California is notoriously hostile to agreements that are seen as having a “restraining effect” on an employee’s ability to practice her chosen profession. Based on that important public policy goal, which is memorialized in California Business and Professions Code section 16600 et seq., California generally prohibits – with very narrow exceptions – so-called “non-compete agreements.”
Non-compete agreements come in three flavors: 1) non-competition agreements, which seek to prohibit a former employee from directly competing with her ex-employer in the same field or geographic region; 2) employee non-solicitation agreements, which seek to prohibit a former employee from “poaching” her ex-employer’s current employees; and 3) customer non-solicitation agreements, which seek to prohibit a former employee from enticing away her ex-employer’s customers.
Non-competition agreements are generally invalid in California, subject to narrow statutory exceptions. First, the purchaser of a company can prevent the seller of the company from directly competing with the company in the future. This exception applies to both sole owners and shareholders of a company.
Second, a non-compete agreement can be enforceable if it is related to the sale of stock or sale of a partnership interest in the company that is requesting the non-compete agreement. Cal. Bus. & Prof. Code §§ 16601, 16602, 16602.5. Typically, this situation occurs if the employee “sells back” his shares or interest in the company, either to the company or to another acquiring company. However, this exception will only apply if (1) the sale of the business’ interests includes “the goodwill of the business entity”; (2) the seller is adequately compensated for that goodwill; and (3) the terms of the non-compete agreement are reasonable. Cal. Bus. & Prof. Code §§ 16601, 16602, 16602.5; see also Alliant Ins. Services, Inc. v. Gaddy (2008) 159 Cal.App.4th 1292.
Each prong of this test involves a fact-intensive inquiry, involving factors that may include (a) the employee’s percentage of ownership in the company; (b) the employee’s contributions to the company’s goodwill; (c) how much the employee was paid for his/her shares or ownership interest; and (d) the size of the current company’s market in relation to the scope of the non-compete restrictions. See generally Monogram Industries, Inc. v. Sar Industries, Inc. (1976) 64 Cal. App. 3d 692; Hill Medical Corp. v. Wycoff, 86 Cal. App. 4th 904 (2001). No single factor is determinative, and courts have interpreted the same factor in opposite ways, so it is best to consult with an attorney regarding the specific facts of your case.
In contrast to non-competition agreements, no statutory exceptions exist to enforce customer non-solicitation agreements, which are routinely held to be invalid. A California court will generally only enforce these agreements where they are directly tied to protecting company trade secrets – for example, where a contract states that an employee “shall not use company trade secrets to solicit company customers” – and where the company in fact possesses legitimate trade secrets. This “trade secrets exception” also applies to employee non-solicitation agreements and to non-competition agreements: in essence, if a company can convince a court that the contractual language was necessary to protect the confidentiality of its legitimate trade secrets, there is a good shot of enforceability.
With respect to employee non-solicitation agreements, the waters are murkier. Until very recently, clauses that prohibited a former employee from “poaching” the ex-company’s employees could be enforced if they were narrowly drafted – for example, if they limited the restriction to 12 months following the employee’s termination. Loral Corp. v. Moyes, 174 Cal.App.3d 268 (1985). In the case of Loral Corp., the Court of Appeals found that a narrowly-drafted employee non-solicitation clause would only “slightly” affect the employment opportunities of an executive officer who left his company, joined the competition, and then “raided” other top employees of his former company, and therefore that the clause did not run afoul of Business and Professions Code section 16600.
However, Loral Corp. has been called into doubt by AMN Healthcare, Inc. v. Aya Healthcare Services, Inc., 28 Cal.App.5th 923 (2018), in which the Court of Appeals struck down an employee non-solicitation agreement that contained a 12-month prohibition on a recruiter who left the company and joined a competitor. The court reasoned that, as applied to this particular employee – whose livelihood depended on his ability to recruit other employees on behalf of his current employer – the non-solicitation clause violated section 16600, as it “could limit the amount of compensation a recruiter would receive with his or her new agency.” While the AMN Healthcare case stopped short of overruling Loral Corp., it noted that section 16600 embodies California’s strong public policy interest in preventing restraints of trade, and does not permit a “narrow-restraint exception” that other jurisdictions may recognize. In light of AMN Healthcare, the continued enforceability of employee non-solicitation clauses is uncertain.
With these concepts in mind, what are some “dos and don’ts” for companies wishing to use non-compete agreements? Generally speaking, a company should not prohibit or limit the ability of a former employee to work elsewhere or to solicit customers, unless the prohibition falls within the statutory exceptions discussed above, or is expressly tied to a legitimate attempt to protect the confidentiality of trade secrets. An employer should give careful thought to the type of work its employees do, and whether that work would be restrained or limited by a standard non-competition clause, before including this language into company contracts. Competent employment counsel can advise on the nuances posed by California law and how it affects your company, and should be consulted on any employment matters.
Krista L. Baughman is a partner at Dhillon Law Group Inc.
Dorothy Yamamoto is an associate at Dhillon Law Group Inc.