California Supreme Court’s Rejection of Non-Statutory, Noncompetition Agreements Reinforces Criticality of Robust Intellectual Property Protections
Employees, trade secrets, and confidential “know-how” typically comprise a company’s most valued assets. In its August 7 ruling on Edwards v. Arthur Andersen 08 C.D.O.S. 10256, the California Supreme Court established that companies with employees working in California cannot protect these assets by relying upon post-employment noncompetition provisions that prevent an employee from going to work for the competition. Because courts in many jurisdictions routinely apply California law in cases involving employees working in California, the Edwards opinion serves as a wake-up call to every company with employees working in the state. The opinion underscores the importance of reviewing and fine-tuning intellectual property protections to prevent employees from taking the company crown jewels to the competition.
Background of Edwards v. Arthur Andersen: Arthur Andersen Attempted to Condition the Release of Noncompetition Restrictions on Future Employment Upon the Release of “Any and All” Claims Against Arthur Andersen, including Those Arising from Edwards’ Employment.
Arthur Andersen’s employment agreement with Raymond Edwards, one of its certified public accountants, included a noncompetition provision that prohibited Edwards from working for or soliciting business from certain of Arthur Andersen’s clients for specific, limited periods of time following his employment. After being indicted by the U.S. government in connection with the Enron investigation, Arthur Andersen sold off portions of its business, including Edwards’ working group. The acquiring entity offered Edwards employment, contingent upon Edwards executing a “termination of non-compete agreement” (the “Termination Agreement”). Among other conditions, the Termination Agreement required that Edwards release Arthur Andersen from “any and all” claims, including “claims that in any way arise from or out of, are based upon or relate to [the employees’] employment by, association with or compensation from” Arthur Andersen. In turn, Arthur Andersen agreed that it would release Edwards from his noncompetition agreement once he executed the Termination Agreement.
Because Edwards was concerned he might be personally sued based upon his work for Arthur Andersen, and understood the release of “any and all” claims in the Termination Agreement to require him to give up the right under Labor Code Section 2802 to be indemnified for the defense of such claims, he refused to sign the Termination Agreement. The acquiring entity withdrew the offer of employment to Edwards. Edwards sued Arthur Andersen and the acquiring entity.1
The California Supreme Court Holds that Section 16600 Prohibits Employee Noncompetition Agreements Unless the Agreement Falls Within a Statutory Exception, and that Arthur Andersen’s Noncompetition Provision Was Void.
The Edwards opinion is the first California Supreme Court opinion to address squarely the extent to which parties may restrain an employee’s ability to pursue her or his lawful profession in a situation not falling within one of the statutory exceptions to Section 16600. On this important issue, the court held that “[n]oncompetition agreements are invalid under section 16600 in California even if narrowly drawn, unless they fall within the statutory exceptions of section 16601, 16602, or 16602.5.”
Section 16600 provides that: “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.” The statutory exceptions to Section 16600 permit noncompetition agreements in connection with the dissolution of, or sale of ownership in, corporations(§16601), partnerships (§16602) and limited liability corporations (§16602.5). In evaluating whether the noncompetition provision constituted an unlawful restraint because it restricted the employee’s right to solicit customers and pursue certain employment opportunities, the court found that Section 16600 evinces “a settled legislative policy in favor of open competition and employee mobility.” The court reiterated that California law protects the legal right of persons to engage in business and occupations of their choosing, and discussed various California state court opinions invalidating otherwise narrowly-tailored agreements as improper restraints under Section 16600. Based on these factors, the court stated that “following the Legislature, this court generally condemns noncompetition agreements.” The court then held that the plain language of Section 16600 and the applicable case law both support a finding that noncompetition provisions are prohibited unless they fall within one of the exceptions to Section 16600. In so holding, the court expressly rejected Arthur Andersen’s argument that California decisional law embraces a “rule of reasonableness” in evaluating competitive restraints. The court explained that the case law Arthur Andersen relied upon for this proposition actually involved the statutory exceptions, which the court found to be the legislative adoption of the “rule of reasonableness” previously applied at common law.
The court also rejected Arthur Andersen’s request that the court adopt the “narrow-restraint exception” discussed in a number of opinions from the Ninth Circuit Court of Appeals, under which restraints on trade would be unlawful only if they completely preclude one from engaging in a lawful profession, and conversely would be permissible if they limit only a small or limited part of the business, trade or profession. The court explained that the California courts have not embraced the “narrow-restraint exception,” and expressed its view that Section 16600 reflects a public policy of the state that should not be diluted by the courts. The court thus held that “Section 16600 is unambiguous, and if the Legislature intended the statute to apply only to restraints that were unreasonable or overbroad, it could have included language to that effect.” The court, therefore, stated that it would leave to the Legislature either to relax the statutory standards or adopt additional exceptions to the prohibitions of Section 16600.
Finally, the court expressly stated that it was not addressing whether an exception to Section 16600 applies for the protection of trade secrets. Notable, however, was the court’s statement that it was not addressing the applicability of “the so-called trade secret exception” to section 16600. Thus, while the court left for another day the extent to which noncompetition agreements may be used to protect trade secrets, its negative characterization of this “so-called exception” reflects the strength of the court’s conviction that judicially-created exceptions are contrary to the legislative intent.
Elimination of the option of using noncompete agreements for post-employment protection of trade secrets makes more critical than ever the use of independent protections for the trade secret and confidential information.
Separately, the California Supreme Court in Edwards Found Lawful the Release of “Any And All” Claims by Reading the Release as Not Encompassing Unwaivable Statutory Claims.
Arthur Andersen conditioned Edwards’ employment with the entity acquiring the relevant portion of Arthur Andersen’s business upon Edwards entering into the Termination Agreement, which included a release of “any and all claims” against Arthur Andersen, including those arising out of Edwards’ work for Arthur Andersen. Edwards argued that this provision was unlawful because it could be construed to release the statutory right to indemnification under Labor Code section 2802 for “necessary expenditures or losses incurred by the employee in direct consequence of the discharge of his or her duties.”
In evaluating Edwards’ claims, the court explained that Labor Code section 2804 voids any agreement to waive the productions of Labor Code section 2802 as against public policy. Because indemnity rights are “nonwaivable,” any contract that purports to waive them would be unlawful. Although the court of Appeal found the Termination Agreement to be unlawful because the broad release language necessarily encompassed and therefore purported to release the statutorily nonwaivable right to indemnification, the California Supreme Court disagreed. Applying circular logic, the court reasoned that, because the right to indemnification was nonwaivable, any agreement attempting to waive those rights is unlawful. The court then concluded that the release did not expressly reference indemnity rights and should not be read as encompassing a waiver of such rights. The court thus held that “a contract provision releasing ‘any and all’ claims, such as that used in the [Termination Agreement], does not encompass nonwaivable statutory protections, such as the employee indemnity protection of section Labor Code 2802.” The court further found that the release language did not implicitly reflect an attempt to cause a waiver of Edwards’ indemnity rights. In so ruling, the court adopted Arthur Andersen’s argument that it was aware the right to indemnification was nonwaivable under the Labor Code and so an express exception for that right was unnecessary. The court explained that it would “treat” the Termination Agreement “as expressly incorporating the law that the employee cannot waive” the right to indemnification.
This secondary holding is significant in that it reflects a departure from prior California state court opinions hostile to the courts “redrafting” contractual provisions in order to preserve their validity. California employers will be wise to watch the California courts to see whether this secondary holding will spark a trend of proemployer decisions upholding provisions by construing them to be consistent with and subject to the limitations of applicable law.
1) Edwards settled his claims against the acquiring entity, leaving only his claim against Arthur Andersen to be tried.