The use of non-disclosure and non-compete agreements is so prevalent online that it is now considered standard operating procedure to demand them in both the business-to-business and business-to-employee environment. While the enforcement of non-disclosure agreements is well established, many business owners and companies mistakenly rely on non-compete agreements that are both useless and invite lawsuits.
Enforceable in California?
Non-compete agreements are legal in most states so long as the restrictions are reasonable. The opposite is true in California. As a general rule, California courts do not enforce non-compete agreements. Section 16600 of the California Business and Professions Code states:
“Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”
This language makes it clear efforts to restrict an employee, independent contractor or business from going to work for a competitor simply are going to fail. The courts are particular hostile when the non-compete agreement involves an employee or independent contractor.
Can a business insist employees sign a non-compete agreement as part of their continued employment? In a word – no. To do so is considered a violation of Section 16600 of the Business and Professions Code. The terminated employee can even sue the business for wrongful termination. [Latona v Aetna U.S. Healthcare Inc. 82 F Supp 2d 1089 (CD Cal 1999).] In Thompson v Impaxx, Inc., the court held even a limited restriction against soliciting customers was a violation of public policy and provided the employee in question with the right to sue for wrongful termination. [113 CA4th 1425 (2003)] As a practical matter, leveraging employees to sign non-compete agreements is a poor business strategy. Businesses, particularly those based outside of California, must be very careful when contemplating the use of non-compete agreements in the California labor environment.
Does the restriction on non-compete agreements apply to transactions between businesses? While the answer is often yes, a minority of courts have restricted the prohibition in licensing and lease situations. If you face this situation, it is strongly suggested you consult with legal counsel to determine the merits of using a non-compete agreement for the particular scenario.
Don’t Let The Door Hit You On The…
Businesses are ever evolving, and so are the relationships between the individuals who own and manage them. A typical scenario that arises in the online environment involves two or three friends starting a business. Eventually, it becomes clear one of the owners needs to be bought out because of a personality conflict or performance issue. As part of the buyout process, the question then becomes can a non-compete clause be used to prevent the owner leaving the company from undertaking actions hostile to the interests of the business? The answer is yes, but the non-compete must be drafted carefully.
Section 16601 of the California Business and Professions Code notes that an owner who is being bought out can be restrained from starting a new business in the same field if the restriction is included as part of the written buyout agreement. For this exemption to be valid, the owner must be selling his or her ownership interest as well as their portion of the “good will” the business has built up since its launch. This rule is applicable whether the business entity is a corporation, limited liability company or partnership.
There is one aspect of this exemption that can cause problems for online businesses. The exemption only allows a company to restrict a former owner from launching a competing business in the “specified geographic area” where the initial business is operating.
This provision was written before the establishment of the web as a commercial platform, which means it does not translate well to the buyout of an owner in an online business. Specifically, what is a “specified geographic area” when the company operates on the web? Will California courts be willing to accept a restriction for the entire world given the reach of the Internet or will the restriction be limited to the general area of the main office of the business? There is no definitive answer at this time.
Businesses relying on non-compete agreements in California are asking for trouble. Not only are these contract usually unenforceable, but they can trigger lawsuits. This outcome is slightly counter-productive, so always consult with a California lawyer prior to using such agreements.
Richard A. Chapo, Esq.