JANUARY 3, 2003 UPDATE:
Recent cases in California in the last few months have indicated that restrictions on competition long held illegal in California may be allowed if the contract stems from another State and that State's law allows it.
The matter is not finally decided in California, but if this is an issue of importance to you, be sure to call our office and determine the current state of the law.
A common desire of a business is to restrict its current managers and employees, ex-employees and exprinciples from entering into direct competition with the company both during and after their employment or ownership of the company. Such a desire is certainly understandable. Employees and owners share access to trade secrets, customer lists, methods and procedures often developed by a company over the years. Further, they often have direct access to customers and/or suppliers and have built up business relationships, while on company time, that would be of extreme value to a competitor. The more active and valuable an employee, the more dangerous that employee may be if working for a competitor.
Nevertheless, California law severely restricts the ability of a company or the ability of a contract to limit the right of an exemployee to compete. The reason is simple: competition among companies is encouraged by anti trust laws and any contracts or activities which restrict competition are discouraged by the courts. All things being equal, no one may be restricted in his or her ability to compete under California law.
There are several instances in which competition may be restricted by an ex employer, however, and in all cases trade secrets may not be misappropriated by an exemployee and utilized for his or her benefit or the benefit of the next employer.
It shall be the purpose of this article to describe what competition may be prohibited and what contractual documents may be created to protect an employer or exemployer.
Remember, a contract which illegally restricts competition is void and may not be enforced: clauses created that legally restrict competition must be carefully crafted or they may do more harm than good.
TRADE SECRET PROTECTION VERSUS RESTRICTIONS ON COMPETITION
It is vital to differentiate between protection of trade secrets,which is allowed uniformly in California, from restrictions on competition, which are allowed only in quite limited circumstances.
Trade secrets are defined as business or other information that is not generally known to the public or competitors, is discovered or developed by a company which takes steps to keep it confidential, and which is of value to a company in its present or future operations. Such types of information may be varied but includes methods and procedures, secret customer lists, plans for marketing or promotion, formulas, manufacturing processes, pricing information, budgeting information, structural information, etc, etc. It is, quite simply, what a company keeps secret and helps it in its business.
Restrictions on Competition are contractual efforts by a company or person to stop a person from either competing or helping a competitor to a company.
Obviously, protection of a trade secret can have the indirect effect of hurting competition, but contractual protection of trade secrets are fully allowed by the law both in terms of upholding contracts that restrict revealing or use of trade secrets and allowing legal action against someone who illegally uses a trade secret. Thus, the courts freely allow protection of trade secrets regardless of the effect on competition.
But the courts do not freely allow restrictions on competition and it is up to the party seeking to restrict competition to prove to the court that such restriction may be legally enforced since it falls within one of the categories described later in this article.
This article shall not discuss trade secrets and means to protect them. That is discussed in detail in other articles. Instead, this article shall discuss what competition may be restricted and how.
RESTRICTIONS ON COMPETITION FOR EXISTING EMPLOYEES, DIRECTORS AND OFFICERS
It is entirely legal to restrict competition of existing employees and officers and directors of a company. Indeed, the law imposes on all of these categories a "DUTY OF LOYALTY" which restricts them from taking any action which would harm the company, including assisting a competitor in any way. Thus, any secret work or assistance for a competitor by an employee, either for oneself or for another entity, would allow the current employer to both terminate the employee and seek legal relief for damages caused. Indeed, the competitor using the services of the employee may be liable to the wronged employer if it knowingly sought to obtain secret information from the employee.
This duty of loyalty extends to officers and directors of the company as well. Any potential "CONFLICT OF INTEREST" must be fully disclosed to the company and the officer or director may be compelled to resign if the conflict is not consented to by the company and may be personally liable for any damages the conflict of interest caused. Owners, who are not active in the company, and who do not own a majority of the shares, are not so restricted though their attendance at shareholder meetings or receipt of confidential information may result in allegations of improper use of trade secrets. It is wise for any owner to disclose to the company such conflict of interest and avoid access to confidential information.
It is also vital for any director or officer of a company to fully disclose any conflict of interest that may result in assisting a competitor of a company. Such disclosure should be in writing and updated from time to time if circumstances alter.
A typical area of dispute occurs when a company has an employee or officer who is considering starting or joining a competing company but has not yet made up his or her mind. The question arises as to when the conflict of interest begins: when must an employee or officer reveal that such plans are underway and offer to resign his or her position?
The courts have generally held that it is a question of fact based on the circumstances inherent in each particular situation but certain guidelines may certainly be set.
1. Very general preliminary planning, such as discussions with possible coowners or potential employers, does not, in itself, violate the duty of loyalty. (Of course, this assumes no revealing or use of trade secrets which is always prohibited, both before and after employment.)
2. However, soliciting of current employees or customers is certainly a violation of the duty of loyalty, as is seeking to obtain access to confidential information for later use, or taking concrete steps to start or join the new business, such as renting new space, setting up new programs, beginning to fashion marketing materials, etc. Common sense is the test here: ultimately, a jury of twelve persons will have to decide if the employee has gone too far, if the efforts constitute a violation of the duty of loyalty. A good basic test: if it goes beyond general strategic planning to actual implementation of the plan to compete, it is time to terminate your employment or directorship.
3. Above all, the day the new company begins operations, or the moment the employee gives advice, information, or assistance to the competitor, that employee or director must be entirely separated from the prior company or the duty of loyalty is breached and the past employer may sue the exemployee...and even the new employer if trade secrets were involved
It is important to be realistic when starting a competing business or beginning work for a competitor. Such action invariably annoys or outrages the prior employer (and sets a dangerous precedent for the new employer to consider) and by far the best method is to terminate the relationship with the old employer, with full disclosure of future plans, as soon as possible. This may eliminate some of the anger and feelings of betrayal of the old employer and avoid its fear that trade secrets were stolen. Carefully planned, it may even result in the old employer feeling that such a move is not necessarily destructive and this writer has known several circumstances in which the old employer gave his blessings to the new company, feeling he was a mentor to the new company.
It is true that often the old employer, angry, will seek to aggressively punish the "betrayal" by competing as hard as possible against the new company or new employer. That is only to be expected. However, the rancor is often diminished if the suspicion of improper activities by the employee while still employed is eliminated by early resignation.
With someone occupying the role of a director to the company but not being active in day to day operations, the duty of loyalty still applies pursuant to California law. As with employees, each director and officer of a company owes a "FIDUCIARY DUTY" to that company, the highest duty known to law and must not intentionally take any action which harms the company or aids the competition. The company may consent to such potential conflicts of interest but only after full disclosure to the company with the director abstaining from voting on the question. Essentially, it is always wise for a director who finds him or herself in a potential conflict of interest to resign or, at the least, make full written disclosure and offer to resign.
RESTRICTIONS ON COMPETITION ON EXEMPLOYEES, EX DIRECTORS OR EX OFFICERS
Here the law is quite simple. Absent purchase of all ownership interest of the employee, director or officer leaving, California law prohibits restrictions on competition and will void any clause in a contract that seeks to limit competition. An exemployee may always work for a competitor and may engage in his or her own competing business at will once the employment is terminated. Further, such work for a competitor may not result in the old employer restricting severance pay, vacation pay, or other benefits owed to the exemployee.
As stated above, the law wishes to allow active competition for the public good and will not allow an employer to restrict competition except in the unique circumstances described below.
It does not matter what the contract states. It does not matter if the employee promised not to compete when hired or executed a contract agreeing not to compete. It does not matter if the employee now competiting may damage or even destroy your business. The law allows and, indeed, encourages such competition and any effort to restrict such competition will be prohibited. (If the employee takes trade secrets it is quite another matter, as described above...but if the employer merely competes without taking trade secrets, the law fully allows such action once the employee has left for the new job.)
It may be noted that there are laws prohibiting unfair competition and that such laws apply to the competitor who may be acting improperly. These laws are discussed in a different article.
Merely hiring your exemployee, however, is not a violation of any of the laws pertaining to unfair competition and is entirely proper...so long as trade secrets are not stolen.
THE MAJOR EXCEPTION: RESTRICTION ON COMPETITION OF DEPARTING OWNERS
It is common knowledge that quite often the major asset that a buyer of a business purchases is the good will, to wit, the reputation of the company, its name, its location, the loyalty of the customers that may have been built up over the years. It is axiomatic that if restriction on competition by the departing owner is not allowed in the purchase of a business, then both the buyer and the seller would be harmed since that good will could never be safely sold: the buyer could never know if the seller was planning to open up a competing business which would, in effect, make the good will that was sold of null value.
Thus, the courts have held that restrictions of competition will be valid if and only if they are connected to the purchase of the entire interest of an owner of a business. Such restriction must be reasonable in scope and duration and limited to the business being purchased. Typical examples are a clause in a purchase contract that provides the departing owner may not open up a competing restaurant, shoe store, distributorship, medical office, or what have you for a period of three years and within the geographical area once served by the business.
The question of reasonableness of scope and duration is a question of fact but common sense is the test. Factors are the past scope of the business being sold; the amount of consideration paid to the departing owner; the extent that good will formed a part of the business being sold. Duration above five years is unusual; duration above ten years is very unusual and difficult to enforce. The most common level of restriction is the geographical extent of the previous business and three to five years of noncom petition. This may also allow restrictions on assisting others in competing against the sold company, e.g. "Indirect competition". It is important to note that all the business interest of the departing owner must be purchased to allow noncom petition, though an installment method of buy out is certainly allowed. It is also important to note that if the buyer breaches the agreement by failing to make payment as required, the seller may immediately commence competition once more.
It is not unusual for a company to offer small portions of its shares to key employees and to buy out their shares if they are terminated coupled with a non-compete clause which the company seeks to enforce. Again, the reasonableness test is often used to challenge these clauses. If the shares being purchased represent a small percentage of the company and the amount of consideration being paid is minor, the jury is unlikely to consider the clause as reasonable and valid. For example, if ten thousand dollars is paid to a top salesman for his stock but he is prohibited from engaging in his profession in the entire state for five years, the jury is unlikely to consider the restriction as reasonable. If the period of non-competition was three months and the consideration was fifty thousand dollars, a very different conclusion could be reached by the jury.
Juries are human beings and are not going to force a person into poverty based on a clause that is clearly unfair. One must carefully balance the restrictions on competition which are fair with the consideration being paid to the departing employee if one wants a contract that is more than a piece of paper.
DISTRIBUTOR AGREEMENTS AND RESTRICTIONS ON REPRESENTING COMPETITORS
Another limited area where competition may be restricted (at least in California) relates to limiting the products and companies an "exclusive distributor" may represent. A manufacturer or supplier may reasonably restrict the competing lines an exclusive distributor may represent so that the distributor's loyalty and commitment to that manufacturer's line is not in question.
Other states and, indeed, other countries often do not allow such restrictions on competition thus the reader is advised to inquire as to the local law.
Again, common sense plays a vital role in this exception to the rule frowning upon restrictions on competition. An exclusive distributor is, in effect, one's only conduit into a particular market and if the conduit is at the same time representing competitors and is aware of all the trade secrets one has, it is hard to see how that relationship could be preserved.
And, again, the reasonableness of the restriction must be apparent or the clause will be voided. The prohibited products or competitors must be direct competitors and the restriction on competition must end when the contractual relationship terminates.
The same basic rule applies to those one hires as independent contractors. By the very nature of the term, independent contractors are independent business people thus allowed to work for other people, often in the same field. While trade secrets may always be protected, the restrictions on independent contractors are necessarily more restricted and their livelihood cannot be impaired by refusing them access to work for competitors minus unusual circumstances. (Thus, a lawyer may restrict an independent contractor lawyer working for his or her firm from working as a lawyer for a firm representing an opposing party but could not prohibit the lawyer from engaging in any practice of law, etc.)
EFFECTIVE MEASURES TO LEGALLY RESTRICT COMPETITION IN A BUY OUT AGREEMENT
As with so much in law, proper drafting and structural planning is critical if one is to successful achieve one's ends. It is not enough to merely state that a seller is not to compete. The clause must be limited in time and geographical area and should recite with some specificity the precise areas of commerce to be covered by the clause and recite in some detail the consideration paid for the restriction on competition. Further, both direct and indirect competition should be banned and ideally the payments being made to the departing owner or owners should be spaced out over time so as to better give an incentive to the departing owner to abide by the terms of the agreement. Lastly, injunctive relief should be recited as an appropriate remedy to be made available should the departing owner violate the provisions.
A typical example of a clause is as follows (FOR ILLUSTRATIVE PURPOSES ONLY...NOT TO BE USED WITHOUT PRIOR ADVICE OF LEGAL COUNSEL.)
It is agreed that for a period of three years, JOHN SELLER shall not, directly or indirectly, compete or aid a competitor of XYZ Company or own, control, purchase, obtain an option for, or in any manner whatsoever give advice or instruction to any competitor of XYZ Company located or selling products within the counties of San Francisco and San Mateo, in the fields of sales or distribution of electrical materials to the construction industry and that of the purchase price, eighty thousand dollars ($80,000.00) is paid by Joe Buyer for said agreement not to compete. It is mutually agreed that it would cause irreparable harm to XYZ Company should this clause be violated thus JOHN SELLER agrees that injunctive relief may be granted should JOHN SELLER violate this provision. JOHN SELLER agrees to show a copy of this provision to any prospective employer, co owner, contractor or other person with whom JOHN SELLER intends to engage in business during the term of this clause.
OTHER RELEVANT ARTICLES
The reader is invited to review the articles on Contracts, Litigation, Trade Secrets, and Arbitration in Employment Contracts found elsewhere in this Website. Again, any contract which seeks to impose restrictions on competition, be it of employees or business associates, must be carefully scrutinized and drafted with professional skill to achieve its ends.