Texas Supreme Court Liberalizes Standard for Enforceability of Non-Compete Agreements

October 30, 2006

With its recent decision in Alex Sheshunoff Management Services, L.P. v. Johnson, the Texas Supreme Court has modified the standard for enforceability of covenants not to compete in the context of at-will employment arrangements. The ruling significantly expands the circumstances under which existing and future employment agreements may be found enforceable under § 15.50 of the Texas Business and Commerce Code and resolves an issue that has caused considerable uncertainty in the lower courts of Texas over the last decade.

To be enforceable under § 15.50, a non-compete covenant must (1) be ancillary to or part of an otherwise enforceable agreement at the time the agreement was made and (2) contain limitations as to time, geographical area and scope of activity to be restrained that are reasonable and do not impose a greater restraint than is necessary to protect the goodwill or other business interests of the employer. In 1994, the Texas Supreme Court in Light v. Centel Cellular Co. of Texas announced that, for a covenant to be "ancillary to . . . an otherwise enforceable agreement," not only must the agreement contain mutual, enforceable promises, but in addition (1) the consideration given by the employer 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 return promise. As a result, an employer’s promise to pay money in exchange for an employee’s promise not to compete is not "ancillary" because the consideration given (money) does not create the need for the restraint (covenant not to compete). 

In addition, Light suggested that the mutual promises that give rise to the need for the non-compete provision must be enforceable at the time the promises are made. As a result, lower courts in Texas have struggled since Light with the question whether non-compete provisions included in the context of an at-will employment agreement are enforceable. Although the courts of appeal have reached differing outcomes, the prevailing view since Light has been that, because the employer in an at-will employment relationship can avoid its obligations under the agreement at any time by simply ending the employment relationship, it’s promise (even if otherwise sufficient to give rise to the need for a non-compete covenant) is "illusory" when made and thus insufficient to create the "otherwise enforceable agreement" to which the non-compete provision must be "ancillary."

In Sheshunoff, the court reaffirmed the rule announced in Light that the consideration must be tied to the employer’s interest in creating the non-compete and the covenant must be designed to enforce the employee’s promise. But, a five member majority rejected the suggestion in Light that the agreement to which the non-compete provision is ancillary must have been immediately enforceable at the time the mutual promises were made. The court noted that, even in a situation where the employer’s promise was avoidable or illusory when made, the employer could subsequently create an enforceable unilateral contract by performing the acts necessary to fulfill its promise. So where, as in Sheshunoff, the employer’s illusory promise to provide special training and confidential materials in exchange for the employee’s promise not to misuse such training and materials and not to compete was not enforceable at the time the agreement was made (because the employer could choose to end the at-will employment arrangement before providing the special training and confidential materials), the employer could nevertheless create an enforceable agreement by thereafter actually providing the training and materials.

The Sheshunoff decision has added a new wrinkle to the tricky field of covenants not to compete in Texas. Because the court applied its holding to the previously existing employment agreement rather than announcing a rule for prospective application, employees and future employers must not only consider the impact of Sheshunoff in drafting future agreements, but also must reconsider existing non-compete agreements that may have been of questionable enforceability under the standard previously suggested in Light. In particular, agreements that were not previously enforceable because the mutual promises upon which the non-compete covenant was based were illusory when made may now be enforceable if the employer can show it actually performed the promised acts. As a result, both employers relying on non-compete provisions and those hiring employees who may have previously signed agreements of questionable enforceability should consider the impact of Sheshunoff.

Gibson Dunn lawyers are available to assist with any questions you may have regarding these issues.  For additional information, please contact the Gibson Dunn attorney with whom you work or Karl Nelson (214-698-3203, [email protected]) in the firm’s Dallas office. 

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.