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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.

The High Cost of Misclassifying Your Employees

Last year, the California Supreme Court opened the floodgates to litigation by employees who claim that they have been misclassified as exempt workers when, in fact, they are non-exempt and entitled to overtime pay.  In Cortez v. Purolator Air Filtration Products Company (2000) 23 Cal.4th 163, the California Supreme Court declared that an employee who believes he has been improperly classified as exempt can bring an action on behalf of both himself and all other similarly situated employees under California’s Unfair Business Practices Act.  If successful, the employee and all other similarly situated employees will be entitled to overtime pay for the four-year period prior to the filing of the complaint, as well as to penalties and attorneys’ fees.

Since the Supreme Court’s decision, hundreds of lawsuits have been filed in California state courts in which current and former employees of California employers claim that they were improperly classified and, consequently, are entitled to overtime pay.  While most of those cases have settled before trial, one case against Farmers Insurance Exchange went to trial last July and resulted in an award to the former employees of $90 million, plus interest and attorneys’ fees.  Given the potential dollar amounts involved in these cases, it is anticipated that the use of these suits in California will continue to increase, subjecting you to potentially staggering liability if you are out of compliance with federal or state wage and hour laws.

Federal v. State Wage and Hour Laws
The Fair Labor Standards Act (“FLSA”) provides the framework for determining exemptions from overtime requirements under federal law.  To qualify as an exempt employee under the FLSA, an employee must meet a two-part test.  First, he must be paid on a salary basis.  Second, he must meet the duties test for executive, administrative, or professional employees as set forth in the FLSA.

For California employers, however, the FLSA does not generally provide a definitive answer as to whether an employee is exempt or non-exempt.  California state law imposes different requirements, which are generally more stringent than the federal standard.  Where state and federal law conflict, the employee is entitled to the standard that provides greater protection (or the standard that imposes a higher threshold for determining exempt status – generally California law).  Because the California test will generally be the test that employers should use to determine if their employees are exempt or non-exempt, the remainder of this article focuses on California’s wage and hour laws with respect to exemptions.

California Exemptions
Like federal law, California provides three basic types of exemptions:  executive, administrative and professional.  To apply for any of these exemptions, the employee in question must receive compensation of at least $2,166.66 per month or $26,000 per year.  In addition, the employee must be paid on a salary basis, meaning that the pay received by the employee must be a fixed sum from week to week and may not be subject to reduction because of variations in the quality or quantity of work performed.  An employee will not be considered to be paid on a “salary basis” if deductions are made for absences from work caused by the employer or the operating requirements of the business.  In addition, an exempt employee’s salary may not be reduced due to time missed for sickness or accident.  An employer may reduce an exempt employee’s salary because of the employee’s absences for personal reasons, so long as deductions are made in increments of full work days.

If an employee meets both of these requirements, she may be considered for exempt status using one of the following tests:

Executive Exemption
An executive employee is one who meets the salary test described above and, in addition, meets the following requirements:

•    The employee’s duties and responsibilities involve the management of the enterprise in which he is employed or of a customarily recognized department or subdivision of that enterprise;

•    The employee customarily and regularly directs the work of two or more other employees;

•    The employee has the authority to hire or fire other employees, or his suggestions and recommendations as to the hiring, firing, advancement, promotion, or any other change of status of employees is given particular weight;

•    The employee customarily exercises discretionary powers; and

•    The employee is primarily engaged in the duties described above.
“Primarily engaged” means that more than one-half of the employee’s work time is spent performing the duties described above.

Administrative Exemption
An administrative employee is one who meets the salary test described above and, in addition, meets the follows requirements:
•    The employee’s duties and responsibilities involve either (1) the performance of office or non-manual work directly related to management policies or general business operations of the employer or the employer’s customers, or (2) the performance of functions in the administration of a school system or educational establishment or institution, or of a department or subdivision of those, in work directly related to the academic instruction or training carried on in the system, establishment or institution;

•    The employee customarily and regularly exercises discretion and independent judgment;

•    The employee (1) regularly and directly assists a proprietor or employee employed in a bona fide executive or administrative capacity, (2) performs specialized or technical work requiring special training, experience or knowledge under only general supervision, or (3) executes special assignments and tasks under only general supervision; and

•    The employee is primarily engaged in the above duties.

Professional Exemption

A professional employee is one who meets the salary test described above and, in addition, meets the following requirements:

•    The employee is licensed or certified by the State of California and is primarily engaged in the practice of one of the following recognized professions:  law, medicine, dentistry, optometry, architecture, engineering, teaching, or accounting; or

•    The employee is primarily engaged in an occupation commonly recognized as a learned or artistic profession; and

•    The employee customarily and regularly exercises discretion and independent judgment in the performance of her duties.
It is important to note that there are exceptions to these tests, including exceptions pertaining to pharmacists, registered nurses, and computer programmers.  It is also important to note that an employee’s job title, job description and employment contract are not determinative as to whether an employee is exempt.  Rather, a court will look at the actual job duties performed by the employee to make that determination.  In addition, it is of no consequence that others in your industry have classified their employees in a particular manner.  Many U.S. employers are out of compliance with wage and hour laws, particularly employers who do business in California.  In order to ensure compliance with California’s tough exemption requirements, you should periodically review your employees’ duties and their classifications to make sure that, in the unfortunate event that an employee brings a lawsuit against you, you can properly defend yourself.