Many states recognize and enforce noncompetition agreements and allow such restraints on the practice of a trade or business provided they are "reasonable." In California, however, a statutory prohibition on noncompetition agreements found in California Business & Professions Code section 16600 embodies the state's long-standing hostility to restraints on trade. In a closely watched decision, last month the California Supreme Court in Edwards v. Arthur Andersen LLP unanimously confirmed the state's disapproval of noncompetition agreements, holding that a contractual provision limiting a former employee's right to compete with or serve customers of his former employer was invalid under state law.
Section 16600 provides that "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 statute explicitly permits noncompetition agreements only in the limited circumstances of the sale or dissolution of corporations (§ 16601), partnerships (§ 16602) and limited liability corporations (§ 16602.5). Beginning in the 1990s, the U.S. Court of Appeals for the Ninth Circuit created what is commonly known as a "narrow restraint" exception to section 16600. Notwithstanding this broad prohibition, the federal courts have upheld certain noncompetition provisions, including an agreement mandating that an employee forfeit stock options if employed by a competitor within six months of leaving his prior employment, and a contractual provision restricting a party from courting a specific customer. The federal courts reasoned that such narrowly tailored restrictions were acceptable—even if they prohibited employment with direct competitors—so long as they did not prevent a former employee from working in another "substantial part" of the market or "entirely preclude" a party from pursuing his trade or business. In Edwards, the California Supreme Court squarely addressed the validity of this "narrow restraint" exception and unequivocally rejected it.
The noncompete provision at issue in Edwards was contained in an employment agreement signed by Edwards when he began working for Arthur Andersen as a tax manager. Under the agreement, Edwards could not solicit any clients of Arthur Andersen's Los Angeles office for one year following termination of his employment. Additionally, for 18 months following termination, Edwards could not perform professional services of the type he performed at Arthur Andersen for any client on whose account he had worked during his last 18 months of employment. Following the Enron scandal, Arthur Andersen sold its tax practice and offered to enter into a Termination of Noncompete Agreement with Edwards, which would release Edwards from his noncompete in exchange for his agreement (among other things) to release any claim he might have against Arthur Andersen related to his employment and continue to preserve Arthur Andersen's trade secrets and confidential information. Troubled by the requirement that he give up his right to indemnification, Edwards refused to sign the Termination of Noncompete Agreement. As a result, Arthur Andersen terminated his employment, withheld severance benefits and refused to release him from the terms of the noncompete agreement.
Edwards subsequently filed suit against Arthur Andersen, alleging, among other things, that the noncompete provision violated section 16600. Arthur Andersen argued that the agreement should be enforced because California courts accept the rule of reasonableness in evaluating the validity of noncompetition restrictions under section 16600. Specifically, Arthur Andersen contended that the law "prohibits only broad agreements that prevent a person from engaging entirely in his chosen business, trade or profession. Agreements that do not have this broad effect—but merely regulate some aspect of post-employment conduct, e.g., to prevent raiding [employer's personnel]—are not within the scope of [s]ection 16600."
The California Supreme Court disagreed with this position, noting that the cases cited by Arthur Andersen in support of a relaxation of the statutory rule did not fully embrace the common law rule of reasonableness in evaluating competitive restraints, but instead merely recognized that the statutory exceptions to section 16600 reflect the same exceptions implied in the common law. Stressing the importance of the law's protection of "the important right of persons to engage in business and occupations of their choosing," the court observed that the noncompete signed by Edwards restricted him from performing work for Arthur Andersen's Los Angeles clients, and concluded that "[t]he noncompetition agreement that Edwards was required to sign before commencing employment with Andersen was therefore invalid because it restrained his ability to practice his profession."
Arthur Andersen also requested that the court adopt the "narrow restraint" exception to section 16600 applied by the Ninth Circuit to allow noncompetition agreements "where one is barred from pursuing only a small or limited part of the business, trade or profession." The California Supreme Court declined, stating that "we are of the view that California courts 'have been clear in their expression that section 16600 represents a strong public policy of the state which should not be diluted by judicial fiat.'" Reasoning that section 16600 was unambiguous, the court denounced the narrow restraint exception and left it to the state legislature to adopt additional exceptions to the law or relax its prohibitions, if it so chooses.
Although the holding of Edwards ultimately is consistent with a long line of California state cases strictly applying section 16600, Edwards is significant for its unequivocal endorsement of section 16600, emphatic rejection of the narrow restraint doctrine, and the fact that it invalidates Ninth Circuit and federal cases that applied that doctrine. On a practical level, the decision should prompt a reexamination of contracts containing noncompetition provisions, including employment agreements, franchise agreements and confidentiality agreements to assess the impact of Edwards.
Some commentators have suggested that Edwards destroys the viability of noncompetition agreements in California that are not expressly permitted in sections 16601, 16602 and 16602.5 of the Business and Professions Code. Indeed, the opinion explicitly states that "[n]oncompetition agreements are invalid under section 16600 in California even if narrowly drawn, unless they fall within the applicable statutory exceptions . . ." However, the Edwards court did not address another widely recognized exception to section 16600 arising in connection with the protection of trade secrets, which provides that "[m]isappropriation of trade secrets information constitutes an exception to section 16600." Readylink Healthcare v. Cotton, 126 Cal. App. 4th 1006, 1022 (2005). The court specifically noted that it did not address the "so-called trade secret exception to section 16600" because Edwards did not dispute the portion of his agreement dealing with trade secrets or contend that the provision in the noncompetition agreement prohibiting him from recruiting Arthur Andersen's employees violated section 16600. As a result, while the Edwards court invalidated the federal courts' narrow restraint exception to section 16600, the continued viability of provisions restricting the use of trade secrets or intellectual property to compete or solicit customers remains unclear.