Updated February 15, 2023
And Why the Rest of the Nation May Soon Follow California’s Ban on Non-Compete Agreements
As the federal government considers limiting or prohibiting employee noncompetition agreements, employers doing business in California should be reminded that such prohibitions have virtually always been the law of the Golden State. Since 1872, employers have been prohibited from enforcing a non-compete on employees working in California. So, employers across the country may want to look at how California employers have handled protecting their information in a state that has already banned non-compete clauses for most employees.
What Is a Non-Compete and Why Are They Suddenly in the News?
A traditional “non-compete” clause is an agreement often included in an employee contract or severance agreement where an employee agrees not to work for a competitor or start a competing business in the same field or industry within a certain time period (generally 6 months -2 years). Non-competes could also require employees to not compete within a specific geographic area after their employment ends. Traditionally, these clauses were used to prohibit sales employees from competing in the same sales territory, but they became more powerful tools for employers in all industries to truly limit the mobility of its employees, and as some would argue, serve as “golden handcuffs” to its workforce. Currently, only four states, including California, prohibit non-competes from being enforced in most circumstances.
But, on January 5, 2023, the Federal Trade Commission proposed a new rule that would ban most employers from imposing noncompete agreements on their workers. The agency estimated that by stopping this practice, the new proposed rule “could increase wages by nearly $300 billion per year and expand career opportunities for about 30 million Americans.”
The proposed rule in its current form (1) makes the act of an employer entering into or attempting to enter into a non-complete clause with a worker, or maintaining such a non-compete clause, an unfair method of competition and subject to the FTC’s enforcement powers; (2) requires an employer to rescind a non-compete clause that was entered into with a worker prior to the compliance date; and (3) requires an employer to provide notice to the worker that the non-compete clause is no longer in effect and may not be enforced against the worker, among other provisions.
President Biden, in his State of the Union address, touted the proposed new rule, which is open for public comment until March 10, 2023. But, the proposal has already faced fierce vocal opposition from stakeholders during the comment period. Thus, it seems probable that any ban will not become effective immediately, as it is likely to face challenges in court even if it does overcome the public objections.
What Is the Law in California?
Covenants not to compete are normally deemed illegal under California law. California courts have recognized that an employer’s business practices concerning its employees are within the scope of California’s Business and Professions Code section 17200. 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 strict application of section 16600 in the employment context is supported by the policy that California courts have consistently declared “this provision an expression of public policy to ensure that every citizen shall retain the right to pursue any lawful employment and enterprise of their choice.”
There are, however, three statutory exceptions to the prohibition against contracts that restrain a profession, trade or business in California, which are:
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- Restrictive covenants entered into in connection with (1) the sale of the business’s goodwill, (2) an owner’s sale or disposal of all ownership interest in the business, or (3) an owner’s sale of (i) all or substantially all of the business’s operating assets and goodwill, (ii) all or substantially all the operating assets of a division or subsidiary of the business plus the goodwill of that division or subsidiary, or (iii) all of the ownership interest in a subsidiary.[1]
- Restrictive covenants entered into in connection with the dissolution of a partnership, or a partner disassociating from a partnership.[2]
- Restrictive covenants entered into in connection to the dissolution of, or the termination of a member’s interest in, a limited liability company.[3]
Fortunately, as recently as 2020, California court have held that an employer, could restrict employees from competing with the employer during employment.
What Can Businesses Do?
As California employers have historically faced this prohibition against non-competes, they have looked at alternatives to noncompete clauses to protect their information from getting into competitors’ hands after a worker leaves employment. For example, employers looking to truly protect sensitive information, knows to focus their agreements on prohibiting disclosure of such information through confidentiality agreements rather than restricting employees from working for a competitor. Clauses that limit an employee from using confidential information taken from a former employer have been found valid, provided that they are reasonable and protect only legitimate trade secrets and confidential information.
Confidentiality agreements can prohibit the employee from using confidential information acquired during an employee’s tenure with the employer. In California, a “trade secret” is defined as “a formula, pattern, compilation, program, device, method, technique, or process, that…derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use…” Examples of confidential or proprietary information can include unique manufacturing processes, recipes, product development initiatives and the most often cited and controversial, customer lists.
Several courts have held that confidentiality agreements are enforceable under California law, so long as they do not unlawfully restrain competition and to the extent the agreements protect information that would be protected under the laws against unfair competition or the misappropriation of trade secrets. But, confidentiality agreements cannot create or protect trade secrets where none exist.
For example, in one recent case, a food distributor claimed that its former salesman improperly used trade secrets that he acquired during his employment to solicit business from retail stores that previously ordered olive oil and vinegar from the former employer. But, the court dismissed the case absent evidence that the former employee used any trade secret knowledge of the customers’ personnel and preferences to solicit customers. Similarly, while courts have held that some customer lists are trade secrets, not all customer lists are found to be confidential and protectable. It will be a factual inquiry whereby factors such as the difficulty in obtaining the information and whether such information is “readily ascertainable” through public sources, will be considered.
Companies can proactively develop policies and procedures to help reduce the risk of misuse of confidential information and trade secrets. While an employer’s definition of “confidential” or “trade secret” is not decisive, it is recommended that the agreement contain as much specific information about what is considered either a trade secret or confidential information as possible. This will put the employee on notice that he/she has legal obligations, and could help a court decide what information to find “confidential” or a “trade secret.”
Invention Assignment Agreements are wise for employees engaged in creative, engineering, design, or development work. Additional tools may include development of non-solicitation agreements related to employees and customers. Such covenants have been upheld by some courts where narrowly drawn and limited solicitation to a narrow group. But, due to the ever-evolving case law in this area, it is always advisable to consult with legal counsel before unilaterally adopting such policies.
As more businesses are faced with the prospect of limiting non-competes in the near future, it is recommended that companies spend time exploring exactly what “trade secrets” and “confidential” information exists within their own business and take steps to define and actually protect such information within their organization if it hopes to prohibit former employees from using that information to compete in the absence of a non-compete agreement.
[1] Cal. Bus. & Prof. Code § 16601
[2] Cal. Bus. & Prof. Code § 16602
[3] Cal. Bus. & Prof. Code § 16602.5
