United States: California Reaches Across State Lines To Invalidate Employee Non-Compete Agreements

We are in the final stretch of the California legislature's first year of a two-year session. One bill that sped through the legislative process—without any registered opposition—is Senate Bill 699, which extends the state's restrictions on non-compete agreements to contracts signed out of state. Despite the deadline of September 14, 2023, to pass bills and send them off to the governor's desk, this bill leapfrogged several others and already has been signed into law.

California Business and Professions Code section 16600 provides that every contract that restrains anyone from engaging in a lawful profession, trade, or business of any kind is void, subject to limited exceptions. So "non-compete" agreements are not enforceable in California. But what if that "contract" was not signed in California, and the employment involved occurred outside of the state?

In general terms, SB 699 extends the reach of California's restriction on non-competes to such contracts and provides a private right of action for enforcement, including attorney's fees.

More specifically, SB 699 adds a new section to the Business and Professions Code (B&P Section 16600.5), implementing the following restrictions:

1. Any contract that is void under B&P Section 16600 is unenforceable regardless of where and when the contract was signed.
2. An employer or former employer "shall not attempt to enforce" a contract that is void regardless of whether the contract was signed and the employment was maintained outside of California.
3. An employer shall not enter into a contract with an employee or prospective employee that includes a provision that is void under this chapter.
4. An employer that enters into a contract that is void or attempts to enforce a contract that is void commits a civil violation. An employee, former employee, or prospective employee may bring a private action to enforce this chapter for injunctive relief or the recovery of actual damages and is entitled to recover reasonable attorney's fees and costs.

A report from the chief counsel of the state Assembly Judiciary Committee cited a statistic that "non-compete" agreements (contracts that prohibit someone from engaging in competition against the employer) affect nearly 20% of workers nationwide, with 30-46%¹ of workers in the private sector subject to such agreements. With nationwide statistics being cited, why is this a California problem? The answer: the economy. California's economy relies on plucking the best workers nationwide for certain industries. In the Assembly's words, "California has benefitted significantly from this law [the restriction on non-competes], fueling competition, entrepreneurship, innovation, job and wage growth, equality, and economic development...noncompete clauses stifle economic development, limit firms' ability to hire and depress innovation and growth." The legislature asserts that California's policy on talent mobility is necessary to California's competitive business interests in the areas of technology, entertainment, biomedicine and pharma.

Can the California legislature do that? Reach across state lines to declare that a contract signed in another state is not enforceable in California?

Consider the following:

1. A California company hires, or wants to hire, an employee to work in California.
2. The employee is subject to a non-compete agreement entered into at a job they held in another state, say, Texas. The non-compete agreement meets all state law requirements to be enforceable in Texas.²
3. The lawyer for the Texas company sends a cease and desist letter to the California company saying they cannot do this, as the former employee has a non-compete, which is enforceable in the Lone Star State.
4. The California company can say in response, "too bad, you can't enforce that agreement here in the Golden State, due to SB 699."

The Texas employer just had their lawful contract with a former employee nullified – by California! The question is, can California employers take this legal position by relying on SB 699?

The question involves the "extraterritorial application" of state law. California applies a presumption against the extraterritorial application of its state laws. North Alaska Salmon Co. v. Pillsbury, 174 Cal. 1, 4 (1916). The presumption can be rebutted only where a contrary intent is "clearly expressed or reasonably to be inferred from the language of the act or from its purpose, subject-matter, or history." Here, it now appears that the presumption is subject to rebuttal, due to the language of the act, and its stated legislative purpose. The wording of the statute specifically states that the law is designed to apply to contracts entered into in another state. And the legislative intent of SB 699 states that non-competes "stifle economic development." With such unambiguous language, this likely is a persuasive rebuttal.

Application of one state's laws to events occurring in a different state also raise constitutional concerns, however. States are limited in their ability to enact laws that impose a substantial burden on interstate commerce. A state law that places an undue burden that exceeds the local benefits of the law runs afoul of the "dormant commerce clause." Pike v. Bruce Church, Inc., 397 U.S. 137, 142 (1970). While SB 699 certainly has extraterritorial application, it can be argued that the law does not restrain commerce at all, rather, it frees up commerce by allowing employees to more freely practice their trade or profession.

One thing is certain. This law will lead to litigation battles between California-based companies and out-of-state employers seeking to prevent their former staff from working for competitors in California. With California' strong policy on maximizing innovation and talent through a diverse workforce (as signaled by not a single "no" vote on this bill), it is no surprise that Governor Newsom signed this bill into law, notably doing so on Labor Day weekend.

SB 699 should also concern employers because it creates a private right of action for employees whose agreements include restrictive covenants and provides for attorney fees for any current, former, or even prospective employee who successfully brings suit against an employer's use of those restrictive covenants. Prior to this new law, most courts directly addressing the issue have held the inclusion of restrictive covenants did not directly create a right of action against employers. In particular, California's Private Attorney General Act (Cal. Labor Code § 2699) ("PAGA") did not create a private right of action for contracts in violation of B&P Section 16600 because (a) PAGA applies only to Labor Code violations, (b) Labor Code Section 432.5 prohibits only contracts "prohibited by law," and (c) B&P Section 16600 provides that restrictive covenants are void, but not prohibited by law. That private right of action is now directly encoded into the new Section 16600.5, as are the remedies of injunctive relief, damages, and attorney fees for prevailing employees, former employees, and even prospective employees.

In addition, the statute states that an employer whose contracts include restrictive covenants has committed a "civil violation." The potential impact of this change is uncertain at this time.

While California employers have known for some time that they cannot enforce restrictive covenants against California employees, SB 699 expands the scope of this prohibition and creates serious liability to employers whose contracts have not been recently updated to account for the shifting legal landscape. Employers are advised to consult with counsel when considering seeking to enforce or oppose a non-compete agreement in California and when asking an employee to enter into any agreement with restrictive covenants.

Footnotes

1. This is not a typo, the report from the Chief Counsel of the California Assembly Judiciary Committee cites the percentages as "30 - 46%."

2. The requirements for an enforceable covenant not to compete are defined by statute in Texas. TEX. BUS. & COM. CODE ANN. §§ 15.50 to 15.52.

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