California – California Supreme Court Invalidates Non-Compete Agreement

In a unanimous decision, the state’s highest court recently ruled that a noncompetition agreement entered into between an employer and one of its former employees is unenforceable under California law.  In so doing, the California Supreme Court upheld a longstanding state law restricting employers from using such agreements to restrain employees’ practice of their professions.  Edwards v. Arthur Andersen LLP, No. S147190, California Supreme Court (August 7, 2008).

Factual Background

Raymond Edwards II, a certified public accountant, was hired as a Tax Manager by Arthur Andersen LLP in January 1997.  As a condition of his employment, Edwards was required to sign a noncompetition agreement.  The agreement stated, in part, “If you leave the Firm, for eighteen months after release or resignation, you agree not to perform professional services of the type you provided for any client on which you worked during the eighteen months prior to release or resignation.  This does not prohibit you from accepting employment with a client.”  The agreement further stated: “For twelve months after you leave the Firm, you agree not to solicit (to perform professional services of the type you provided) any client of the office(s) to which you were assigned during the eighteen months preceding release or resignation.”

Arthur Andersen eventually went out of business and sold its practice to various entities.  The firm’s Los Angeles tax practice, including Edwards’ group, was sold to HSBC.  As a condition of the sale, Arthur Andersen required that all managers execute a “Termination of Non-Compete Agreement” in order to obtain employment with HSBC.  The agreement required employees to: (1) voluntarily resign from Arthur Andersen; (2) release Arthur Andersen from “any and all” claims, including “claims that in any way arise from or out of, are based upon or relate to Employee’s employment by, association with or compensation from” Arthur Andersen; (3) continue to indefinitely preserve confidential information and trade secrets except as otherwise required by a court or governmental agency; (4) refrain from disparaging Arthur Andersen or its related entities or partners; (5) cooperate with Arthur Andersen in connection with any investigation of, or litigation against, the Firm.

In exchange, Arthur Andersen would agree to accept Edwards’ resignation, agree to Edwards’ “employment by or affiliation with” HSBC, and release Edwards from the 1997 noncompetition agreement.  Edwards signed and returned HSBC’s written employment offer, but refused to sign the Termination of Non-Compete Agreement.  As a result, Arthur Andersen terminated his employment, and HSBC withdrew its employment offer.

In April 2003, Edwards filed a lawsuit alleging intentional interference with prospective economic advantage and anticompetitive business practices in violation of the Cartwright Act.  The trial judge dismissed the intentional interference claim, after finding that both the 1997 noncompetition agreement and the 2002 Termination of Non-Compete Agreement were valid.  The trial judge also held that Edwards lacked standing to sue under the Cartwright Act.  Edwards appealed this decision to the California Court of Appeal.

The California Court of Appeal disagreed, holding that the 1997 noncompetition agreement was invalid and against public policy.  Likewise, the court concluded, requiring Edwards to execute the Termination of Non-Compete Agreement as consideration for release from the 1997 noncompetition agreement was also in violation of public policy and an independently wrongful act for purposes of Edwards’ intentional interference with prospective economic advantage claim.  The case was ultimately heard by the California Supreme Court.

Legal Analysis

Section 16600 of California’s Business and Professions Code sets forth the general rule in California – covenants not to compete are void.  There are several exceptions to this general rule, however.  For example, Sections 16601 and 16602 “permit broad covenants not to compete in two narrow situations, i.e., where a person sells the goodwill of a business and where a partner agrees not to compete in anticipation of dissolution of a partnership.”

Arthur Andersen asked the court to adopt another theory for concluding that a noncompetition agreement is valid – the “narrow restraint” exception, which the trial judge relied on to uphold the 1997 agreement.  This exception provides that a noncompetition agreement does not violate Section 16600 as long as the restriction imposed is limited and leaves a substantial portion of the market available to the employee.

Finding that California courts have not embraced the narrow restraint exception, the California Supreme Court declined to adopt this exception to Section 16600.  According to the court, “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.”

The “plain meaning” of Section 16600, the court noted, indicates that an employer may not “restrain a former employee from engaging in his or her profession, trade, or business unless the agreement falls within one of the exceptions to that rule.” The court rejected Arthur Andersen’s effort to relax the statutory rule such that only contracts that totally prohibit an employee from engaging in his or her profession would be illegal.  The court reasoned that by restricting Edwards from working for Arthur Andersen’s Los Angeles clients, the 1997 noncompetition agreement restricted his ability to practice his profession and was therefore invalid.

However, the court rejected Edwards’ argument that the Termination of Non-Compete Agreement violates Labor Code section 2804.  According to the court, while the agreement released Arthur Andersen from “any and all claims,” it did not expressly reference indemnity rights.  Since the agreement did not implicate Edwards’ nonwaivable right to indemnity, the court held that it was not unlawful.

Practical Impact
 
According to Marcus McDaniel, a shareholder in Ogletree Deakins’ Los Angeles office: “This decision confirms that noncompetition agreements are invalid under California law except in the limited situations expressly permitted by statute.  Requiring employees to sign unenforceable non-competes can lead to troubling consequences.  Separately, the court’s ruling reduces the concern that general releases will be unenforceable unless they expressly carve out nonwaivable statutory claims.”

Note: This article appeared in the August 18, 2008 issue of the California eAuthority.