Trade Secrets and California Ban on Noncompetition Agreements

, New York Law Journal

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Jeffrey S. Klein

In California, employee covenants not to compete or solicit customers or clients are void, subject to certain specific exceptions. Historically, those exceptions arose both from statute (e.g., permitting noncompetes in connection with the sale of a business) and from common law (e.g., permitting noncompetes that are "narrow restraints" or necessary to protect trade secrets). In 2008, the California Supreme Court in Edwards v. Arthur Andersen, 189 P.3d 285 (Cal. 2008), refused to recognize and adopt one of those common law exceptions to California's general prohibition against noncompetition/solicitation agreements, which had developed in the federal courts. Before Edwards, some courts would enforce an employee noncompetition/solicitation agreement that was found to create only a "narrow restraint" on the former employee's business or trade. The California Supreme Court rejected the narrow restraint exception because that exception was not expressly authorized by the California Legislature. However, the court in Edwards expressly declined to address the trade secret exception, which also developed at common law. Under the trade secret exception, a court may enforce an employee noncompetition/solicitation agreement that is necessary to protect the former employer's trade secrets.

Some lower courts have read Edwards' rejection of the narrow restraint exception as broadly rejecting, or at least casting doubt on, all other non-statutory exceptions to California's prohibition against noncompetition/solicitation agreements, including the trade secret exception. There is language in Edwards that supports that view. The court held that "[n]on-competition 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." 189 P.3d 285, 296 (Cal. 2008). The court also noted 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." Id., at 291-92.

However, because the court in Edwards expressly declined to address the trade secret exception, some federal courts have continued to enforce employee noncompetition/solicitation agreements necessary to protect a former employer's trade secrets, notwithstanding Edwards. Because the trade secret exception to California's prohibition against noncompetes has never been expressly rejected by the California Supreme Court, California employers may argue that for the time being it remains a tool available for them to consider when drafting and enforcing agreements with employees. But employers who go down that path should carefully consider the unsettled case law that has developed regarding this issue in recent years.

Background

California's prohibition against certain noncompetition agreements is codified in Section 16600 of the California Business and Professions Code. Section 16600 provides 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." Cal. Bus. & Prof. Code §16600. This prohibition applies both to agreements forbidding former employees from engaging in work for a competitor, and agreements with former employees not to solicit the former employer's customers or clients.

There are three statutory exceptions to California's prohibition on noncompetition/solicitation agreements:

• Any person who sells the goodwill of a business, or all of one's ownership interest in a business entity, or substantially all of its operating assets and goodwill, to a buyer who will carry on the business may agree with the buyer not to carry on a similar business within a specified geographic area, if the business will be carried on by the buyer (Cal. Bus. & Prof. Code §16601);

• Upon dissolution of a partnership or dissociation of a partner, such partner may agree not to carry on a similar business within a specified geographic area, if the business will be carried on by remaining partners or anyone deriving title to the business or its goodwill (Cal. Bus. & Prof. Code §16602); and

• A member of a limited liability company may agree not to carry on a similar business within a specified geographic area, so long as other members or anyone deriving title to the business or its goodwill carries on a like business (Cal. Bus. & Prof. Code §16602.5).

In addition to the express statutory exceptions to California's prohibition against noncompetition agreements, courts in California have recognized certain other, limited, exceptions to Section 16600.

One such exception is the "narrow restraint exception," under which federal courts would enforce noncompetition agreements that do not completely prohibit an employee from engaging in his or her profession. The narrow restraint exception permitted noncompetition agreements that prevented a party from practicing only a narrow part of his or her profession, rather than completely barring a former employee from engaging in his or her business or trade. For example, in International Business Machines v. Bajorek, 191 F.3d 1033, 1041 (9th Cir. 1999), the U.S. Court of Appeals for the Ninth Circuit held that a six-month noncompetition provision contained in a stock option agreement did not violate Section 16600 because it excluded defendant from only "one small corner of the market," and not "from engaging in his profession, trade, or business."

A second exception is the "trade secret exception," under which California courts have enforced noncompetition agreements which are narrowly tailored to protect the former employer's trade secrets. The trade secret exception has its roots in the 1958 decision of the California Supreme Court in Gordon v. Landau, 321 P.2d 456, 459 (Cal. 1958). In Gordon, the California Supreme Court reversed a judgment of the trial court after finding that an employment agreement in which a salesman agreed not to solicit his employer's customers for one year after the termination of employment did not violate Section 16600. The agreement was lawful because it did not prevent the salesman from engaging in his chosen business or any other business; it merely prevented him from using the employer's confidential customer lists to solicit his clients.

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