Covenants Not To Compete

A recent decision from the Santa Ana division of the Fourth District Court of Appeal prompts consideration of California law on covenants not to compete. Fillpoint, LLC v. Maas, Case No. G045057 (Aug. 24, 2012).

From the days of common law employers have found it difficult to enforce promises by their employees not to compete after the termination of the employment relationship. The common law principles are explored in a case that many law students encounter in their contracts casebooks -- Karpinski v. Ingrasci, 28 N.Y.2d 45 (1971), which concerned a promise by an employee of a dental practice never to practice dentistry or oral surgery in five New York counties. The court explained: "Since there are 'powerful considerations of public policy which militate against sanctioning the loss of a man's livelihood,' the courts will subject a covenant by an employee not to compete with his former employer to an 'overriding limitation of "reasonableness."'" In that case, it was unreasonable to enforce the prohibition on practicing dentistry because the former who employer who sought to enforce the restriction had only practiced oral surgery.

In California, the hostility to covenants not to compete is codified in Business and Professions Code section 16600: "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 chapter provides exceptions for promises not to compete within a "specified geographic area" that accompany (1) sale of a business (section 16601), (2) joining a partnership (section 16602), or (3) becoming a member of a limited liability company (section 16602.5).

There are some Ninth Circuit decisions that purport to find a "narrow restraint" exception to the overall ban imposed by section 16600. See, for example, International Business Machines Corp. v. Bajorek, 191 F.3d 1033 (9th Cir. 1999). In 2008, the California Supreme Court put an end to that interpretation, and ruled that any exceptions must come from the legislature. Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008).

There were two covenants not to compete at issue in the Fillpoint case. When Fillpoint's predecessor in interest acquired Crave Entertainment, Maas, a Crave Entertainment stockholder and employee, signed (1) a stock purchase agreement in which he promised not to engage in the business that Crave Entertainment had for three years following the purchase, and (2) an employment agreement in which he promised not to compete with the purchaser of the business for one year following the termination of his employment. Although both agreements referred to each other, the Court of Appeal rejected Fillpoint's argument that both covenants should be considered part of the sale of a business. The provision in the stock purchase agreement was enforceable, but that in the employment agreement was not.

Employers who are concerned about the damage that departing employees might inflict on their businesses have the following limited options:

• A promise not to solicit the former employer's employees will probably be enforced. Loral Corp. v. Moyes, 174 Cal. App. 3d 268 (Cal. App. 6th Dist. 1985).
• The former employer may prevent a former employee from disclosing or using its trade secrets to benefit another business. Although a customer list or a list of prospects may meet the definition of a trade secret, the former employer may only bar solicitation. It may not prohibit the former employee from accepting business from its customers, nor from engaging in marketing efforts that do not involve use of the customer lists. The Retirement Group v. Galante, 176 Cal. App. 4th 1226 (2009).