The Reading List (2017, No. 8): An Example of How Differently Courts Treat Non-Competes

Non-Compete and Trade Secret News for the week ended February 24, 2017

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Overbroad Non-Competes in Virginia

This week's first two updates could be called a Tale of Two Non-Competes.

A federal district court in Virginia ruled that an employee's non-compete agreement, ancillary to a stock option award, was unenforceable because of its overly broad geographic scope. This case illustrates the perils of linking a restrictive covenant to customers or markets about which an employee has "confidential information." For starters, that may require a court to assess how the agreement treats that defined term - a notorious plot of unruly thatch.

But additionally, a restrictive covenant that is drafted this way often lacks objective parameters. In NVR, Inc. v. Nelson, the covenant's geographic term extended to areas "from which [the employee] received...Confidential Information." Because he received information digitally and since there was no way to tell from where the information originated, the non-compete was overbroad. A copy of the opinion denying the employer's temporary restraining order motion is available here.

Preliminary Injunction in New Jersey

The employer fared better with pursuing injunctive relief in Menasha Packaging Co. v. Pratt Industries, a New Jersey case in which the district court applied Illinois law. This dispute stems from the movement of three ex-Menasha employees to Pratt Industries during the period in which Menasha's client, Mondelez, had put up a packaging contract for bid. Unlike the NVR case, the competition and the immediate threat to Menasha were more tangible and apparent from the record. Menasha also sought very limited enforcement of the restrictive covenant, despite some dispute about whether the contract was facially overbroad. The court enjoined the employees' work with Mondelez, on Pratt's behalf, for the 18-month non-solicit term. The case illustrates the wisdom of narrowing the dispute and seeking relief that is directly tailored to the conduct in question. A copy of the New Jersey' court's preliminary injunction opinion is available here.

Non-Competes in Bankruptcy

The United States Bankruptcy Court for the Northern District of Illinois held in United Providers, Inc. v. Pagan that a claim for intentional breach of contract is dischargeable in bankruptcy. The breach arose from the debtor's alleged violation of an employee no-hire agreement in the medical billing field.

The nondischargeability provision of the Bankruptcy Code for "willful and malicious" injuries, Section 523(a)(6), requires that the breach of contract also give rise to an independent tort claim (e.g., breach of fiduciary duty, trade secrets misappropriation). And even then, a court's finding of nondischargeability is not guaranteed. The court's opinion makes sense because many breach-of-contract scenarios give rise to an economically efficient result, regardless of whether the employer likes it or feels as if it has been the victim of a maliciously designed plot. Only if the underlying conduct is intended to produce a harmful result will a viable nondischargeability argument arise. The opinion is available here.

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One of the more interesting trade-secret filings in a long time comes from the Central District of California, where Songkick has amended its suit against Live Nation Entertainment and Ticketmaster to allege trade secrets theft. The 91-page Complaint is quite a read, but the pertinent allegations of trade-secret theft appear to rest on a departed executive's misappropriation of thousands of documents in order to benefit Ticketmaster's "Artist Services" division, which is now known as OnTour. Consumers may be familiar with this type of service, since it promotes ticket pre-sales, fan clubs, and more direct fan engagement. Songkick's trade-secret theft allegations bolster a more robust antitrust claim against Live Nation, which vigorously has disputed the veracity of the accusations.

For those interested in exploring the data concerning non-competes' impact on wages and mobility, please see the University of Michigan Working Paper entitled Locked In? The Enforceability of Covenants not to Compete and the Careers of High-Tech Workers. The paper details a number of interesting conclusions, including that technology workers in higher enforcement states (think Florida) earn lower wages than their counterparts in lower enforcement states (think California). This at least seems to support the notion that employers do not share the marginal gains from non-compete regimes with their existing employees, a theoretical justification many on the pro-enforcement side frequently offer.

Restrictive Covenants Tied to Stock Option Grant Subject to Lower Scrutiny (The Selmer Co. v. Rinn)

Traditionally, courts will analyze restrictive covenants under two tiers of scrutiny. Those covenants incidental to the sale of a business are subject to a common law rule of reason, while those tied to employment are governed by a stricter standard of scrutiny requiring the courts to examine certain other factors (which vary state-by-state).

But not all employment-related covenants merit strict scrutiny. For instance, an employment contract given to the seller of a business who stays on to assist the buyer likely will be judged under the rule of reason since it was given in connection with the underlying transaction. And even some higher level executives will have their covenants examined with a less exacting standard of review in some states given their pervasive exposure to confidential information.

Another example is one I have written about before: covenants extended in the context of a stock option grant. The law is not uniform on this, but the prevailing sentiment is that covenants which are part of a stock option award agreement will be adjudicated under the less stringent rule of reason rather than the traditional employment standard.

The Wisconsin Court of Appeals held as such in a recent case and articulated the reason behind why courts traditionally are not as likely to invalidate such covenants:

"...[U]nlike typical restrictive covenants, upon which a prospective employee's position may depend, there were no consequences attached to [the employee]'s refusal to accept the agreement. The circuit court found [the employee] was not pressured to sign the stock option agreement, nor was his employment conditioned upon his doing so. Indeed, the circuit court found [the employee]'s refusal would not have affected his employment in any way." In fact, the evidence in the Wisconsin court's case revealed the employee quadrupled his investment in company stock by accepting the agreement's benefits.

The Wisconsin court obviously reached the right result, as covenants executed in exchange for participation in an incentive program are not compulsory and are intended to align the employee's goals with the long-term best interest of the company. In fact, that case did not even deal with a traditional non-compete agreement, but rather applied only if the employee solicited firm clients or disclosed confidential information of the employer.

It is somewhat of a mistake to call the two tests used by courts as the "employment test" and the "sale of business" test. They are not limited to such confining topics. It is more appropriate to say generally that covenants that are part of an adhesive agreement are subject to strict scrutiny, while those which are the product of a bargained-for-exchange are governed by a rule of reason.

Covenants in the latter group almost certainly include those in a franchise agreement, operating or shareholder agreement, settlement agreement, or incentive plan award agreement. It might even include covenants tied to long-term employment contracts for high-level executives, though the law on this is not particularly well-developed. The former group normally will be found in most employment or independent contractor agreements.

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Court: Court of Appeals of Wisconsin, District Three
Opinion Date: 7/13/10
Cite: The Selmer Co. v. Rinn, 789 N.W.2d 621 (Wisc. Ct. App. 2010)
Favors: Employer
Law: Wisconsin

Texas Supreme Court to Review Key Non-Compete Issue (Marsh USA v. Cook)

Last year, I wrote a not-too-flattering piece on a Texas case where the appellate court in Dallas held that a grant of stock options does not constitute sufficient consideration for an employee non-compete agreement. The ruling was ridiculous.

The Texas Supreme Court has now agreed to hear an appeal in this case. Say what you will for Texas. The case law sucks for anyone with half a brain to try and make sense of, but at least the Supreme Court actually takes these cases on. In Illinois, the Supreme Court acts like this area of law doesn't exist.

I will continue to follow the Marsh case and opine on what I'm sure will be a reversal.

Grant of Stock Options Not Sufficient Consideration for Non-Compete Agreement (Marsh USA v. Cook)

The best way to predict the outcome of a Texas non-compete dispute is to take every instinct you have as an attorney and do the opposite.

Texas is notoriously employer-friendly, and courts hand out injunctions like garage band flyers. But the Texas Supreme Court has interpreted one aspect of the Covenants Not to Compete Act fairly narrowly. That provision requires a covenant to be ancillary to an otherwise enforceable agreement. The Court has interpreted that phrase to mean that the covenant must "give rise to the employer's interest in restraining the employee from competing." Generally, employers are able to satisfy this requirement by agreeing to provide employees with confidential or proprietary business information. According to Texas courts, this is intrinsically related to the restraint, because the covenant protects potential use or disclosure of confidential information.

The odd part of this rule, however, is that financial consideration does not "give rise to" the interest in preventing competition. In Marsh USA v. Cook, the Court of Appeals held that an employer's covenant not to compete was invalid when the employee's consideration was a grant of stock options.

Most states would hold the opposite - that financial consideration is indeed valuable enough to support a non-compete. Even employee-friendly states such as Illinois would not invalidate a covenant on grounds of inadequate consideration if the employee was given stock options. In fact, giving an employee an equity stake in exchange for a non-compete is generally viewed as far less problematic when assessing the reasonableness of the covenant.

But, alas, Texas goes its own way again. At least we haven't heard all that secession talk of late.

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Court: Court of Appeals of Texas, Fifth District, Dallas
Opinion Date: 5/26/09
Cite: Marsh USA, Inc. v. Cook, 287 S.W.3d 378 (Tex. Ct. App. 2009)
Favors: Employee
Law: Texas