• California Court Rejects So-Called "Narrow Restraint" Exception to Rule Invalidating Covenants Not to Compete
  • September 21, 2006
  • Law Firm: Nixon Peabody LLP - New York Office
  • In a case arising out of the collapse of the Arthur Andersen accounting firm (“Andersen”), a California court of appeals has ruled that covenants not to compete are generally unenforceable in California, even when they are narrowly drafted and leave a substantial portion of the market available to the affected individual. Edwards v. Arthur Andersen (8/30/2006) __ Cal. App. 4th __, 2006 Cal. App. LEXIS 1320.

    In 1872, the California Legislature adopted the rule that covenants that restrict an individual’s right to compete with another business are generally not enforceable. That restriction is now found in California Business and Professions Code Section 16600, which provides:

    “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.”

    Given the sweeping nature of this generalized prohibition, litigation in the area has, not surprisingly, focused on the existence and scope of various statutory and common law exceptions that uphold non-compete agreements in certain prescribed circumstances. California courts have recognized three express statutory exceptions to this rule and one common law exception. Under these exceptions, a person can lawfully agree not to compete with another business:

    • where a person sells the goodwill of a business;
    • where a partner agrees not to conduct a like business in connection with the dissolution of that partnership;
    • where a member of a limited liability company agrees not to conduct a like business in connection with the dissolution of that limited liability company; or
    • where a restrictive covenant is necessary to protect a company’s trade secrets.

    In addition to these four clearly defined exceptions, federal courts in California have, since 1987, recognized a fifth, vaguely defined exception, commonly referred to as the “narrow restraint” exception. This judicial creation holds that a non-compete agreement is enforceable if it merely prohibits an individual from competing in a “narrow segment” of the market. One of the more notable decisions in this line of cases was International Business Machines v. Bajorek (9th Cir. 1999) 191 F.3d 1033.

    In Bajorek, an IBM employee signed a stock option agreement that provided that, if he worked for a competitor within six months after exercising his stock options, he would have to return any profits to IBM. After leaving IBM, the employee went to work for a competitor without waiting the requisite six-month period, and then tried to exercise his stock options, which were then worth $1 million. Relying on the “narrow restraint” exception, the court held the stock option agreement’s restraints on the employee were legal. The court reasoned that all the employee had to do to receive the million dollars was to refrain from working for a competitor for six months, which the court found was reasonable. Other federal courts have applied the narrow restraint exception in circumstances where an agreement prevents a former employee from working for a narrowly defined group of competitors, arguably leaving that employee free to find employment outside that narrow group. However, while various federal courts continue to follow the narrow restraint doctrine, California state courts never adopted this exception and had, in some cases, issued rulings which questioned the doctrine.

    In Edwards, the California court of appeals issued a decision squarely rejecting the narrow restraint exception as a “misapplication of California Law.” The Edwards dispute arose from a somewhat complicated set of circumstances In 1997, Edwards, a certified public accountant, was hired as a tax manager in Andersen’s Los Angeles office. Edwards signed Andersen’s standard non-compete agreement, which contained three promises by Edwards:

    • For a period of 18 months from separation, Edwards would not perform professional services for any Andersen client to whom Edwards had provided services within 18 months prior to separation.
    • For a period of 12 months from separation, Edwards would not solicit business from any client of the Andersen office to which he had been assigned for the 18 months prior to separation.
    • For a period of 18 months from separation, Edwards would not solicit away any of Andersen’s professional employees.

    In 2002, as Andersen’s demise approached, Andersen began selling off various business units. Andersen agreed to sell the Los Angeles tax practice, in which Edwards worked, to HSBC. To secure employment with HSBC, Edwards and other employees were required to sign a termination of non-compete agreement (“Termination Agreement”), whereby Andersen released Edwards from its standard non-compete agreement, in exchange for which Edwards voluntarily resigned from Andersen and released all legal claims he might have against Andersen.

    Edwards refused to sign the Termination Agreement. Andersen then terminated Edwards, and HSBC withdrew its employment offer from Edwards. Edwards sued Andersen for interference with prospective business advantage and other claims. Edwards alleged that Andersen’s demand for consideration in exchange for releasing him from the non-compete agreement was wrongful, inasmuch as the agreement was illegal in the first place. Edwards alleged that, by refusing to relinquish the non-compete agreement, Andersen had prevented him from securing employment with HSBC.

    The trial court followed the earlier federal court rulings recognizing the narrow restraint exception. It ruled that the non-compete agreement signed by Edwards was not unlawful, because it did not constitute a “significant restriction on his ability to work,” reasoning that “there were more than enough of these wealthy folks in L.A.” who needed services of the type provided by Edwards.

    The court of appeals reversed this determination, holding that California law did not recognize the purported narrow restraint exception on which the trial court had relied. The court of appeals reviewed the federal decisions that had recognized this additional exception, and concluded that the federal courts had simply gotten it wrong. The court stated that the California Legislature had created three express exceptions to 16600, and that the courts should not create additional exceptions that are not suggested by the statutory language. With respect to the common law exception for protection of trade secrets, the court noted that exception had long been recognized by the courts, and was rooted in considerations of equity and fairness. (The court might have also noted that the California Legislature had impliedly recognized the trade secrets exception when it enacted the Uniform Trade Secrets Act in 1984.) Finally, the court observed that the narrow restraint doctrine would encourage employers to require employees to sign non-compete agreements that “pushed the envelope” of the exception, since the only way an employee could find out if the restraint were sufficiently “narrow” to be legal would be to litigate the issue. Ultimately, the court issued a sweeping rejection of the narrow restraint doctrine, holding that: “Noncompetition agreements are invalid under section 16600 even if narrowly drawn, unless they fall within the statutory or trade secret exceptions.”

    Based on this holding, the court concluded that Andersen had acted unlawfully in demanding a release of claims in exchange for releasing Edwards from the unlawful non-compete agreement.

    Given the court’s scholarly discussion of the history of the narrow restraint exception, and its unequivocal rejection of that doctrine, it is likely that this case marks the end of the narrow restraint exception. Under general principles of federalism, California courts have authority to interpret California law, and federal courts should defer to California courts on such issues. However, federal courts are only required to follow decisions of the California Supreme Court, and a federal court could conceivably opine that the Edwards decision does not, in its view, reflect the probable ruling of the California Supreme Court. Until the issue is addressed by either the California Supreme Court or a federal court applying California law, one must conclude that that narrow restraint doctrine may not be completely dead, but, at most, it has a very faint pulse.

    In another significant portion of the opinion, the court ruled that the release provision contained in the Termination Agreement violated California Labor Code Section 2802, which requires employers to indemnify employees for “all necessary expenditures or losses incurred by the employee in direct consequence of the discharge of his or her duties.” The court ruled that California law does not permit an employee to waive his rights under Labor Code Section 2802, and that the release language in the Termination Agreement was sufficiently broad to include Edwards’s rights under section 2802. Thus, the court ruled that Andersen acted unlawfully in demanding that he waive his indemnity rights as a condition of securing employment with HSBC.

    In the final portion of the opinion, the court ruled that the non-disparagement provision in the Termination Agreement did not violate various Labor Code provisions cited by Edwards. The court also accepted that trial court’s determination that the Edwards’s agreement not to solicit Andersen’s professional employees was lawful.

    Recommendations

    The Edwards decision constitutes a timely reminder to employers of the risks they undertake when they attempt to enforce non-compete agreements against former employees. Prudent employers should:

    • Have agreements that contain provisions restricting an employee’s ability to solicit or accept business, or to compete in any fashion, reviewed by counsel, to assure proper drafting.
    • To the extent any current employees have signed agreements that were drafted to fall within the narrow restraint exception, consider replacing those agreements with agreements less vulnerable to legal attack.
    • Be extremely careful in demanding anything from an employee in exchange for the company’s agreement not to enforce contract provisions that might be found to be invalid or unenforceable.
    • Exercise caution in conditioning the receipt of benefits, such as severance benefits or new employment, on the employee’s relinquishment of non-waivable statutory rights, such as those under Labor Code Section 2802.