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Just Say Non: California's Hard Line on Non-Compete and Non-Solicitation Agreements

June 28, 2017

 

Non-compete, non-solicitation and other promises to restrain from future business practices are collectively referred to as restrictive covenants. A typical non-compete clause prohibits a party to a contract from doing business with the other party’s customers or from engaging in the same business as the other party entirely. A typical non-solicitation clause prohibits a party from trying to hire away the other party’s employees or other business partners.

Restrictive covenants routinely show up in a variety of contracts. Their most familiar habitat may be employment agreements, but they are often included as part of franchising agreements, licensing agreements, distributor agreements, sales rep agreements, business acquisitions, and plenty of other common commercial transactions.

Because of their potential for abuse, the courts and/or legislatures of most states impose limits on restrictive covenants. The most common approach is that restrictive covenants won’t be enforced unless they’re reasonable in terms of how long they last and what activities they prohibit. California law, however, goes much further. This is because Section 16600 of California’s Business and Professions Code consists of the following single stark sentence:


“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.”

 

Any ambiguity about how strictly this passage should be interpreted was removed in 2008 when the California Supreme Court ruled in Edwards v. Arthur Andersen LLP that 16600 does not allow even the sorts of reasonable or narrow restrictive covenants permitted in other jurisdictions. Non-compete and non-solicitation clauses really are presumptively invalid in California.
 

The only explicit exceptions to this rule (set forth in sections 16601 and 16602 of the business code, respectively) apply to business owners who dispose of their entire interest in the business and to business partners upon dissolution of the partnership.

However, contractual restrictions that aim to protect a business’s trade secrets (such as non-disclosure and confidentiality agreements) are still considered valid, given California’s Uniform Trade Secrets Act. For that reason, California courts may still be willing to enforce a clause that prohibits a party from using the other party’s trade secrets, even if that prohibition is presented as a non-compete or non-solicitation agreement.
 

 

Nevertheless, businesses must be cautious in relying on this so-called “trade secrets exception.” Restrictive covenants must be narrowly drafted such that the contract prohibits solicitation of their customers or employees only if doing so entails use of trade secrets (such as a customer list). If the non-compete language appears overbroad, it will likely be invalidated entirely. California courts have refused to interpret restrictive covenants narrowly (as is often the practice in other states), reasoning that overreaching contract terms, even if not fully enforceable, chill competition and thwart the purpose of Section 16600.

Invalidation of restrictive covenants usually comes up with respect to restrictions that continue after the termination of the agreement. At least in the employment context, “in-term” restrictions, such as agreements by current employees not to work for competing companies, are generally considered valid, even if framed in terms of non-competition or non-solicitation, due to the duty of loyalty employees owe to their employer. Outside the employment context, however, even in-term restrictive covenants may fall within Section 16600. For example, restrictive covenants in partnership agreements and franchising agreements have been invalidated even when they only applied while the parties had an ongoing business relationship.
 

Some businesses, especially those with an interstate presence, attempt to circumvent California law by stating that the contract should be interpreted based on another state’s law. This is a non-starter as far as California courts are concerned, since California conflict of laws rules have been interpreted to override these contractual choice of law provisions. However, by combining a choice of law provision with a forum selection provision (a clause requiring any dispute to be resolved in a certain jurisdiction), it is sometimes possible to skirt Section 16600.

 

If you have questions about enforcing a clause in a commercial contract, give us a call, send us an email or schedule a consultation online. 831-275-1401 info@knowmad.law

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