Non-compete clauses in employment contracts typically seek to preclude employees from working for a competitor for a specific period of time and within a specific geographic area. Most states allow non-competition agreements, provided they are reasonable in scope and justified by the employer’s legitimate business interests. California, however, generally prohibits covenants not to compete, subject to limited exceptions.
California’s Broad Ban On Non-Competition Agreements
California Business and Professions Code Section 16600 is the source of the state’s fundamental public policy against non-competition agreements. It ensures that except as specifically provided by a statutory exception, “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 fundamental public policy behind Section 16600 has been articulated by the California Supreme Court:
Every individual possesses as a form of property, the right to pursue any calling, business, or profession he may choose. A former employee has the right to engage in a competitive business for him- self and to enter into competition with his former employer, even for the business of those who had formerly been the customers of his former employer, provided that such competition is fairly and legally conducted.
Continental Car-Na-Var Corp. v. Moseley (1944), 24 Cal.2d 104, 110.
Applying Section 16600, California courts have repeatedly struck down non-compete agreements, even when limited in time and geographic scope. Scott v. Snelling & Snelling, Inc., (N.D. Cal. 1990) 732 F. Supp. 1034. Employers have also been held liable for wrongful termination for requiring employees to sign unlawful non-competes. D’Sa v. Playhut, Inc. (2000), 85 Cal.App.4th 927. Moreover, choice-of-law provisions that seek to escape Section 16600′s ban on non-competes will typically not be enforced. If the employment at issue substantially relates to California, public policy almost always trumps the choice-of-law provision. Application Group, Inc. v. Hunter Group, Inc., (1998) 61 Cal. App.4th 881.
The California Supreme Court addressed Section 16600 in Edwards v. Arthur Andersen LLP (2008), 44 Cal.4th 937. Andersen hired Edwards as a tax manager. Edwards’ employment agreement prohibited him, following termination of employment, from providing tax services for former Andersen clients for 18 months, and likewise from soliciting former clients for 12 months. Thus, although the agreement did not prohibit him from providing tax services in general, it limited the number of potential clients he could serve.
Edwards brought suit, arguing that the non-competition agreement was unenforceable. Andersen argued that the agreement was enforceable under the U.S. Court of Appeals for the Ninth Circuit’s “narrow restraint” doctrine, which allowed non-competition agreements if they minimally restrained the employee in “engaging in his or her profession, trade, or business.” The Supreme Court expressly rejected the narrow restraint doctrine (which had generated a raft of conflicting decisions in California). Instead, it emphatically made clear that noncompetition agreements, including those narrowly tailored, are prohibited in California, subject to limited statutory limitations, and unanimously held that a non-compete clause that “partially or narrowly” restricts an employee’s mobility is unlawful. (The narrow exceptions referenced by the Supreme Court in Edwards are set forth in Business and Professions Code Sections 16601 and 16602.)
The Sale of Shares or Business Exception
Under California Business and Professions Code Section 16601, a contract can include an enforceable non- competition agreement when a person sells the goodwill of a business or otherwise disposes of an entire ownership interest in the business entity. Under this exception, sellers can be prohibited from conducting business for a specified period in the geographic region in which the business was sold. The exception is designed to foster economic activity by protecting the buyer from immediate competition from the seller.
When a shareholder sells shares in a company, a non-compete clause is potentially enforceable if: 1) the sale is “of a substantial interest” in the company; and 2) the shareholder transfers interest in the company’s “goodwill.” Courts require a clear indication that the parties incorporated goodwill into the sales price. Monogram Industries, Inc. v. Sar Industries, Inc. (1976), 64 Cal.App.3d 692.
If “fair market value” is paid for shares, an inference can be made that the price includes payment for goodwill. In Hill Medical Corp. v. Wycoff (2001) 86 Cal.App.4th 895, a medical company’s employment contract included a non-compete clause and a stock repurchase agreement. The repurchase agreement required shareholders to sell back shares at net book value upon termination of employment. However, the selling shareholder received no compensation for relinquishing rights to continued patronage from patients and doctors with whom he had developed a personal relationship.
Therefore, the transaction lacked evidence that goodwill was transferred. To reflect goodwill, the sale price must protect the purchasers from “competition from the seller which … would have the effect of reducing the value of the property right that was received.” Moreover, the former employee only owned 7% of the shares, so the transfer did not involve a substantial ownership interest in the corporation. Thus, the court found the non-compete clause invalid.
In Bosley Medical Group v. Abramson (1984), 161 Cal.App.3d 284, an employer required all employees to buy a minimal amount of shares and resell them at termination. The court found this to be a scheme deliberately designed to circumvent Section 16600. The employee was required to purchase the shares, the amount of shares was limited, the employee could not significantly benefit from the payment of dividends or a capital gain in the value of the shares, and the stated purpose of the agreement — an “additional incentive” for the employee and to foster a vaguely defined “professional relationship” — made no sense given the nominal value of the shares. As the court noted in Hill, simply selling shares back to a corporation does not necessarily demonstrate that goodwill is part of the agreement; to hold otherwise would constitute an end run around the statute.
Minority shareholders, however, can be bound by a non-compete agreement in certain circumstances. For example, in Vacco Industries, Inc. v. Van Den Berg (1992), 5 Cal.App.4th 34, the court considered a minority shareholder to be a “substantial” shareholder for purposes of the sale of shares exception. Although the shareholder owned less than 3% of shares, he was the ninth largest shareholder; therefore, acquiring his shares was necessary for a buyer to purchase all outstanding stock in the company.
Despite the allowance of the sale of shares exception in limited circumstances, covenants not to compete must not target employment mobility. In Fillpoint, LLC v. Maas (2012) 208 Cal.App.4th 1170, an employee signed both a stock purchase agreement with a three-year covenant not to compete, and an employment contract with a one-year covenant not to compete. The court, in rejecting the non-compete in the employment agreement, held that because the stock purchase agreement’s non-compete provision adequately protected the goodwill of the business, the inconsistent and additional non-compete clause in the employment agreement was unenforceable. The provision in the stock purchase agreement “protected the business’s acquired goodwill” for a limited period of time, while the provision in the employment agreement “targeted an employee’s fundamental right to pursue his or her profession.”
Dissolution of a Partnership/LLC Exception
Under Business and Professions Code Section 16602, when a limited liability company or a partnership dissolves, the person leaving the business entity can be prevented from conducting the same business in the geographic region where the entity is located. Unlike the sale of shares exception, the dissolution exception does not require payment to departing partners for “partnership goodwill.”
For example, in Howard v. Babcock (1993), 6 Cal.4th 409, law firm partners consented to a covenant-not-to- compete agreement in the Los Angeles area if any partners withdrew from the partnership. The Supreme Court upheld their agreement, finding that the imposition of a “reasonable cost” on withdrawing partners who later competed was enforceable. Such agreements, however, must be executed during a partnership’s formation; agreements made during dissolution are unenforceable. Kelton v. Stravinski (2006) 138 Cal.App.4th 941, 946.
Restrictions Must Still Be Reasonable
To be valid under Sections 16001 and 16602, the non-compete provision must still be reasonable and necessary to protect the buyer’s interest in terms of duration, activity, and territory. Fleming v. Ray-Suzuki, Inc. (1990), 225 Cal.App.3d 574, 581. In addition, the restriction is enforceable only to the extent that the person seeking to enforce the covenant “carries on a like business.” Such covenants should be limited to the specific geographic areas in which the business sold was carried on (In Re Marriage of Greaux & Mermin (2014), 223 Cal.App.4th 1242, 1254-55), and are enforceable as to the sold businesses’ customers and employees, but not to other customers and employees. Strategix, Ltd. v. Infocrossing West, Inc. (2006), 142 Cal.App.4th 1068, 1073.
The Trade Secret Exception
Employers may use agreements prohibiting disclosure of their trade secret information during and after employment without violating Section 16600. Muggill v. Reuben H. Donnelly Corp. (1965), 62 Cal.2d 239, 242; ReadyLink Healthcare v. Cotton (2005), 126 Cal.App.4th 1006, 1022 (“[i]f a former employee uses a former employer’s trade secrets or otherwise commits unfair competition, California courts recognize a judicially created exception to Section 16600 and will enforce a restrictive covenant in such a case”). The nature of this exception is outside the scope of this article, but employers should carefully consider this exception, and take full advantage of their judicially recognized right to protect their trade secrets when preparing non-compete agreements.
Non-Solicitation of Employees
California courts have permitted clauses designed to prevent former employees from raiding their former employer’s workforce by soliciting employees to leave and join the former employee’s new company. Such clauses, however, must be reasonable in scope. In Loral Corp. v. Moyes (1985), 174 Cal.App.3d 268, the court held that a non-interference covenant, which prohibited solicitation of employees for one year following termination of employment, to be reasonable. In finding that the provision did not violate Section 16600, the court reasoned that it promoted stability in the former employer’s workforce, and had “no overall negative impact on trade or business.”
While other courts have suggested that non-solicitation can only be restricted in cases where the former employee engages in unlawful acts or other forms of unfair competition (e.g., Metro Traffic Control, Inc. v. Shadow Traffic Network (1994), 22 Cal.App.4th 853), Loral remains good law, and thus provisions restricting non-solicitation of employees remain commonplace in California employment agreements.
Employers can take several steps to maximize the chances that their confidentiality and non-compete agreements will be permitted under California law, including the following: 1. Ground any restrictions on competition in provisions relating to well-defined trade secrets or specified statutory exceptions; 2. Ensure that any statutory exception, such as sale of shares, is vetted for issues such as goodwill, fair market value, and reasonableness of restrictions; 3. Establish a clearly defined point of review within the company for all offer letters, employment agreements, shareholder agreements, handbooks, and other company documents, policies and procedures that address confidentiality, non-competition, or related issues; and 4. Be prepared to justify choice-of-law provisions with facts supporting a decision to utilize a law other than California.
California’s dynamic economy, which has been spurred in no small part by its fundamental public policy favoring employee mobility, ensures that litigation over non-compete agreements will always be part of doing business in the state. Nevertheless, employers that take proactive steps on non-compete agreements will be well-positioned when disputes arise.
Spencer Hamer is a partner at Michelman & Robinson, LLP, resident in the firm’s Orange County, CA, office. Mr. Hamer leads the firm’s Employment Transactional Practice Group.
The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.