Podcast Episode 22—Can a Noncompete be Enforceable in Texas?

Podcast Episode Timestamps

00:00 — Two competing myths: “noncompetes are never enforceable in Texas,” and “noncompetes are always enforceable.”
00:20 — Intro
00:44 — Received wisdom can be wrong.
01:08 — Although many noncompetes are unenforceable, since 1989 noncompetes can be enforcible in Texas if they comply with the statute.
01:35 — To be enforceable, the statute requires a noncompete to be (1) ancillary to an otherwise enforceable agreement, (2) be reasonable in terms of time limit, geography, and scope of restriction, and (3) be supported by consideration reasonably related to the business interest sought to be protected.
02:25 — But first, some discussion of the competing public policies at play.
04:48 — Element 1—ancillary to an otherwise enforceable agreement.
06:22 — Element 2—reasonable in terms of time limit, geography, and scope of restriction.
07:44 — Element 3—supported by consideration reasonably related to the business interest sought to be protected.
12:12 — There are special rules for physicians and attorneys (not discussed in this episode).
12:36 — Why can noncompetes be important? They can help protect a business’s competitive advantages.
13:12 — Third parties can have liability for employing someone who is violating a noncompete.
13:43 — Assignment of noncompetes in the context of sale of a business.
14:21 — Takeaways from this episode.
14:55 — Subscribe, check the show notes, and email or schedule a call with your questions.
15:30 — Outro

Received Wisdom can be Wrong

I’ve often heard folks say that noncompete agreements, commonly referred to as noncompetes, cannot be enforced.  At least as often I’ve heard it said that someone changed industries because there was a noncompete in place.  Neither of these opposite views—that noncompetes are never enforceable or that they are hot potatoes to avoid running afoul of—are always right.  Many noncompetes are unenforceable; on the other hand, since 1989, in Texas many noncompetes are enforceable within a carefully defined, limited period of time, limited geography, and limited activity.

The Basic Requirements

To be enforceable in Texas, a noncompete agreement has to be (1) ancillary to an otherwise enforceable agreement, meaning they can’t stand alone; (2) be reasonable in terms of time limit, geography, and scope of activity to be restrained; and (3) be supported by consideration that is reasonably related to an interest worthy of protection, such as trade secrets, confidential information or goodwill (check out THIS previous post for what “consideration” means in the contract formation context).  I’ll dig into each of these later in this post.  But, first let’s step back to get a sense of the competing public policies in support of and opposition to the permissibility of noncompetes in general.

Competing Public Policies: Freedom to Compete vs. Freedom to Contract

In Texas, competition is generally encouraged and protected except for narrow exceptions that fall under the umbrella of ‘unfair competition’ or competition that violates an enforceable contractual promise not to compete.  Texas also embraces freedom to contract within certain limits.  Among other things, contracts are not enforceable when the subject matter of the contract is illegal or contrary to public policy. 

What happens in the face of competing public policies?  Rules are created and like a pendulum, the rules can be perceived as going too far in one direction and sent in the other direction until they are viewed as going too far in that direction.  Freedom to compete is fundamental to modern economies and free societies, generally.  However, as business became more complex, it has been observed that within reason a business may have a legitimate business interest to prohibit competition for a limited period of time—such as in certain employment relationships, in the event of the sale of a business, franchising arrangements, and some commercial lease situations. 

In some states, noncompetes have been outlawed.  Similarly, it appears that the federal government has recently signaled its interest in pushing in that direction too.  But, as of now, the Texas statutory exception to its pro-competition general policy is found in chapter 15 of the Texas Business & Commerce Code.

Enforceable Noncompetes Must be Ancillary to an Otherwise Enforceable Agreement

Noncompetes are different from confidentiality agreements, nondisparagement agreements, and other employee restrictive covenant agreements.  However, they are usually found in the same document as one or more of these other types of agreements.  This is because to be enforceable, noncompetes must be ancillary to an otherwise enforceable agreement.  Other common examples of “otherwise enforceable agreements” to which noncompetes may be ancillary include employment agreements, franchise agreements, and business sales agreements.  If you come across a purported noncompete that stands alone, meaning it’s not ancillary to some other enforceable agreement, then the purported noncompete is unenforceable in Texas under Texas law.  Be sure to check for “choice of law” provisions (choosing another state’s law to govern the agreement) that may have an impact.

Enforceable Noncompetes Must be Reasonable as to Time Limit, Geography, and Scope of Activity to be Restrained

Because a covenant not to compete restrains trade, it is enforceable only to the extent it is reasonable. The covenant must contain reasonable limitations as to time, geographic area, and scope of activity to be restrained that don’t impose a greater restraint on the promisor than is necessary to protect the goodwill or other legitimate business interests of the business.  However, an unreasonable or overbroad noncompete (that is otherwise enforceable) may be reformed by the court so that it is reasonable and becomes enforceable as reformed.

Enforceable Noncompetes Must be Supported by Scrutinized Consideration

An unusual debate pertaining to noncompetes is what type of value will count as sufficient consideration to support its enforceability.  Prior to 2011, to be enforceable, noncompetes had to be supported by consideration that passed a Texas Supreme Court-designed two-part test that’s not worth going into in this post.  Then, in 2011, the Texas Supreme Court loosened its requirement for sufficient consideration that could support an enforceable noncompete to a requirement that the consideration be “reasonably related” to the business interests to be protected such as confidential information, trade secrets, or business goodwill.  Common examples of consideration supporting a noncompete include providing access to the business’s trade secrets after signing the agreement, providing specialized training, and providing stock options.  Although stock options come close to being a bare financial form of consideration, the court found it was sufficient consideration to support a noncompete because the stock options incentivized the employee to protect the business’s goodwill because, as owner of stock, the employee became an owner invested in the company’s goodwill. 

Special Rules for Physicians and Attorneys

This post is aimed at providing the most basic overview of noncompetes and special cases exist such as special rules for physicians and attorneys.

Noncompetes can Protect a Business’s Competitive Advantages

Although noncompete agreements cannot serve as a bare restraint of trade, they can be used to protect the business’s goodwill and enhance the protection of its trade secrets and other confidential information.  See Ep010 & Ep011.  Third parties such as competing businesses can, under certain circumstances, be exposed to liability for employing someone who violates their noncompete agreement.  See Ep001.  In the event of a sale of a business, the sophisticated buyer will be interested in including assignment of covenants not to compete to protect the new owner from the employees leaving the business to compete with the new owner; however, the employees need to consent to the assignment. To be clear, consent is already provided if the noncompete says it’s assignable, or consent is inferred if the employee continues to work for the new employer even if the noncompete doesn’t say it’s assignable.     

Takeaway

Although noncompetes can be valuable tools to help a business protect its competitive advantages, they are strictly governed.  Notably, enforceable noncompetes must be connected to another enforceable contract; must be reasonable in terms of limitations as to time, geography, and activities restrained; and have special consideration requirements. 

Disclaimer: This audio and blog post are for informational purposes only and should not be misinterpreted as legal or other professional advice. If you have a legal question, you should consult with an attorney in your jurisdiction. Thank you for tuning in to Keith Law, PLLC.

(Photo by Isaac Garcia from Pexels)