Covenants Not to Compete – Not Only Unenforceable in California, They May Subject You to Liability

Two recent California cases have sounded the death knell in California for any attempt to use a non-compete clause in an employment or stock option agreement.  In the first, D’Sa v. Playhut, Inc. (2000) 85 Cal.App.4th 927, an employee sued his employer for wrongful termination, alleging that the employer had violated California public policy when it fired him after he refused to sign an agreement that contained a covenant not to compete.  The employer attempted to have the case dismissed arguing that, because the employee was an at-will employee, he could be fired for any reason that was not illegal.  While the court agreed with that general proposition, it found that any attempt to condition employment upon an illegal covenant not to compete violated California’s public policy and that terminating the plaintiff for refusing to sign an illegal provision constituted a wrongful termination in violation of public policy.

In coming to its decision, the court focused on a particular statute, which states “[E]very contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”  (Business & Professions Code section 16600.)  The court then reviewed the non-compete agreement proposed by the employer, which stated “[E]mployee will not render services, directly or indirectly, for a period of one year after separation of employment with Playhut, Inc. to any person or entity in connection with any competing product. . . .”  The court found that this provision violated section 16600 and was void and unenforceable.  Firing an employee for refusing to agree to such an illegal provision, the court held, violated public policy and exposed the employer to liability.

The employer next attempted to argue that the covenant not to compete should be construed narrowly as a restraint only against the disclosure of trade secrets and other confidential information.  While the court acknowledged that a contract provision will not be viewed as a violation of the Business & Professions Code if it is necessary to protect the employer’s trade secrets, the provision at issue in the case was not so narrowly drafted that a typical lay-person reading it would interpret it in such a manner.  Thus, the court concluded that if it were to agree to narrowly construe the provision, it would undermine the protection given to employees since “many, if not most, employees would likely interpret the provision as a covenant not to compete, and might act according to their interpretation rather than consult an attorney to find out if their interpretation is correct.”  The court prophesied a situation where employers would attempt to use illegal covenants not to compete so that, upon leaving employment, uninformed employees would forego legitimate employment rather than assume the risk of expensive and time consuming litigation to challenge the illegal provision.

While many employers are aware that covenants not to compete are illegal and unenforceable in California in some circumstances, a large number erroneously believe that covenants not to compete may be used for high-level management personnel or in conjunction with the grant of stock or stock options.  In Hills Medical Corporation v. Wycoff (2001) 86 Cal.App.4th 895, another California Court of Appeal rejected this notion entirely.  Hills involved a medical corporation that sued one of its former employees and shareholders to prohibit him from competing against it after he severed his relationship with the corporation.  The employee, a doctor, had signed a stock redemption agreement in which he had agreed that, in the event that his employment relationship with the medical corporation was terminated, he was required to sell his stock back to the corporation and not practice medicine within a 7½ mile radius from any medical corporation facility for three years.

After the doctor tendered his resignation, he indicated that he intended to practice medicine within 7½ miles of a medical corporation facility.  He sold his stock back to the corporation for $217,000, and the corporation thereafter sued him to enforce the covenant not to compete based upon an exception to Business & Professions Code section 16600, which provides that any shareholder of a corporation selling or otherwise disposing of all his/her shares in a corporation may agree with the buyer to refrain from carrying on a similar business within a specified area.  (Business & Professions Code section 16601.)

Although section 16601 appeared, by its wording, to support the medical corporation’s position, the court decided to look beyond the wording of the statute and impose a further requirement that a contract for the sale of shares of stock not circumvent California’s deeply rooted public policy favoring open competition.  When a seller’s shares constitute only a fraction of the total corporate shares, the court determined that the sale of the shares must involve so substantial an interest in the corporation that the transfer of the seller’s shares amounts to a transfer of the goodwill of the corporation.  The court then went on to find that, even through the doctor had been paid a substantial amount of money for his shares, the repurchase price did not include any payment for goodwill and that, because the doctor owned only seven percent of the shares, the transfer did not involve a substantial interest such that it could be said that the transfer of goodwill was considered in the agreement.

What This Means For You
Although it is extremely difficult to bind an employee to a non-compete agreement in California (unless the employee sold you the entire business), you can still protect your company’s trade secrets and other confidential information by requiring non-solicitation and confidentiality agreements of your employees.  These provisions should be narrowly drafted to ensure that they are not construed as illegal non-compete provisions.  Moreover, your employees are prohibited by California law from stealing your trade secrets, such as customer lists, even without a confidentiality or non-solicitation agreement.