What investors should know about restrictive covenants

To protect against today's key employees becoming tomorrow's competitors, oil and gas investors need to consider a patchwork of state laws that dictate what forms of restrictive covenants, or non-competition and non-solicitation agreements, are enforceable within a particular state. For many oil and gas investors, the starting point of that analysis is Texas law.

Regardless of the choice of law that parties may designate, Texas courts often apply Texas law when considering restrictive covenants that will be enforced within the state. This makes an understanding of the evolving standards of Texas non-compete law an important aspect of securing the value of an oil and gas investment.

Texas Non-Compete Principles Evolve to More Employer-Friendly Regime

Like many states, Texas forbids restraints on trade. There is an exception for sale-of-business non-competes and limited, employment-related non-competes, if certain requirements are satisfied. The Covenants Not to Compete Act (the "Act") creates the exception. Although, the Act has not been amended since 1993, a series of judicial decisions has reshaped its principles and created evolving standards of what is required for a non-compete to be enforced in the state.

The Act sets out two primary requirements for employment-related non-competes. First, a non-compete must be "ancillary to or part of an otherwise enforceable agreement at the time the agreement is made." Second, any limitations on time, scope of activity, or geographic area contained must be "reasonable and . . . not impose a greater restraint than is necessary to protect the [employer's] goodwill or other business interest."

In the 1994 decision in Light v. Centel Cellular Company, the Texas Supreme Court narrowly interpreted the types of consideration that could support a non-compete under the Act. The court held that to create an enforceable restriction an employer needed to provide a benefit that "gave rise" to the interest in restraining trade, such as: confidential information or specialized training. The court also determined consideration had to be given to the employee at the same time as the execution of the non-compete.

In the wake of this ruling, Texas businesses were faced with a complex regime where they could not just pay money to "buy" a non-compete from their employees, nor could they ask for a non-compete at the end of the employment relationship, whether through a severance agreement or otherwise. This resulted in intriguing scenarios to create enforceable contracts. For instance, some employers would hand over confidential documents to new employees as they executed a non-compete agreement.

Beginning in 2006, a series of Texas Supreme Court decisions chipped away at the technical requirements courts followed after Light. In the 2006 decision of Alex Sheshunoff Management Services LP v. Johnson, the court held that consideration for a non-compete did not have to be provided at the same time the non-compete was signed. An employer only needed to prove an employee eventually received the consideration giving rise to the need for a non-compete. Three years later, the court held that an "implied promise" to provide the required consideration at a later date was sufficient to satisfy this standard.

Then, in 2011, the court issued a seemingly game-changing opinion in Marsh USA Inc. v. Cook. In that case, the court reconsidered Light's "give rise to" requirement and emphasized the proper questions to ask when evaluating enforceability were: was the non-compete ancillary to an otherwise enforceable agreement and was the non-compete reasonable?

Applying those standards, the court held an agreement to provide an employee with stock options could satisfy the consideration requirements of the Act, and so long as the restraints within that agreement were reasonable, non-competes or non-solicits within option agreements could be enforced. This created significant new opportunities for investors, as Texas came into line with most other states where equity agreements could be used as vehicles for creating non-compete restrictions.

Texas Courts Still Carefully Scrutinize Employee Restraints

Marsh gave Texas employers expanded means to secure non-compete and non-solicit protections. However, even after Marsh, Texas courts have provided important reminders that restraints of trade still will be scrutinized closely. For instance, a Texas appellate court has determined that a "clawback" clause that would allow a company to revoke stock awards in the event an employee chose to compete needed to be examined through the prism of the Act and would be enforceable only if the non-compete restrictions were reasonable, even though the clause itself didn't prevent an employee from competing, but instead established a cost for doing so if the employee so chose.

That case is now before the Texas Supreme Court, and investors should carefully consider the forthcoming ruling, which is expected soon. That opinion should clarify whether equity clawbacks are subject to the Act and, if so, just what steps employers need to take in order to avoid a consequence where they provide equity incentives, but do not receive the attendant protection of enforceable restrictive covenants.

Another note of caution to employers is provided in the Marsh decision, which notes that both customer and employee non-solicitation covenants are subject to the requirements of the Act. This principle is a departure from most states, as most jurisdictions have concluded employee non-solicitation restraints are not subject to the same scrutiny as non-competition principles. Thus, while Texas employers may be able to use employee non-solicits in order to stave off the raiding of former co-workers, they need to be mindful that a covenant that overreaches in trying to do so could be unenforceable as a violation of the Act.

Investors also should be aware that, although the statute includes an employer-friendly clause that requires a court to reform an overly broad non-compete or non-solicit, the consequences of doing so can be costly: an employer cannot recover damages for breaches that occur before that reformation. In addition, an employer who seeks to enforce the restriction "to a greater extent than was necessary to protect [its] goodwill or other business interest," could be liable for the attorneys' fees incurred by an ex-employee in defending the claim.

Important To Consider Multiple States' Laws

An investor also should remember that even if the workforce or business is primarily within Texas, Texas law alone may not dictate the enforceability of a particular employee's non-competition or non-solicitation commitments. Most states (including Texas) consider restraint of trade law to be a matter of fundamental public policy and, accordingly, may apply their own, state-specific standards when considering the enforceability of restrictions within their borders, regardless of parties' contractually-designated preference for a particular state's law.

Given these principles, the multi-state employer needs to carefully consider how to customize its contracts to account for the unique requirements of other oil- and gas-producing states where its business may exist or may expand. For instance, a Louisiana statute requires particular language within non-competition agreements (which cannot exceed two years) and a failure to list the specific parishes where the restrictions will be enforced can stymie enforcement.

An Oklahoma statute only allows for limited customer non-solicitation clauses and will not permit blanket non-competition restrictions. California and North Dakota have statutory bans on non-competes in the employment context. Given these sometimes competing principles, an employer will need to consider how to draft to comply with particular state standards and whether alternatives to non-competes, such as confidentiality agreements could be sufficient to protect its interests.

Avoiding State Non-Competition Laws?

Finally, employers also may consider whether they want to establish an ERISA-governed benefit plan that includes non-competition clauses. Although doing so would subject the employer to the administration and reporting requirements dictated by ERISA and create additional burdens, it could allow an employer to side step state-specific restrictions that may prevent or limit non-competition clauses. Investors should consider whether they could include restraints within existing or a future ERISA-governed plan, especially if doing so could allow them to avoid challenges presented by the laws of particular states in which they do business.

Conclusion

Employment agreements, incentive plans, equity arrangements and other benefit plans all create potential opportunities to institute restrictive covenant protections and offer an expanded repertoire to Texas oil and gas investors in order to protect against key employees becoming competitors. However, structuring a particular restrictive covenant regime and drafting the specific language to apply to particular employees requires a familiarity with evolving legal principles, an ability to craft reasonable restrictions, and sometimes, the consideration of multiple states' laws. Investors who successfully balance these principles are more likely to be rewarded with increased stability among their key employees and management teams.

About the authors

Vinson & Elkins Partner Sean Becker advises clients regarding all phases of the employment relationship and represents employers before state and federal courts and administrative agencies. Becker has significant experience pursuing and defending actions involving non-competition agreements, managing the labor and employment aspects of transactions and in drafting and evaluating restrictive covenants. Associate Alan Colley joined Vinson & Elkins in 2013 and is a member of the firm's Employment, Labor, and OSHA practice group.