Non-Compete Clauses after Edwards
California Lawyer

Non-Compete Clauses after Edwards

March 2014

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Since 1872, California law has invalidated contractual restraints on the ability of a person to engage in a trade, business, or profession here. (Cal. Bus. & Prof. Code § 16600.) Indeed, the California Supreme Court applied this bright-line mandate to hold that covenants not to compete are facially invalid under section 16600; they are therefore unenforceable in California - unless covered by one of three statutory exceptions designed to protect goodwill in connection with the sale or dissolution of a business. (See Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008); see also Cal. Bus. & Prof. Code §§ 16601 (sale of business), 16602 (dissolution of partnership), and 16602.5 (limited liability company).)

In so holding, the court rejected two arguments regarding the scope of section 16600: first, that it applies only to contracts that absolutely prohibit an employee from engaging in his or her profession, trade, or business; and second, that those agreements, which "merely regulate some aspect of post-employment conduct," do not fall within the scope of section 16600. (Edwards, 44 Cal. 4th at 947-948.) The court's language was unambiguous: "Noncompetition agreements are invalid under section 16600 in California even if narrowly drawn, unless they fall within the applicable statutory exceptions of section 16601, 16602, or 16602.5." (44 Cal. 4th at 955.) Moreover, Associate Justice Ming Chin, writing for a 5-2 majority, noted that "section 16600 represents a strong public policy ... which should not be diluted by judicial fiat." (44 Cal. 4th at 949.)

The Edwards ruling creates substantial risk for employers who seek to utilize non-compete clauses as part of an employment agreement. If a court concludes that such a clause is invalid, the employee may well have a tort claim against the employer for interfering with his or her prospective advantage. (See Edwards, 44 Cal. 4th at 950.)

Restrictive Covenants
In the wake of the Edwards decision, the analysis of a restrictive covenant under section 16600 should be straightforward, based on only two questions: Does the covenant restrain one from engaging in a trade, business, or profession? And if so, does the covenant fall within one of the three statutory exceptions?

Nevertheless, some courts and many businesses routinely ask a third question: Did any non-statutory exceptions to section 16600 survive Edwards? The two most common non-statutory exceptions found in employment agreements today relate to post-employment restraints on solicitation of employees generally, and restraints under the so-called trade secret exception.

Non-Solicitation Agreements
More than 20 years before Edwards, in an action filed by a corporation against its former chief executive officer for breach of a termination agreement - which restrained the defendant from disrupting, damaging, impairing, or interfering with the plaintiff's business by "raiding" its employees - an intermediate appellate court found that the termination agreement was not void on its face under section 16600. (Loral Corp. v. Moyes, 174 Cal. App. 3d 268, 280 (1985).)

In reaching this conclusion, the Loral court cited three Georgia state court opinions to support its holding that the potential impact on trade must be considered before invaliding a non-solicitation covenant, and that "enforceability depends upon [the covenant's] reasonableness, evaluated in terms of the employer, the employee, and the public." (Loral, 174 Cal. App. 3d at 278-279 (citing Orkin Exterminating Co., Inc. v. Martin Co., 240 Ga. 662 (1978); Harrison v. Sarah Coventry, Inc., 228 Ga. 169 (1971); and Lane Co. v. Taylor, 174 Ga. App. 356 (1985).)

Given the ruling in Loral, a common perception is that restraints against employee raiding or against the targeting of key employees are enforceable. (Such covenants are routinely included in California employment agreements.) However, the issue is not so clear-cut: An analysis under section 16600 in light of Edwards places their viability in question.

Very few cases decided under California law have addressed this threshold issue - whether a covenant not to solicit employees of a former employer restrains the departing employee from engaging in a trade, business, or profession. Yet the jurisprudence that does exist uniformly holds that non-solicitation covenants do, in fact, restrain trade and are therefore subject to analysis under section 16600. Even the court in Loral acknowledged that the non-solicitation covenant at issue there had "the apparent impact of limiting [the restricted party's] business practices... ." (Loral, 174 Cal. App. 3d at 280; see also Cap Gemini America, Inc. v. Judd, 597 N.E. 2d 1272, 1287 (Ind. Ct. App. 1992) (holding that a non-solicitation covenant governed by California law was invalid under section 16600 as an "unreasonable restriction on business").)

Commercial logic and experience also support the argument that the identification, solicitation, and hiring of the most qualified employees constitutes an important aspect of a trade, business, or profession. Solicitation and hiring of known performers is often a critical component of a successful start-up company or the expansion of a business enterprise. Under the plain language of the typical non-solicitation covenant, however, promisors are precluded from engaging in any conduct that would induce employees to leave their former employers; such conduct may include active solicitation or even the simple act of responding to job inquiries from former colleagues. Such restraints limit the ability of the promisor to seek out and hire the most trusted and qualified employees to staff a competing business; they also restrain existing employees who might be targeted for solicitation from engaging in business and professional endeavors by moving to a new firm founded by a former colleague.

The potential competitive and financial advantages available to an employee when prospective employers are vying for his or her services are significant, and the lost opportunity to entertain competitive solicitations constitutes a restraint on that person's ability to engage in a competitive trade, business, or profession. This is a major factor given the holding in Edwards that "restraint" as used in section 16600 means any restraint - not only complete prohibitions. An employer contemplating whether to include a non-solicitation covenant in its employee agreement should understand the risk that including such a provision may run afoul of section 16600.

Statutory Language
Under Edwards, once the court determines that a non-solicitation covenant restrains trade, the only other inquiry should be whether the covenant falls within one of the statutory exceptions to section 16600. Those exceptions, as noted above, would include a non-compete covenant tethered to the protection of goodwill.

The Loral line of cases seems to suggest that a covenant against solicitation of employees may be enforceable if it restricts the raiding of employees or solicitation that interferes with the former employer's business. (See Thomas Weisel Partners, LLC v. BNP Paribas, 2010 WL 546497 at *4 (N.D. Cal.) ("the Loral court appears to have construed the prohibition on 'raiding' to proscribe the solicitation of employees").)

As discussed above, in Loral, the defendant employee's termination agreement contained language that restricted him from raiding the plaintiff's employees. The court applied a balancing test extrapolated from foreign case law to enforce the covenant. It held that the agreement constituted only a narrow restriction, which appropriately balanced the burden imposed by the restriction on the employee against the risk of harm to the employer if it was not enforced. (Loral, 174 Cal. App. 3d at 278.) Thus, the Loral decision was based on the kind of judicially created, narrow-restraint exception to section 16600 that Edwards rejected. When determining the enforceability of a non-solicitation covenant, it's risky to focus the evaluation on the provision's potential impact on an employer's overall trade or business - as directed by the Loral court. Better to simply determine whether the covenant restrains the former employee's trade or business.

Although the holding in Edwards was expressly limited to the validity of a non-competition covenant and did not address non-solicitation covenants, it provides guidance on this question. Loral and its progeny, which apply judicially created exceptions to section 16600, are inconsistent with this guidance and are therefore of very questionable authority at this point. (See SriCom, Inc. v. EbisLogic, Inc., No. 2012 WL 4051222, at *5 (N.D. Cal.).) ("Edwards rejects the contention that Section 16600 'embrace[s] the rule of reasonableness in evaluating competitive restraints.' "))

Trade Secrets
The Edwards opinion also failed to resolve - and perhaps fueled - the ongoing dispute about the viability of the trade secret exception to section 16600. That exception originated more than 55 years ago when an employer sued a former employee for breach of an employment agreement that precluded the employee from soliciting customers for one year after termination. The California Supreme Court first determined that the terms of the contract did not prevent the employee from carrying on his business as he "merely agreed not to use plaintiffs' confidential lists to solicit customers for himself for a period of one year following termination of his employment." The court also noted that the "Plaintiffs' preferred customers are a real asset to their business and the foundation upon which its success, and indeed its survival, rests. It thus logically follows that a list of such customers is a valuable trade secret and that plaintiffs were damaged by defendant's unlawful use thereof." (Gordon v. Landau, 49 Cal. 2d 690, 694 (1958).)

In support of this conclusion, the court cited a court of appeal decision that enjoined a former employee from using his former employer's trade secrets to solicit the employer's customers. (See Calif. Intelligence Bureau v. Cunningham, 83 Cal. App. 2d 197 (1948).) Notably, the Cunningham decision was based on a provision of the state Labor Code which provides that everything acquired by an employee by virtue of his employment, except his compensation, belongs to the employer; the court observed that the statute applied to information that may be acquired either lawfully or unlawfully, and during or after the term of employment. (Cunningham, 83 Cal. App. 2d at 204; see also Cal. Labor Code § 2860.)

The state Supreme Court reaffirmed its Gordon holding in Muggill v. Reuben H. Donnelley Corp. (62 Cal. 2d 239 (1965)). In that case, the court stated that section 16600 "invalidates provisions in employment contracts prohibiting an employee from working for a competitor after completion of his employment ... unless they are necessary to protect the employer's trade secrets." (62 Cal. 2d at 242 (emphasis added).)

The current uncertainty stems from the broad strokes of the court's opinion in the Edwards case, specifically the pronouncement that "Section 16600 is unambiguous, and if the Legislature intended the statute to apply only to restraints that were unreasonable or overbroad, it could have included language to that effect." Rather than create or follow judicially imposed exceptions to or limitations on section 16600, the court concluded that it should "leave it to the Legislature, if it chooses, to either relax the statutory restrictions or adopt additional exceptions ... ." (Edwards, 44 Cal. 4th at 950.)

The court introduced ambiguity into the section 16600 analysis through a footnote in which it declined to "address the applicability of the so-called trade secret exception." (Edwards, 44 Cal. 4th at 946 & n.4.)

In the years since Edwards was decided, the Legislature has not seen fit to amend section 16600 and the California Supreme Court has not revisited the issue. As a result, state and federal courts in California are currently divided on whether the trade secret exception still exists. While California state courts have read Edwards as a broad rejection of all non-statutory exceptions, including the trade secret exception, some federal court decisions continue to recognize it.

One intermediate state appellate court has held that "section 16600 bars a court from specifically enforcing (by way of injunctive relief) a contractual clause purporting to ban a former employee from soliciting former customers to transfer their business away from the former employer to the employee's new business [even if narrowly tailored to the use of trade secrets] ... ." The court did hold that such conduct could be enjoined, however, if it violates the Uniform Trade Secrets Act and/or the Unfair Competition Law. (The Retirement Group v. Galante, 176 Cal. App. 4th 1226, 1238 (2009).)

Similarly, in Dowell v. Biosense Webster, Inc. (179 Cal. App. 4th 564 (2009)), the court found that the covenant at issue was not narrowly tailored to protect trade secrets and therefore did not reach the issue of whether the trade secret exception still applies post-Edwards. But the court did note in dicta that it "doubt[s] the continued viability of the common law trade secret exception to covenants not to compete ... ." (Dowell, 179 Cal. App. 4th at 577.)

In contrast, two federal courts in California have continued to apply the trade secret exception, or have at least suggested that it remains viable. In one case, a district court held that the " 'so-called trade secret exception' to §16600 still applies." (Bank of America v. Lee, 2008 WL 4351348 at *5-*6 (C.D. Cal.).) Similarly, the Ninth Circuit has noted that section 16600 "invalidates non-compete contracts unless they are necessary to protect an employer's trade secrets." (Asset Marketing Systems v. Gagnon, 542 F.3d 748, 758 (9th Cir. 2008) (citing Edwards).)

Dealing with Uncertainty
Given the division among the federal and state courts, employers need to proceed with caution when relying on the trade secret exception, or on any other judicially created exception to section 16600, to fashion a post-employment restraint on trade. Such a non-statutory exception may not salvage an otherwise invalid restrictive covenant. A better course is to use confidentiality agreements and compliance with the requirements of the Uniform Trade Secrets Act to identify and protect trade secrets before a misappropriation claim arises; this will protect an employer's valuable assets without the risks associated with relying on judicially created exceptions to section 16600.

In the meantime, lawyers and clients must wait for the California Supreme Court to clarify the scope of section 16600.

Christopher Cox leads Weil Gotshal & Manges' complex commercial litigation practice in the firm's Silicon Valley office, where Bambo Obaro is a litigation associate. Gregory Hull is a partner at Ellenberg & Hull in San Jose.

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