California Court of Appeal Rejects “Narrow Restraint” Exception to the Prohibition on Non-Competition Agreements

With limited exceptions, under California law, an agreement prohibiting an employee from competing with the employer after the employment terminates is void. This is true even if the limitation is “reasonable” in duration and geographic scope and would therefore be acceptable in most other states.

This strong statement of California public policy is codified in Business & Professions Code section 16600: “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.” Business & Professions Code sections 16601 and 16602 state the only statutory exceptions: non-competition agreements entered into in connection with the sale of a business or partnership interest, the sale of stock by a major shareholder in a corporation, and other such business-related transactions are enforceable. There is only one other exception in the typical employer-employee setting—Section 16600 does not permit a former employee to use the former employer’s trade secrets.¹

Although California Courts of Appeal have applied section 16600 strictly, the federal Ninth Circuit Court of Appeals has been more permissive, allowing an employer to restrict a former employee’s post termination activity as long as the restrictions imposed only a “narrow restraint.” A permissible non-compete provision would leave a substantial portion of the market available to the former employee. For example, in General Commercial Packaging v. TPS Package Engineering, 126 F.3d 1131 (1997), the Ninth Circuit held that a non-competition agreement did not violate Section 16600 because it prevented a subcontractor from doing business with only a single named customer. The Court reasoned that because “[t]he contract thus only limits TPS’s access to a narrow segment of the packing and shipping market,” it was enforceable.

In Edwards v. Arthur Anderson, decided on Aug. 30, 2006, the California Court of Appeal squarely rejected the “narrow restraint” exception, concluding that non-competition agreements are “invalid even if the restraints imposed are narrow and leave a substantial portion of the market open to the employee.”

The Edwards Court also reinforced earlier rulings that held that an employer cannot require an employee or job applicant to sign an unenforceable covenant not to compete, or terminate or refuse to hire someone who refuses to sign such a covenant, and that such conduct is “an independently wrongful act” for purposes of asserting a claim of interference with prospective economic advantage. The Court relied on D’Sa v. Playhut (2000) 85 Cal.App.4th 927, for the proposition that “an employer cannot lawfully make the signing of an employment agreement, which contains an unenforceable covenant not to compete, a condition of continued employment, even if such agreement contains choice of law or severability provisions which would enable the employer to enforce other provisions of the employment agreement. We further hold that an employer’s termination of an employee who refuses to sign such an agreement constitutes a wrongful termination in violation of public policy.”

An additional ruling in the Edwards case concerns California’s public policy against requiring employees to waive their right to indemnification under California Labor Code section 2802. The Court concluded that a release that purports to waive any and all of the employee’s claims under the California Labor Code (typical release agreement wording) is void as against public policy absent an express exception for claims of indemnification.

Employers who have or are contemplating non-competition agreements with California employees or contractors (regardless of where the employer has its headquarters) should seek advice from California employment counsel, without regard to whether such agreements would be imposed at the inception of employment, during employment, or in connection with a sale of the business or transition of the employee workforce to a successor company. In addition, “standard” release agreements that are lawful elsewhere should be revised in light of Edwards to exclude claims for legally required indemnification.

FOOTNOTE

1 While employers may enforce their rights under the Uniform Trade Secrets Act, employers may also want to bind their employees by contract not to misappropriate their trade secrets through proprietary information agreements.