Alert: California Court Finds Restrictive Covenants Not Salvaged By Narrowness

September 01, 2006

The California Court of Appeals has redefined this week the acceptable scope of employee covenants not to compete or solicit clients.  In Edwards v. Arthur Andersen LLP, the California Court of Appeals, Second District, has held that such covenants will only be enforced if necessary to protect a trade secret or if executed as part of the sale of business goodwill or partnership.  The court soundly and unequivocally rejected a line of cases, mostly decided by federal courts interpreting California law, which had allowed such covenants if only precluding a narrow segment of the market.

In Edwards, an accounting manager had signed a covenant not to service or solicit certain firm clients for a period after his departure.  When his practice group moved to another firm, that firm required that he obtain a waiver of the covenant as a condition of employment.  His original firm required a general release in exchange for waiving the covenant. Edwards declined and sued the original firm for interference with his potential new job on the grounds that the covenant was void under California Business & Professions Code § 16600.  That Section provides that "[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."  The trial court dismissed his claim, citing Ninth Circuit opinions that Section 16600 did not preclude covenants that only restricted a person from engaging in business with a narrow segment of their potential market.  The trial court observed that the covenant allowed the accountant to work with the universe of clients that had not worked with his original firm and, thus, he was not "restrained from engaging in his profession" under Section 16600.

The California Court of Appeal reversed, finding that the so-called "narrow restriction" exception did not exist.  The court examined the historical development of that exception and concluded that the Ninth Circuit had developed it without sufficient authority under California law.  Instead, the Court of Appeals held that the only California court-developed exception to Section 16600 was to allow covenants "where necessary to protect trade secrets."  This is in addition to the statutory exceptions involving the transfer of business goodwill or partnership interest.  Moreover, the court held that Andersen could be liable for interference with prospective business advantage by requiring consideration to "release" him from the covenant.

Thus, employers need to assure that any covenants not to compete or solicit customers are expressly justified as necessary to protect trade secrets.  This means that they are best incorporated into employee non-disclosure, confidentiality agreements.  Such agreements should specifically identify the information to be designated as trade secrets (rather than boilerplate language listing every conceivable trade secret which may or may not exist at your company).  Other demonstrable efforts should be made to protect the confidentiality of the information so as to support its status as a trade secret.  Most importantly, the covenant should be only as broad as necessary to protect the trade secret.  California courts will not narrow the covenant for an employer in order to allow enforcement. 

This decision also counsels that employers should be careful about asserting a right to enforce a potentially invalid covenant.  If the threat prevents employment and the covenant is held invalid, the employer may be found liable for tortuous interference with the potential new employment relationship.