Are Non-Solicitation Agreements Enforceable?...Only Where Trade Secrets Are Directly Involved

September 10, 2009
Introduction

The August 2008 issue of the Personnel File reported on a California Supreme Court ruling which re-affirmed that non-competition agreements are generally prohibited by Business and Professions Code section 16600 regardless of how limited or narrow the covenant not to compete provision may be. Edwards v. Arthur Andersen LLP (2008) 44 Cal 4th 937. The Supreme Court noted in Edwards that its ruling did not apply to the "so-called trade secret exception to section 16600." As a result, the Court declined to address the application of section 16600 to non-solicitation agreements often used to protect a company’s trade secrets from being misappropriated following an employee’s departure from the company.

Many employers require their employees to execute non-solicitation agreements as a condition of employment to counter against the potential misappropriation of trade secrets. Typically, these non-solicitation agreements preclude a current or former employee from soliciting a company’s clients or customers based on the "trade secret" information the employee may have gathered while working for the company. Depending on the circumstances, trade secrets may be protected from misappropriation by California’s Uniform Trade Secrets Act, Civil Code § 3426 et. seq. ("UTSA"). As a result, a non-solicitation agreement that protects trade secrets can potentially preclude a former employee from competing against their former employer. However, to what extent can a contractual non-solicitation agreement be enforceable under the UTSA without being considered an unlawful covenant not to compete under section 16600?

In The Retirement Group v. Galante (Case No. D054207, July 30, 2009), the Court of Appeal considered this interaction between a non-solicitation agreement and the general prohibition of covenants not to compete under Business and Professions Code section 16600.

Factual Background in The Retirement Group

The Retirement Group ("TRG") was a business started in the early 1990’s by John Jastremiski and Frank Cuenca. Through the use of independent contractor broker/dealers and registered investment advisors, TRG provided investment advice and sold securities to its clients.

TRG expended substantial resources over the years to develop its customer base through seminars, direct telephone contacts, and other marketing efforts. As a result of these marketing efforts, TRG compiled a detailed database of client and potential client contact information. TRG took precautions to maintain the confidentiality of this database. No one was allowed access to the database unless they signed a confidentiality agreement. Furthermore, the database was configured to prevent the electronic copying of its information.

In the summer of 2008, Cuenca notified Jastremiski that he was leaving TRG to join a competing company, Monarch Retirement & Investments ("Monarch"). Monarch was formed by several individuals who had been independent contractors for TRG (the "Advisors"). After forming Monarch, the Advisors contacted their former TRG clients to notify them of their new operation at Monarch and to offer them the opportunity to transfer their accounts to Monarch. In many instances, the contact information used to solicit the former TRG clients was not obtained from the TRG database, but rather through other third party databases or even personal lists maintained by the Advisors.

TRG filed a lawsuit against the Advisors and alleged that they had violated their confidentiality agreements by misappropriating confidential trade secrets contained in TRG’s database to solicit existing TRG clients to switch to Monarch. As part of this lawsuit, TRG sought and obtained a preliminary injunction that prohibited the Advisors from "[d]irectly or indirectly soliciting any current TRG [customers] to transfer any securities account or relationship from TRG to [the Advisors] or any broker-dealer or registered investment advisor other than TRG..." The injunction also prohibited the affected parties from "[u]sing in any manner TRG information found solely and exclusively on TRG databases...[s]imilar information found on servers, databases an other resources owned and operated by other entities or businesses is excluded from the injunction..."

TRG then claimed that the Advisors had continued to solicit TRG clients in violation of the preliminary injunction. In response, the Advisors argued that TRG clients were contacting them directly to seek their services. The Advisors sought clarification to determine if their interactions with these clients would be considered "solicitation" under the injunction. The trial court declined to modify the original injunction order. The Advisors then appealed the preliminary injunction order and asserted that it constituted an improper covenant not to compete in violation of Business and Professions Code section 16600 and the California Supreme Court’s precedent in Edwards.

Contractual Non-Solicitation Agreements Are Unenforceable Unless the Solicitation is Directly Connected to a Misappropriation of Trade Secret Information

In reviewing the case, the Court of Appeal noted that two competing principles were potentially at odds here: (1) California’s general public policy that noncompetition agreements are prohibited under Business and Professions Code section 16600; and (2) the prevailing case law which allows a court to protect an employer from the misappropriation of trade secrets by its former employees under the UTSA and other unfair competition laws.

Relying on Edwards, the Court noted that an employer cannot by contract restrain a former employee from engaging in his or her profession, trade or business unless the agreement falls within one of the limited exceptions to section 16600. Such a contract would be considered an invalid covenant not to compete.

Applying this principle to situations where there is a potential misappropriation of trade secrets, the Court looked to Morlife, Inc. v. Perry (1997) 56 Cal. App. 4th 1514. Morlife had examined the application of the UTSA to protect a company’s trade secrets from being misappropriated by former employees who were using the information to compete against Morlife. Trade secrets are defined in the UTSA as information that:

"(1) Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use; and

(2) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy." Civil Code § 3264.1(d).

In Morlife, the court ruled that the former employees were properly enjoined from soliciting former customers because the customer lists used were trade secrets that included information not generally known to the public and that were properly safeguarded by the company.

Reconciling the rulings in Edwards and Morlife, the Court held that any order to enjoin parties from soliciting former clients or customers would need to based on an actual misappropriation of trade secret information. In effect, the Court ruled that it could not enforce an injunction based upon a violation of a confidentiality or non-solicitation agreement unless there was tortuous conduct involved that violated a statute, such as the UTSA or another unfair competition law:

"Thus, it is not the solicitation of the former employer’s customers, but it is instead the misuse of trade secret information, that may be enjoined." (original emphasis).

As applied to TRG’s preliminary injunction to preclude the Advisors from soliciting TRG clients, the Court found that this injunctive relief was overly broad and was not limited to solicitations involving misappropriation of trade secrets. The Advisors’ solicitation of customers was not necessarily the result of a misappropriation of TRG’s database. Rather, client lists were generated from independent third parties and some solicitation was the result of clients directly contacting the Advisors for services. The expansive language of the preliminary injunction would prohibit the Advisors from interacting with and soliciting any of TRG’s clients, even if no trade secret was misappropriated. As a result, the Court ruled that enjoining all solicitation under these circumstances would unlawfully restrain the Advisors from engaging in competition and this would violate Business and Professions Code section 16600 and Edwards.

Conclusion

The Court’s decision in The Retirement Group is a reminder that confidentiality and non-solicitation agreements used by employers need to be narrowly tailored to protect actual trade secrets in order to avoid being designated as unlawful covenants not to compete. Although the Court implied that contractual confidentiality and non-solicitation agreements are not enforceable to the extent that their protections go beyond the UTSA and other statutory unfair competition laws, that should not be interpreted to mean that such agreements do not have any value for employers. To the contrary, confidentiality and non-solicitation agreements are often invaluable tools to put employees on notice of protectable trade secrets in the workplace. Following this, such agreements can be used as evidence in unfair competition lawsuits of an employee’s awareness of the company’s efforts to protect certain trade secrets.

Employers should also review their procedures for protecting trade secret information in the workplace. Conducting an audit of proprietary information and the safeguards used to protect that information from misappropriation, along with placing employees on notice of the proprietary nature of such information, are good proactive measures to address these issues. Because the protection and designation of trade secrets can involve a detailed analysis, employers are encouraged to seek legal counsel for proper advice and guidance in this process.

This article was written by Gage C. Dungy, an attorney with the labor and employment law firm of Liebert Cassidy Whitmore. 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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