California Law on the Validity of Non-Compete Agreements

May 9, 2006 | By: Michael J. Hassen

Scope of California Business & Professions Code Section 16600

As businesses increasingly seek to hire the key employees of their competitors, the differences in state laws concerning non-compete agreements and protection of trade secrets has become more important. In California, the general rule is that non-compete agreements are unenforceable. That statement, however, is an oversimplification. In fact, non-compete agreements are enforceable in California under the right circumstances.

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.” The California Supreme Court has held that that “[t]his section invalidates provisions in employment contracts prohibiting an employee from working for a competitor after completion of his employment or imposing a penalty if he does so [citations], unless they are necessary to protect the employer’s trade secrets [citation]. Muggill v. Reuben H. Donnelley Corp., 62 Cal.2d 239, 242 (1965) (italics added). (California’s Uniform Trade Secrets Act may be found at Civil Code section 3426.1.)

Despite the sweeping language utilized by some courts, the exception to the statutory prohibition against non-compete agreements is actually read expansively. In fact, several cases hold that the “trade secret” exception encompasses any act that may be considered “unfair competition.” Thus, one appellate court recently held that Section 16600 “prohibits the enforcement of [a] noncompete clause except as is necessary to protect trade secrets,” Metro Traffic Control, Inc. v. Shadow Traffic Network, 22 Cal.App.4th 853, 860 (1994) (citing Muggill, 62 Cal.2d at 242), but then explained:

“Any attempt to restrict competition by the former employee by contract appears likely to be doomed under section 16600 of the Business and Professions Code, unless the restriction is carefully limited and the agreement protects merely a proprietary or property right of the employer recognized as entitled to protection under the general principles of unfair competition.”

Metro Traffic, 22 Cal.App.4th at 861 (citation omitted, italics added).

Metro Traffic did not enforce the non-compete agreement because it was not designed to protect trade secrets or other confidential or proprietary information. Rather, Metro Traffic involved the efforts of a traffic reporting service to enjoin its reporters from working for a competitor. The Court rejected the noncompete agreement because the “trade secret” consisted of nothing more than “the personal qualities of the announcers, not the information related to them.” Metro Traffic, 22 Cal.App.4th at 862. Indeed, the Court characterized Metro’s description of its trade secrets as “nothing more than a ‘job classification’ for radio traffic announcers.” Id. at 862-63.

In holding that an employee cannot be fired for refusing to execute a particular noncompete agreement, another court recently acknowledged, “it is true that a covenant not to compete will not be viewed as a violation of section 16600 if it is ‘necessary to protect the employer’s trade secrets’ (Muggill v. Reuben H. Donnelley Corp., supra, 62 Cal.2d at p. 242 . . .), and . . . it is true that employers have the right to protect proprietary and property rights which are subject to protection under the law of unfair competition (Metro Traffic Control, Inc. v. Shadow Traffic Network, supra, 22 Cal.App.4th at p. 861 . . .),” D’Sa v. Playhut, Inc., 85 Cal.App.4th 927, 935 (2001) (italics added).

Almost 30 years ago, another court explained it this way:

Covenants not to compete have been the subject of a considerable amount of attention from legal writers and courts. The number of texts, treatises and judicial opinions that have been written in the field constitute a “sea vast and vacillating, overlapping and bewildering” and the sheer volume can “drown the researcher.” [Citations.]

A few generalizations, however, can be stated. . . . Enforceability appears to rest on a notion, often unarticulated, of preventing “unfair” competition.

[¶] . . . [¶] In brief at common law a restraint against competition was valid to the extent it reasonably provided for the protection of a valid interest of the covenantee. [Citations.] . . .

Monogram Indus., Inc. v. Sar Indus., Inc., 64 Cal.App.3d 692, 697-98 (1976) (italics added).

Much more recently, in upholding a preliminary injunction issued in favor of an employer against an employee that prohibited the employee from soliciting the employer’s employees and customers, and from using or disclosing the employer’s trade secrets, an appellate court explained,

“While it has been legally recognized that a former employee may use general knowledge, skill, and experience acquired in his or her former employment in competition with a former employer, the former employee may not use confidential information or trade secrets in doing so.” (Morlife, Inc. v. Perry (1997) 56 Cal.App.4th 1514, 1519, 66 Cal.Rptr.2d 731.) This is precisely what [the employee] Cotton attempted to do and there remains the threat he will do so in the future if not enjoined. We acknowledge the important legal right of persons to engage in businesses and occupations of their choosing. However, we also recognize that, fundamental to the preservation of our free market economic system, there is “the concomitant right to have the ingenuity and industry one invests in the success of the business or occupation protected from the gratuitous use of that ‘sweat-of-the-brow’ by others.” (Morlife, [at 1520].)

ReadyLink Healthcare v. Cotton, 126 Cal.App.4th 1006, 1017 (2005) (italics added).

ReadyLink has excellent language in it for the employer seeking to enforce a non-compete agreement. For that example, the opinion holds that, “The court may also enjoin the use or disclosure of trade secrets under the unfair competition provisions, particularly Business and Professions Code section 17203, which provides for injunctive relief against ‘[a]ny person who engages, has engaged, or proposes to engage in unfair competition. . . .’” Id., at 1018 (footnote omitted).

ReadyLink explains that an employee may be enjoined from competing irrespective of the existence or validity of a noncompete agreement:

. . . In John F. Matull & Associates, Inc. v. Cloutier (1987) 194 Cal.App.3d 1049, 240 Cal.Rptr. 211, the court upheld a covenant not to compete for five years after the defendant, who had been an employee and officer of the plaintiff firm, left the firm. The court concluded the covenant did not violate Business and Professions Code section 16600 to the extent it sought to prevent use of the firm’s confidential information to compete and solicit the firm’s labor-relations clients. Business and Professions Code section 16600 prohibits contracts restraining employees from engaging in a lawful profession. Misappropriation of trade secret information constitutes an exception to section 16600.

While we need not consider ReadyLink’s contract claim since there is sufficient evidence ReadyLink will prevail on its trade secret misappropriation claims, we note that “[I]f a former employee uses a former employer’s trade secrets or otherwise commits unfair competition, California courts recognize a judicially created exception to section 16600 and will enforce a restrictive covenant in such a case.” (Scott v. Snelling and Snelling, Inc. (1990) 732 F.Supp. 1034, 1043, citing Hollingsworth Solderless Terminal Co. v. Turley, supra, 622 F.2d at p. 1338; see also D’Sa v. Playhut, Inc. (2000) 85 Cal.App.4th 927, 934, 102 Cal.Rptr.2d 495; Trans-American Collections, Inc. v. Continental Account Servicing House, Inc. (1972) 342 F.Supp. 1303 [This section does not apply to a covenant not to compete if the covenant is necessary to protect trade secrets, including customer lists].) Furthermore, injunctive relief is proper under the tort of misappropriation of trade secrets even without an enforceable confidentiality or nondisclosure agreement. (Klamath-Orleans Lumber, Inc. v. Miller (1978) 87 Cal.App.3d 458, 465-466, 151 Cal.Rptr. 118.)

Regardless of the legality of ReadyLink’s noncompetition and nondisclosure agreements Cotton signed while working at ReadyLink, there is sufficient evidence supporting the trial court’s finding that ReadyLink was likely to prevail on its misappropriation of trade secrets claims and thus injunctive relief was appropriate.

ReadyLink, at 1021-22 (italics added).

The bottom line is that employees still are bound to honor the confidentiality of their former employers’ trade secrets when they exercise their right to work for a competitor:

Case law provides that the terms of Business and Professions Code section 16600 do not invalidate an “employee’s agreement not to disclose his former employer’s confidential customer lists or other trade secrets or not to solicit those customers.” (Loral Corp. v. Moyes (1985) 174 Cal.App.3d 268, 276 [219 Cal.Rptr. 836].) Thus, while the statute invalidates agreements which penalize a former employee for obtaining employment with a competitor, it does not necessarily affect an agreement delimiting how that employee can compete. (Ibid.) Similarly, a former employee may engage in a competitive business for herself and compete with her former employer, provided such competition is fair and legal. (Rigging, Internat. Maintenance Co. v. Gwin (1982) 128 Cal.App.3d 594, 600 [180 Cal.Rptr. 451].) “A former employee’s use of confidential information obtained from [her] former employer to compete with [her] old employer and to solicit the business of [her] former employer’s customers is regarded as unfair competition.” (Ibid.)

John F. Matull & Assoc., Inc. v. Cloutier, 194 Cal.App.3d 1049, 1054-55 (1987) (italics added).

Another useful case for employers is Courtesy Temporary Service, Inc. v. Camacho, 222 Cal.App.3d 1278 (1990). The Courtesy court reversed the trial court’s denial of a preliminary injunction because of the “substantial time, effort, and expense” incurred in developing the employer’s customer list, which it deemed trade secret. Id., at 1287. The Court held at page 1288,

Here, the evidence established that Courtesy’s customer list and related information was the product of a substantial amount of time, expense and effort on the part of Courtesy. Moreover, the nature and character of the subject customer information, i.e., billing rates, key contacts, specialized requirements and markup rates, is sophisticated information and irrefutably of commercial value and not readily ascertainable to other competitors. Thus, Courtesy’s customer list and related proprietary information satisfy the first prong of the definition of “trade secret” under section 3426.1.

California recognizes, then, that trade secrets can relate to “marketing and sales” just as easily as they can relate to “manufacture and production.” See e.g., Sentex Systems, Inc. v. Hartford Acc. & Indem. Co., 93 F.3d 578, 580 (9th Cir. 1996).[1]

Taken back to its roots, the Sentex case an insurance coverage dispute between an insurer and insured arose out of an action by an employer (ESSI) against a former employee for violating a non-compete agreement by joining a competitor (Sentex) and “using confidential information and trade secrets to promote and advertise Sentex’s products to ESSI’s customers.” Sentex Systems, Inc. v. Hartford Acc. & Indem. Co., 882 F.Supp. 930 (C.D. Cal. 1995), aff’d, 93 F.3d 578 (9th Cir. 1996), disagreed with by Simply Fresh Fruit, Inc. v. Continental Ins. Co., 84 F.3d 1105 (9th Cir. 1996), opn. amended and superseded by 94 F.3d 1219. Specifically, ESSI alleged that its former employee, and Sentex through the former employee, “misappropriated ESSI’s ‘trade secrets and other confidential information’ including ‘customer lists, methods of bidding jobs, methods and procedures for billing, marketing techniques, and other inside and confidential information’” and that he “used ESSI’s trade secrets to promote and advertise Sentex’s products and to solicit business from ESSI’s customers.” 882 F.Supp. at 935. Sentex ultimately paid ESSI to settle the lawsuit, and Sentex then pursued an action against its insurer.

The reason sales and marketing information may be deemed trade secret is explained plainly in In re Adobe Systems, Inc. Securities Litigation, 141 F.R.D. 155 (N.D. Cal. 1992), a case discussing whether certain documents produced in discovery and marked “confidential” pursuant to a protective order should un-designated. In analyzing the issue, the Adobe court held that “protected information” may include “proprietary and technical information, financial information and business strategy or marketing information which, if revealed to a competitor, would put a company at a competitive disadvantage.” Id., at 158. The Court later explained,

Many of the documents produced to plaintiffs contain sensitive information regarding Adobe’s business and marketing strategy which, if made public, will educate Adobe’s competitors as to how Adobe conducts its business and what its future plans are. Many of these documents are forward-looking and therefore remain sensitive even though they were created one or two years ago.

Information about the Application Products Division would educate competitors regarding Adobe’s marketing success or the lack.

OEM (Original Equipment Manufacturers) Revenues would adversely impact Adobe’s negotiating leverage in areas of royalty rates, product development and strategic alliances.

Adobe, at 162 (italics added). Information about a company’s customers, and the customers’ “strategic relationship” with the company, also warrants protection. See id., at 163.

An employer also may be confronted with a situation in which the employee may have started “working” for a competitor before formally leaving the company. The law in this regard is clear: “While California law does permit an employee to seek other employment and even to make some ‘preparations to compete’ before resigning [citation], California law does not authorize an employee to transfer his loyalty to a competitor. During the term of employment, an employer is entitled to its employees’ ‘undivided loyalty.’ [Citation.]” Fowler v. Varian Associates, Inc., 196 Cal.App.3d 34, 41 (1988).

In addition to the “implied conditions of loyalty to an employer which the law imposes on an employee,” Dana Perfumes, Inc. v. Mullica, 268 F.2d 936, 937 (9th Cir. 1959), Batra owed heightened duties to Estée Lauder.

A director, officer, or employee who, by reason of his relationship to his corporation, acquires trade secrets of his employer during his employment, cannot thereafter use nor disclose to another his employer’s secret to the detriment of his employer.

Diodes, Inc. v. Franzen, 260 Cal.App.2d 244, 251 (1968) (citations omitted). As the United States Supreme Court recognized, “There is no more elemental cause for discharge of an employee than disloyalty to his employer.” (N.L.R.B. v. International Brotherhood of Electrical Workers (1953) 346 U.S. 464, 472, 74 S.Ct. 172, 176, 98 L.Ed. 195.)

An employer must keep in mind that regardless of the apparent strengths or weaknesses of a particular case, “The law is well settled that the decision to grant a preliminary injunction rests in the sound discretion of the trial court.” ReadyLink, 126 Cal.App.4th at 1016 (citations and internal quotations omitted).

[1] “ESSI’s complaint against Sentex alleged that Sentex had obtained from Colombo ‘knowledge, information and trade secrets, including customer lists, methods of bidding jobs, methods and procedures for billing, marketing techniques, and other inside and confidential information….’ In subsequent depositions, ESSI’s president testified that the company was contending there had been a misappropriation of trade secrets for use in Sentex’s sales materials. Although ESSI’s president disclaimed having seen its trade secrets in Sentex’s written sales materials, he testified that the information was used to market Sentex products in other ways. In this day and age, advertising cannot be limited to written sales materials, and the concept of marketing includes a wide variety of direct and indirect advertising strategies. It is significant that ESSI’s claims for misappropriation of trade secrets relate to marketing and sales and not to secrets relating to the manufacture and production of security systems.” Sentex, 93 F.3d at 580 (italics added) (citation omitted).

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