The interest of the public in having active and effective competition has long been a recurring theme in the United States. It was the source for enactment of many of the Federal and State antitrust laws and is also the source for many State laws restricting agreements which prohibit competition.
Some states do allow parties to agree to restrict competition so long as the restriction is not sufficient to create price fixing or a monopoly in violation of antitrust laws. But California has enacted some of the strictest laws voiding provisions in an agreement that restrict competition and has one of the strongest public policies favoring open and free competition.
Does that mean that there are no non compete clauses allowed in California? Non compete clauses are allowed in California in specific instances described below and protection of confidential information is also fully allowed. This article shall describe both the methods and the benefits that are obtained by the appropriate use of the exceptions.
Non Competes Compared to Protection of Confidential Information:
It is important to grasp the difference between non compete clauses and clauses that seek to safeguard confidential information. In the current business climate, intellectual property and information as to markets and customers is often the most valuable asset a company owns and the courts recognize that face and allow strict clauses prohibiting any person, including employees, from utilizing confidential information for themselves or for third parties. It is necessary for the plaintiff to be able to demonstrate that the information was truly confidential and proprietary. That normally requires the plaintiff to show reasonable steps the plaintiff took to keep the information confidential, including enforcing the very clause that is at issue. It also requires the plaintiff to demonstrate that the information is confidential and not already available and known to third parties before the defendant communicated it. Assuming those grounds are met, plaintiffs can obtain damages or even injunctions to prohibit the use or transferring of such confidential information and clauses protecting same are common in most employment and independent contractor agreements.
Non compete clauses, on the other hand, simply prohibit a person from competing with another party, usually for a specific market and for a specific period of time. That may have to do with access to confidential information but need not. They are clauses that simply state that X cannot engage in a specific business.
Where matters may overlap is when a confidential clause is so broad that its ultimate effect is to prohibit competition by an exemployee or contractor. The courts have routinely viewed clauses that effectively put a person out of business with great disfavor. The typical example is when a “confidential” very broad customer list or a unique methodology used by a company may be confidential but the exemployee could never be in any business in the field if the clause is strictly enforced. The public policy in favor of competition could overcome the contractual provision.
The solution is to draft confidential provisions carefully so that it still allows an exemployee to potentially start a business. Make sure the customer list protected is not so wide that it encompasses every potential customer and that methods and marketing plans are not so broadly defined that they encompass what anyone in the field would have to utilize. Too much protection can result in no protection.
Non Competes From Other Jurisdictions?
Many states do allow non compete clauses and some allow them with certain limitations. A common provision found in agreements with entities engaged in business in other States is to have the agreement subject to the law of the foreign jurisdiction, and include the restrictive non compete clause.
If the tasks performed by the employee or contractor are not largely performed in California, this effort may be successful. As discussed in our article on Contracts, courts give wide latitude to parties to craft their own agreements and further are prone to accept utilizing the law of other jurisdictions in an agreement if the parties actually have substantial contacts with those jurisdictions. However, where there is a strong public policy at risk, such as the policy against restrictions in competition, the courts are much more inclined to refuse to utilize foreign law. And if two California entities or persons try to graft onto a contract to be performed in California outside law to evade the non compete restrictions of California, one can expect the courts to reject such an attempt.
The Allowed Non Compete Clauses of California:
There is one type of situation in which the California courts do allow effective “reasonable” non compete provisions and that is when the clause is applied to a departing owner of a business being purchased. The courts rightfully reasoned that a substantial asset of most businesses being sold is the position in the market place of the business and if the departing owner can reenter the market at will, that asset can not readily be sold. That hurts both the owner and the buyer. The courts thus have held that if a person is selling all of his or her interest in a business, a non compete clause reasonable in scope will be allowed.
What is “reasonable?” That depends on the type of business and the market. A nationwide market will allow a broader area to be covered than a pizza restaurant. As for the time of the non compete, courts become hostile if the period is greater than five years but are seldom going to object to a period of three years. Such clauses are routinely enforced in California and the courts often grant injunctions prohibiting a past owner from seeking to violate that clause. Note, however, that if the buyer is in breach of the purchase agreement, the prohibition against competition would no longer be enforceable.
This exception to non compete clause restrictions in California have led many employers and businesses to attempt to create “golden chains” to retain key employees. A small percentage of ownership in the Company is either sold or bonused to the employee and a buy and sell agreement executed which combines the sale of the ownership if the employee leaves the company with a non compete clause that protects the company.
Such restrictions in competition are usually allowed by California courts in valid buy and sell agreements and this is an excellent way to keep good employees. The employee is encouraged by owning a part of the business, the company is safeguarded from that employee starting his or her competing business or even working for a competitor by the valid non compete, so long as the clause is reasonable in scope.
The courts do not like such buy and sell agreements which constitute only token ownership or whose terms are such that the exemployee is barred from making a living for a relatively token payment for stock. Thus, if your exemployee receives ten thousand dollars for his two percent ownership, payable over five years, but is barred from competition in the field for five years anywhere in the entire state, the courts are going to view that clause very, very closely. But if the employee is to receive two hundred thousand over five years for that same clause, that clause will be almost certainly upheld.
Of course the “chilling” effect of the clause has benefit to a company worried about whether a key employee would leave and begin competing since the employee is unlikely to want to face the possible litigation and uncertainty that violating the clause would entail. So long as the clause is not too extreme in what restrictions apply for what consideration, the clause is likely to be enforced.
An elderly and successful business man known to this writer was a great proponent of the California scheme of allowing protection of confidential information but not noncompetes. “Keeps me on my toes to know that competition is out there and if one of my exemployees can do a better job than me, good for him. I just don’t want him stealing my secrets…”
But note there are other protections that may apply to a business when an exemployee begins his or her own business. The employee has a fiduciary duty to the company and cannot normally solicit other employees or customers until the relationship is terminated. Commencing a competing business without running afoul of those duties requires careful advance planning by the employee seeking to make his or her own way in the field.