Can California Law on Noncompete Agreements Affect You?

Joel Morhman and Andy Cao
October 8, 2008 — 2,471 views  
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California is known as one of the most difficult places to enforce a noncompete agreement. The California Supreme Court’s recent decision in Edwards v. Arthur Andersen LLP reinforces that reputation. Though Edwards interprets California noncompete law, it carries repercussions for employers outside of California.

Raymond Edwards worked for Arthur Andersen in Los Angeles. Edwards signed a noncompetition agreement prohibiting him from working for and soliciting certain Andersen clients for a period after his termination. The agreement also barred him from raiding Arthur Andersen’s employees on behalf of his next employer. After its indictment and failure after the Enron collapse, Andersen sold Edwards’s practice group to HSBC USA, Inc.

HSBC offered employment to Edwards and required him to sign an agreement terminating his noncompete agreement with Andersen as a condition of that employment. The HSBC termination agreement also required Edwards, among other things, to release Andersen from any claims and cooperate with Andersen in any investigation. Edwards refused to sign the termination agreement, Andersen refused to release Edwards from the noncompetion agreement, and HSBC withdrew its employment offer. Edwards sued Andersen for international interference with prospective economic advantage and anticompetitive practices. Edwards alleged that Andersen’s noncompete agreement was illegal, and thus Andersen’s requirements for a waiver of any claims and for Edwards’s cooperation for his release from the noncompete agreement wrongfully interfered with his prospective employment with HSBC.

California’s noncompete statute states 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.” The statute lists a few exceptions related to the sale of a business. The statute is one of the most strict—if not the strictest—law against noncompetes in the nation. The 9th Circuit Court of Appeals in California—a U.S. federal court—interpreted California’s law to include a “narrow-restraint” exception allowing noncompetes against “only a small or limited part of the business, trade, or profession.”

In Edwards, the California Supreme Court rejected the federal court’s interpretation and reiterated that California’s noncompete statute does not contain a “narrow restraint” exception. Thus, Andersen’s noncompete was illegal, and requiring Edwards to bargain out of it wrongfully interfered with his prospective right to employment from HSBC.

Though the California Supreme Court rejected the narrow restraint exception because the exception did not exist in statute, the court left intact a trade secret exception also not present in statute. California courts, including the California Supreme Court, allow a noncompete agreement if it protects an employer’s trade secrets. California reconciles this exception with the statute’s bright line prohibition against noncompetes by explaining that in protecting trade secrets, a noncompete may restrict how an employee may compete without restricting that employee’s right to earn a living. In other words, a noncompete cannot prevent a former employee from working for a competitor, but it can prevent that employee from using a client list or other trade secret information from his former employer to compete.

Edwards suggests that employers should use the trade secret exception in drafting noncompetes. This means that employers must place more emphasis on identifying their trade secrets, establishing their secrecy, and crafting agreements that protect those trade secrets by barring disclosure or use of those trade secrets. These agreements should focus on prohibiting unfair competition practices rather than restricting subsequent employment.

A trade secret does not need to be highly technical in nature. Customer lists, processes for handling data, or even such low tech tech items as means for manufacturing pencils, have been considered to embody trade secrets. Managers should carefully consider what information their company considers important and determine whether it gives the company an economic advantage, is not generally known outside of the company, and if the company has taken reasonable steps to protect its privacy. If these requirements are met, the information may, in fact, be a trade secret. Nondisclosure agreements are uncontroversial and useful for protecting trade secrets.

It is unlikely that the Edwards decision will start a trend that spreads to other states. California’s noncompete law has long been the strictest while more jurisdictions have moved toward enforcing noncompete agreements. Rather than leading the way, Edwards reinforces California’s status as being the most extreme example of a public policy against noncompetes. The aspect of the Edwards decision that is more generally applicable is the court’s focus on trade secrets. In Texas, for example, enforceability of noncompetes often are tied to the existence of protectable trade secrets. In Light v. Centel Cellular, the Texas Supreme Court stated that noncompetes designed to protect trade secrets could be enforceable. Similarly, courts in other states would likely find noncompetes were reasonable if designed to protect the employer’s intellectual property, such as trade secrets. Therefore, it is wise, where possible, to include language within the noncompete linking the noncompete to the protection of the company’s trade secrets.

If Edwards was a decision by a California court about California law, why should employers across the country care? California jealously guards its public policy against noncompete agreements and asserts it in any situation that implicates California. For example, the Application Group, Inc. v. Hunter Group, Inc. case involved a Maryland company (Hunter) and its employment of a Maryland resident (Pike). Pike had a noncompete with Hunter. During Pike’s tenure with Hunter, Pike never set foot in California. Hunter had other employees residing in California, and those California employees did not have noncompete agreements. In fact, Hunter tailored its employment agreements to the noncompete laws of each state in which it operated. Application Group, Inc. (AGI) hired Pike away from Hunter, and away from Maryland,  to work for AGI in California. Hunter’s noncompete agreements contained choice-of-law provisions selecting Maryland. AGI and Hunter agreed that under Maryland Law Pike’s noncompete agreement would be enforceable.

Despite all this, when AGI reached into Maryland, recruited Pike, and brought her back to California, the California court held that Hunter’s noncompete with Pike was void. Even though Pike’s noncompete with Hunter pertained to employment in Maryland, and at the time of formation, neither party anticipated anything implicating California or its law, the California court discarded the choice-of-law provision and imposed California noncompete law on the agreement. The California court discounted the importance of the fact that Maryland “was the place where the contract was negotiated, entered into and performed, as well as the domicil, residence, nationality, place of incorporation and place of business of the parties to the contract.”

When combined with Application Group, Inc., it is clear that Edwards affects employment practices nationally, not just in California. Edwards reiterates that noncompete agreements are very difficult to enforce in California. Additionally, any attempt to enforce a noncompete in California could make the employer liable for tortious interference, as in Edwards. As shown by Application Group, Inc., California’s aggressiveness in imposing this policy can catch employers on the opposite coast by surprise. Even if the employer and employee take every step to avoid California law and comply with local law, and even if applying California law was not part of the parties’ bargain, California can still inject itself into a foreign employment through no action of the employer. Not only that, but the new employer’s unilateral action bringing California law into the scenario can also expose the former employer to liability for tortious interference.

The court in Application Group, Inc. suggested that Hunter imagine into every one of its noncompete agreements the phrase, “void in California.” And that may be the lesson Edwards has for employers nationwide. Today’s business environment pays little attention to state borders. The internet has turned sales territories into anachronisms, and technology allows today’s employees to be more mobile than ever. Sooner or later, the flow of business will bring even a Maryland company into California, and when it does, all the carefully crafted noncompete agreements may as well say, “void in California.” Regardless of the jurisdiction, noncompete agreements are more likely to be enforced when they are designed to protect an employer’s trade secrets, such as by requiring nondisclosure. Even California recognizes that trade secrets are worthy of protection against former employees.

There are a number of lessons from the Edwards decision that your company can use.  First, know which law will apply to a noncompete agreement that you believe would be beneficial to the company. Second, make sure that the noncompete is protecting legitimate interests, such as trade secrets, rather than simply trying to stifle competition. Third, tailor the noncompete to the jurisdiction or jurisdictions you think might apply their law to the noncompete. Fourth, have the noncompete only restrict those activities that are absolutely necessary. Overbroad noncompetes seldom find favor with courts.  If a company obeys these basic precepts, all of which are evident in the analysis in the Edwards case, it is much more likely to have its noncompetes held to be enforceable in court.

Joel W. Mohrman is a member of McGlinchey Stafford in its Houston office.  He is Board Certified in Civil Trial Law by the Texas Board of Legal Specialization and the National Board of Trial Advocacy.  He heads McGlinchey Stafford’s Intellectual Property litigation group and has litigated covenant not to compete and trade secret cases for 28 years.

Andy Cao is an associate of McGlinchey Stafford in its Houston office. His practice focuses on business litigation and has handled trade secret cases at all phases including trial. Andy’s experience with noncompete agreements includes drafting and advising all the way to jury trial and appeals. He represents and advises employers, former employees, and subsequent employers on noncompete agreements.

Joel Morhman and Andy Cao

McGlinchey Stafford