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The Death of the Noncompete

October 10, 2008
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Related Topics: Miscellaneous Legal Issues
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The California Supreme Court recently affirmed that noncompete agreements are unenforceable against departing employees. The court expressly rejected decisions by the federal 9th Circuit Court of Appeals that allowed enforcement of noncompete agreements if they were narrowly drafted.

    Because so many national and international employers do business in California and because California is often on the leading edge of legal and technological development, non-California businesses should take note of the decision.

    First, some background: Noncompete agreements, or more commonly, noncompete provisions in broader employment agreements, are used by employers to prevent their employees from competing with them after termination. Employers invest substantial time and money training and developing their employees and are loath to see those employees quit and join a competitor or set up a competing business across the street. In turn, employees reject being tied to a single employer or situation, instead seeking to maximize their abilities and income by looking for better employment in the same industry.

    Noncompete agreements can be broadly written ("employee shall never perform similar type of work within the state") or they can be narrow ("employee shall not solicit or contact employer clients for six months following termination of employment").

    Historically, most states were initially hostile to noncompete agreements and other restraints of trade, either applying a reasonableness test that greatly favored the employee or enacting laws prohibiting contracts restraining trade. However, as time passed, many states adopted a more balanced approach, and courts, when faced with onerous noncompete agreements, would often redraft the terms to make them reasonable, rather than voiding the agreements altogether.

    The pendulum appears to be swinging the other way, and courts are increasingly weighing noncompete agreements with emphasis on the employee’s rights over the employer’s rights.

    Today, most states enforce noncompetes if they are reasonably drafted to balance the rights of the employer and employee. But since 1872, California has rejected such agreements. California Business and Professions Code Section 16600 provides that, with exceptions unrelated to the normal employer/employee relationship, "every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void."

    In the recent case, Edwards v. Arthur Andersen, the California Supreme Court examined an employment agreement between Arthur Andersen, formerly one of the five largest public accounting firms, and one of its former tax-manager employees, Raymond Edwards. Edwards’ employment agreement included a typical noncompetition clause, prohibiting Edwards from working for or soliciting Arthur Andersen clients for limited periods after his employment ended.

    When Edwards was terminated without severance benefits, he sued Arthur Andersen, alleging that the noncompete agreement violated Section 16600. The trial court ruled in favor of Arthur Andersen, finding that the noncompete agreement was narrowly drafted and therefore enforceable. The court of appeal reversed the trial court, finding for Edwards, and the Supreme Court decided to review the case, apparently to stamp out any confusion that noncompete agreements can be enforced if they are narrowly drafted.

    The Supreme Court largely affirmed the court of appeal’s ruling, holding that the Edwards/Arthur Andersen noncompete agreement was void. The court emphasized California’s strong public policy favoring open competition and employee mobility, and determined that noncompetition agreements are permissible only if they fit within one of the statutory exceptions of Section 16600, relating to the sale or dissolution of corporations, partnerships and limited liability companies. None of those exceptions were present in the Edwards case.

    The Supreme Court noted that the trial court had erred by relying on the "narrow restraint" exception to Section 16600, which is not part of Section 16600 but had evolved from several cases from the federal 9th Circuit Court of Appeals. Under the "narrow restraint" exception, some federal courts have enforced noncompete agreements if the restriction on the employee "is limited and leaves a substantial portion of the market available to the employee." The California Supreme Court found that Section 16600 does not include any "narrow restraint" exception and that this exception cannot be implied. The court recognized that allowing a "narrow restraint" exception would give employers "an incentive to draft noncompetition agreements that push the envelope of the ‘narrowness’ requirement" and the exception would "burden a terminated employee with the task of guessing, at his or her peril, whether a court might find particular restrictions sufficiently narrow or overly broad."

    Federal courts are often required to apply state law in situations involving diversity jurisdiction, in which one of the parties to a lawsuit does not reside in the state where the dispute occurred. But the federal courts must apply that law based on that state’s interpretation of its own law. Here, the 9th Circuit had misinterpreted California’s rule against noncompete agreements, and the California Supreme Court expressly rejected the 9th Circuit’s interpretation, finding that "the ‘narrow restraint’ doctrine is a misapplication of California law. Noncompetition agreements are invalid under Section 16600 even if narrowly drawn, unless they fall with the statutory or trade secrets exceptions."

    The court was referring to two statutory exceptions in Section 16600 to the general rule that noncompete agreements are unenforceable in California, and they both relate to the good will of an existing company. First, if a company owner sells his business and the company’s good will is part of the sale, the seller can be bound by a noncompete agreement. Second, when partnership is dissolved, one partner can agree not to compete with the other partner who intends to carry on the business, and that noncompete agreement can be enforced.

    The court also referred to a trade-secrets exception to California’s rule against noncompete agreements. California has adopted the Uniform Trade Secrets Act, and the court noted that under California law, an employer can prevent its former employees from taking and using the employer’s trade secrets after his or her termination.

    In the Edwards case, Arthur Andersen relied entirely on the noncompete agreement language and did not allege that Edwards had misappropriated its trade secrets. The Edwards decision merely emphasizes that trade secrets will continue to grow as the key battleground between employers and employees. While an employer cannot bind an employee with a noncompete agreement, it can require the employee to acknowledge that he or she will be obtaining trade-secret information that shall not be used for any purpose that does not further the employer’s interests.

    Many employers try to throw the trade-secret blanket over everything they share with their employees, but under California law, information only qualifies as a trade secret if it: (1) has economic value from not being generally known, and (2) has been subject to reasonable efforts, under the circumstances, to maintain its secrecy. Thus, an employer seeking to prevent a former employee from contacting its clients would need to show that the list of clients would be difficult to create and that the employer actually made reasonable efforts to keep the list confidential. "Reasonable" is in the eye of the beholder, but obviously, the courts are more likely to protect highly valuable and deeply protected trade secrets like computer chip design or the recipe to Coca-Cola than they are to protect the names of potential real estate investors.

    Under California law, even non-California employers cannot enforce noncompete agreements against their California employees. Moreover, out-of-state employers cannot avoid the rule merely by including language in the employment contract that the law of another state applies. California courts have jealously protected California employees by striking down such "choice of law" provisions. While a non-California employer can sue in its home state to enforce a noncompete agreement against the former employee, California courts are reticent to enforce such judgments in California, viewing it as inimical to public policy. Some employers have successfully enforced noncompete agreements by avoiding the judicial system completely through the use of a binding-arbitration provision in the employment agreement. In such situations, the arbitrators may apply the reasonableness standard in determining the validity of the noncompete agreement.

    Since noncompete agreements are unenforceable in California, an employer seeking to prevent former employees from using its legitimate trade secrets will need to be proactive and establish the trade-secret status of the information before the employee leaves. Thinking creatively, non-California employers can draft employment agreements that will increase, if not guarantee, the chances that the noncompete agreements will remain enforceable when it comes to their California employees.

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