Confidentiality (NDA) and Non-Compete Agreements in LLCs

Introduction

When investors join together to form an LLC, the newly-formed company is a legal person with an independent right to possess and own confidential and proprietary information. Clearly, the LLC has a core interest in protecting this information as well as preventing company insiders from entering into direct competition with its primary business.

During the formation process and subsequent business operations, it is likely (if not inevitable) that individual LLC members and managers will acquire knowledge of trade secrets, concepts, strategies, marketing, and other methodologies used by the company to promote its business. From the perspective of the LLC, it is vital that this information be protected. A written agreement executed by the LLC and its members and managers should make clear that confidential and proprietary company information exists that is the sole and exclusive property of the company.

Similarly, there is a risk that LLC members or managers who have access to the internal workings of the company could eventually choose to leave the LLC and compete (directly or indirectly) with the company in its home territory. A non-compete agreement signed by all members can limit competition with the LLC: (1) while a person is a member or manager and (2) afterward for a reasonable period of time within a reasonable geographic area (reasonable being defined with reference to the specific situation and standards in the industry).

CONFIDENTIALITY PROVISIONS

Confidential and Proprietary Information

LLC members and managers signing a confidentiality agreement should: (1) be required to expressly relinquish any right to possess or utilize the information for any purpose, gainful or not; and (2) be designated as fiduciaries with respect to such information with an obligation not to act contrary to the interests of the company. All signatories should accept an ongoing duty not to discuss or disclose confidential or proprietary information to anyone without first obtaining the company’s consent.

Confidential and proprietary information would include information and records relating to company:

(1) trade secrets as that term is defined and described in The Texas Uniform Trade Secrets Act (Civ. Prac. & Rem. Code Chap. 134A);

(2) research and development including concepts, designs, and specifications;

(3) feasibility and market studies;

(4) sources, vendors, and supply chains;

(5) manufacture, assembly, and distribution of company products and services;

(6) marketing strategies advertising, pricing, and sales;

(7) customer and prospect lists;

(8) legal structure and operations;

(9) communications (oral, written, or electronic);

(10) members, managers, officers, beneficial owners, contractors, and employees;

(11) human resources policies as well as training methods and materials;

(12) accounting policies and practices;

(13) banking, depository, and investment accounts;

(14) federal and state taxation;

(15) local, state, and federal regulatory compliance;

(16) pending, threatened, or contemplated cases and litigation;

(17) intellectual property such as proprietary means and methods, patents, trademarks, and copyrights (actual, pending, or prospective);

(18) work product of whatever kind or nature whether produced during or outside of normal working hours and whether produced at the premises of the company or elsewhere.

The foregoing is only a partial list that would need to be expanded and customized to suit the circumstances. Broad, bland wording is problematic. The more specific and grounded in the industry that the list is the more likely that it will be enforceable.

Law Applicable to Trade Secrets

Chapter 134A of the Civil Practices and Remedies Code is known as The Texas Uniform Trade Secrets Act. Under Section 134A.002(6) of TUTSA:

“Trade secret” means all forms and types of information, including business, scientific, technical, economic, or engineering information, and any formula, design, prototype, pattern, plan, compilation, program device, program, code, device, method, technique, process, procedure, financial data, or list of actual or potential customers or suppliers, whether tangible or intangible and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing if: (A) the owner of the trade secret has taken reasonable measures under the circumstances to keep the information secret; and (B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information.

In order to state a claim under TUTSA, the company must show that: (1) a trade secret existed; (2) the defendant acquired the trade secret through breach of a confidential relationship or other illicit means; (3) no authorization was given by the company to use the trade secret; and (4) the company incurred measurable harm from its wrongful use.

Under Section 134A.002(3) of the Act, wrongful misappropriation of a trade secret is:

(A) acquisition of a trade secret of another by a person who knows or has reason to know that the trade secret was acquired by improper means; or

(B) disclosure or use of a trade secret of another without express or implied consent by a person who: (i) used improper means to acquire knowledge of the trade secret; (ii) at the time of disclosure or use, knew or had reason to know that the person’s knowledge of the trade secret was: (a) derived from or through a person who used improper means to acquire the trade secret; (b) acquired under circumstances giving rise to a duty to maintain the secrecy of or limit the use of the trade secret; or (c) derived from or through a person who owed a duty to the person seeking relief to maintain the secrecy of or limit the use of the trade secret; or (iii) before a material change of the position of the person, knew or had reason to know that the trade secret was a trade secret and that knowledge of the trade secret had been acquired by accident or mistake.

TUTSA relief may include an injunction, damages, exemplary damages, attorney’s fees, and costs.

In matters relating to interstate commerce, there is also the federal Defend Trade Secrets Act (DTSA, 18 U.S. Code Sec. 1836). DTSA has provisions similar to TUTSA.

Duration and Geographical Area

Duration of the confidentiality obligation should be clearly set out in the agreement. It is common to require that confidential information be preserved indefinitely, and this may indeed be reasonable and appropriate under the circumstances. However, if a limited confidentiality period is specified, it should be reasonable with reference to the specific case and standards in the industry.

Given instant worldwide internet communications, confidentiality agreements are not usually limited in geographical area, it being presumed that when such information is disclosed anywhere it is disclosed everywhere.

Additional Clauses

A member or manager executing the confidentiality agreement should expressly agree that it will not be a defense to argue that the confidential or proprietary information is available in whole or in part from another source. An unambiguous obligation on the part of that person not to discuss or disclose the information should apply regardless.

The agreement should impose a duty to return all originals and copies of any confidential or proprietary information that might come into the possession of an LLC member or manager.

NON-COMPETE PROVISIONS

Law Applicable to Non-Competes

It is of vital interest to the LLC that its members and managers not be allowed to compete, directly or indirectly, with the company in its main line of business. Applicable statutory law—The Covenants Not to Compete Act—is found in Chapter 15 of the Business & Commerce Code. This statute and case law interpreting it are the only legal criteria for determining the validity and enforceability of a non-compete agreement in Texas. “[It is] clear that the legislature intended the Covenants Not to Compete Act to largely supplant the Texas common law relating to enforcement of covenants not to compete.” Marsh USA Inc. v. Cook, 354 S.W.3d 764 (Tex. 2011).

Enforceability of Non-Competes

Bus. & Com. Code Sec. 15.50. Criteria for Enforceability of Covenants Not to Compete

(a) [A] covenant not to compete is enforceable if it is ancillary to or part of an otherwise enforceable agreement [e.g., an independent contractor agreement or LLC company agreement] at the time the agreement is made to the extent that it contains 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 interest of the [company].

Bus. & Com. Code Sec. 15.51. Procedures and Remedies in Actions to Enforce Covenants Not to Compete

(a) Except as provided in Subsection (c) of this section, a court may award the [business] under a covenant not to compete damages, injunctive relief, or both damages and injunctive relief for a breach by the promisor of the covenant.

(b) If the primary purpose of the agreement to which the [non-compete] covenant is ancillary is to obligate the promisor to render personal services, for a term or at will, the [company] has the burden of establishing that the covenant meets the criteria specified by Section 15.50 of this code. If the agreement has a different primary purpose, the promisor has the burden of establishing that the covenant does not meet those criteria. . . .

(c) If the covenant is found to be ancillary to or part of an otherwise enforceable agreement but contains limitations as to time, geographical area, or scope of activity to be restrained that are not reasonable and impose a greater restraint than is necessary to protect the goodwill or other business interest of the [business], the court shall reform the [non-compete] covenant to the extent necessary to cause the limitations contained in the covenant as to time, geographical area, and scope of activity to be restrained to be reasonable [italics added] and to impose a restraint that is not greater than necessary to protect the goodwill or other business interest of the [company] and enforce the covenant as reformed. . . .

Consideration Requirement

The employee or contractor (the promisor) is giving up something of value from the company (the promisee), therefore something of value must also be provided by the company in exchange. Unless there is a two-way street of benefits, a non-compete agreement may fail. This is part of an overall reasonableness test. Powerhouse Prods. v. Scott, 260 S.W.3d 693 (Tex.App.—Dallas 2008, no pet.).

Reasonableness Requirement

Despite the inclination of Texas law to allow maximum freedom of contract, restraints on trade tend to be viewed unfavorably. “A covenant not to compete is a restraint of trade and unenforceable as a matter of public policy unless it meets a reasonableness standard. . . . Restraints [on trade] are unreasonable if they are broader than necessary to protect the legitimate interests of the employer.” John R. Ray & Sons, Inc. v. Stroman, 923 S.W.2d 80 (Tex.App.—Houston [14th Dist.] 1996, writ denied).

The standards of the industry and the specific circumstances of the case are crucial in determining reasonableness. “The hallmark of enforcement is whether or not the covenant [restraining trade] is reasonable . . . . [T]he statute’s core inquiry is whether the covenant contains limitation 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” and other valid business interests of the company. Marsh USA Inc. v. Cook, 354 S.W.3d 764 (Tex. 2011).

In litigation, the company has the burden of proving to the court that any restraints on trade (restrictions on competition) are reasonable (Bus. & Com. Code Sec. 15.51(b)).

Ancillary Agreement Requirement

Business & Commerce Code Section 15.51(a) states that “a covenant not to compete is enforceable [only] if it is ancillary to or part of an otherwise enforceable agreement at the time the agreement is made.” This typically means that non-compete provisions must be part of a broader valid agreement between the parties such an employment contract, an independent contractor agreement, or (in the case of LLCs) a company agreement or operating agreement.

Restricting Versus Eliminating Competition

In considering restraints on competition, it is important to understand that restricting competition is different from eliminating competition altogether. An attempt by a company to entirely eliminate competition is likely to be viewed as excessive, at least when it comes to any specific non-compete period that follows separation from the company. “The goal of a [post-separation] covenant not to complete is to establish [a geographical area or other] restraint on trade [but only to the extent] reasonably necessary to protect the goodwill or other business interests of the [company], not to prevent any competition [at all].” Ortega v. Abel, 562 S.W.3d 612 (Tex.App.—Houston [1st Dist.] 2018, pet. denied].

Scope of Work or Activity

A “noncompetition agreement that prohibits a larger scope of activity [or work] than is reasonably necessary to protect [the company] is unenforceable. . . .” Diversified Human Res. Grp. V. Levinson-Polakoff, 752 S.W.2d 8 (Tex.App.—Dallas, 1988, no writ).

It is important in drafting a non-compete agreement to be narrow and specific as to the scope of work that is being restricted. A non-compete agreement that contains “an industrywide exclusion is almost always going to be unreasonable because it restrains more activity than necessary to protect the business interest of a former employer. . . . Covenants not to complete must bear some reasonable [and rational] relationship to the [actual] activities of the employee . . . . [Otherwise such covenants are] overbroad and unenforceable.” Forum US, Inc. v. Musselwhite, No. 14-17-00708-CV, 2020 WL 4331442 (Tex.App.—Houston [14th Dist.] 2020, no pet.).

Geographical Non-Compete Area

The geographical area covered by post-separation non-compete provisions must be reasonable with reference to the circumstances and standards in the industry. Case law suggests that it is better to be conservative in determining the non-compete period and non-compete area so as not to risk voiding the agreement by overreaching.

“To be enforceable, a noncompetition agreement must be reasonable in time, scope [of work], and geographical area. Generally, the territory in which the employee worked for the employer is a reasonable geographical restriction. A covenant not to compete is unreasonable if it imposes a greater restraint [over a greater geographical area] than necessary to protect the employer’s business and goodwill.” Byun v. Hong, 641 S.W.3d 821 (Tex.App.—Tyler 2022, no pet.).

A reasonable geographical restraint upon competition from a real estate agent might be a circle with a 10 or 20 mile radius from the company’s headquarters for a period of 9 to 18 months. A prohibition encompassing the entire Houston metropolitan area for 5 years would almost certainly fail. In the case of an oilfield consultant, an appeals court affirmed the judgment of the trial court in reducing the non-compete area from 250 to 50 miles, agreeing that this smaller area was more reasonable and also corresponded to the company’s actual area of business. GTG Automation, Inv. V. Harris, No. 11-16-00317—CV, 2018 WL 5624206 (Tex.App.—Eastland 2018, no pet.).

Duration of Non-Compete Provisions

An indefinite or unduly lengthy non-compete period is unenforceable in most cases. “A covenant not to compete that extends for an indeterminable amount of time is [by definition] not reasonable and, as a result, is not enforceable. Central States Logistics, Inc. v. BOC Trucking, LLC, 573 S.W.3d 269 (Tex.App.—Houston [1st Dist.] 2018, pet. denied).

What is reasonable in the case of a member or manager who is still associated with the LLC may not be reasonable after separation has occurred—at least not unless reasonably limited in time, scope of work, and geographical area. It is important to distinguish between these two time periods. Non-compete provisions between an LLC and its members and managers should be drafted so as to apply for the duration of: (1) the entirety of the time that a person is associated with the LLC as a member or manager; and (2) for a reasonable period of time within a reasonable geographical area after the member or manager departs the LLC.

A post-employment, post-association non-compete period should be reasonable with reference to the specific case and standards in the industry. In most personal services cases, one to two years has been found to be reasonable. Longer non-compete periods are risky. In litigation the burden of proving reasonableness is be on the company, so the argument needs to be a sound one.

Examples of Prohibited Competition

Subject to the foregoing caveats and considerations, the non-compete agreement should prohibit members and managers from directly or indirectly, openly or covertly:

(1) competing with the company or its subsidiaries or affiliates in its main line of business;

(2) advertising or providing products or services similar to those offered by the company;

(3) acting as an owner, investor, or participant in a competing business;

(4) collecting revenue or profits from a competing business;

(5) acting as an employee, member, manager, or officer of a competing business;

(6) exercising substantial control over a competing business;

(7) providing financial, technical, or other support services for a competing business;

(8) contacting, recruiting, or enticing company customers;

(9) contacting, recruiting, soliciting, or enticing company employees, associates to compete with the company;

(10) contacting, recruiting, or enticing company members, managers, or other governing persons to engage in competition with the company; or

(11) contacting, recruiting, or enticing company suppliers, vendors, middlemen, or third-party contractors for the purpose of competing with the company.

As was the case with the list of confidential information items provided in the previous section, this list is only partial and would need specific customization to suit the circumstances. In particular, the listed items should be tailored to the company’s line of business and location. Narrow specificity, not breadth, is what the case law tells us will be upheld. Broad and sweeping prohibitions (the kind that lawyers most enjoy writing) are likely to be seen as unreasonable per se and restraints on trade that are contrary to public policy.

Protecting the Company Name

A primary goal of an LLC in using a non-compete agreement is to prevent a member or manager (present or former) from setting up shop nearby under a similar name. Accordingly, it is important that all business and trade names of the company be expressly protected by a specific list. Such names would include entity names, assumed names, and trade names employed by the company. These should be stipulated to be the sole and exclusive property of the company. It should be made clear in the agreement that association with the company does not grant any right or entitlement to a member or manager to use the company name or any version of it.

In addition to the list provided above, a comprehensive non-compete agreement should prohibit members or managers from using any business or trade name that is substantially the same as or deceptively similar to the formal or informal names that are used by the Company or its subsidiaries or affiliates. Such a provision would apply in addition to protections already afforded trade names by statute and common law.

ADDITIONAL CONTRACT PROVISIONS

Agreement Confidentiality

A confidentiality and non-compete agreement should itself be confidential except that persons signing may acknowledge to third parties that the agreement exists and is binding upon them. Beyond that, discussion of specific terms should in most situations be prohibited.

Non-Disparagement

A non-disparagement clause is often overlooked in the drafting of confidentiality and non-compete agreements. Just as the terms of the agreement should not be discussed with third parties, all signatories should commit in advance to avoid publicly criticizing or disparaging the LLC or any other parties to the agreement—whether or not a breach occurs. It is in the interest of all parties to avoid the potential devastation of a nasty social media dispute that could in turn lead to defamation litigation.

Tolling Provision upon Breach

It is useful to include a provision that the term (duration) of a post-separation non-compete agreement will be paused (tolled) for a specific period in the event it is breached by the employee or contractor. Otherwise, the ability of the company to seek relief may effectively run out if the agreement expires before a judgment can be obtained. Sadler Clinic Ass’n v. Hart, 403 S.W.3d 891 (Tex.App.—Beaumont 2013, pet. denied).

Mandatory Mediation

Mediation is effective in settling business disputes around 75% of the time. In other words, mediation works. Including a clause requiring a half-day mediation—so long as the company is not prevented from immediately seeking a temporary restraining order—can be useful and add value for everyone involved.

CONTRACT REMEDIES FOR BREACH

Contractual Assignment of Proceeds

All well-drafted contracts should prepare for the possibility that they will be breached. In the case of confidentiality and non-compete agreements, certain ready-made default remedies should be built in. For example, members and managers should agree, in advance, to assign to the LLC: (1) all gross proceeds and profits that may wrongfully accrue to the violator as a result of the breach, with the company being designated as a constructive trustee of such funds; and (2) all patent, trademark, copyright, or other intellectual property rights that a breaching party may wrongfully acquire as a consequence of the violation.

Liquidated Damages

Confidentiality and non-compete agreements may provide for liquidated damages. This would include a declaration that since actual monetary damages may be difficult to ascertain in the event of breach, the parties agree and stipulate that fixed liquidated damages will apply. The agreement might provide that a violator will be liable to the company for liquidated damages in the amount of the lesser of (say) $100,000 or $10,000 per month. Again, there is a reasonableness requirement in setting these numbers that must be rationally related to actual anticipated losses.

LITIGATION REMEDIES FOR BREACH

Injunctive Relief

As to non-compete agreements, “[A] court may award the [company] under a covenant not to compete damages, injunctive relief, or both damages and injunctive relief for a breach by the promisor of the covenant” (Bus. & Com. Code Sec. 15.51(a)). While it is useful for a contract to state that a party will be irrevocably and substantially harmed by a breach (thus establishing the usual predicate for injunctive relief), “a showing by [the company] of an irreparable injury for which [it] has no adequate legal remedy is not a prerequisite for obtaining injunctive relief under [Section 15.51 of] the Covenants Not to Compete Act.” Butler v. Arrow Mirror & Glass, Inc., 51 S.W.3d 787 (Tex.App.—Houston [1st Dist.] 2001, no pet.).

As to trade secrets, “actual or threatened misappropriation [of a trade secret] may be enjoined if the order does not prohibit a person from using general knowledge, skill, and experience that person acquired during employment” (Civ. Prac. & Rem. Code Sec. 134A.003).

Reformation of Contract Terms

If the contract is litigated, the trial court has the power to change (reform) the restraints contained in a non-compete agreement. In fact, this is a statutory duty under Business & Commerce Code Section 15.51. “[If there is an unreasonable restraint] the covenant is not invalidated; instead the court must reform the covenant to make the restraint reasonable.” Neurodiagnostic Tex, L.L.C. v. Pierce, 506 S.W.3d 153 (Tex.App.—Tyler 2016, no pet.). The standard for reformation is what is reasonable and necessary to protect the goodwill or other business interests of the company. Sentinel Integrity Solutions, Inc. v. Mistras Grp., 414 S.W.3d 911 (Tex.App.—Houston [1st Dist.] 2013, pet. denied).

In requesting reformation of the contract (i.e., requesting that restraints be reduced), the burden of moving forward and setting a hearing on this subject is on the employee or contractor. Omission of this step can constitute a waiver. John R. Ray & Sons, Inc. v. Stroman, 923 S.W.2d 80 (Tex.App.—Houston [14th Dist.]1996, writ denied).

Actual and Exemplary Damages

The company may also recover for actual and exemplary damages and attorney’s fees in the case of both non-competes (Bus. & Com. Code Sec. 15.51) and trade secrets (Civ. Prac. & Rem. Code Sec. 134A.004-005).

Attorney’s Fees, and Costs

An award of attorney’s fees and costs is available for breach of non-compete agreements, but such relief is limited by the express terms of the statute. The Covenants not to Compete Act “controls the award of attorney’s fees . . . Tex. Bus. & Com. Code Sec. 15.52 preempts an award of fees under Civ. Prac. & Rem. Code Sec. 38 and any other law.” Perez v. Texas Disposal Sys.,103 S.W.3d 591 (Tex.App.—San Antonio 2003, pet. denied).

For an employee or contractor to recover fees and costs for defending a suit by the company for breach of a non-compete agreement, it must be shown that: (1) the company knew that the non-compete agreement did not contain reasonable restraints; and (2) the company nonetheless sought to enforce the agreement. Bus. & Com. Code Sec. 15.51(c) and Boucher v. Thacker, 609 S.W.3d 206 (Tex.App.—Texarkana 2020, no pet.).

To the extent not expressly preempted, the general attorney’s fees statute (Civ. Prac. & Rem. Code Sec. 38) applies to cases of contract breach.

CONCLUSION

Members investing in an LLC at its formation should be able to rely on agreements and representations made by other insiders that they will not go rogue and destroy the viability of the company. Business lawyers know from experience to plan for this common and foreseeable risk. A solid solution is requiring execution of an agreement protecting confidential and proprietary information as well as prohibiting competition arising from LLC members and managers. This agreement can be signed at the same time other governing documents (company agreement, organizational meeting, and so forth) are executed.