As companies grow and expand into multiple U.S. states, particularly in our increasingly knowledge and relationship-based economy, determining the applicable law for companywide restrictive covenants can be puzzling. Determining which law applies can make the difference between enforcement or the inability to enforce the covenants.
In Cardoni et al. v. Prosperity Bank (Case Nos. 14-20682 and 15-20005), decided on Oct. 29, 2015, the Fifth Circuit provided a useful roadmap for how a court should analyze various covenants involving interstate parties and interests. Simplifying the facts somewhat, Prosperity Bank in Texas acquired F&M Bank in Oklahoma by merger. In connection with the purchase, Prosperity signed several of the F&M employees to new employment agreements that included noncompete, customer nonsolicitation, and confidential information nondisclosure provisions. These agreements were governed by Texas law and had an exclusive Texas choice of forum provision, even though the employees did most of their work, both before and after signing the agreements, in Oklahoma. Four of the employees later became parties to the litigation. Those four individuals also had been very small shareholders in F&M, and sold their stock in exchange for cash and Prosperity stock as part of the merger transaction; however, the covenants at issue in their new employment agreements were not included in the merger agreement.
The case started with dueling actions, one filed by the employees in Oklahoma state court to declare the covenants invalid, and one filed in Texas state court by Prosperity Bank to declare them valid and to enforce the covenants through a preliminary injunction proceeding. Both cases were removed to federal courts on diversity grounds, and eventually they were consolidated in a U.S. District Court in Texas, based on the exclusive forum selection clause. By the time the case got to the Fifth Circuit, the parties were not contesting or appealing the choice of Texas forum. However, the Fifth Circuit discussed both federal and Texas law, distinguishing between forum selection clauses (which dictate the court in which a case should proceed) and choice of law clauses (which dictate the law to be applied, regardless of the forum). The Court noted that the former were much more easily upheld than the latter, because choice of law provisions “create more tension with a state’s power to regulate conduct within its borders.”
The Court then turned to the choice of law analysis, which, in a diversity case, begins with the conflicts of laws jurisprudence of the forum state. Choice of law principles in Texas, like in many other states, emanate from Section 187(2) of the Restatement (Second) of Conflicts of Laws, which generally provides that the parties’ chosen law will apply to the dispute unless either (a) the chosen state has no substantial relationship to the parties or the transaction, or otherwise has no reasonable basis, or (b) the application of the chosen state’s law would be contrary to another state’s fundamental policy, the latter state has a materially greater interest than the chosen state in the issue, and the latter state’s law would be chosen under the Restatement’s multifactor test in the absence of any choice of law provision. This latter clause (b), involving an inquiry into whether the fundamental public policy of a nonchosen state would be contravened by application of the chosen state’s law, has increasingly found its way into restrictive covenant litigation over the last several years. And the Cardoni case is, in fact, another outcome-determinative example.
The Fifth Circuit first analyzed the 3-year noncompete provision in the employment agreements. It held that there was a substantial connection to Texas because Prosperity Bank was based there, but then the Court looked very closely at clause (b) of Restatement Section 187 (2) and found that Oklahoma law should apply to the noncompete because:
Oklahoma law would apply in the absence of a choice of law provision because of where the contract was negotiated and mainly performed, even though the last signature on the agreements made Texas the place of contracting;
Oklahoma had a greater interest in the parties and the dispute on this issue because the place of performance of the contracts and enforcement would be against employees and their new employer in Oklahoma, and according to Texas conflicts principles, this interest outweighed the Bank’s interest in uniformity of enforcement of its employee covenants; and
Oklahoma’s statutory ban on noncompetes (with limited exceptions) was a fundamental policy of Oklahoma that would be undermined by enforcement of the noncompete under Texas law.
The Appeals Court had a different view of the 3-year customer nonsolicitation provision, however. It found that an Oklahoma statute that allowed contractual restrictions on direct solicitation of established customers did not rise to the level of a fundamental policy that would be violated by application of Texas law to the nonsolicitation clauses, even though those clauses prohibited indirect, as well as direct solicitation of customers and prospective customers. Thus, Texas law could be applied to the nonsolicitation provision, even if Texas law was somewhat more liberal in its approach to nonsolicitation provisions compared to Oklahoma. As the Court put it, “applying Texas law to this nonsolicitation agreement does not violate a fundamental policy of Oklahoma law merely because applying Texas law might lead to enforcement of a clause that would be invalid under the nuances of Oklahoma law.”
Regarding the confidential information nondisclosure provision at issue, the Fifth Circuit noted the district court’s unopposed application of Texas law (Oklahoma had no material prohibitions on such provisions, so there was no conflict or fundamental opposing policy), and affirmed the district court’s denial of injunctive relief to enforce that provision because the Bank had not made a sufficient showing of irreparable harm; that is, it had not shown that the employees had actually used or disclosed the Bank’s confidential information. The Court also affirmed the district court’s determination that Texas has not adopted the “inevitable disclosure doctrine,” though some Texas courts have issued injunctive relief when the use or disclosure of confidential information is “probable.” The district court’s finding that the claim of improper use or disclosure was speculative was affirmed as not clearly erroneous.
A final interesting and important aspect of the Fifth Circuit’s ruling was that the party employees’ sale of their stock in F&M Bank as part of the merger transaction did not qualify for the exception in the Oklahoma noncompete statute that allows enforcement of a limited noncompete agreement if entered into in connection with the sale of goodwill in a business. The Court found that the party employees’ combined ownership of 0.39% of the stock of F&M, and the highest individual holding of 0.18%, was far too minimal to reasonably qualify for the statutory exception. The Court cited one Oklahoma case that found that 0.8% was too “miniscule” to implicate the goodwill exception, and another case where the sole business operator’s 20% stock interest was sufficient to trigger the exception. The Court also pointed out that the restrictive covenants were contained in separate employment agreements rather than in the merger agreement, though the Court said it did not have to rule on whether that fact alone precluded application of the goodwill exception.
What are the key takeaways from this decision? How can companies, particularly those with operations in multiple or many states, maximize the chances that their restrictive covenants are enforced in accordance with the law they wish to choose? While Cardoni and other cases demonstrate that there is no certainty that the chosen law will be enforced against employees in other states, the following are steps that employers can take to maximize the chance of enforcement:
Choose the optimal state law for enforcement, where the chosen state has a reasonable connection to the parties and/or the transaction(s) involved. It’s advisable to choose a state with favorable law, because the choice of law provision will likely be enforced in more cases than not.
Understand the legal landscape for restrictive covenants in states, other than the chosen state, where the company has offices and employees, including whether any of the nonchosen states generally prohibit noncompetes like Oklahoma or California, have enacted a statute governing restrictive covenants, or take a particularly liberal or restrictive approach to covenant modifications or “blue penciling.”
If possible, conduct contract negotiations and execution in the chosen state.
Develop a record of contract performance in and involving the chosen state, even if employees are generally based in another state. Trips to the chosen state for meetings and training, emails and other communications to the chosen state, and customer and employee connections necessary to conduct the work in the chosen state should be documented. The contract itself should note that contract performance occurs in the chosen state as well as others.
Consider whether the sale of business/goodwill exception might allow enforcement of an otherwise unenforceable covenant under the chosen state’s law, or another relevant state’s law. If so, consider including such covenants in the transaction documents, and incorporating them by reference in employment agreements.
Stay abreast of changes in laws and court decisions on restrictive covenants in relevant states, particularly the chosen state. If the chosen state’s law materially changes, the company may need to consider entering into amended agreements with employees that conform to the changed law.
Include a choice of forum clause that coincides with the choice of law provision. Choice of forum provisions are easier to enforce than choice of law clauses, and the chosen forum courts are likely to be somewhat more favorably inclined to apply their own substantive law to the covenants.
With the increasingly complex legal environment for restrictive covenants, and increased use of such covenants in a global economy focused on protecting confidential data and business relationships, companies would be wise to work closely with legal counsel to develop and, if necessary, update restrictive covenant agreements to maximize enforceability and protection of valuable company assets.
Mike Karpeles is Chair of Greenberg Traurig’s Labor and Employment Practice in Chicago, a member of the firm’s Noncompete, Trade Secret and Employment Contract group, and regularly litigates restrictive covenant cases and drafts restrictive covenants for the firm’s clients. He is a Fellow in the College of Labor and Employment Lawyers, and for several years has been included in Chambers USA Guide, Best Lawyers in America, Illinois Super Lawyers and other similar listings.