In ExxonMobil Corp. v. Drennen, the Texas Supreme Court held that Texas-based parties can elect the law of another state to govern certain employment compensation arrangements, including by selecting New York law to govern a forfeiture-for-competition clause intended to allow the employer to clawback outstanding unvested awards in a non-contributory profit sharing plan (No. 12-0621, (Tex. Aug. 29, 2014)).

Practical Law asked Sean Becker of Vinson & Elkins LLP to discuss Drennen and other notable 2014 developments in non-compete law.

Sean is a Partner in Vinson & Elkins' Houston office. He counsels employers about compliance with an array of labor and employment laws and represents employers in business transactions and litigation, including negotiating executive employment agreements and structuring and enforcing restrictive covenant arrangements.

Drennen is a case that could have significant ramifications for how Texas-based employers structure their restrictive covenant regimes.

Drennen was a 31-year employee of ExxonMobil who rose to the rank of vice president. He participated in various incentive compensation plans, including restricted stock option plans with benefits that vested over time. The applicable award agreements provided that Drennen would forfeit unvested benefits if he engaged in "detrimental activity." The incentive agreements listed accepting employment with a competitor among the detrimental activities. The restricted stock agreements included choice of law clauses that designated New York law.

After Drennen received an unfavorable review and was told that the company was trying to find him a new position, he resigned and went to work for Hess, a competitor. At the time, he had approximately $5 million worth of unvested ExxonMobil stock grants still in their restricted period. After Drennen took the Hess job, ExxonMobil invoked the detrimental activity clauses in his incentive agreements and canceled his outstanding unvested awards.

Drennen sued to recover the forfeited stock, arguing that the detrimental activity provisions in the incentive programs were unreasonable and therefore unenforceable covenants not to compete in violation of Texas restraint of trade statutes. ExxonMobil argued that the plans' choice of New York law should be respected and under New York's "employee choice" doctrine, the forfeiture should be upheld. That principle provides that a forfeiture invoked against an employee who voluntarily left employment or was terminated for cause is not a restraint of trade because it does not restrict future employment rights, but instead only sets an opportunity cost that employees can choose to incur if they wish to compete.

Although a jury found for ExxonMobil on all counts, an intermediate court of appeals accepted Drennen's arguments. The appellate court disregarded the incentive plans' New York choice of law clauses and held that:

The appeals court concluded that the forfeiture clauses were unenforceable because they lacked reasonable temporal, geographic and scope of activity limitations, as Texas non-compete law requires.

The appeals court rejected ExxonMobil's choice of law arguments, relying on 1990 Texas Supreme Court precedent, DeSantis v. Wackenhut Corp. (793 S.W.2d 670 (Tex. 1990)). In DeSantis, the court held that despite a Florida choice of law clause in a non-competition agreement with a Florida-based employer, Texas law must be applied when analyzing the enforceability of that agreement because:

The Drennen facts were similar to the DeSantis case in these respects. Following the DeSantis reasoning, the Drennen appeals court emphasized that determining whether non-competition agreements are reasonable restraints on employees who live and work in Texas is a matter of fundamental Texas public policy to which Texas law must be applied, regardless of the contractual choice of law designation.

The Texas Supreme Court diverged from its DeSantis precedent and applied the New York law designated in ExxonMobil's incentive plans. It held that the forfeitures were enforceable under the employee choice doctrine as New York law recognizes.

The Texas Supreme Court stopped short of determining whether Texas would recognize the employee choice doctrine, but articulated two important themes:

Applying choice of law standards of the Restatement (Second) of Conflict of Laws § 187(2), the court held that there was a reasonable basis for the New York law designation, because:

Even though the court determined that Texas had a materially greater interest in the Drennen-ExxonMobil controversy than New York, it held that enforcement of the forfeiture clause would not offend fundamental Texas policy, because:

This latter conclusion was especially notable, as the court cited a Dallas Morning News article about the growing prevalence of Fortune 500 companies headquartered in Texas and emphasized:

This holding, and the court's citation to a comment to the Restatement (Second) of Conflict of Laws that parties should have power to choose the applicable law because of the demands for certainty, predictability and convenience, suggested a new degree of deference to contractual choices of law.

Applying this deference, the court concluded that it should apply New York law to ExxonMobil's forfeiture agreements, even if it resulted in an economic consequence that could deter a Texas resident from assuming competitive work in Texas, because that would be consistent with a new Texas policy favoring the predictability of contracts on a national basis.

Although the Texas Supreme Court did not incorporate the employee choice doctrine into Texas law in Drennen, it opened the door for a range of forfeiture clauses to be enforced in the state. The court clarified that "bad boy" forfeiture provisions in certain compensation programs are distinct from non-competition agreements. Forfeiture-for-competition provisions may not be contrary to Texas policy, even if they do not incorporate the reasonableness limitations required for a non-compete to be enforceable. This is an important development that should validate some existing forfeiture-for-competition regimes and create new opportunities for employers to incentivize employee loyalty and retention.

The opinion also emphasizes:

Based on Drennen, Texas courts should consider the importance of uniform interpretation of an agreement across jurisdictions for a company's employees, even if it means applying different standards to individuals working for different employers within Texas. This seems analogous to the rationale applied to ERISA plan administration, where courts apply federal preemption and a standard deferential to plan sponsors to facilitate uniformity and predictability, even if it trumps the forum state's law. This is a potentially significant development for how Texas employers draft their contracts and advocate for their enforceability.

Drennen and other recent Texas Supreme Court non-compete decisions enhance opportunities for Texas employers to deter competition and discourage key employees from becoming competitors. In light of Drennen, employers should review their compensation regimes and consider whether to implement programs that could act as a "carrot" to discourage competition and a complement to the "stick" of traditional non-competition agreements.

Given the importance that Drennen places on choice of law designations, employers should also consider whether their contracts bear a reasonable relation to a state applying the employee choice doctrine and, if so, whether that state's law could apply to their forfeiture-for-competition agreements.

When arguing for the enforceability of their choice of law designations, employers should also consider the themes of Drennen and evaluate whether they could cite to:

Finally, even though Drennen creates new opportunities, employers should recognize its limitations. Even if the law of a state recognizing "employee choice" principles would apply in an enforcement action, that doctrine does not apply to employees who are terminated without cause.

Further, an employer may not win the choice-of-law argument and (as the Drennen appeals court demonstrated) could be left in a situation where its forfeiture agreement is enforceable only if it satisfies statutory or common law restraint of trade standards under applicable state law. Therefore, employers should consider whether their clawback regimes should be narrowly tailored and have specific geographic, temporal and scope-of-activity restrictions. If these standards are met, employers that lose a choice of law argument or seek to impose forfeiture against an involuntarily departed employee nonetheless may be able to exercise clawback rights.

Two opinions that stand out are an Illinois appellate court's decision in Fifield v. Premier Dealer Services, Inc., which the Illinois Supreme Court declined to review, and the Kentucky Supreme Court's ruling in Charles T. Creech, Inc. v. Brown. Each decision invalidated an employer's non-compete because at-will employment was deemed insufficient consideration for the restrictive covenant.

The Fifield decision could have far-reaching implications, as the court in that instance held that two years of continued employment was required to enforce a post-employment non-compete in Illinois, even if the restrictive covenant agreement was signed at the outset of the employment relationship. Under this reasoning, which the Illinois Supreme Court tacitly endorsed by refusing to consider the case on appeal, employers must offer extra consideration besides at-will employment if they want to enforce a non-compete against their short-term employees. Given the significant turnover in many companies and the fact that the Fifield rationale extends to employees who voluntarily depart, this could be an expensive development for employers who want to deter competition. Drafters of non-compete agreements may also move away from Illinois law in choice of law clauses and litigators may raise important, threshold arguments over whether Illinois law should apply to restrictive covenant agreements. (993 N.E.2d 938 (Ill. App. Ct. 2013).)

Notably, after the Illinois Supreme Court declined to review Fifield in the latter part of 2013, this year Illinois federal district courts reached different conclusions about whether to apply Fifield (see Instant Tech., LLC v. DeFazio, No. 12 C 491, (N.D. Ill. May 2, 2014) and Montel Aetnastak, Inc. v. Miessen, No. 13 C 3801, (N.D. Ill. Jan. 28, 2014).)

The Charles T. Creech decision was a bit more employer-friendly. The case did not disturb Kentucky precedent holding that an offer of at-will employment is valid consideration for a non-compete an employee signs at hiring. However, it held that continued at-will employment is not sufficient consideration for a non-compete entered by a current employee. However, that case also emphasized that employers in certain states must pay for their non-competes if they want to take new defensive measures to protect against today's employees becoming tomorrow's competitors. (433 S.W.3d 345 (Ky. 2014).)

The themes of Creech and Fifield were echoed by a notable Pennsylvania decision, Socko v. Mid-Atlantic Systems of CPA. In that case, a Pennsylvania trial court held that the Pennsylvania Uniform Written Obligations Act, which provides that there is sufficient consideration for a written promise if the writing includes a representation that the "signer intends to be legally bound," would not apply to restrictive covenant agreements. Accordingly, the court invalidated a mid-employment non-compete in which the employee stipulated that he "intend[ed] to be bound" by its terms, but only received continued, at-will employment as consideration. Under the court's rationale, the sufficiency of consideration for non-competition agreements are subject to heightened scrutiny and that could not be overcome by the presumption of enforceability created by the Uniform Written Obligations Act. This case further emphasized how employers must be aware of varying state-law restrictive covenant consideration requirements and the requirement in many states of providing additional consideration other than at-will employment in order to create an enforceable non-compete. ( (Pa. Super. Ct. May 13, 2014).)

One case that was also notable was a Texas appeals court case titled Ally Financial, Inc. v. Gutierrez and Homeward Financial. In that case, the employer (Ally) sponsored a long-term incentive plan that included clawback clauses if departing employees solicited Ally's customers or employees. After an employee-plan participant (Gutierrez) left the company, she joined a competitor and recruited several of her former coworkers. In response, Ally sent a letter to Gutierrez in which it accused her of breaching her non-solicitation obligations, warned her that it would initiate an enforcement action and emphasized that she would forfeit awards under the incentive plan for violating the plan's restrictive covenants. Six weeks later, Ally paid Gutierrez the next installment of her incentive payments. That payment proved fatal to the lawsuit that Ally later initiated against Gutierrez after several other Ally employees joined her new employer.

The court held that Ally waived its enforcement rights by paying the installment to Gutierrez and declining to enforce its restrictive covenant agreements against other former employees. The case was an important reminder of the need for employers to act consistently and enforce their restrictive covenant agreements at an early stage. The best-drafted contract could prove worthless if it is not accompanied by a well-considered enforcement strategy. (No. 02-13-00108-CV (Tex. App. Jan. 23, 2014).)