COVENANTS NOT TO COMPETE IN CALIFORNIA
It is a long-standing (if little known) principle of California law that non-compete covenants, pursuant to which employees agree not to pursue employment with a competitor of the employer for some designated period after terminating work, are generally not enforceable. This pro-employee rule has recently been broadened by two recent cases in which employers were held liable for damages after terminating employees who refused to sign agreements containing covenants not to compete. This memo will offer a brief discussion of those cases as well as issues relating generally to the protection of confidential information.
California Law Provisions
Covenants not to compete are governed in California by Business and Professions Code Section 16600 et seq. Section 16600 says that, except as otherwise provided, every contract that restrains a person from engaging in a lawful profession, trade or business is void to the extent of the restriction. Carve-outs are made within the B&P Code to permit covenants not to compete in connection with the sale of a business, and an additional carve-out has been made by courts in cases where restrictions are small or limited. For example, a contractor can lawfully prohibit its subcontractor from engaging the contractor's customer for a reasonable period following termination of the subcontracting agreement. General Commercial Packaging, Inc. v. TPS Package Engineering, Inc., 126 F.3d 1131 (9th cir. 1997). The reasoning for this is that the prohibition does not prevent the subcontractor from engaging in its principal activity, it merely prevents the sub from engaging one particular customer.
Two recent cases have extended the scope of the prohibition on covenants not to compete. Whereas the issue has most commonly arisen in cases following termination of employment, where the employer has attempted to prohibit the employee from competing with the employer in some fashion, these new cases have held the employer liable without any showing of the employee's intent or desire to engage in a competitive business.
The cases are factually similar. In the first, the employee was initially hired based on an oral agreement, then later presented with a written agreement containing a prohibited covenant not to compete. D'Sa v. Playhut 85 Cal. App. 4th 927 (2000). In the other, the employee's original employer was acquired, and the new employer required all employees to execute a non-compete and confidentiality agreement. Walia v. Aetna 93 Cal. App. 4th 1213 (2001).
In each case, the employee refused to sign the agreement and was terminated as a result. The California Court of Appeal held in each case that termination based on refusal to sign an agreement containing an unlawful covenant not to compete was wrongful. In each case, the court assigned damages against the employer.
It is important to note that because neither agreement was signed, the court rejected arguments from the employers that the prohibited clauses were separable from the remainder of the agreements, which were otherwise acceptable. Many employers take the position that it "can't hurt" to include potentially prohibited provisions in agreements, knowing that the offensive provisions could be separated in the event of a dispute, leaving the remainder of the agreement intact. These cases, however, lead to the conclusion that such a policy could indeed by very hurtful. So long as the employee can make a credible argument that she refused to sign the agreement based on the existence of the prohibited clauses, the employer may be liable for both compensatory and punitive damages.
A further question that arises from these cases is whether a prospective employee who refuses to sign an agreement containing a prohibited covenant might also have a claim. In such a case, damages could be more difficult to prove, but the possibility also exists that such claims could be put forth by significant numbers of prospective hires.
Restriction On Use Of Confidential Information
In most cases, covenants not to compete arise not out of an employer's desire to create indentured servants of its employees, but to prevent competitors from hiring away employees, thereby potentially gaining access to the employer's intellectual property and other confidential information. In light of California law and these cases in particular how, it may be asked, does an employer takes steps to protect its confidential information?
The answer is that California law does permit employers to restrict employees from using the employer's confidential information on behalf of a competitor. More limited than a broad prohibition on employment within a given industry or geographic area, these restrictions prevent an employee from disclosing confidential information following termination of employment. In this context, "confidential information" can include an employer's customer lists or similar data. Here, as elsewhere within this area, the restriction may not be perpetual- the time period must be reasonable given the nature of the information.
Thus, employers can take definite steps to protect their confidential information, but must be very careful to ensure that the protection is framed as a prohibition on use of information rather than an outright restriction on employment.
Many business people are unaware of the extent to which California restricts covenants not to compete, and are thus caught unaware when the issue arises. Following these cases, the "can't hurt" attitude has the potential to cause serious injury. Employers should be extremely careful to ensure that restrictive provisions are permitted under California law.
For more information, or for assistance in reviewing agreements regarding covenants not to compete please contact one of the attorneys in our transactions group.