VALIDITY OF NONCOMPETITION CLAUSES IN CALIFORNIA
By: Roman P. Mosqueda, Esq.
You own a business, either as a single proprietorship, a general or limited partnership, a limited liability company, or a corporation.
You wish to protect your company’s trade secrets from employees, who, after separation from, or even during their employment with, your company, may disclose such trade secrets to a new or another employer, or put up their own business like yours.
California Civil Code Section 3426.1(d) narrowly defines trade secret as: “information, including a formula, pattern, compilation, program, device, method, technique, or process, 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.”
And California Business and Professions Code Section 16600 states that: “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.”
This article discusses California’s strict ban on noncompetition clauses, its unenforceability, and the exceptions thereto.
State’s Public Policy Against
Noncompetition Clauses:
For the protection of employees in California, the Legislature has prohibited restraints on practice of a lawful profession, trade, or business of any kind, in Section 16600 of the Business and Professions Code.
This broad prohibition renders noncompetition clauses in employment contracts unenforceable in California. Thus, the main goal of noncompetition clauses, the protection of legitimate economic interests of employers, is frustrated by such prohibition.
Although the California Legislature has not seen fit to provide exceptions to the prohibition (outside of the areas of sale of goodwill or ownership interest in a business, partners, and members of limited liability company in dissolution or dissociation of partner), California courts have judicially recognized the exception of an employer’s right to protect its trade secrets.
Indeed, in the 1994 case of Metro Traffic Control, Inc. v. Shadow Traffic Network, 22 Cal. App. 4th 853, 859, the Court of Appeal invalidated a noncompete restriction that restrains employees from working for competitors, after completion of their employment, “because it severely restricts Metro’s employees’ mobility and betterment.”
But the Court of Appeal therein qualified that Section 16600 of the Business and Professions Code “prohibits the enforcement of Metro’s noncompete clause except as is necessary to protect trade secrets,” citing Muggill v. Reuben H. Donvelley Corp., 62 Cal. 2d 239, 242 (1965).
And the Court concluded that: “a stable of trained and talented at-will employees does not constitute an employer’s trade secret;” and “the information imparted to Metro by KFWB is equally available to anyone contracting with KFWB. Consequently, there is no statutory (under Section 3426.1(d)(1) of the Civil Code) trade secret.”
Trade Secrets Exception To
Clauses:
On January 19, 1965, the Supreme Court of California acknowledged the trade secrets exception, in Muggill v. Reuben H. Donvelley Corp., supra, when it declared that: “This section (Section 16600 Bus. & Prof. Code) invalidates provisions in employment contracts prohibiting an employee from working for a competitor after completion of his employment or imposing a penalty if he does so (citations omitted), unless they are necessary to protect the employer’s trade secrets (Gordon v. Landau, 49 Cal. 2d 690, 694 [321 P. 2d 456]).”
On February 14, 1958, the Supreme Court of California held in Gordon v. Landau, supra, that: “It clearly appears from the terms of the contract that it did not prevent defendant (collector-salesman) from carrying on a weekly credit business or any other business.”
The Court continued that: “He merely agreed not to use plaintiffs’ (employers’) confidential lists to solicit customers for himself for a period of one year following termination of his employment. Such an agreement is valid and enforceable.”
The Supreme Court concluded that: “Plaintiffs’ preferred customers are a real asset to their business and the foundation upon which its success, and indeed its survival, rests. It thus logically follows that a list of such customers is a valuable trade secret and that plaintiffs were damaged by defendant’s unlawful use thereof.”
Exceptions Under The
Bus. & Prof. Code:
A. Sale Of Goodwill Of Business
Interest Or Operating Assets
Together with Goodwill:
Another exception to the invalidity of noncompetition clauses in California is a statutory one: the sale of the goodwill of a business, or of all of ownership interest in a business entity, or of all or substantially all of the operating assets together with the goodwill of a division or subsidiary, or all of the ownership interest of any subsidiary, under Section 16601 of the Business and Professions Code.
Thus, the seller of such goodwill, ownership interest, operating assets together with the goodwill of a business entity, a division thereof or a subsidiary, may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold, or that the business entity, division, or subsidiary has been carried on, so long as the buyer or an assignee carries on a like business therein.
B. Partnership In Dissolution
Or Dissociation of Partner:
Another statutory exception is the case of a partner, who upon or in anticipation of the dissolution of the partnership, or the dissociation of the partner from the partnership, may agree not to carry on a similar business within a specified geographic area where the partnership business has been transacted, so long as any other member of the partnership, or assignee carries on a like business therein, under Section 16602 of the same Code.
C. Limited Liability Company
In Dissolution:
A third statutory exception to the invalidity of noncompetition clauses is the case of a member of a limited liability company who, upon or in anticipation of the dissolution thereof, may agree not to carry on a similar business within a geographic area where the limited liability company business has been transacted, so long as any other member of the limited liability company, or an assignee carries on a like business therein, under Section 16602.5 of the same Code.
In addition, Section 16606 of the same Code categorizes the customer list of a telephone answering service as a trade secret and confidential information. And Section 16607(a) of the same Code likewise characterizes the customer list of an employment agency as a trade secret and confidential information.
And Section 16607(b) of the same Code states that: “…no liability shall attach to, and no cause of action shall arise from, the use of a customer list of an employment agency by a former employee who enters into business as an employment agency more than one year immediately following termination of his employment.”
Federal Preemption
Under ERISA:
A federal exception to the invalidity of noncompetition clauses in California is based on the preemption of state (California) law (Section 16600 of the Business and Professions Code) by the federal Employee Retirement Income Security Act of 1974 (ERISA). See Section 514(a) of ERISA, 29 U.S.C. § 1001 et. seq.
ERISA covers two types of employee benefit plans set up by employers: pension plan that provides retirement income and welfare plan that provides medical, disability or other specified benefits. See 29 U.S.C. §§ 1002(2) & 1002(1).
Noncompetition clauses that provide forfeiture of benefits are permissible in pension plans covered by ERISA. See Clark v. Lauren Young Tire Center Profit Sharing Trust, 816 F. 2d 480 (9th Cir. 1987).
As stated by Marcus A. McDaniel, in his article on “An Alternative to California’s Prohibition on Noncompete Clauses” (October 4, 2004 issue of Los Angeles Lawyer), “(a)lthough a noncompetition forfeiture provision cannot actually prohibit former employees from competing, it can provide a powerful financial incentive for them to refrain from doing so.
(The Author, Roman P. Mosqueda, is a real estate broker and attorney, who has drafted noncompetition clauses in employment, agreements, partnership and limited liability company agreements, and purchase agreements.)