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Non-Competition Agreements in California

Non-competition agreements, also known as covenants not to compete or restrictive covenants, are employment contracts used by employers to limit the ability of an employee to compete with the employer by stealing customers or trade secrets. Enforceable agreements must strike a balance between protecting the employer’s legitimate business interests from an unfair competitive advantage with the employee’s right to work in a field for which he or she is trained.  In general, courts decide what is considered reasonable or not reasonable by examining the type and size of the business, how long and over what geographic area the restrictions apply and whether adequate consideration, or benefit, was given the employee at the time the agreement was signed.

The Law In California

California law specifically forbids any employment contract that restrains anyone from engaging in a lawful profession, trade or business of any kind.  Although several California Federal courts have found such agreements enforceable within very narrow exceptions (eg: a restriction from doing business with one specific customer), the California Supreme Court has taken a very strict view of the statute’s language.  In a case decided in August of 2008, the Supreme Court reiterated this view and stated that “if the legislature intended the statute to apply only to restraints that were unreasonable or overbroad, it could have included language to that effect.” (Edwards v. Arthur Andersen, LLP, No. BC 294853 (Cal. Aug. 7, 2008)

Even though the law explicitly forbids these kinds of restrictions, the courts have heard cases involving them.  They have consistently declared any kind of restriction on an employee’s ability to work as void and against public policy.  Some examples are:

  • An 18-month non-solicitation restriction on a former employee of a tax services company that prohibited the employee from providing services to any of the former employer’s clients for a year.
  • A 1-year restriction on traffic reporters from providing services to any television or radio station.
  • A geographic restriction on solicitation of remaining employees by a former employee in a California company’s Indiana office was deemed to be invalid. 

However, the courts have recognized a judicially created exception in the case of trade secrets or unfair competition.  California adopted the Uniform Trade Secrets Act in 1984 which, among other things, codified the exception that had been allowed by the courts. 

 

Sale of Business or Dissolution of a Partnership

Although forbidden in an employment context, non-competition agreements are permitted when an owner sells all of her stock or a substantial portion of the assets and related goodwill.  The buyer and seller may agree that the seller will not compete with the buyer for a specific period of time and in a specific geographic area.  The same hold true for a partner withdrawing from a partnership.  The California Appeals Court has said, however, that the practice of requiring employees to purchase a non-controlling interest in a business and selling it back when they leave employment in order to get around the prohibition of restrictions on former employees is not permitted.

Examples of restrictions in non-compete agreements in the sale or dissolution context that California courts have found to be reasonable include:

  • A restriction against a former shareholder who owned less than three percent of the company’s stock was determined to be a “substantial shareholder” because he was the ninth largest shareholder and one of the company’s principal officers.
  • A 3-year, 7.5-mile-radius restriction on a radiologist’s stock redemption agreement because goodwill was not a factor.

 

Non-Competition Agreements in California

GR > non-competition agreements are illegal

Exceptions –

  • Legal to protect trade secrets
  • Legal when a substantial portion of the company stock is being sold, enough that goodwill is being transferred
  • Legal when a substantial portion of the company’s assets are being sold, does not require that goodwill be transferred.
  • Legal to prohibit a withdrawing partner from practicing in a limited geographical area.  “Rule of reason” applies.

Unlawful competition means > substantial competitive business activities, does not mean isolated or occasional transactions.

Court will not modify or narrowly construe an agreement to make it legal except when goodwill is being sold.  The court may attempt to save the agreement.

The employer and employee may not agree that non-competition provisions are legal.  That is illegal restraint of trade.

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