California Supreme Court Re-Affirms that Covenants Not to Compete Are Generally Unlawful in California

August 21, 2008
Covenants not to compete (also known as non-competition agreements) are legal in many states and commonly used in employment contracts as a deterrent to prevent employees from switching jobs and taking their wealth of knowledge to go work for a competitor. For example, non-competition agreements are quite common for employees working in sales, banking/finance, and computer technology industries. However, while covenants not to compete are valid in many states, they are generally unlawful and considered void under California laws dating as far back as 1872. Nonetheless, a number of California employers – especially those based outside of California – still improperly require California employees to submit to non-competition agreements as a condition of employment. The California Supreme Court recently re-affirmed the principle that non-competition agreements in California are prohibited by statute regardless of how limited or narrow the covenant not to compete provision may be. Edwards v. Arthur Andersen LLP (Case no. S147190, issued August 7, 2008). Below is an overview of the Edwards case, along with some additional information to remind California employers to generally avoid the use of non-competition agreements among their employees.

The History of California’s Prohibition of Covenants Not to Compete.

Most states follow the common law principle that contractual restraints on the practice of a profession, business, or trade are valid so long as they are reasonably imposed. California has generally strayed away from this principle since 1872, when the Legislature enacted former Civil Code section 1673 as a means to prohibit covenants not to compete in favor of a public policy to promote open competition. In 1941, Civil Code section 1673 was re-codified to its current form as Business and Professions section 16600, which states:

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.

As a result of this broad language, section 16600 has been construed generally to prohibit most non-competition agreements in California. There are a few limited exceptions to this general rule codified in the Business and Professions Code where non-competition agreements are permitted:

  • Non-competition agreements related to the sale of goodwill of a business or business interest (Business and Professions Code section 16601). For example, a non-competition agreement related to a doctor’s sale of his practice and patients to another doctor could be enforced if the selling doctor opens up a new medical practice next door and competes for the same patients that were just sold as goodwill.
  • Similar principles apply to the dissolution/sale of a partnership or limited liability corporation where a non-competition agreement can be valid (Business and Professions Code sections 16602 and 16602.5).

Even where non-competition agreements are permitted under these limited circumstances, California law still requires that such agreements be narrowly tailored in scope and duration only to limit competition in a reasonable manner. As a result, the extent of territorial restrictions and the duration of the covenant not to compete will be carefully scrutinized by courts to avoid an undue restraint on an affected individual’s ability to engage in a lawful profession, trade or business.

Factual Background in Edwards.

Raymond Edwards was a certified public accountant (CPA) hired as a tax manager in Arthur Andersen’s Los Angeles office. On taking the job, he was required to sign a non-competition agreement which prohibited him from working for or soliciting certain Arthur Andersen clients for limited periods following his termination. The agreement was required for all managers and read in relevant part:

If you leave the Firm, for eighteen months after release or resignation, you agree not to perform professional services of the type you provided for any client on which you worked during the eighteen months prior to release or resignation. . . .For twelve months after you leave the Firm, you agree not to solicit (to perform professional services of the type you provided) any client of the office(s) to which you were assigned during the eighteen months preceding release or resignation. You agree not to solicit away from the Firm any of its professional personnel for eighteen months after release or resignation.

Edwards signed the agreement. Edwards worked for Arthur Andersen for five years, was promoted, and was on track to become a partner.

However, in 2002, Arthur Andersen became embroiled in the Enron financial scandal. After Arthur Andersen was indicted in March 2002 in connection with the Enron investigation, the company announced it would cease its accounting practices in the United States. Later that year it began selling off practice groups. Edwards’ practice group was sold to a newly formed subsidiary of a New York-based banking corporation HSBC. HSBC offered employment to Edwards, but he was required to execute a "termination of non-compete agreement" as a condition of his employment. Edwards refused to sign the agreement and HSBC withdrew its offer of employment to him. Edwards then sued Andersen, HSBC and the new subsidiary on a number of theories including anti-competitive business practices. Edwards alleged that the Arthur Andersen non-competition agreement violated California Business and Professions Code section 16600.

Edwards settled with all parties except Arthur Andersen but the trial court eventually dismissed all claims against Arthur Andersen and held that the Arthur Andersen non-competition agreement did not violate section 16600 because it was narrowly tailored and did not deprive Edwards of his right to pursue his profession. The Court of Appeal disagreed and held that the non-competition agreement was invalid under section 16600.

The California Supreme Court Re-Affirms that Non-Competition Agreements of Any Kind Are Void Unless a Statutory Exception Applies.

Many employment contracts include provisions in which the employee agrees that he or she will not work for a competitor or engage in a competitive occupation, for periods of either one or two years following the employee’s termination of employment. The Arthur Andersen provision at stake in this case was far less restrictive . The agreement did not prevent Edwards from working as an accountant if he were to leave the company. In fact, it did not even prohibit him from taking a job with a client. Rather, the restrictions prohibited Edwards from performing services for any Arthur Andersen client for whom he had worked with while employed and prohibited him from soliciting business from any Arthur Andersen client.

Relying on federal caselaw from the Ninth Circuit Court of Appeals that had interpreted section 16600, Arthur Andersen argued that the non-competition agreement’s restrictions were valid because they were narrowly drawn and did not completely restrain Edwards from practicing his profession because the agreement was reasonably imposed.

The California Supreme Court rejected these arguments and agreed with the Court of Appeal that Edwards’ non-competition agreement was invalid. The Court began its discussion of the issues in Edwards by holding that an agreement with any restrictions placed on an individual’s right to engage in a lawful business or profession is void under Business and Professions Code section 16600, except as provided by statute. As noted by the Court:

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.’ . . .Section 16600 is unambiguous, and if the Legislature intended the statute to apply only to restraints that are unreasonable and overbroad, it could have included language to that effect. We. . .leave it to the Legislature, if it chooses, either to relax the statutory restrictions or adopt additional exceptions to the prohibition against restraint rule under section 16600.

Following this, the Court rejected Arthur Andersen’s arguments that the restrictions in Edwards’ non-competition agreement were narrowly drawn and reasonably imposed so as not to prevent Edwards from fully engaging in his profession. The fact that the agreement restrained

Edwards’ ability to engage in his profession was sufficient enough to establish a violation of section 16600. As noted by the Court:

The non competition agreement that Edwards was required to sign before commencing employment with Andersen was therefore invalid because it restrained his ability to practice his profession.

As a result of the Court’s decision, non-competition agreements and covenants not to compete will not be enforced by California courts no matter how carefully drawn or narrowly tailored unless one of the limited statutory exceptions applies.

Conclusion - California Employers Should Avoid the Use of a Non-Competition Agreement Unless One of the Limited Exceptions Applies

The lesson to learn from the Edwards case is that California’s law and public policy generally prohibits non-competition agreements and covenants not to compete. California employers should avoid the use of such non-competition agreements, and if used, understand that they will be void and unenforceable. Employers who may be able to invoke one of the statutory exceptions to the general prohibition on non-competition agreements (Business and Professions Code sections 16601, 16602, and 16602.5) should contact legal counsel for assistance in drafting the non-competition agreement to ensure that it satisfies California’s legal standards.

Finally, it is important to note that the prohibition on non-competition agreements in California does not preclude employers from implementing and enforcing non-solicitation agreements and other confidentiality provisions to prevent employees from misappropriating an employer’s trade secrets and proprietary information. Employers should contact legal counsel for assistance in implementing such non-solicitation and confidentiality/trade secrets agreements.

This article was written by Jeffrey C. Freedman and Gage C. Dungy, attorneys with the labor and employment law firm of Liebert Cassidy Whitmore (LCW). Mr. Freedman is a Partner in the Los Angeles office and can be reached at (310) 981-2000 or at jfreedman@lcwlegal.com. Mr. Dungy (gdungy@lcwlegal.com) is an Associate in the Fresno office and can be reached at (559) 256-7800. For more information regarding the discussion above or on our firm please visit our website at www.lcwlegal.com, or contact one of our offices below.

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