Noncompete Clauses

By Damon C. Anastasia and Robert B. Milligan

Things are good for your client. She has a successful company with valued and productive employees, who have signed long-term contracts that include a provision preventing them from competing with her company should they decide to leave. Time passes, sales are up, and then the unthinkable happens: A trusted employee leaves and - of all things! - sets up a competing enterprise just down the street.

What can the employer do? Can she enforce that rock-solid noncompete clause you inserted into the employee's contract? The answer is dismaying: maybe, maybe not. In fact, in most cases, just plain not.

The Edwards Decision
Last year the California Supreme Court tackled this very issue. Acknowledging the state's long-standing public policy favoring employee mobility, the court confirmed as a general rule that employee noncompetition agreements are unenforceable in California (Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008)). To fully understand the Edwards decision, it is helpful to examine the dispute that spawned the case.

Raymond Edwards II was a CPA who worked for Arthur Andersen in Los Angeles. Hired in 1997, he was required to sign a noncompetition agreement as a condition of his employment. The agreement provided that if Edwards were to leave Arthur Andersen, he would not perform professional services for any of the firm's clients; would not solicit those clients; and would not hire away any of Arthur Andersen's professional service employees. Varying time limits applied to these prohibitions, ranging from one year to 18 months. The agreement did not prohibit Edwards from accepting employment with an Arthur Andersen client. (See 44 Cal. 4th at 942.)

In 2002, after the demise of infamous energy giant Enron, Arthur Andersen was indicted by the federal government. The firm then announced it would cease its accounting practice in the United States. A subsidiary of HSBC USA, Inc. purchased the Arthur Andersen group that employed Edwards.

In July 2002 HSBC offered Edwards employment, but as part of the deal it required him to sign a termination of noncompete agreement (TONC). The TONC released Edwards from his noncompetition agreement with Arthur Andersen (thus freeing him to work for HSBC, a competitor), but it also required him to waive any and all claims he might have against Andersen.

Fearing that he might need to call on his former employer to indemnify him should he be named as a defendant in future Enron-related litigation, Edwards refused to sign the TONC. Arthur Andersen terminated his employment, and HSBC withdrew its job offer. Edwards then sued Arthur Andersen, alleging that its noncompetition agreement was invalid because it violated California Business and Professions Code section 16600 (44 Cal. 4th at 943). Edwards's complaint also included a specific claim that Arthur Andersen's conduct amounted to an unlawful interference with prospective advantage (a tort), as well as a claim under the Cartwright Act (Cal. Bus. & Prof. Code §§ 16700-16770) alleging anticompetitive business practices.

The trial court ruled in favor of Arthur Andersen, finding that: (1) the noncompetition agreement did not violate section 16600 because it was narrowly tailored and did not deprive Edwards of his right to pursue his profession; and (2) requiring Edwards to sign the noncompetition agreement and TONC was not unlawful. Edwards appealed, and the case eventually reached the California Supreme Court.

The Right to Compete
The state supreme court focused on the following question, as it stated: "To what extent does Business and Professions Code section 16600 prohibit employee noncompetition agreements?" (44 Cal. 4th at 942.)

The court began its analysis by reviewing the history and application of section 16600, which states that a contract that restrains anyone "from engaging in a lawful profession, trade, or business of any kind" is void. This language was enacted in 1872, and ever since then "our courts have consistently affirmed that section 16600 evinces a settled legislative policy in favor of open competition and employee mobility." The court further stated that the code "protects the important legal right of persons to engage in business and occupations of their choosing." For that reason, "this court generally condemns noncompetition agreements." (44 Cal. 4th at 946.) The court did acknowledge, however, that many other states permit noncompete provisions as long as they are reasonably imposed. (See 44 Cal. 4th at 945.)

The court ruled that section 16600 prohibits all employee noncompetition agreements - with limited statutory exceptions that are not typically found in the usual employment relationship.

The exceptions are set forth in neighboring code sections. They include noncompetition agreements executed in connection with the sale of a business (Cal. Bus. & Prof. Code § 16601), dissolutions of or disassociations from partnerships (§ 16602), and dissolutions of or terminations of interest in limited liability companies (§ 16602.5).

The Edwards decision provides a bright-line rule (44 Cal. 4th at 948-51). As a result, employers with noncompetition provisions in their employment agreements run the risk not only of having a future court invalidate those agreements but also of being sued for interfering with their ex-employees' ability to obtain new employment - and, in some cases, for anticompetitive business practices or unfair competition (44 Cal. 4th at 943-45).

No Narrow-Restraint Exception
In interpreting the broad mandate of section 16600, the court was not writing on a blank slate. Previously, a line of federal cases had established a judicial rule that noncompete clauses could survive the reach of section 16600 if they were narrowly drawn. (See Campbell v. Trustees of Leland Stanford Jr. Univ., 817 F.2d 499 (9th Cir. 1987); General Commercial Packaging v. TPS Package, 126 F.3d 1131 (9th Cir. 1997).)

But the Edwards decision put an abrupt end to this line of authority. The court noted that no California court had endorsed the Ninth Circuit's "narrow- restraint exception." As the court put it, "we are of the view that California courts have been clear in their expression that section 16600 represents a strong public policy of the state which should not be diluted by judicial fiat." (44 Cal. 4th at 949.) Indeed, the court's disposition of the noncompete agreement issue was specific and unequivocal: "[N]oncompetition agreements are invalid under section 16600 in California even if narrowly drawn, unless they fall within the applicable statutory exceptions of sections 16601, 16602, or 16602.5." (44 Cal. 4th at 955.)

Closely related to the narrow-restraint analysis was a rule that noncompete clauses were permissible as long as they were reasonable. But the court rejected that notion too. The court focused on the impact of the clause and concluded that the noncompetition agreement at issue was invalid because it "restricted Edwards from performing work for Andersen's Los Angeles clients and therefore restricted his ability to practice his accounting profession." (44 Cal. 4th at 948.)

Lingering Questions
Despite the sweeping language of the Edwards opinion, two key questions remain. Specifically, can an employer enforce a clause that prohibits the solicitation of customers when the prohibition is necessary to protect a trade secret? And what about a clause that bars the ex-employee from raiding the company by soliciting fellow employees to leave and join a rival firm?

The Edwards court specifically avoided deciding these issues, observing in a footnote that: "[W]e do not here address the applicability of the so-called trade secret exception to section 16600 as Edwards does not dispute that portion of his agreement or contend that the provision of the noncompetition agreement prohibiting him from recruiting Ander-sen's employees violated section 16600." (44 Cal. 4th at 946, fn. 4.) Thus, in the wake of Edwards, it may still be possible to enforce a nonsolicitation clause to protect trade secrets and to prevent a departing employee from inducing fellow employees to jump ship.

Lawyers who find solace in footnote 4 must proceed with caution, however, for it remains unclear whether a viable trade-secret exception to section 16600 continues to exist. Indeed, given the explicit language in the court's opinion, lawyers certainly will argue in future cases that a trade-secrets exception does not exist, because it is not specifically identified in sections 16601, 16602, or 16602.5. That said, there are some markers on the legal trail to support a trade-secret exception. For instance, the Edwards court itself cited with approval the decision in Muggill v. Reuben H. Donnelley Corp. (62 Cal. 2d 239, 242 (1965)), in which the court held that section 16600 invalidates employment noncompetition agreements unless they are necessary to protect an employer's trade secrets (44 Cal. 4th at 946). The court's seeming endorsement of Muggill gives some hope for the continuing viability of the trade-secrets exception.

Additionally, one must reckon with Civil Code section 3426, a separate statutory framework that protects against trade-secret misappropriation (and allows the use of nondisclosure covenants). In light of this statutory framework, it would seem that a business could enforce a nondisclosure covenant and a narrowly tailored nonsolicitation covenant designed to protect genuine trade secrets.

Post-Edwards Case Law
Seeking to fill the gap left by the California Supreme Court, two recent federal cases relying on Edwards found that there is, in fact, a trade-secrets exception to section 16600 (Asset Marketing Systems, Inc. v. Gagnon, 542 F.3d 748, 758 (9th Cir. 2008) ("Under California law, non-competition agreements are unenforceable unless necessary to protect an employer's trade secret."); Bank of America, N.A. v. Lee, 2008 WL 4351348 at *5, 6 (C.D. Cal. Sep 22, 2008) ("The court concludes that 'trade secret exception' to § 16600 still applies.")). It remains to be seen how a state court will address this issue.

In addition to the Muggill decision noted above, there appears to be ample state court authority supporting a trade-secret exception to section 16600. (See Thompson v. Impaxx, Inc., 113 Cal. App. 4th 1425, 1430 (2003) (quoting Moss, Adams & Co. v. Shilling, 179 Cal. App. 3d 124, 129 (1986)) ("Antisolicitation covenants are void as unlawful business restraints except where their enforcement is necessary to protect trade secrets."); Readylink Healthcare v. Cotton, 126 Cal. App. 4th 1006, 1022 (2005) ("Misappropriation of trade secrets information constitutes exception to section 16600.").)

One thing is clear after Edwards: Companies seeking to invoke the trade-secrets exception to section 16660 must show that the information they seek to protect is, in fact, a bona fide trade secret. The alleged trade secret must be specifically identified, and a detailed showing is required in order to obtain injunctive relief - that's what noncompetition litigation is all about. (See Whyte v. Schlage Lock Co., 101 Cal. App. 4th 1443 (2002).)

Nonsolicitation of Employees
Going after a company's customers is one thing; raiding the ranks of its employees is another. As noted above, the Edwards court did not address whether a contractual restriction prohibiting recruitment of employees for the benefit of a competitor violates section 16600. (See 44 Cal. 4th at 946, fn. 4.) Under prior case law, however, it is well established that competitors generally may solicit each other's employees if they do not use unlawful means or engage in acts of unfair competition (Metro Traffic Control, Inc. v. Shadow Traffic Network, 22 Cal. App. 4th 853, 860 (1994)).

In one leading case, Loral Corp. v. Moyes (174 Cal. App. 3d 268, 284 (1985)), the court of appeal ruled that a contract may prohibit departing employees from directly soliciting fellow employees to join a new business. The court of appeal expressly found that the nonsolicitation or "anti-raiding covenant" did not constitute an impermissible covenant void under section 16600: Although it may restrict the former employee's business practices in a small way, the court determined it was enforceable, as it had no overall impact on trade or business. Furthermore, the court found that the duration of the covenant depends on its "reasonableness, evaluated in terms of the employer, the employee and the public." The court found a one-year restriction reasonable, but it declined to rule on whether a longer limitation would pass muster (174 Cal. App. 3d at 279).

A departing employee may still set up a competing business and may also hire employees from the old firm. As the Loral court noted, equity "will not enjoin a former employee from receiving and considering applications from employees of his former employer, even though ... he should be enjoined from soliciting their applications." (174 Cal. App. 3d at 279-80.)

One should note that these protections for employers may be more apparent than real. Although cases such as Loral may prohibit direct solicitation, they do not prohibit a former employee from luring fellow employees by advertising new positions that promise greater salaries and better working conditions.

How does the Loral decision fare after Edwards? It's hard to say. In coming years, courts surely will scrutinize employers' nonsolicitation provisions, but as of this writing the Loral decision is still valid law.

Looking Ahead
While the Edwards court articulated a clear interpretation of section 16600, it reserved key questions for another day. In the wake of that ruling, companies should audit their trade-secret protections to ensure that no restrictive clauses run afoul of Business and Professions Code section 16600 and, equally important, that their organization's intellectual capital is adequately protected.

An anti-raiding clause that prohibits solicitation of fellow employees may survive Edwards, but it may have limited effectiveness, given a departing employee's right to advertise in a variety of media, including the Internet.

Employers with restrictive covenants should know that the covenants may not hold up in court, and also that they put their companies at risk of being sued - as Arthur Andersen was - for interfering with an employee's ability to obtain a new job, as well as for anticompetitive business practices.

The Edwards decision is a powerful statement from the California Supreme Court. It is the product of a free marketplace, where competition is king. A carefully crafted and narrowly drawn noncompete clause designed to protect legitimate employer interests may well remain viable, but everyone should understand that there are no guarantees. Lawyers and judges will continue to sort out the vexing issues that arise whenever a valued employee departs and sets ups a competitive enterprise.

Damon C. Anastasia is a partner and Robert B. Milligan is a senior associate in the Los Angeles office of Seyfarth Shaw, where they practice commercial litigation, including intellectual property theft.

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