Several recent court decisions have effectively eliminated the lawful use of non-compete and non-solicitation agreements in California except in certain limited circumstances. Those decisions recognize that California law favors open competition and freedom for employees to move from employer to employer. However, this does not mean employers must accept the risk of employees taking their valuable information and resources to the competition.
A non-compete agreement is a contract in which one party agrees not to compete with the other. If the parties are both independent business entities, a non-compete agreement is an unlawful restraint of trade, like a monopolistic practice, prohibited by the anti-trust laws. For example, several tomato growers and processors in the Central Valley were recently criminally indicted for allegedly agreeing to fix prices. The same logic applies to individual employees—the economy benefits from the competition that results when employees are free to practice their professions.
A non-solicitation agreement is an agreement in which one party agrees not to contact the customers of the other party to solicit business. Employers often ask employees to sign non-solicitation agreements so that when the work relationship ends, the employees cannot contact former clients to try to solicit business away from their former employers. Older court decisions implied that some non-solicitation agreements were enforceable, despite the potential effect of such an agreement on an individual’s ability to practice his or her profession. Recently, however, courts have subjected non-solicitation agreements to the same analysis as non-competition agreements, and also found them to be illegal in most cases because they act as a restraint on trade.
So, if an employer cannot protect itself through non-competition and non-solicitation agreements in California, are there any alternatives? The short answer is “yes.”
Protecting Valuable Information
Sir Francis Bacon, the English philosopher, attorney, and scientist, famously commented in 1597 that “knowledge is power.” In years since, businesses have learned that their success and ultimate viability often depends on protecting their confidential and proprietary information. That is relatively simple when the intellectual property can be protected by copyright, trademark, or patents. However, not all valuable information is subject to those protections. Marketing information, for instance, such as a highly specialized client list of “key players” in a particular industry, can be extremely valuable to a supplier, but is not the kind of information that can be copyrighted, trademarked, or patented.
The need to protect information is greater now than in Bacon’s time because employees are more mobile than ever. Employers often must share valuable information with employees. They take the risk that employees will simply walk away and take the information to a competitor. Unfortunately, as mentioned above, non-competes are not the answer to this problem in California.
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.” Courts have applied this statute to invalidate non-compete agreements in various forms. Employers have argued for implied exceptions to section 16600 similar to those that exist in other states, such as the “rule of reason.” Under the “rule of reason,” a non competition agreement is enforceable if it is limited to a small geographic area or a short period of time. In Edwards v. Arthur Anderson, LLP, the California Supreme Court stated that it will not infer exceptions to California’s rule against non-competes, so no “rule of reason” applies here.
Some employers have attempted to avoid the prohibition on non-compete agreements by arguing that the rule should not apply when “trade secrets” are at issue. Trade secrets include information that is valuable, protected from disclosure by the owner of the information, and derives economic value from being secret. Many courts have held that customer lists can be protected as trade secrets, and therefore, former employees may be prohibited from using that information to solicit customers.
Notably, last year, the California Court of Appeal held in The Retirement Group v. Galante that the existence of a trade secret itself is not an exception to section 16600. In other words, as the court stated in Galante, “it is not the solicitation of the former employer’s customers, but is instead the misuse of trade secret information, that may be” prohibited. So, non-solicitation agreements must now be tied to the protection of trade secrets, and not simply blanket prohibitions on solicitation.
After Galante, employers may still require employees to sign non-disclosure and confidentiality agreements that restrict employees from using trade secrets. An enforceable non-disclosure agreement will put employees on notice that they have access to the employer’s confidential information, including trade secrets, and the employee may only use the information for the employer’s benefit. Every non-disclosure agreement should be tailored as closely as possible to the employee’s actual responsibilities and the information to which he or she actually has access.
Beyond Trade Secrets äóñ Employees’ Duty of Loyalty
There is, then, some good news for employers who want to protect trade secrets. But what about other information and resources? They may be protected by the duty of loyalty. Section 16600 does not allow employees to transfer their loyalty to a competitor during the term of employment. Simply put, employees owe their undivided loyalty to their current employer. As the U.S. Supreme Court has observed, “there is no more elemental cause for discharge of an employee than disloyalty to his employer.”
One area where the duty of loyalty comes up is business leads. Under California Labor Code section 2863, “[a]n employee who has any business to transact on his own account, similar to that entrusted to him by his employer, shall always give the preference to the business of the employer.” If an employee uses work time and company resources to divert business to a new employer or to her own venture, the employee can be sued, sometimes for millions of dollars.
In Oaktree Capital Management, L.P. v. Bernard, the California Court of Appeal ruled that section 16660 did not prevent a claim against a former employee for breach of his fiduciary duty. In that case, the former employee managed a real estate hedge fund for Oaktree. Prior to leaving the firm, the employee gathered certain information to take to his new venture, including identifying certain property as an investment opportunity. He then made an offer to purchase the property using Oaktree’s name and financial clout, without Oaktree’s permission, and with no intention of actually purchasing the property for Oaktree. Instead, he opened his own firm and took the investment opportunity for himself.
After Oaktree sued the former employee, an arbitrator found that “the obvious conclusion is that [the ex-employee] was stalling the launch of [a new investment fund at Oaktree] so that he could deflect possible investment sources to the new entity he was forming.” Consequently, he not only used Oaktree’s resources for his personal benefit, but he did not give Oaktree his best efforts during his employment. Accordingly, the ex-employee owed Oaktree $12.3 million in lost management fees, and $6.7 million in attorneys’ fees.
A Limited Exception to the Duty of Loyalty: “Preparing” to Compete
Despite the protections afforded to employers under the duty of loyalty, employees are allowed to “prepare” to compete. The California Supreme Court explained this concept in a 1966 case, Bancroft-Whitney Co. v. Glen.
There, a publisher hired its competitor’s president. Prior to joining the new organization, the president helped the new employer to identify employees for potential hire and provided the new employer with those employees’ salaries and other strategic information. The Court explained that the “mere fact that the officer makes preparations to compete before he resigns his office is not sufficient to constitute a breach of duty. It is the nature of his preparations which is significant. No ironclad rules as to the type of conduct which is permissible can be stated, since the spectrum of activities in this regard is as broad as the ingenuity of man itself.” Because the president was an officer of the company and a fiduciary, however, the court found that his actions were unlawful and the former employer could pursue a claim against him for breach of loyalty.
More recently, in Stokes v. Dole Nut Co. , two employees developed a tree-nut processing business that competed with their current employer, Dole. When Dole found out about the new venture, it fired the employees. Ironically, the employees sued Dole, claiming there was not good cause for their termination. The court disagreed, ruling that the employees deserved to be fired because “an employer has the right to expect the undivided loyalty of its employees. The duty of loyalty is breached . . . when the employee takes action which is inimical to the best interests of the employer.”
Of course, what is “inimical to the best interests of the employer” will vary from case to case. It is difficult to say how far employees may go in “preparing” to compete. But courts have found that employees who visited each client on a sales route and solicited business for a new employer, developed competing products in their basement labs while still employed, used staff to produce schematics of the employer’s top secret devices to take to a new venture, or copied the former employer’s contracts and construction specifications all violated the duty of loyalty and were subject to liability.
Reeves v. Hanlon, a 2004 decision, provided a twist to the analysis. There, the California Supreme Court seemingly approved the practice of employees using a former employer’s client list to “merely announce a new business affiliation, without more.” Of course, the “without more” language can be the subject of heated litigation. For that reason, most lawyers advise departing employees to announce nothing more than the address and telephone number of their new office. Even sending a website address with an announcement can appear to be an unlawful use of the employer’s customer list and computer systems if the website promotes the new employer’s business.
California law limits employers’ control over individual employees after the employment relationship ends. Because non-compete agreements generally are not enforceable in California, employers should focus on preventing the disclosure of information and double-dealing by employees by carefully drafting confidentiality and non-disclosure agreements that are appropriate in scope and taking all reasonable steps to protect their valuable information.