Noncompete Agreement - Commonly Used Provision Found to Be Invalid
October 26, 2006
Toby Rose Mallen - Los Angeles
In California, noncompetition agreements are generally unenforceable, except under exceptionally limited circumstances. Some California courts, especially the Ninth Circuit, had created a limited exception to this rule called the “narrow restraint” exception, finding enforceable noncompetition agreements that only narrowly restricted an employee from working in a limited market. General Commercial Packaging v. TPS Package Engineering, Inc., 126 F.3d 1131 (9th Cir. 1997). However, in the recent case of Edwards v. Arthur Andersen, 142 Cal. App. 4th 603 (2006) the Court rejected the “narrow restraint” exception and reaffirmed California’s strong policy against noncompetition agreements. The Court also ruled that an employer’s refusal to hire an individual because he or she refused to sign an illegal noncompetition agreement can result in a wrongful discharge claim.
California has a strong policy against covenants not to compete. This policy is reflected in California Business and Professions Code Section 16600 which states: “Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Statutory exceptions to this policy are set forth in Sections 16601 and 16602 of the California Business and Professions Code, which permit covenants not to compete to be legally used by the following:
1) anyone selling the goodwill of a business
2) anyone selling or disposing of all of his or her business ownership interest
3) anyone selling all or substantially all of the business assets together with the goodwill or selling all of the ownership interest of any subsidiary
4) a partner on dissolution of or disassociation from the partnership
Trade Secret Exception
In addition to the statutory exceptions to the Section 16600 prohibition, California courts have recognized a “trade secret” exception. Section 16600 “invalidates provisions in employment contracts prohibiting an employee from working for a competitor after completion of his employment or imposing a penalty if he does so unless they are necessary to protect the employer’s trade secrets.” Muggill v. Reuben H. Donnelley Corp., 62 Cal.2d 239, 242 (1965). This exception was reiterated by the court in Edwards, which stated that “it has long been recognized that Section 16600 does not invalidate covenants not to compete where necessary to protect the employer’s trade secrets.”
The Uniform Trade Secrets Act (California Civil Code Section 3426), which embodies the trade secret protection, defines the term “trade secret” as information that derives economic value from not being known to others and is the subject of reasonable efforts to keep it secret. For example, a customer list or a business plan could be a trade secret.
Narrow Restraint Exception
The final exception to the Section 16600 prohibition had, until now, been provided for restrictions that were only a “narrow restraint” on competition. Restrictions against pursuing “only a small or limited part of a business, trade or profession” have been upheld as valid. Boughton v. Socony Mobil Oil Co., Inc. 231 Cal.App.2d 188, 192 (1964). However, this exception was rejected by the Edwards court.
In Edwards, an employee sued his employer claiming that the employer’s standard noncompetition agreement he had been required to sign was unenforceable. The noncompetition agreement prohibited the employee, for a period of 18 months, from providing the kind of services he provided to the employer’s clients during the 18 months prior to termination. The agreement also prohibited solicitation of any of the employer’s clients to which the employee was assigned during the18 month period prior to termination. The Edwards court found that although the noncompetition clause was limited in time and scope, it restricted the employee’s ability to engage in his profession.
The Edwards court rejected the “narrow restraint” exception and held that a “noncompetition agreement between an employee and employer, prohibiting the employee from performing services for certain former clients, is invalid under Business and Professions Code Section 16000 unless it falls within the statutory or ‘trade secret’ exceptions to the statute. Such a noncompetition agreement is invalid even if the restraints imposed are narrow and leave a substantial portion of the market open to the employee.” In addition, the court reiterated its earlier ruling which stated that an employer may not legally make signing of an unenforceable covenant not to compete a condition of employment and that the law would protect an employee from being terminated for refusing to sign such an agreement.
As stated above, the Edwards case leaves intact the “trade secret” exception to Section 16600 and employees may be prohibited from using an employer’s trade secrets.
In conclusion, except under limited circumstances as statutorily recognized or permitted by law, noncompetition agreements are unenforceable under California law. California employers should therefore consult with legal counsel before asking their employees to enter into agreements which contain noncompetition clauses.
For more information, e-mail Toby Rose Mallen at toby.mallen@hklaw.com or call toll free, 1-888-688-8500.