Today

The California Supreme Court rejects non-competition agreements

by Jeffrey Tanenbaum, Partner, and Matthew Frankel, Associate 10/29/2008
The California Supreme Court has now clarified state law governing non-competition agreements between employers and employees. In Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (Cal. 2008), the Court held that Section 16600 of the California Business & Professions Code (“Section 16600”) prohibits virtually all contractual provisions that purport to limit a former employee’s ability to compete with a former employer. In so doing, the Court wholly rejected the so-called “rule of reasonableness”—previously intermittently applied by California’s federal courts and the majority rule across the country—which allowed for the enforcement of contractual provisions that reasonably restrict, but do not prohibit outright, competition by a former employee.

Non-Competition Agreements

In his suit, Edwards challenged Andersen’s attempt to contractually prohibit him from performing services or soliciting Andersen’s clients following his departure. The California Supreme Court (quoting the Court of Appeals) noted that “[t]he first challenged clause prohibited Edwards, for an 18-month period, from performing professional services of the type he had provided while at Andersen, for any client on whose account he had worked during 18 months prior to his termination. The second challenged clause prohibited Edwards, for a year after termination, from ‘soliciting,’ defined by the agreement as providing professional services to any client of Andersen’s Los Angeles office.”[1] The Court held that the agreement was “invalid because it restrained his ability to practice his profession.”[2]
The Court’s ruling upheld California’s long-standing legislative policy rejecting restrictions on competition by former employees. Outside of certain exceptions in the context of a dissolution or sale of a business,[3] California employers cannot restrict their employees from competing with them post-employment. In fact, other courts have held that even attempting to do so may be a violation of California’s unfair competition laws, potentially subjecting wayward employers to liability and injunctive relief.[4]
With the Supreme Court removing any doubt about the scope of California’s wide-ranging prohibition on noncompetition agreements, employers should be especially wary of including such provisions in their California employment agreements. Employers can still require employees to sign agreements that protect the employer’s trade secrets and other confidential or propriety information. However, those provisions must not extend to preventing the employee from competing with the employer—by, for example, working for a competitor or soliciting the employer’s clients—once the employment comes to an end. Employers who transgress the bright line drawn by the California Supreme Court in Edwards may well find themselves defending lawsuits filed by aggrieved current and former employees. Conversely, when hiring new employees in California, pre-existing non-competition clauses should prove far less troublesome to resolve.

Trade Secrets

Parties contemplating acquisitions in the technology or product development sectors probably do not need to fret over the continuing validity of agreements protecting trade secrets and other confidential or propriety information. California courts have consistently avoided application of Section 16600 to those agreements that protect an employer’s legitimate interest in protecting such secrets and information. The California Uniform Trade Secrets Act[5] provides statutory protection as well, although contractual trade secret protection is inevitably useful to establish that the employer took reasonable action to protect its confidential information. Due diligence should always include a review of standard and specialized employer-employee agreements for the protection of confidential information and trade secrets.

Implications for Private Equity

Those performing due diligence in evaluating acquisitions should be cognizant of additional challenges posed by the Edwards decision. Evaluation of the acquisition of entities that do business in California—or acquisitions that result in the transfer of employees to California—should certainly take into account the reality that existing non-compete agreements will very likely not be enforceable in California.
This may make it more difficult to ensure that key personnel do not depart and join a competitor in the context of an acquisition. Thus, the acquiring entity may have to offer increased incentives to key California personnel in order to ensure their continued loyalty. Further attempting to enforce existing non-compete agreements through litigation, in the immediate aftermath of an acquisition, is likely to be an expensive and unsuccessful prospect.
Additionally, California state courts, in particular, tend to look unfavorably upon companies that attempt to enforce non-competes despite the prohibition of Section 16600. This sentiment is likely to increase as a result of the clear directives from the California Supreme Court in Edwards. As noted above, courts have allowed individuals to sue their former employers under California’s unfair competition law[6] for merely attempting to enforce noncompete agreements. Ex-employees with savvy counsel will also likely find some success against companies attempting to enforce invalid non-competes through resort to interference claims under tort law. Potential exposure of this nature must be considered as part of due diligence and negotiations in the mergers and acquisitions context. A litigation plan (or a no-litigation plan) for dealing with potentially problematic California non-compete agreements should be part of preacquisition discussions.
One alternative to attempting to enforce a likely unenforceable non-compete agreement is to establish exclusive consulting agreements with key departing employees that may withstand scrutiny under California law. Nothing in Section 16600 or in the Edwards decision would seem to prohibit an employer from preventing a current employee (or consultant) from competing with the employer during the course of the employment (or consultancy). Put differently, nothing in Section 16600 or Edwards curtails long-standing duties of loyalty arising under the common law. A company may therefore wish to enter into exclusive consulting agreements with key employees that might otherwise depart for competitors.
In consideration for payment and/or other benefits, such agreements could provide that the departing employee provide consulting services to the company on an exclusive basis vis-à-vis that company’s competitors. Of course, the company must ensure that such a relationship does, in fact, involve actual services so as to not be successfully challenged in court as a sham intended to avoid Section 16600. As with any creative approach, companies should consult with employment counsel before making any decisions, as there is inherent risk that such agreements may not pass judicial muster.