United States: Non-Compete Agreements

California has strict rules outlawing covenants not to compete. But there are exceptions.

California is notorious for outlawing non-competition agreements. It is one of the few states that generally prohibits the unlawful restraint of one's profession or business, with limited exceptions. Knowing how to navigate these limited exceptions is critical for companies that utilize employment agreements to protect trade secrets and other valuable business assets.

The Right to Compete Under Edwards

In the seminal case Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008), the California Supreme Court reinforced the state's long-standing public policy favoring employee mobility and confirmed, as a general rule, that employee non-competition agreements are unenforceable in California. This public policy is codified in section 16600 of the California Business and Professions Code, which provides that, "every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void."

The Edwards court thus ruled that section 16600 prohibits employee non-competition agreements, with limited statutory exceptions. Notably, the court acknowledged that it was not addressing the applicability of any "trade secret exception" to section 16600 (i.e., the enforcement of restrictive covenants to the extent necessary to protect trade secrets).

Importantly, section 16600 has been applied to agreements with both employees and independent contractors. See, e.g., Ret. Grp. v. Galante, 176 Cal. App. 4th 1226, 1237 (2009).

Employers that utilize non-compete agreements with California employees run the risk that the non-competes will likely be deemed void and unenforceable under California law. Some California courts have even extended the protections of section 16600 to out-of-state employees who plan to become California employees. See Application Group, Inc. v. Hunter Group, Inc., 61 Cal. App. 4th 881 (1998) (invalidating non-compete agreement between Maryland corporation and a former Maryland employee who accepted a new job in California).

Employers that use strategic and threatened litigation to enforce non-competes solely for anticompetitive purposes may risk exposure to liability for business torts such as unfair business practices. See Robinson v. U–Haul Co. of California, 4 Cal. App. 5th 304 (2016) (awarding over $800,000 in attorneys' fees under section 17200, $195,000 in compensatory damages, and a permanent injunction against former employer that initiated and threatened litigation to enforce its non-competes in California for purportedly anticompetitive purposes).

Statutory Exceptions

As recognized in Edwards, section 16600's neighboring code sections contain several statutory exceptions. Specifically, these exceptions are non-competition agreements executed in connection with the sale of a business (section 16601), dissolutions of or disassociations from partnerships (section 16602), and dissolutions of or terminations of interest in limited liability companies (section 16602.5).

Contracting parties who wish to avail themselves of these statutory exceptions should make it clear in their respective agreements that their purpose is to protect business goodwill. For example, the court of appeal in Fillpoint, LLC v. Maas, 208 Cal. App. 4th 1170 (2012), invalidated a non-compete in an employment agreement executed ancillary to the sale of a business because it did not appear focused on protecting the acquired business goodwill.

The defendant in Fillpoint was an employee of a videogame publisher who sold his company stock and signed a stock purchase agreement. The purchase agreement required the employee to sign an employment agreement for three years of continued employment after closing and integrated a blank form employment agreement. Importantly, the purchase agreement contained a three-year non-compete after closing while the employment agreement contained a separate non-compete after the termination of the continued employment.

The court concluded that both agreements should be read together because they were part of the same business transaction but that did not automatically mean that the "sale of business" exception under section 16601 applied to the employment agreement. The court explained that "the purchase agreement's covenant was focused on protecting the acquired goodwill for a limited period of time" but "[t]he employment agreement's covenant targeted an employee's fundamental right to pursue his or her profession." Fillpoint, 208 Cal. App. 4th at 1183. Thus, Fillpoint reflects that merely signing an agreement during the sale of a business does not automatically invoke the protections of section 16601.

California's appellate courts have also recognized the authority of a family court judge to order non-competes based on their broad statutory powers under Family Code sections 2550 and 2553 to justly and equally divide marital property. In one such case, a trial court order awarded a community property rum business to a husband and issued a five-year non-compete against his wife after she purportedly tried to damage the business during the dissolution. The court of appeal affirmed the trial judge's ability to issue non-compete orders to preserve the value of the community property asset, although the court remanded the case because the judicially mandated non-compete did not contain any geographical restrictions.   See In re Marriage of Greaux and Mermin, 223 Cal. App. 4th 1242 (2014).

Non-Solicitation of Customers

Clauses prohibiting the solicitation of customers have generally been treated as non-competition provisions by California courts. Yet there is ample California federal and state court authority supporting a trade-secret exception to section 16600 and allowing enforcement of related non-solicitation agreements.

Specifically, "courts have repeatedly held a former employee may be barred from soliciting existing customers to redirect their business away from the former employer and to the employee's new business if the employee is utilizing trade secret information to solicit those customers." Galante, 176 Cal. App. 4th at 1237; see also Pyro Spectaculars N., Inc. v. Souza, 861 F. Supp. 2d 1079, 1098 (E.D. Cal. 2012) (Galante and Edwards have both acknowledged that a non-solicitation restriction may sometimes be necessary as long as it is focused on protecting against the misuse of trade secrets).

Companies seeking to invoke the trade-secrets exception to section 16600 must show that the information they seek to protect is, in fact, a bona fide trade secret. They will also need to show that the scope, duration, and geographical restrictions of the purported non-solicitation covenant are narrowly tailored and necessary to protect those trade secrets. See Asset Mktg. Sys., Inc. v. Gagnon, 542 F.3d 748, 758 (9th Cir. 2008).

Non-Solicitation of Employees

It is well established under California law that competitors may generally solicit each other's employees provided they do not use unlawful means or engage in acts of unfair competition. See Metro Traffic Control, Inc. v. Shadow Traffic Network, 22 Cal. App. 4th 853, 860 (1994).

It is also well established that employee non-solicitation covenants are not unlawful under section 16600. See Loral Corp. v. Moyes, 174 Cal. App. 3d 268, 279-80 (1985); see also Sunbelt Rentals, Inc. v. Victor, 2014 WL 492364, at *9 (N.D. Cal. 2014) (citing Loral: "A contractual provision preventing a departing employee from 'raiding' his former employer's employees is 'not void on its face under Business and Professions Code section 16600'"); Thomas Weisel Partners LLC v. BNP Paribas, 2010 WL 546497, at *6 (N.D. Cal. 2010) (recognizing that section 16600 permits restraints on solicitation).

An important distinction is that while restrictions on the solicitation of employees may not be deemed void under section 16600,  restrictions on the actual hiring of employees may be unenforceable.

Unwritten agreements not to hire employees will likely not escape the ire of California's public policy in favor of employee mobility. Indeed, the Department of Justice has filed civil antitrust complaints against several Silicon Valley high-tech titans for their purported handshake agreements not to poach each other's employees. See Justice Department Requires Six High Tech Companies to Stop Entering into Anticompetitive Employee Solicitation Agreements, September 24, 2010, http://www.justice.gov/opa/pr/justice-department-requires-six-high-tech-companies-stop-entering-anticompetitive-employee.

Stipulated Injunctions and Settlement Agreements

California courts have upheld stipulated non-solicitation and non-conduct business covenants that were entered into to protect trade secrets. For example, the court of appeal in Wanke, Indus., Commercial, Residential, Inc. v. Superior Court, 209 Cal. App. 4th 1151 (2012), upheld a stipulated injunction prohibiting former employees from serving their former employer's customers as enforceable. The court recognized that common sense and fundamental fairness support its ruling. The court explained that parties cannot stipulate to injunctions that identify certain customers whom they will not solicit in order to resolve claims that they misappropriated trade secrets, then proceed to violate the injunction and claim that the customer list is not a trade secret.

Whether section 16600 extends beyond traditional non-compete clauses in employment agreements has not been decided by the California Supreme Court.

Nonetheless, a divided Ninth Circuit panel in Golden v. California Emergency Physicians Med. Grp., 782 F.3d 1083 (9th Cir. 2015), held that a "no re-hire" provision in a settlement agreement could, under certain circumstances, constitute an unlawful restraint of trade under California law. That case involved a physician who agreed to settle his discrimination claim against his employer and agreed to waive all rights to employment with that employer or at any of its current or future owned facilities. The panel majority concluded that a clause creating a restraint of "substantial character" that could limit an employee's opportunity to engage in a chosen line of work would fall under section 16600's "considerable breadth."

Golden likely furnishes no clear guidance as to the continued viability of "no re-hire" clauses in California settlement agreements. It can be expected, however, that plaintiffs' lawyers will closely scrutinize "no-rehire" clauses. This is even more likely if a clause applies beyond the employee's prior employer to, for example, subsidiaries and affiliates of the employer, or if the employer commands a substantial share of the relevant labor market. More limited "no re-hire" clauses, for most employers, would likely not seem to create any restraint that one could reasonably consider to be of "substantial character."

Regardless,  until the California Supreme Court weighs in, California employers should consider the Ninth's Circuit's decision in Golden when drafting settlement agreements that contain "no re-hire" clauses.

Forum Selection and Choice of Law Provisions

California's strong public policy against non-competes not only affects local employers, but it often complicates efforts of multi-state employers to utilize uniform restrictive covenants–such as non-competes and non-solicitation provisions–with its employees

Companies have long used forum selection clauses and choice-of-law provisions in an effort to avoid California courts applying California law to employment disputes, especially those concerning attempts to enforce non-competition provisions. A recently enacted law, however, may likely change such practices.

California recently enacted Labor Code section 925, which restrains the ability of employers to require employees, who primarily reside and work in California, to litigate or arbitrate employment disputes (1) outside of California or (2) under the laws of another state. The statute contains an exception when the employee is individually represented by a lawyer in negotiating an employment contract.

Section 925 is not retroactive and only applies to employment contracts "entered into, modified, or extended on or after January 1, 2017."  The statute gives the employees the right to void offending provisions, as well as recover reasonable attorneys' fees. Accordingly, employers should use caution when utilizing or attempting to enforce potentially offending provisions.

Looking Forward

Employers are more limited in California than other jurisdictions in their ability to contractually prevent business from walking out the door with departing employees. However, California's strong public policy against non-competes is not an absolute ban on restrictive covenant agreements. Both state and federal courts in California have increasingly upheld reasonable restrictive covenants that were  necessary to protect trade secrets.

California employers should seek advice from competent counsel to ensure their employment agreements and policies comply with, among other things, section 16600.

Employers can also utilize various mechanisms to protect their trade secret and other valuable business information, including robust confidentiality and invention assignment agreements, effective entrance and exit interview protocols, and employee education programs that create a culture of confidentiality whereby employees understand the value of protecting company data.

Effective trade secret protection measures should also take into account new technologies and threats, including cyber threats and social media/cloud computer issues.

Previously published in California Lawyer

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.