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When Is a Non-Compete Not a Non-Compete? The Texas Supreme Court's Decision in Exxon v. Drennen

On its face, the recent Texas Supreme Court decision in Exxon Corp. v. Drennen, No. 12-0621 (Tex. Aug. 29, 2014), might seem to have limited relevance to Texas law.  The Court held that the case was governed by New York law and decided the case based on New York precedent.  But a closer look at the case reveals that Drennen may have significant consequences for Texas law.

Drennen is a non-compete case.  Drennen was an Exxon employee who was a participant in certain incentive programs that included stock options and the like.  The incentive programs contained a New York choice of law clause.  The incentive clauses also provided that Exxon could terminate the incentives if an employee engaged in detrimental activity, which included working for a competitor.

Drennan quit his job at Exxon and went to work for Hess.  Exxon cancelled his incentive awards because Hess is a competitor.  Drennen then sued for damages, claiming that the forfeiture provision was a non-compete subject to the Texas Non-Compete Act.  Drennen argued that the forfeiture provision was void because it was unlimited as to time, geographic area, and scope of activities.  Exxon argued that the forfeiture provision was subject to New York law and was valid under New York precedent.

The Court of Appeals ruled in favor of Drennen, but the Supreme Court reversed.  The Supreme Court found that New York law applied and that the forfeiture provision was valid under New York law.  On their face, those rulings have limited relevance to employees and employers in Texas.

However, the Supreme Court made a significant holding in the midst of its choice of law discussion.  Specifically, the Supreme Court held that the forfeiture provision was not a non-compete and thus was not subject to the Texas Non-Compete Act.  This was relevant to the choice of law analysis because it allowed the Supreme Court to hold that the forfeiture provision did not implicate fundamental Texas public policy.  If the forfeiture provision had been subject to the Texas Non-Compete Act, then Texas public policy would have overridden the choice of law clause.

The Court noted that it had previously defined non-competes as follows: “Covenants that place limits on former employees’ professional mobility or restrict their solicitation of the former employers’ customers and employees are restraints on trade and are governed by the Act.”  Marsh USA Inc. v. Cook, 354 S.W.3d 764 (Tex. 2011).  That definition would seem to encompass the forfeiture provision, because it certainly limited Drennen’s ability to go to work for Hess.  However, the Supreme Court followed a convoluted route to reach precisely the opposite conclusion:

Looking at the facts in our prior non-compete cases, it is clear that the agreement here does not fit the mold. In Marsh, the employee agreed that he would not solicit or accept business of the type offered by his employer, perform or supervise any services related to that business, solicit clients, or solicit employees for a period of two years following his termination.  In another landmark non-compete case, Light v. Centel Cellular Co. of Texas, 883 S.W.2d 642 (Tex. 1994), the employee agreed that, upon termination of employment and for one year after, she would not directly or indirectly compete with her employer in the Longview–Tyler–Kilgore–Marshall service area. Finally, in DeSantis v. Wackenhut Corp., a third historic Texas noncompete case, the employee signed an agreement that, as long as he was employed by Wackenhut and for two years thereafter, he would not compete in any way with Wackenhut in a forty-county area in south Texas. 

There is a difference, although a narrow one, between an employer’s desire to protect an investment and an employer’s desire to reward loyalty. Non-competes protect the investment an employer has made in an employee, ensuring that the costs incurred to develop human capital are protected against competitors who, having not made such expenditures, might appropriate the employer’s investment.  Forfeiture provisions conditioned on loyalty, however, do not restrict or prohibit the employees’ future employment opportunities. Instead, they reward employees for continued employment and loyalty. As we recognized in Marsh, employee stock-ownership plans have a purpose that is unrelated to restraining competition—linking the interest of key employees with the employer’s long-term success.  Under a noncompete, the former employer can bring a breach of contract suit to enforce the clause. But under a forfeiture provision, the former employer does not need to take legal action because the profitsharing plan belongs to the employer.

. . . .

. . . Drennen did not promise to refrain from competing with ExxonMobil or refrain from soliciting clients or employees from ExxonMobil.  Instead, he agreed that, in reward for his hard work and loyalty, he would receive bonus compensation in the form of stock options. One of the conditions of this bonus compensation was continued loyalty, which was not a promise on Drennen’s part, but rather a power reserved to his employer should he opt into the Incentive Programs. If he chose to compete with ExxonMobil (which he did), he would forfeit the shares still in the restricted phase that were to be awarded as bonus compensation. There is a distinction between a covenant not to compete and a forfeiture provision in a non-contributory profit-sharing plan because such plans do not restrict the employee’s right to future employment; rather, these plans force the employee to choose between competing with the former employer without restraint from the former employer and accepting benefits of the retirement plan to which the employee contributed nothing. Whatever it may mean to be a covenant not to compete under Texas law, forfeiture clauses in non-contributory profitsharing plans, like the detrimental-activity provisions in ExxonMobil’s Incentive Programs, clearly are not covenants not to compete.

Accordingly, we hold that, under Texas law, this provision is not a covenant not to compete. Whether such provisions in non-contributory employee incentive programs are unreasonable restraints of trade under Texas law, such that they are unenforceable, is a separate question and one which we reserve for another day. (citations omitted).

The Court thus concluded that the forfeiture provision was not subject to the Texas Non-Compete Act and that the case therefore did not implicate fundamental Texas public policies that might have negated the New York choice of law clause. 

The Supreme Court's reasoning is certainly open to question.  Mr. Drennen was probably surprised to learn from the Supreme Court that the forfeiture provisions did not restrict his future employment opportunities.  Furthermore, employees will doubtlessly be surprised to learn that they contributed nothing to incentive programs that were part of their compensation.  Did the employees similarly contribute "nothing" to their own salaries, so that their salaries were a gift from the employer?

Regardless of whether that rationale makes any sense, it is now the law in Texas.  This may have profound implications for future cases in which employers seek to disguise non-compete obligations as forfeiture provisions, liquidated damages clauses and the like.

So here are some questions to consider:

1          The Supreme Court expressly withheld judgment on whether the forfeiture provision would be an unreasonable restraint of trade under Texas law.  If Texas law had been applicable, would the forfeiture provision have survived?  The discussion in Drennen strongly suggests that the answer is “no.”  The Supreme Court’s discussion of its prior decision in Haass is instructive:

 Here, the detrimental activity provisions in the Incentive Programs are not like the provisions in Marsh, Light, or DeSantis. They are, however, similar to the provision at stake in Peat Marwick Main & Co. v. Haass, 818 S.W.2d 381 (Tex. 1991). Haass, an accountant, begrudgingly signed a merger agreement with the accounting firm of Main Hurdmann (MH) whereby he promised to compensate MH as provided for in the partnership agreement should Haass withdraw from MH and take MH clients with him. After Haass left MH, the firm sued him for breach of the partnership agreement and breach of fiduciary duty. Haass, in response, asserted that the agreement operated in restraint of trade and as a penalty, and was thus unenforceable and counterclaimed for his capital account, which MH was holding. The parties disagreed as to whether this provision was, in fact, a covenant not to compete. The provision in question did not expressly prohibit Haass from providing accounting services to clients of MH and was not an express promise by Haass not to compete. While we ultimately determined that the provision in Haass was an unreasonable restraint of trade, notably, we never concluded that the damage provision was, itself, a covenant not to compete. Further, we did not provide a definition of a covenant not to compete. The Covenants Not to Compete Act likewise does not define what it is to be a covenant not to compete.  (citations omitted) (emphasis added).

The provision in Haass would seem indistinguishable from the forfeiture provision in Drennen, except that the provision in Haass actually required the employee to pay money to his former employer.  Haass will provide ammunition for an employee seeking to argue that these sorts of provisions should not be enforced under a Texas law contract.

2. What does this mean for liquidated damages clauses?  Some employers have used clauses that require an employee to pay a penalty if the employee goes to work for a competitor.  Liquidated damages clauses are often unenforceable as penalty clauses, but could an employer argue that the liquidated damages are compensation for the lack of “loyalty” as discussed in Drennen?  This seems questionable, but under the reasoning of Drennen, these sorts of clauses are no longer a direct violation of the Texas Non-Compete Act.

3. Are we about to go through another era of sophistry and surrealistic distinctions with the Texas Non-Compete Act?  We just finished the headache-inducing “unilateral contract” era.  Are we now looking at hair-splitting semantic analysis of the meaning of “non-compete”?  And how do we reconcile the comment in Marsh that an employer cannot simply buy a non-compete with the holding in Drennen an employer can buy “loyalty” by placing restrictions on stock options?

Perhaps Drennen will prove to be a one-time aberration.  However, it is remarkable that, in the course of a single generation, we have gone from non-competes being enforceable only if they complied with the Texas Non-Compete Act to a non-compete being upheld because it was not within the scope of the Act.

David C. Holmes is a Houston employment lawyer with The Law Offices of David C. Holmes