On June 24, the Texas Supreme Court further relaxed the requirements of covenants not to compete in Texas, moving further from the technical questions of contractual enforceability and emphasizing the core question of whether the scope of such covenants are reasonable. In Marsh USA Inc. v. Cook, the court held that an employer may obtain a covenant not to compete in return for an employee’s acceptance of a stock option grant, so long as the covenant is reasonable in time, scope and geography. Marsh USA Inc. v. Cook, No. 09-0558, Texas Supreme Court (June 24, 2011)
Factual Background
Rex Cook had been employed by Marsh USA Inc. since 1983. In 1996, Marsh’s parent company, Marsh & McLennan Companies, Inc. (MMC), granted Cook an option to purchase 500 shares of stock. To exercise a stock option, Cook was required to sign a Non-Solicitation Agreement and pay for the stock at the strike price. In 2005, Cook exercised the option and signed the agreement.
The agreement provided that if Cook left the company within three years after exercising the option, then for two years after termination of his employment Cook would not solicit or accept business from current or former clients and prospects that Cook or his subordinates serviced or solicited. It also prohibited Cook from soliciting any employee who reported directly or indirectly to Cook. The agreement further required Cook not to disclose Marsh’s confidential information and trade secrets during and after his employment with Marsh.
Legal Analysis
The Texas Supreme Court initially reviewed the doctrine of covenants not to compete in general, focusing on Texas Business and Commerce Code Section 15.50, which lays out the standard for covenants not to compete. A covenant is enforceable if it is reasonable in time, scope and geography, and, as a threshold matter, “if it is ancillary to or part of an otherwise enforceable agreement at the time the agreement is made.” It is this latter definition that was the focus of the court’s analysis in Marsh.
In the words of the court, Section 15.50 imposes a “two-step” inquiry; the first step is to determine whether there is an “otherwise enforceable agreement” between the parties, and if so, whether the covenant is “ancillary to or part of” that agreement. The court assumed that there was an “otherwise enforceable agreement” between Marsh and Cook (a grant of stock options by Marsh and, among other things, a promise not to disclose trade secrets by Cook); the question was whether the covenant not to compete was “ancillary to or part of” that agreement.
In its 1994 landmark decision on covenants not to compete, Light v. Centel Cellular Co. of Texas, the Court defined “ancillary to or part of” as having two distinct requirements: (1) the consideration given by the employer in the “otherwise enforceable agreement” must “give rise to the employer’s interest in restraining the employee from competing”; and (2) “the covenant must be designed to enforce the employee’s consideration or return promise in the otherwise enforceable agreement.” The problem with a grant of stock options under this test, according to the court of appeals below, was that such a grant did not give rise to the employer’s interest in restraining the employee from competing, the first part of that test. The Texas Supreme Court’s answer to this problem was simple: “it does not have to.”
The court held that Section 15.50 merely requires that a covenant not to compete be “ancillary to an otherwise enforceable agreement.” Following its recent pattern of partially overruling or clarifying Light, the court held that consideration given by the employer need not give rise to the employer’s interest in restraining the employee from competing. Instead, the court required only that the covenant not to compete be “supplementary” or part of (“one of several units of which something is composed”) an “otherwise enforceable agreement.” Put simply, the “otherwise enforceable agreement must be reasonably related to the interest worthy of protection.”
In this case, the interest worthy of protection was the goodwill of the company. Marsh’s grant of stock options to Cook furthered Marsh’s interest in developing its goodwill by giving a key employee, Cook, an incentive to develop long-term relationships with customers and share in the long-term profitability of the company.
The court saw no problem with Marsh using a noncompete to protect this goodwill interest. As such, the court upheld the covenant not to compete as “ancillary to or part of” Marsh’s stock option agreement. The court took no position on whether the covenant not to compete otherwise satisfied Section 15.50, specifically whether it was reasonable in time, scope and geography.
Unrelated to the court’s holding concerning stock options, the court also stated in its opinion that covenants not to solicit employees are “restraints on trade and are governed by [Section 15.50].” It had previously been unclear whether such covenants are subject to Section 15.50, which would obviously impose extra requirements for such covenants to be enforced. Some may argue that this statement by the court is unrelated to its holding (in legal terms, “dictum”) and therefore does not establish conclusively that employee nonsolicitation covenants are subject to Section 15.50.
Practical Impact
According to a shareholder in Ogletree Deakins’ Austin office: “This decision is both a major departure from prior precedent and a consistent extension of the court’s departure from the technical issues of noncompete enforceability. While it is a major change to hold that an employer may obtain a covenant not to compete in return for a stock option grant, this decision further advances the court’s central theme over the past five years that we should focus on whether the covenants are reasonable, not ‘overly technical disputes’ of whether a covenant is ‘ancillary’ to an agreement.”
A shareholder in Ogletree Deakins’ Houston office, added: “The court focuses on goodwill as an interest worthy of protection. Goodwill is expressly identified by Section 15.50; but since Light it has been difficult to tie a non-compete to anything but confidential information or trade secrets. The court has now recognized customer relationships developed while working for an employer as goodwill that may be protected with a covenant not to compete.”
Additional Information
If you have any questions regarding the impact of this ruling, contact the Ogletree Deakins attorney with whom you normally work or the Client Services Department at 866-287-2576 or via e-mail at clientservices@ogletreedeakins.com.
