California Law Gets Tougher On Non-Competition Agreements  

In two recent cases, the California Court of Appeal further tightened the stranglehold on covenants not to compete in the State. Edwards v. Arthur Andersen LLP, 2006 DJDAR 11780 (August 30, 2006); Strategix, Ltd. v. Infocrossing West, Inc., 2006 DJDAR 12186 (September 11, 2006). In doing so, the Court signaled that non-competition agreements will withstand judicial scrutiny only possibly in the rarest of circumstances, and that companies that include such unlawful provisions in employment agreements risk doing so at their own peril.

These cases arose against the backdrop of California's long-standing ban on non-competition agreements. The general rule prohibiting non-competition covenants is codified in California Business and Professions Code Section 16600, which provides: "[E]very contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void."

Business and Professions Code Sections 16601 and 16602 carve out limited exceptions to the general rule, providing that covenants not to compete may be enforceable when given by: (1) anyone selling the goodwill of a business; (2) a shareholder "selling or disposing" of all of his or her shares in a corporation; (3) a shareholder of a corporation that sells all or substantially all of its operating assets and goodwill, or all of the shares of a subsidiary; or (4) a partner upon dissolution of the partnership, the partner's withdrawal from the partnership or disposition of the partner's interest.

The law also recognizes a limited exception for non-compete agreements to protect an employer's trade secrets. It should be noted, however, these types of agreements are not conventional non-compete agreements, but rather take the form of a "proprietary information agreement" or similarly-named agreement. By these agreements, employees covenant not to misappropriate their employer's trade secrets during or after employment.

While the California courts traditionally have applied the exceptions conservatively, federal courts in California have been more liberal, recognizing an additional exception that has come to be known as the "narrow restraint" exception. This exception permits a non-compete agreement that prohibits a former employee from competing in a narrow portion of the market. The "narrow restraint" exception came under scrutiny in the recent case, Edwards v. Arthur Andersen.

The case was brought by Raymond Edwards, who was hired by Arthur Andersen in 1997. At that time, he was required to sign a standard non-competion agreement, which, among other things, prohibited him from working for, or soliciting business from, certain firm clients for a limited period after the end of his employment. In 2002, as Andersen's business was folding, it sold the practice group in which Edwards worked to HSBC. As a condition of employment with HSBC, Andersen required Edwards (and others) to sign an agreement through which Andersen released Edwards from his non-competition agreement, in exchange for which Edwards released all claims against Andersen. When Edwards refused to sign the agreement, his offer was withdrawn, prompting him to sue and assert various claims, including intentional interference with prospective business advantage, i.e., Edwards' employment opportunity with HSBC.

The lower court, invoking the "narrow restraint" exception, ruled that the non-competition covenant was enforceable. The Second District Court of Appeal reversed, holding that California law does not honor the "narrow restraint" exception. The Court concluded that the only common law exception to Section 16600 is to allow agreements where necessary to protect trade secrets. In so ruling, the Court clarified and confirmed California's strong public policy against non-competition covenants.

While Strategix v. Infocrossing is less significant for employers, it is worth noting because it, like Edwards, serves to confirm that California courts are loathe to uphold covenants not to compete. In Strategix, the Fourth District Court of Appeal addressed one of the statutory exceptions under Business and Professions Code Section 16601.

At issue in Strategix was a nonsolicitation covenant set forth in connection with the sale of Strategix's assets and goodwill to Infocrossing's predecessor, SMS. As part of that transaction, Strategix and its parent company, ePassage, agreed not to solicit SMS' employees and customers for a period of one year. When Strategix and ePassage rescinded the agreement, Infocrossing sued and sought injunctive relief precluding ePassage/Strategix's solicitation. The trial court issued a preliminary injunction.

On appeal, the Fourth District reversed and expunged the injunction, holding that the nonsolicitation provision was overbroad and unenforceable. The Court reasoned that the provision at issue did not fit within the exception under Section 16601 because it did not restrain the seller from soliciting the seller's former employees and customers (as addressed by Section 16601), but rather restrained the seller from soliciting the buyer's employees and customers, including even those that were not employees or customers of the seller (which is not circumscribed by the Section 16601 exception). Furthermore, the Court refused to sever the unlawful provision and enforce the balance, thereby invalidating the entire covenant.

There are significant lessons to be learned from these cases:

• California employers should review their agreements to ensure that they do not maintain non-competition provisions. In spite of Section 16600, historically many employers have chosen to retain non-compete agreements, rationalizing that, even if they are unenforceable, they may accomplish the goal of stifling competition by former employees. Any impetus for utilizing non-compete agreements for this purpose, however, should be abandoned following the Edwards decision and the wave of litigation that may surface in its wake. Now, employers who retain non-compete agreements or condition employment on their execution face almost certain liability.

• Equally important, employers should revisit their agreements to protect what still lawfully may be protected. While California courts will invalidate efforts undertaken to restrict an employee's ability to earn his or her livelihood, California law retains a strong body of statutory and case law that protects one of an employer's most valuable commodities -- its proprietary information and trade secrets. California employers, therefore, are encouraged to formulate strong policies to guard against misappropriation and other acts of unfair competition. Confidentiality, Nondisclosure and Non-solicitation (of employees) Agreements should be presented to all employees.

• Finally, employers should implement internal security measures to protect sensitive proprietary information and trade secrets.

Collectively, these efforts should have the effect of not only minimizing exposure to liability, but also diminishing any potential harm to be done by departing employees. With the broad freedom of mobility afforded California employees under Business and Professions Code Section 16600, it is imperative that employers not permit the departing employee to "take the farm" along with his or her final paycheck.