California businesses face a tough task by trying to prevent its employees from leaving the company and going to work for the company’s competitor or starting their own competing business. In order to protect the company’s business, many employers consider covenants not to compete (non-compete clauses) in employment agreements essential to protecting the company. However, most employers do not realize that non-compete clauses are generally invalid in California unless the non-compete clause falls within an exception.
This post briefly addresses California’s law that generally prohibits non-compete clauses, when non-compete clauses may be enforceable, and what employers may try to do to protect their business.
California Business and Professions Code section 16600 (Section 16600) states that, “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 addition, California has a strong, fundamental public policy that promotes freedom of competition between an employee and an employer, allowing the employee the ability to freely pursue any lawful employment provided that certain exceptions do not apply. Thus, California courts typically interpret Section 16600 broadly and continually refuse to enforce non-compete clauses.
ATTEMPTS TO AVOID CALIFORNIA’S GENERAL PROHIBITION AGAINST NON-COMPETE CLAUSES
Even when California courts consistently refuse to enforce non-compete clauses, employers still try to work around the California court system by having a choice of provision law where the employment contract refers to the laws of another state. For instance, most states other than California enforce non-compete clauses. Thus, a multi-state employer who is incorporated in Maryland (non-compete clauses are valid in Maryland) but has offices in California may have a provision in its employment contract that states employment disputes shall be governed by Maryland law. By having this choice of law provision, it would seem as though the provision circumvents California’s public policy against non-compete clauses.
However, the Application Group, Inc. v. Hunter Group, Inc. case involved a Maryland company (HGI) and its employment of a Maryland resident (Pike). Pike had a non-compete clause with HGI that was valid in Maryland. Application Group, Inc. (AGI) hired Pike away from HGI, and away from Maryland to work for AGI in California.
When AGI recruited Pike and brought her back to California, the California court held that HGI’s non-compete clause with Pike was void. Even though Pike’s non-compete clause with HGI pertained to employment in Maryland, and at the time of formation, neither party anticipated anything implicating California or its law, the California court discarded the choice-of-law provision and imposed California’s non-compete law on the agreement. The California court discounted the importance of the fact that Maryland “was the place where the contract was negotiated, entered into and performed, as well as the domicile, residence, nationality, place of incorporation and place of business of the parties to the contract.”
As a result of this case, there a few scenarios employers should be aware of:
- California employees that have a non-compete agreement signed in California: the non-compete clause is invalid unless an exception applies;
- Non-California individuals with an out-of-state non-compete seeking employment in California: if the employee or new California employer files suit in California, the non-compete clause may be invalid;
- California employers seeking to hire an employee with an out-of-state non-compete clause: the law is undecided in this matter. However, it is very likely given California’s law and the way how California courts have consistently ruled on this issue that this non-compete clause would likely be invalid as well.
EXCEPTIONS TO THE RULE
Although California courts generally refuse to enforce non-compete clauses, an employer may be allowed to enforce certain non-compete clauses such as:
- Allowing Non-Compete Clauses for Business Owners – California Business and Professions Code Section 16601;
- An Employee From Disclosing Trade Secrets.
One example of such an exception involves a person who sells the “goodwill of a business” or otherwise disposes of his/her ownership interest in the business entity. This person may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business is sold. When the goodwill of a business is sold, non-competition covenants are generally enforceable because it would be “unfair” for the seller to engage in competition which diminishes the value of the assets he sold.
Other exceptions concern the dissolution of either a partnership or limited liability company. Again, in these circumstances, the person who is leaving the existing entity agrees that he or she will not carry on a similar business within a specified geographic area where the existing partnership or limited liability company is located. (See California Business and Corporations Code Section 16600 – 16602).
WAYS AN EMPLOYER CAN PROTECT ITSELF
Despite the difficulty in enforcing non-compete clauses, an employer has several options in protecting itself:
- Confidentiality Agreement
Employers should include a confidentiality provision in the employment agreement that defines trade secrets to include, if applicable, customer lists, customer contacts, vendor lists, vendor contacts, pricing lists, product information and testing results, and strategic business and other similar information. Although the employee may take employment with a company competitive with the employer, the employee may not use the protected information against the employer. If practical, the employer should restrict access to trade secrets and maintain a log of all trade secrets provided to the employee.
- Covenant Not to Solicit Employees
Employers should include in the employment agreement a covenant not to solicit the employer’s employees, providing that “during the term of this agreement and for a period of one (1) year after leaving the company, the employee will not solicit the company’s employees.”
- Return of Property
Employers should include in the employment agreement a provision requiring employees to return all company property upon leaving the company.
- Include an Arbitration Clause And Have a Choice of Law Provision
Some employment contracts require any disputes to be decided by binding arbitration. If an arbitrator upholds an illegal non-compete term, assume the arbitrator’s decision cannot be reversed by a court.
The rule that arbitration is final often trumps the correctness of the arbitrator’s ruling.
In Jones v. Humanscale Corp. (2005), this situation happened. An arbitrator in New Jersey decided New Jersey rules would apply and upheld a non-compete clause. The general rule is that an arbitrator’s ruling cannot be reversed by a court simply because it is wrong. Otherwise, the losing party in arbitration would always appeal to the court, and this would eliminate the benefits of arbitration.
California has a strong public policy that is against enforcing non-compete clauses. However, an employer may still try to protect itself by following the suggestions above.
If you are interested in learning more about enforcing non-compete clauses in California, then please contact Larry Horwitz at firstname.lastname@example.org.