By: Philip A. Toomey, Esq.
Traditional “non-compete” agreements usually take one of three forms. First are agreements, based upon legitimate and reasonable business reasons, providing that for some limited amount of time and in some limited geographic area, a departing employee may not engage in any activity that competes with the business of her former employer (“Absolute Prohibition Agreements”). The second are agreements that a departing employee may not solicit or engage in competitive business with any client or customer with whom the employee or employer has business dealings with prior to the employee’s departure (“Non-solicitation Agreements”). Third are agreements where the employee is permitted to fairly compete but is restricted from soliciting the employer’s existing workforce (“Anti-raiding Agreements”).
When presented with a request to enjoin a former employee from competing, soliciting or raiding, or award damages because of such actions, most states examine the “reasonableness” of the restriction. Factors such as legitimate business reasons for having such agreements in the first place, the investment of the former employer in developing the business and business methods, inevitable use of sensitive or confidential information (based upon exposure to information while employed), and the time and geographic limitation on restrained activity are usually balanced and given fair consideration. Even though the recent trend in many states has been to revisit and recraft the rules, California fundamental public policy has always been different. And that difference has now been dramatically expanded.
As of December 2018, absent misuse by the former employee of an actual trade secret (as specifically defined by the California Uniform Trade Secret Act, which is a much narrower definition than most employers assume) or bona fide “confidential proprietary information,” all three types of non-compete agreements are invalid. Even more importantly, multi-state employers using standardized forms that require California residents (or employees who primary perform work duties in California) to agree to any such post-separation restrictions as a condition of obtaining or retaining employment most likely violate California Unfair Business Practices Act (Business and Professions Code §17200)(“UBPA Claims”) and California’s very liberal Private Attorney General Act (“PAGA Claims”). The mere presence of such restrictive language, not the employer’s intent or action to enforce, exposes the employer to both UBPA Claims and PAGA Claims. It is no longer “no harm- no foul.”
To the question, “You mean the employee I fired because she was cheating, lazy, bad-mouthed me, and refused to come to work can now move next door, set up a business, solicit from my clients, undercut my prices and raid my employees?” absent misuse of an actual trade secret or bona fide confidential proprietary information, the answer is “yes.” Welcome to California.
Absolute Prohibition Agreements
In California, any agreement that attempts to restrain or prohibit competition by former employee is invalid. Outside the situation where an employee is also a bona fide owner of a business, and the employee’s interest in reacquired or the business (together with all of its accompanying goodwill) is sold or transferred to a third party, Business and Professions Code §16600 invalidates any effort to restrain the departing employee from competing. Since some businesses, in an effort to gain advantage of the narrow exception, have coupled employment agreements with phantom stock, or non-voting or non-participating interests that are reacquired at the time of separation, courts are careful to examine “if” the departing employee is a “real” owner. If the interest turns out to be insignificant and issued for the primary purpose of obtaining the benefits of the exception (e.g., non-participating, not issued for actual consideration, reacquisition at the time of separation is for purely nominal amounts or on terms not commercially reasonable), the effort will fail, and the departing employee can compete. To fall within the exception, the rule is the ownership interest must be meaningful and reacquisition accompanied by attributes reasonably associated with actual business ownership.
A Rose by Any Other Name
Before discussing the other two forms of non-competition agreements (Non-solicitation Agreements and Anti-raiding Agreements), it is important to understand the judicial distinction between the words “restrain” and “prohibit.” That distinction explains how California courts will interpret non-compete agreements, and the liability exposure faced by employers.
Generally, when someone is “prohibited” from competing, since prohibition can result in forfeiture of the ability to practice a livelihood or earn a living, courts historically have balanced the prohibition against articulated and legitimate business needs. If, for example, time or geographic limitations are overbroad or unreasonable, courts either reform the agreement to be fairer, or if unable to do so, refused to enforce. Mitigation in favor of a prohibition may be whether the former employee is prevented from competing only in a narrow or insignificant area of business. Legitimate business needs are balanced, including the inevitable disclosure or use of confidential business information (since the employer cannot delete information in the former employee’s memory). Historically the employer has had the opportunity to present evidence and show forfeiture is limited, narrow and reasonable, or that on balance the employer’s legitimate business interests are entitled to the protection sought.
As has become clear in California court decisions, the word “restrain” is interpreted differently. If an agreement “restrains” competition, concepts like overbreadth, limited scope, reasonableness, or legitimate business needs are irrelevant. The only question is whether the language used in the agreement “restrains” the former employee in any manner from engaging in her profession, trade, or business. If so, the agreement violates the law, unless the restraint falls within one of the exceptions or the former employee is misusing trade secret or bona fide confidential information.
Business and Professions Code §16600 uses the word “restrained.” That use of that word is then critical when examining the other two general forms of non-compete agreements.
The California Supreme Court, in Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008), held an agreement that prevented a former employee from soliciting business from clients he serviced while employed was an impermissible “restraint” prohibited by Business and Professions Code §16600. At the time Edwards was decided, California already allowed its residents to accept business from previous customers or clients provided they had not engaged in an impermissible solicitation. And for over 30-years, sending a “professional announcement” to former customers or client with all necessary contact information, but doing nothing more, was not “solicitation” (Moss, Adams & Co. v. Shilling, 179 Cal.App.3d 124 (1986)). So, to some extent, Edwards simply eliminated the illusion that sending an announcement was not really a solicitation, and then went further to permit direct lawful solicitation of the former customers or clients. Edwards, in effect, opened the flood gates. Absent misuse by the former employee of actual trade secrets or bona fide confidential proprietary information, the former employee’s client or customer information or lists, as well the client or customer information or lists of all of her co-workers, was now fair game.
Even prior to Edwards, a former employer attempting to establish that client or customer information or lists were protectable trade secrets or bona fide confidential proprietary information (and hence lawfully protected) had to overcome a very difficult burden. Former clients normally can be easily identified from existing public sources (e.g., the internet, public records, etc.). Other competitors can normally become easily aware that the former clients “might be” interested in the goods or services being sold (e.g., companies that compile and sell lists to businesses of potential customers culled from internet marketing data). And former employees can easily (without downloading or copying) learn and recall contact data. After Edwards, what was very difficult became, and remains, almost insurmountable.
What the court in Edwards did not decide was whether the departing employee could be restricted from soliciting the existing workforce to leave. For over 30-years, the decision in Loral Corporation v. Moyes, 174 Cal. App. 3d 268, 280 (1985), supported the position that a separation agreement restraining a departing employee from disrupting, damaging, impairing, or interfering with her former employer’s business by “raiding” employees was valid. Even after Edwards, Loral established that while an employer’s customers and clients were not protected, at least the employee base was.
This last vestige of traditional non-compete agreements met its doom (at least for California residents or employees who primary perform work duties in California) in December in the AMN Healthcare decision (AMN Healthcare, Inc. v. Aya Healthcare Services, Inc., 28 Cal.App.5th 923 (2018)). AMN Healthcare held a non-solicitation agreement restricting former employees from recruiting existing employees also violated Business and Professions Code §16600.
AMN Healthcare once again focused on the use of the word “restrained.” The court held the non-solicitation provision clearly restrained former employees from practicing their chosen profession of recruiting nurses. While the former employer argued its former employees could freely recruit nurses from any other employers, and therefore they were not “prevented” from engaging in their profession of choice, AMN Healthcare expressly rejected that argument. All that mattered was restraint, not the extent or reasonableness of the restraint, or that former employees could adequately recruit elsewhere. Since the former employees were restrained in some fashion, the agreement was invalid.
As stated above, if the end result of Edwards and AMN Healthcare was simply such agreements are not enforceable, then multi-state employers seeking to have valid post separation non-compete agreements in other states might feel they can leave such language in hiring and on-boarding documents and referenced in employee handbooks, even if such language is included in document provided to California residents (or employees who primary perform work duties in California). Since the employer is not going to sue over a non-enforceable provision, what is the harm?
The answer is “plenty.” The risk is knowingly including an unenforceable post-separation restriction in agreements required as part of employment hiring or retention most likely is an unfair business practice, for which the employer has exposure for both UBPA Claims and PAGA Claims. And since California remains the class action capital for employment matters, a prudent employer doing business in California will immediately review all employment documents and eliminate any such language.
Leech Tishman’s Employment Practice Group can help clients ensure compliance with California’s complex and technical employment laws and can assist clients with defending against civil or administrative actions.
If you have any questions regarding California’s unique employment laws or these employment law updates, please contact Philip Toomey. Phil serves as Leech Tishman’s West Coast Business & Employment Client Relations Partner and practices in the firm’s Employment, Corporate, Litigation and Real Estate Practice Groups. Phil is based in the Leech Tishman’s El Segundo, CA office. He can be reached at 424.738.4400 or firstname.lastname@example.org.
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