These employees leave the business every day, and the business’s most important assets leave right along with them. How can service-based businesses protect these revenue-generating assets? Well, here are three ways, all in the context of a written employment agreement: (1) covenants not to compete; (2) non-disclosure agreements; and (3) non-solicitation agreements. These are very different animals, and subject to very different rules for their recognition and enforcement. This year has already produced at least three different decisions from three different courts on this topic. First, the general rules. “Covenants not to compete” prevent a person from competing against the identified business, usually defined by type of activity or industry, and geographical region. They are considered restraints of trade and have historically been unenforceable unless the restrictions were reasonable. In 1989, the Texas Legislature passed a new law allowing covenants not to compete if: (1) the covenant was “ancillary” to or part of an otherwise enforceable agreement at the time the covenant was made; and (2) the covenant contained reasonable limits on time, geography and scope of activity to be restrained, which did not impose a greater restraint than was necessary to protect the good will or other business interest of the one imposing the restriction. (Section 15.50 of the Texas Business & Commerce Code.) Texas courts have added a substantial number of very technical requirements to this statute, such that covenants not to compete are, in practice, very difficult to enforce. And whether they are, or aren’t, enforceable, is a matter decided by the judge, not by a jury. Non-disclosure and non-solicitation agreements are not considered restraints of trade, and are not subject to the same restrictive rules as covenants not to compete. A non-disclosure agreement typically prevents a person from using confidential information obtained during the course and scope of employment, for any purpose other than that employment. If that person begins working with a competitor, they cannot “disclose” or use the information to benefit their new employer. This does not prevent the person from working, nor earning a living, but rather simply regulates the way the person goes about it. Non-disclosure and non-solicitation agreements are treated by courts more like a traditional breach of contract claim. Employees have a common law duty not to use confidential or proprietary information acquired during employment adversely to his employer. So how do these restrictions work in the real world? Well, sometimes they do, sometimes they don’t, as these three recent cases show. Read through these examples. Then, at the end of this article is a list of steps employers can take to increase the likelihood of winning a contest on these sorts of restrictions. First up is the employment of Harold Phillips, an engineer. While working for Rimkus Consulting Group in the Houston area, Rimkus had him sign a very lengthy covenant not to compete. It’s over 2 pages long. In 1998, Rimkus moved from Rimkus to Brown Engineering, a Rimkus competitor. Rimkus sued its former employee Rimkus for breach of the covenant not to compete. Rimkus lost in the trial court and immediately appealed. Over two pages worth of words seemed to be worth no more than the paper on which they were written. It is very difficult to have an enforceable covenant not to compete in the context of an at-will employment, given the way Texas courts view these things. An “at will “employment is not an “otherwise enforceable agreement” required to be ancillary to a covenant not to compete, because an at will employment does not bind the employer, who retains the option of terminating employment at any time. This sort of ancillary agreement is “illusory.” In Phillips’ case, both parties just assumed that the employment was an at-will situation. Stunningly, none of the lawyers involved bothered to really read and analyze the written agreement. Even more stunning, the Court caught the mistake. Phillips’ contract was for 90 day terms, which automatically renewed absent termination. During each 90 day period, Phillips could only be fired for two causes as defined in the agreement. Rimkus also agreed to pay Phillips 3 weeks salary as compensation in the event he was terminated due to a reduction in work force. The employment was not “at will”, and both of these provisions were “non-illusory” promises “ancillary” to the covenant not to compete. And so the court moved to the second part of the statute governing non-compete agreements, whether the agreement was reasonable in time, geographic area and scope of activity. Now, if a business wins on the first part of the test, success on the second part usually follows right along. There will be some sort of restriction. And under Texas law, if a court finds an enforceable covenant not to compete, the trial court MUST either enforce it as written, or “reform” the covenant to the extent necessary to cause the limitations to be reasonable. A court cannot refuse to reform the covenant. A court can’t even throw in the towel and say “it’s not capable of being reformed.” And so in Mr. Phillips’ case, in January of 2003 Rimkus won the opportunity to go back to the trial court and have its 2+ page covenant not to compete “reformed” to be reasonable. Meanwhile, back at the ranch, Mr. Phillips has now been working for his new company since 1998, which would put his current employment at about 5 years. And all this is over a covenant not to compete that lasted 18 months after separation from Rimkus. How much do you think Rimkus will win in the trial court at this point in the game? As we’d say where I come from, that company can’t win for losing. And so you can see one big practical problem with covenants not to compete. If you don’t win the injunction right off the bat to enforce the restriction, and have to resort to appeals, you’re on the practical side of losing anyway, even if you technically later win. On to the next example. Let’s see if Tom James, a custom clothing manufacturer who sells directly to customers, made out any better. In January of 2002, 4 salesmen left Tom James and were promptly sued for enforcement of covenants not to compete, plus non-disclosure agreements. Now, at least the timeline of this case favored Tom James better than the timeline in the Rimkus case above. The employees left in January of 2002. Tom James immediately filed suit, and won a temporary restraining order. But after a four day hearing, Tom James lost on its attempt to extend the TRO into an injunction. The former employees were free to work their former sales territory for another employer. Then things slowed down. In December of 2002, the employees tried to end the district court suit, and won, but the trial court reversed itself on reconsideration, in April of 2003. The court of appeals went on to hear the appeal, on an expedited basis, and rendered its written opinion July 11, 2003. Now we’re standing about a year and a half after the date of injury. In lawyer terms, this case flew through the system, and that makes it a rare exception. Here we have an “at will” employment relationship, and so the big challenge Tom James faced was coming up with an “ancillary” agreement to the covenant not to compete, that wasn’t “illusory.” And Tom James said “we three otherwise enforceable agreements–(1) we agreed to provide sales aids; (2) we agreed to disclose confidential information and trade secrets; and (3) we agreed to provide specialized training.” Unfortunately, Tom James was basically sloppy in how it drafted its contract forms. In order for these three agreements to stick, they require a little, very technical matter called “consideration.” And consideration must be exchanged simultaneously with the agreement on the covenant not to compete. Quid pro quo, in other words. Past quid pro quo won’t work. This is where Tom James basically gave away the game. Its contract forms said that as a result of the employee’s employment, the employee “has received” (1) sales aids, (2) confidential information; and (3) specialized training. “Has received” is past quid pro quo. With Tom James in complete control of its own forms, it only had itself to blame. With the covenant not to compete blown, Tom James moved on to its non-disclosure agreement. Most printed forms Tom James used in selling its products included a printed legend to the effect that the information is a confidential trade secret and may be used only to sell Tom James stuff. At least Tom James had its forms down on this one. Unfortunately, its practices stunk up the joint. In order to enforce a non-disclosure agreement, the employer has to prove that information is confidential and secret. The evidence in this case showed that Tom James freely made customer lists, sales techniques, training meetings, and other information, available to potential recruits before they signed confidentiality agreements. Even Tom James’ national sales meetings were open to sales recruits and (gasp!) competitors! And so, even though they had the confidential legends printed on dang near everything, in practice Tom James didn’t have any secret information they could protect. And so we move on to the third case, a June 17, 2003, opinion from the U. S. Fifth Circuit Court of Appeals. Anthony Provenzale signed an employment agreement with Sedgwich Payne Co., a reinsurance company, in 1993, to be a branch manager. It had both a covenant not to compete, as well as a non-disclosure agreement. In 1999, Sedgwich Paynet merged into Guy Carpenter & Co., and the parties amended the employment agreement to (1) add an arbitration provision, (2) change the compensation and term-of-employment provisions, and (3) reduce Provenzale’s severance in the event of a discharge for no cause, from 3 years to 1 year of salary. Oh, and Sedgwich paid Provenzale $35,000 to sign this 1999 agreement. By July 13, 2001, Provenzale had had enough of the new culture, and he moved to greener pastures with Benfield Blanch. Wasting just less than a month, on August 3, 2001, Guy Carpenter sued Provenzale for breach of contract (non-disclosure and non-solicitation provisions) and misappropriation of trade secrets. Central to the case was Guy Carpenter’s charge that Provenzale was soliciting clients of Guy Carpenter, for his new employer. And Provenzale even agreed that he was doing exactly that. On September 5, 2001, the district court granted Guy Carpenter a restraining order against Provenzale preventing him from continuing such acts, but the victory was short lived. Just over a month later, on October 19, 2001, the district court dissolved the TRO and refused to issue any injunction against Provenzale. The district court decided the non-disclosure and non-solicitation agreements were unenforceable, and that there was no confidential information to protect on the “misappropriation of trade secrets” claim. At the Fifth Circuit, the court noticed that the district court took the standards used to test a covenant not to compete, as in the whole “ancillary to an otherwise enforceable agreement/non-illusory promise” test, and used that to judge the enforceability of the non-disclosure and non-solicitation provisions. Eventually the Fifth Circuit sent the case back to the trial court to fix this problem and determine how to enforce those provisions. And then the court came to the misappropriation of trade secrets claim. Guy Carpenter identified 13 categories of “confidential information”:
The court concluded that none of these categories could be protected by Guy Carpenter as a trade secret. Do you think your customer list should be protected? There are three factors which determine whether a customer list is a protectable trade secret: (1) what steps, if any, an employer takes to maintain the confidentiality of a customer list; (2) whether a departing employee acknowledges that the customer list is confidential; and (3) whether the content of the list is readily ascertainable. In this case, customer lists were readily ascertainable, and so the customer lists were not confidential, subject to protection. In fact, Provenzale’s list of customers was relatively short. It included only the companies he personally serviced while at Guy Carpenter. He could easily reproduce the list even without the aid of a trade publication. As for the other 12 categories of confidential information, Guy Carpenter could not prove that Provenzale had breached a confidential relationship. Guy Carpenter said “we should be able to infer (in other words, assume) that it was probable Provenzale would use the trade secrets, because he had them.” Provenzale said “not so fast. First, I didn’t take any confidential information with me, (2) Guy Carpenter admits that it could use employees it had hired away from Benfield Blanch to service customers without using Benfield Blanch’s confidential information, and (3) Benfield Blanch didn’t need Guy Carpenter’s proprietary software, because it had its own that he was using, and (4) the 9-11 terrorist attacks completely altered the reinsurance market, so any confidential information Provenzale may have left with in July of 2001 was completely out of date. And the Court of Appeals said “sounds good enough to us.” And so yet again, the employer got the practical shaft. That leaves them 0 for 3 in this stretch run, which isn’t uncommon in the covenant not to compete/non-disclosure arena. What is an employer to do? First, instead of just ordering some boilerplate thrown into an employment agreement, the employer needs to spend more time, and focus more attention, on determining what is information is confidential, and proprietary, given these legal definitions. Second, spend some time to craft a written agreement that includes a covenant not to compete, which meets the “otherwise enforceable agreement/non illusory promise” tests, along with non-disclosure and non-solicitation provisions that specifically address and protect the identified confidential information. Third, exchange quid pro quo in these agreements. Fourth, conduct business in a way that shows you really believe the confidential, proprietary information is valuable, and protect its confidentiality. Be credible. Make sure your conduct matches the words in your written agreements. Fifth, be consistent from employee to employee. Courts have a natural tendency to not want to prevent someone from working to earn a living. Businesses who need to enforce covenants not to compete, non-disclosure and non-solicitation agreements have an uphill battle when it comes to enforcement. Not even time is on your side. Better to be safe and careful, than loose and sorry.
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