Covenants Not To Compete (Non-Compete Agreements)

A common misconception among employers is that covenants not to compete are enforceable against an employee so long as the covenant is not overly broad or unduly restrictive on the employee, i.e., it is limited in time, place, and scope. In most states, this belief would be correct. However, in California, the law holds quite to the contrary and virtually all such covenants not to compete are unenforceable. Pursuant to California Business and Professions Code §16600, “[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.”

California courts have consistently declared this code section as an expression of strong public policy to ensure that every person shall retain the right to pursue any lawful employment and enterprise of his or her choice (See Metro Traffic Control, Inc. v. Shadow Traffic Network). Given California’s significant public policy against restraints on employment, employers can be assured that California courts are virtually certain to strike down such restrictive covenants.

Statutory Exceptions

There are, however, two narrow statutory exceptions to Business and Professions Code §16600’s ban on covenants not to compete. The first exception is codified in Business and Professions Code §16601, which allows a buyer of an existing business to require the seller not to compete with the acquiring company. This section permits agreements not to compete made by a party selling the goodwill of a business or all of the shares of stock in a corporation. (See Vacco Industries, Inc. v. Van Den Berg). Even in this limited circumstance where a buyer sells his or her interest in the company, the covenant must still be narrowly tailored to be enforceable.

There are, however, two narrow statutory exceptions to Business and Professions Code §16600’s ban on covenants not to compete. The first exception is codified in Business and Professions Code §16601, which allows a buyer of an existing business to require the seller not to compete with the acquiring company. This section permits agreements not to compete made by a party selling the goodwill of a business or all of the shares of stock in a corporation. (See Vacco Industries, Inc. v. Van Den Berg). Even in this limited circumstance where a buyer sells his or her interest in the company, the covenant must still be narrowly tailored to be enforceable.

Trade Secrets and Inevitable Disclosure

California courts have also held that in limited circumstances, covenants that impose restrictions on employees merely to protect a former employer’s trade secrets or proprietary information are valid. As stated by one commentator, “Any attempt to restrict competition by the former employee by contract appears likely to be doomed under Section 16600 of the Business and Professions Code, unless the restriction is carefully limited and the agreement protects merely a proprietary or property right of the employer recognized as entitled to protection under the general principles of unfair competition.” (See Metro Traffic Control, supra, citing Hays, Unfair Competition–Another Decade (1963))

Recently, the Fourth Appellate District of California struck down application of the inevitable disclosure doctrine, a variant of trade secret protection. Under the doctrine of inevitable disclosure, “a plaintiff may prove a claim of trade secret misappropriation by demonstrating that defendant’s new employment will inevitably lead him to rely on the plaintiff’s trade secrets.” (See Whyte v. Schlage Lock Co). The doctrine results in an injunction prohibiting employment, not just use of trade secrets, and permits an employer to enjoin the former employee without proof of the employee’s actual or threatened use of trade secrets. Consistent with the above principles, the Court unmistakably rejected application of the doctrine in California and held: . . . a court should not allow a plaintiff to use inevitable disclosure as an after-the-fact noncompete agreement to enjoin an employee from working for the employer of his or her choice.” (Whyte). Given this decision, employers will no longer be able to rely on this doctrine to prohibit employees from working for competitors despite the fact that trade secret information will inevitably be disclosed to the new competitor.

Alternatives Available to Protect Employers

Notwithstanding the fact that covenants not to compete are generally unenforceable, California employers are not left without alternatives to restrict former employees whose departure may have an adverse impact on the employer’s business.

Specifically, two practical types of restrictions are permitted in California. The first is the employee non-solicitation clause, which requires the departing employee to refrain for some period (usually one or two years) from soliciting his or her former coworkers to leave their jobs at the former employer. The second is the business non-solicitation clause, requiring the departing employee to promise that he or she will not solicit customers or business away from the former employer.

As to the employee non-solicitation clause, this restriction must also be limited and not overly broad in the sense that it must not affect (or limit) other employees from subsequently working at the departed employee’s new employer. (See Loral Corp. v. Moyes). The clause also must not prohibit other employees from contacting the departed employee or his or her new employer, but may simply prohibit the departed employee from soliciting the employees for the purpose of securing new employment.

Business or client non-solicitation clauses are generally given more latitude and are permitted to restrict departing employees from soliciting their former employers’ customers or business. Frequently, courts will examine whether customer lists or other business information constitute trade secrets. If they do, then departing employees cannot use them for their own benefit or for the benefit of a third party, and a business non-solicitation limitation will be enforceable. (See American Paper v. Kirgan). Case law suggests that parties may be able to agree to broader restrictions than those simply authorized under trade secret law, and covenants narrowly tailored to the non-solicitation of an employer’s business or customers for a limited duration, whether involving trade secrets or not, will generally be found enforceable. (See Loral).

A third alternative available for employer protection is use of a nondisclosure agreement. Under California law, a company is entitled to strict protection of its confidential business information. An employee may not at any time disclose or use the employer’s confidential information on behalf of anyone other than the company. (See California Civil Code §3426-3426.11). Nondisclosure agreements may be the most useful protection available to an employer and if drafted properly, may confer many of the same benefits that a covenant not to compete would provide. Nondisclosure agreements are also most likely to be upheld by a court (as compared to noncompete and non-solicitation agreements) in determining whether the restrictions placed on the departing employee are reasonable and not in violation of Section 16600. Often, the main reason a company wants a covenant not to compete is that the company fears an employee who joins a competitor will disclose the company’s proprietary information to that competitor, thus giving the competitor an advantage. Protection from the danger of disclosure thus protects the company against this significant risk.

Given the common misconception surrounding the enforceability of covenants not to compete, employers may think that such restrictions should nevertheless be incorporated into an employment or severance agreement, as the covenant will act as a future deterrent to the unsuspecting employee who may lack the understanding that the covenant would not be enforceable in a court of law. This tactic is not recommended, however, as it can place the company in great peril, for several reasons. First, the employer may be found liable for violation of public policy. In the case of Walia v. Aetna, Inc., currently on review by the California Supreme Court, the First District Court of Appeal ruled that the termination of an employee for her refusal to sign an invalid covenant not to compete constituted a violation of fundamental public policy. In flatly condemning noncompete agreements, the Court reasoned that the inclusion of the void covenant in the employment agreement implicated California’s policy in the same manner as actual enforcement of the covenant, and held that a tort claim could be pursued against the employer since it was necessary to further promote the policy against such conduct (Walia).

An invalid covenant not to compete could also violate Business and Professions Code §17200, which prohibits unfair business practices and unfair competition. In the case of Application Group, Inc. v. Hunter Group, Inc., the court ruled that a violation of Section 16600 can constitute such a practice and thus can form the predicate for a finding of violation of section 17200.

In sum, the one approach that an employer cannot take is to simply draft a traditional covenant not to compete that appears reasonable in geographic scope and limited in time, and hope that the restriction will pass judicial muster. Such a restriction is not only likely to be unenforceable, but may also subject the employer to liability for violating California’s strong public policy in favor of employee freedoms and mobility. California employers should avoid using such covenants and instead should avail themselves of the protections afforded in nondisclosure, non-solicitation, and narrowly tailored confidentiality agreements.