The Competing Interests of Employee Covenants

The current recession has lead to a historic exodus of workers from the workforce. In addition, competition is as heated as ever due to shrinking consumer demand. As a result, the use of employment agreements and termination agreements has been at an all time high. One type of provision in employment agreements that is often used to prevent employees from becoming competitors and/or improperly usurping company trade secrets is the covenant “not-to- compete.” These provisions have been used for decades and have been included in contracts either at the inception of employment, during employment (pursuant to a raise or promotion) or at termination typically as part of a severance package.

As California is known as an “employee-friendly” state, covenants not to compete are generally not enforceable as the restrictions imposed on employees “compete” with the public policy of encouraging people’s ability to be employed and move freely in the marketplace. However, as discussed fully below, with limited and appropriate geographic and time restrictions, covenants may be enforceable if drafted carefully in accordance with the law.

Covenants Not to Compete Are Generally Void Unless An Exception Applies
The general law against covenants not to complete is found in Business & Professions Code § 16600, which voids any employment contract which restrains anyone from engaging in a lawful profession, trade or business.

The term “restrain” in Bus & Prof Code § 16600 applies not only to prohibitions on engaging in a profession, trade or business, but also to limitations on an employee’s ability to practice his or her vocation. Edwards v. Arthur Anderson LLC (2008) 44 Cal.4 th 937, 946.

Using an invalid covenant to prevent former employees from obtaining employment by a competitor may be actionable as an Unfair Business Practice under Bus & Prof Code § 17200.

Exceptions to The Rule
There are several exceptions to the general rule against covenants not to compete. One exception is where the covenant is necessary to protect the employer’s trade secrets. D’sa v. Playhut, Inc.(2000) 85 Cal.App.4 th 927, 935. However, this exception is applied in a limited manner as the employer will only be able to restrain by contract that conduct of the former employee that would have been subject to judicial restraint under the law of unfair competition (namely the Trade Secrets Act and the Unfair Competition Law). Retirement Group v. Galante (2009) 176 Cal.App.4 th 1226, 1234.

A covenant not to work for someone else (negative covenant) in a personal services contract may also be enforceable (and breach may be enjoined) where – the employee’s services are of a “special, unique, extraordinary or intellectual character” giving the employee’s promise “peculiar value” the loss of which cannot be adequately compensated in damages and the employees compensation exceeds a statutory minimum ($9,000 for the first year, $12,000 for the second, $15,000 for the third). Cal Civil Code 3423(e); MCA Records, Inc. v. Newton-John (1979) 90 Cal.App.3d 18, 23.

With respect to owners, shareholders and partners of a business, covenants not to compete may be enforceable under Bus & Prof Code §§ 16601 – 16602 in the following situations:

    1. Anyone selling the goodwill of a business;
    2. A shareholder selling or otherwise disposing of all of his shares in a corporation;
    3. A shareholder that sells all or substantially all of his operating assets and good will; or
    4. A partner upon dissolution of the partnership, the partner’s withdrawal from the partnership or disposition of the partner’s interest.

Under the second exception listed above, although the statute does not expressly state, such covenants are valid only when the shareholder’s sale is of a substantial interest in the corporation so that the shareholder can be said to transfer his interest in the corporation’s goodwill. Bosley Med. Corp v. Abramson (1984) 161 Cal.App.3d 284, 290. There must be a clear indication that the parties valued or considered goodwill as a component of the sales price. Hill Med Corp. v. Wycoff(2001) 86 Cal.App.4 th 895, 903. The parties need not have allocated a specific portion of the price to goodwill, so long as it appears that goodwill was part and parcel of the transaction involving a substantial corporate interest. Id. at 904.

Under the fourth exception discussed above, a partner may agree, upon dissolution or withdrawal from the partnership or transfer of his interest, not to carry on a similar business within a specific area where the partnership business has been carried on, so long as every other member carries on a like business thereon. Business & Professions Code 16602. The goodwill requirements do not apply to this partnership exception. Hill Med Corp. v. Wycoff (2001) 86 Cal.App.4 th 895, 907-08.

Covenants Not to Compete Must Be Reasonable In Scope
If a covenant not to compete falls under a specific exception, to be enforceable, it must also be reasonable in scope – it must be reasonable and necessary to protect the buyer’s interest in terms of duration, activity and territory. Monogram Industries, Inc. v. Sar Industries, Inc. (1976) 64 Cal.App.3d 692, 698. A “rule of reason” applies in evaluating non-compete agreements and the restraint will be upheld “to the extent necessary for the protection of the covenant.” Howard v. Babcock , (1993) 6 Cal.4 th 409, 416. Duration: The reasonableness of the duration varies and depends on the employer, employee and the public. Loral Corp v. Moyes (1985) 174 Cal.App.3d 268, 279. Unlimited duration has been held reasonable in some cases.

Territory: Covenants are enforceable if limited to the specific geographic areas in which the business sold was carried on. “Carried on” refers to any place where business was conducted including production, promotion, marketing and sales. Monogram Indus., Inc. v. Sar Indus, Inc.,(1976) 64 Cal.App.3d 692, 702. The area is at least as broad as the area where goodwill of the business has been established. Alliant Ins. Services, Inc. v. Gaddy (2008) 159 Cal.App.4 th 1292, 1301.

As terminated employees are encountering greater difficulties finding employment, they will resort to desperate measures including misappropriating confidential trade secrets of their former employers in addition to becoming more litigious. Now, more than ever, employers must be alert in avoiding future problems and pitfalls in dealing with employment agreements.

Employers who are considering using covenants in employment contracts or who are seeking an analysis of the enforceability of their existing covenants should consult competent legal counsel who can access the employer’s specific situation and advise the employer accordingly.

Gregory G. Brown, Certified Trial Specialist
Brown & Charbonneau, LLP