Latest Thinking

The Trade Secrets Exception to California’s Ban on Employee Noncompetition and Nonsolicitation Agreements After Edwards v. Arthur Andersen, LLP

In California, employee covenants not to compete or solicit customers or clients are void, subject to certain specific exceptions. Historically, those exceptions arose both from statute (e.g., permitting non-competes in connection with the sale of a business) and from common law (e.g., permitting non-competes that are “narrow restraints” or necessary to protect trade secrets). In 2008, the California Supreme Court in Edwards v. Arthur Anderson LLP, 189 P.3d 285 (Cal. 2008) refused to recognize and adopt one of those common law exceptions to California’s general prohibition against non-competition/solicitation agreements, which had developed in the federal courts. Before Edwards, some courts would enforce an employee non-competition/solicitation agreement that was found to create only a “narrow restraint” on the former employee’s business or trade. The California Supreme Court rejected the narrow restraint exception because that exception was not expressly authorized by the California legislature. However, the court in Edwards expressly declined to address the trade secrets exception, which also developed at common law. Under the trade secrets exception, a court may enforce an employee non-competition/solicitation agreement that is necessary to protect the former employer’s trade secrets.

Some lower courts have read Edwards’ rejection of the narrow restraint exception as broadly rejecting, or at least casting doubt on, all other non-statutory exceptions to California’s prohibition against non-competition/solicitation agreements, including the trade secrets exception. There is language in Edwards that supports that view. The court held that “[n]on-competition agreements are invalid under section 16600 in California even if narrowly drawn, unless they fall within the applicable statutory exceptions of sections 16601, 16602, or 16602.5.” 189 P.3d 285, 296 (Cal. 2008). The court also noted 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.” Id., at 291-92.

However, because the court in Edwards expressly declined to address the trade secret exception, some federal courts have continued to enforce employee non-competition/solicitation agreements necessary to protect a former employer’s trade secrets, notwithstanding Edwards. Because the trade secret exception to California’s prohibition against non-competes has never been expressly rejected by the California Supreme Court, California employers may argue that for the time being it remains a tool available for them to consider when drafting and enforcing agreements with employees. But employers who go down that path should carefully consider the unsettled case law that has developed regarding this issue in recent years.

Background

California’s prohibition against certain non-competition agreements is codified in Section 16600 of the California Business and Professions Code. Section 16600 provides that “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Cal. Bus. & Prof. Code § 16600. This prohibition applies both to agreements forbidding former employees from engaging in work for a competitor, and agreements with former employees not to solicit the former employer’s customers or clients.

There are three statutory exceptions to California’s prohibition on non-competition/solicitation agreements:

  • any person who sells the goodwill of a business, or all of one’s ownership interest in a business entity, or substantially all of its operating assets and goodwill, to a buyer who will carry on the business may agree with the buyer not to carry on a similar business within a specified geographic area, if the business will be carried on by the buyer (Cal. Bus. & Prof. Code § 16601);
  • upon dissolution of a partnership or dissociation of a partner, such partner may agree not to carry on a similar business within a specified geographic area, if the business will be carried on by remaining partners or anyone deriving title to the business or its goodwill (Cal. Bus. & Prof. Code § 16602); and
  • a member of a limited liability company may agree not to carry on a similar business within a specified geographic area, so long as other members or anyone deriving title to the business or its goodwill carries on a like business (Cal. Bus. & Prof. Code § 16602.5).

In addition to the express statutory exceptions to California’s prohibition against non-competition agreements, courts in California have recognized certain other, limited, exceptions to Section 16600.

One such exception is the “narrow restraint exception,” under which federal courts would enforce non-competition agreements that do not completely prohibit an employee from engaging in his or her profession. The narrow restraint exception permitted non-competition agreements that prevented a party from practicing only a narrow part of his or her profession, rather than completely barring a former employee from engaging in his or her business or trade. For example, in Int'l Bus. Machines Corp. v. Bajorek, 191 F.3d 1033, 1041 (9th Cir. 1999), the Ninth Circuit held that a six-month non-competition provision contained in a stock option agreement did not violate Section 16600 because it excluded defendant from only “one small corner of the market,” and not “from engaging in his profession, trade, or business.”

A second exception is the “trade secret exception,” under which California courts have enforced non-competition agreements which are narrowly tailored to protect the former employer’s trade secrets. The trade secret exception has its roots in the 1958 decision of the California Supreme Court in Gordon v. Landau, 321 P.2d 456, 459 (Cal. 1958). In Gordon, the California Supreme Court reversed a judgment of the trial court after finding that an employment agreement in which a salesman agreed not to solicit his employer’s customers for one year after the termination of employment did not violate Section 16600. The agreement was lawful because it did not prevent the salesman from engaging in his chosen business or any other business; it merely prevented him from using the employer’s confidential customer lists to solicit his clients. Seven years later in Muggill v. Reuben H. Donnelley Corp., 398 P.2d 147 (1965), the California Supreme Court reaffirmed the existence of the trade secret exception by stating that Section 16600 “invalidates provisions in employment contracts prohibiting an employee from working for a competitor after completion of his employment . . . unless necessary to protect the employer’s trade secrets.” Id., at 149. (In Muggill, the court relied on 16600 to invalidate a provision in a retirement plan that provided for the suspension or termination of retirement payments to any retired employee who “enters any occupation or does any act which . . . is in competition with any phase of the business” of the employer.)

Edward v. Arthur Andersen

In 2008, in Edwards v. Arthur Anderson LLP, 189 P.3d 285 (Cal. 2008), the California Supreme Court took up the question of whether to recognize the narrow restraint exception. The court declined to do so, holding that Section 16600 prohibits employee non-competition agreements unless the agreement falls within a statutory exception. Although the Ninth Circuit had recognized the narrow restraint exception, at the time Edwards was decided no reported California state court decision had endorsed that exception. The California Supreme Court viewed it as the exclusive province of the California legislature to relax the “clear” statutory restrictions or create additional exceptions to the rule prohibiting non-competition and non-solicitation agreements. Id., at 288-292. Notably, however, the court acknowledged the trade secret exception by citing Muggill with approval, but expressly declined to address the applicability of that exception to Section 16600. Id., at 289 & n.4.

Since Edwards, federal district courts in California have continued to apply the trade secret exception, or have at least suggested that the exception continues to be viable. For example, in Bank of America v. Lee, 08-CV-05546 CAS(WJX), 2008 WL 4351348, at *5 (C.D. Cal. Sept. 22, 2008), the court granted a preliminary injunction seeking to enforce employment agreements which prohibited the bank’s former employees from using the bank’s trade secrets and other confidential information to contact bank clients and solicit them to transfer their accounts to the former employees’ new employer. The court explicitly held that the “‘trade secret exception’ to § 16600 still applies.” Id., *6. More recently, in Richmond Technologies Inc. v. Aumtech Bus. Solutions, 11-CV-02460-LHK, 2011 WL 2607158 (N.D. Cal. July 1, 2011)the court granted a motion for a temporary restraining order seeking to enforce a non-competition clause finding that if the clause was construed to bar only the use of the plaintiff’s “confidential source code, software, or techniques developed for [plaintiff’s] products or clients, it is likely enforceable as necessary protect [plaintiff’s] trade secrets.” Id., at *19. Other federal courts, including the Ninth Circuit, have continued to acknowledge the existence of the trade secret exception after EdwardsSee Asset Marketing Systems v. Gagnon, 542 F.3d 748, 758 (9th Cir. 2008) (noting that “Cal. Bus. & Prof. Code § 16600 invalidates noncompete contracts unless they are necessary to protect an employer’s trade secrets.”) (citing Edwards); Applied Materials, Inc. v. Advanced Micro-Fabrication Equipment (Shanghai) Co., 630 F. Supp. 2d 1084, 1089 n.7 (N.D. Cal. 2009) (finding that “case law amply supports the existence of” the trade secret exception) (citing Edwards and Bank of America v. Lee).

On the other hand, at least two California state courts post-Edwards have staked out a more restrictive position in response to the question of whether Section 16600 continues to permit non-competition/solicitation agreements that are designed to protect trade secrets. See Retirement Group v. Galante, 98 Cal. Rptr. 3d 585 (Cal. App. 4th 2009); Dowell v. Biosense Webster, 102 Cal. Rptr. 3d 1, 6, 10 (Cal. App. 2d, 2009). In Retirement Group v. Galante, the appellate court reversed a trial-court-issued injunction which prevented the plaintiff’s former employees from soliciting the plaintiff’s current customers. One provision of the injunction—which the defendants did not challenge on appeal—also enjoined the defendant from using information “found solely and exclusively” on plaintiff’s databases. Id., at 1232. According to the court, because the latter provision of the injunction already protected against the defendant’s use of the plaintiff’s trade secrets, the only additional effect of the non-solicitation provision would be only to bar solicitations not involving the use of trade secrets. Therefore, the court found that the non-solicitation requirements were invalid and unenforceable. Id., at 1241. In its discussion, the Retirement Group court stated in broad terms that:

Section 16600 bars a court from specifically enforcing (by way of injunctive relief) a contractualclause purporting to ban a former employee from soliciting former customers to transfer their business away from the former employer to the employee’s new business but a court may enjointortious conduct (as violative of either the Uniform Trade Secrets Act and/or the Unfair Competition Law) by banning the former employees from using trade secret information to identify existing customers, to facilitate the solicitation with such customers, or to otherwise unfairly compete with the former employer.

Id., at 1238 (emphasis in original). Thus, the court that decided Retirement Group was unwilling to enforce any non-solicitation agreement, even one that is narrowly tailored to protect trade secrets. The court would require that the employer rely upon other sources of law to protect those interests.

In Dowell v. Biosense Webster, 102 Cal. Rptr. 3d 1 (Cal. App. 2d, 2009), the court discussed Retirement Group before stating in dicta that the court “doubt[s] the continued viability of the common law trade secret exception to covenants not to compete.” Id., at 11. However, in Dowell, the court did not answer the question of whether the trade secret exception continues to exist. That is because the court found the non-competition and non-solicitation clauses at issue to be overly broad, and not narrowly tailored or carefully limited to the protection of trade secrets. Id. A more recent decision from the Northern District of California adopted the restrictive view that Edwards prohibits all non-statutory exceptions to the prohibition against non-competition agreements, but did so without specifically considering the trade secrets exception. SriCom, Inc. v. Ebislogic, Inc., 2012 WL 4051222, at *5 (N.D. Cal. Sept. 13, 2012) (also dismissing a breach of contract claim based on the alleged violation of a non-solicitation/no-hire provision based on Edwards’ rejection of the “rule of reasonableness”).

Conclusion

The trade secrets exception to California’s prohibition against employee non-competition/solicitation agreements has never been expressly overruled or invalidated by the California Supreme Court. Accordingly, California employers may argue that they continue to have at their disposal employee non-competition/solicitation agreements to use when entering into agreements with employees, if drafted so as to protect the employer’s trade secrets. There are California state appellate courts which have suggested in dicta that they might refuse to enforce employee non-competition/solicitation agreements even if narrowly drafted to protect trade secrets. However, federal courts (including the Ninth Circuit) have made comments that appear to favor enforcement.

Putting aside what courts may do in litigation, employers in California appear to believe there is a valid basis for including customer non-solicitation agreements in their executive employment agreements. Our research of publicly available senior executive employment agreements entered into after Edwardsreflects that public companies continue to include non-solicitation provisions aimed at protecting trade secrets.

Although the trade secret exception will continue to be the subject of future litigation, we anticipate that employers in California will continue to enter into and enforce non-competition/solicitation agreements on the grounds that such agreements are necessary to protect the employers’ trade secrets. Employers who wish to implement such non-competition/solicitation agreements based on the trade secret exception should define their trade secrets with as much precision as possible and ensure their definitions are supportable both legally and factually. For example, to the extent factually supportable in specific cases, employers may seek to include within the scope of trade-secret information their customer lists, vendor lists, product information, financial information and strategic business information. Employers should be aware that California law defines trade secrets as information that “derives independent economic value . . . from not being generally known to the public” and information that “is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.” Cal. Civ. Code § 3426.1(d).

Jeffrey S. Klein and Nicholas J. Pappas are partners at Weil, Gotshal & Manges LLP, where they practice labor and employment law. Daniel J. Vendittian associate in the firm’s Employment Litigation Practice Group, assisted with the preparation of this article.

Reprinted with permission from the December 6, 2013 edition of the New York Law Journal © 2013 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

Legalese