Are Non-compete Agreements Enforceable in California?

Are Non-Compete Agreements Enforceable In California?

In today’s increasingly competitive marketplace, businesses owners are constantly on the lookout for ways to protect themselves from the dangers of employee raiding by competitors and the transfer of valuable information in an age when a businesses’ most essential information can be stolen with the click of a mouse.

Many business owners may be surprised to learn that in California, agreements that restrict employees from joining a competitor or starting a competing business are, as a general rule, illegal and unenforceable. Sometimes known as “covenants not to compete,” or non-competition agreements, non-compete provisions in employment or other contracts are generally not enforceable.

The General Rule in California: Covenants Not to Compete Are Not Enforceable

Any discussion of California law on non-compete agreements starts with the general principle.  As the California Supreme Court ruled in its landmark decision on the topic, Edwards v. Arthur Andersen LLP, 44 Cal.4th 937 (2008), California law embodies a fundamental policy in favor of competition.

This policy is reflected in a statute, California Business & Professions Code § 16600, which states that with a few exceptions, “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Courts interpret section 16600 as invalidating most agreements restricting competition.

Exceptions to the Rule: Non-Compete Agreements Are Enforceable in Certain Circumstances

Despite its general prohibition, California law does recognize a limited number of exceptions – circumstances where non-compete agreements are legal and enforceable.

Exception 1: Sale of Goodwill of a Business

The most commonly invoked exception applies to the sale of goodwill of a business and is found in California Business & Professions Code § 16601, which states that “Any person who sells the goodwill of a business, or any owner of a business entity selling or otherwise disposing of all of his or her ownership interest in the business entity, or any owner of a business entity … may agree with the buyer to refrain from carrying on a similar business within a specified geographic area ….”

This exception allows parties to an agreement for the sale of a business, which includes the business’ goodwill, to agree that the seller will not continue to compete in the same market as the purchaser.

The exception can also apply to the sale or redemption of shares by a company from a minority shareholder or employee.  Founding members of start-up stage companies often sign redemption agreements, which allow the company to repurchase the shares when that member decides to leave the company. These agreements often contain non-compete provisions, which may be enforceable under the exception in Section 16601.

The parties must take care however. To ensure that the non-compete is enforceable, the purchase price must include an amount for goodwill. Simply selling shares back to the company for a price does not necessarily provide for the sale of goodwill and will not ensure the enforceability of a non-compete provision. The sale should be well documented and should expressly state that goodwill is part of the transaction. Companies hoping to enforce a non-compete provision are well served by obtaining the services of an independent valuation expert.

Exception 2: Dissolution and Sale of Partnerships and Limited Liability Companies

California law also allows enforcement of non-compete agreements in transactions involving the sale or dissolution of partnership interests and interests in limited liability companies.  Under this exception a departing partner or member of a limited liability company can be lawfully bound by a non-compete agreement.

Exception 3: For the Protection of Trade Secrets

Another so-called exception to California’s prohibition against non-compete agreements arises in the context of provisions seeking to protect trade secrets. This is really a misnomer and not a real exception to the rule. Agreements prohibiting the disclosure of trade secrets are enforceable not because they fall into an exception to the rule against restraining competition, but because misappropriation of trade secrets is itself unlawful. In fact, you don’t need any agreement to restrain a party from disclosing or misusing trade secrets.

To Be Enforceable Non-Compete Agreements Must Be Limited in Scope

Overly broad non-compete agreements will not be enforced. They must be limited in terms of time and geographic reach. For example, in situations where a selling business owner agrees not to compete in exchange for purchase of the company’s goodwill, California courts determine the provision’s enforceability based on where the business is “carried on.” “Carried on” is not limited to the business’ physical location or where it makes its sales.  Rather, the it covers all phases of the business, including production, marketing and sales.

Contact Our Orange County Office Today

If you or your business are facing a legal issue involving a non-compete agreement, contact the Law Offices of Corbett H. Williams today at 949-649-4723 or contact us using the form below, and we will respond promptly.