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Texas Supreme Court Considers Whether Stock Options are Consideration for Covenants Not to Compete

by E. Dale Burrus, JD, LLM on October 26th, 2010

Physician employment contracts often contain clauses limiting their ability to compete if they leave their employment. Texas Business and Commerce Code (TBBC) §15.50 governs these covenants not to compete. The trend in Texas courts is to find these covenants enforceable. A case pending before the Texas Supreme Court involves the limits of the enforceability of these covenants. In Marsh USA Inc. and Marsh & McLennan Companies, Inc. v. Rex Cook, the Texas Supreme Court is deciding whether the exercise of stock options in the employer’s company is sufficient to serve as consideration for a covenant not to compete. The Justices most likely will base their decision on whether the exercise of the stock option was a naked restraint of trade or was the establishment of goodwill in the company.

TBBC §15.50 requires, among other criteria, that a covenant not to compete be “ancillary to an otherwise enforceable agreement” and that this obligation occur “at the time the agreement is made.” Through a series of opinions, the Texas Supreme Court has interpreted the section’s terms, heavily debating these two conditions and leaning more and more strongly in favor of finding the covenants enforceable. Although timing of performance remains an open question, the contract can be unilateral with future performance by one party completing the formation of the contract. See for example, Light v. Centel Cellular Co. of Tex., 883 S.W.2d 642 (Tex.1994); Alex Sheshunoff Mgmt. Servs., L.P. v. Johnson, 209 S.W.3d 644 (Tex.2006); Mann Frankfort Stein & Lipp Advisors, Inc. v. Fielding, 289 S.W. 3d 844 (Tex. 2009).  The Texas Supreme Court focuses on whether the limitations are reasonable as to time, geographical area, and scope of activity to be restrained, as set forth in TBBC §15.50.

From the line of cases interpreting TBBC §15.50, the Texas Supreme Court has identified two requirements for a valid covenant not to compete:

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

The covenant not to compete “must be designed to enforce the employee’s consideration or return promise” in the otherwise enforceable agreement.

Mann Frankfort Stein & Lipp Advisors, Inc. v. Fielding, 289 S.W.3d 844, 849 (Tex. 2009).

The Texas Supreme Court consistently has held that the payment of money alone is not a sufficient basis for enforcing a covenant not to compete. The consideration must be an “interest worthy of protection,” and generally not just the payment of money or something illusory such as a promise to work at the company for an extended period of time in an otherwise at will employment. Sheshunoff, 209 S.W.3d at 650. Examples of consideration found appropriate have been the provision of trade secrets and the preservation of confidential information. Id. at 249. The Texas Supreme Court also has stated that goodwill in the company is legitimate consideration for enforcing a noncompete clause. Id.

The interpretation of the meaning of “goodwill” is at the heart of the argument in Marsh USA Inc. and Marsh & McLennan Companies, Inc. v. Rex Cook. In Marsh, the consideration for the noncompete contract was the exercise of stock options. At the trial court level, Cook, a long time key employee, won summary judgment on the basis the consideration was invalid and the covenant was thereby unenforceable. The Dallas Court of Appeals affirmed, holding that the consideration must create “the interest in restraining competition,” which can only occur when the interest in restraining the competition did not occur before the consideration was given. Marsh USA Inc. v. Cook, 287 S.W.3d 378 (Tex. App.—Dallas 2009, pet. pending).

At the Texas Supreme Court level, the focus of the argument changed from the timing of the consideration to the type of consideration. The employer argued that the stock options were an award for key employees. This award was an incentive for the employee to buy into the company and to grow the company by creating customer relations, thereby increasing the company’s goodwill. Cook argued the stock option was a reward in recognition for past performance, which did not give rise to an enforceable restraint of competition.

In the oral arguments, the judges grappled with whether this type of consideration was sufficient to make the contract enforceable. On one extreme, Chief Justice Wallace B. Jefferson, a vocal opponent of allowing money to be the consideration for a noncompete covenant, commented that the stock option appeared to be nothing more than a naked restraint of trade. Other Justices disliked the idea that the stock option equated to nothing more than a payment of money. These Justices questioned the equity in allowing Cook to exercise the stock option, pocketing approximately $50,000, and then attempting to excuse himself from what appeared to be the critical obligation for obtaining this money.

The Justices’ ultimate decision may erase years of past precedence that money alone is not sufficient consideration for enforcing a covenant not to compete. If the Court decides that the exercise of stock options is goodwill and thus a reasonable consideration for a covenant not to compete, in the future some may argue that other forms of “money” are also sufficient consideration. Productivity bonuses or increases in commissions that encourage employees to further the business interest of the employer may ultimately be deemed to be goodwill. The trend of the Court is to find in favor of the employer and in the enforcement of these clauses. The result of this case could expand the manner in which an employer can impose this restrictive covenant. If the Court allows the use of stock options as consideration,  physicians who currently do not have a covenant not to compete may be faced with an employer who desire to impose this type of restriction and may be able to do so with some type of monetary compensation. The more common scenario though will be that employers will include a covenant not compete at the inception of the employment relationship with confidence that the provision will be enforced.

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From → Health Law