It is common in many commercial contexts for individuals and businesses to execute agreements containing covenants not to compete clauses. The legality and enforceability of covenants not to compete vary between contexts and states. We explain how covenants not to compete operate in California.
California is one of the states most averse to enforcing covenants not to compete. Under the rules enunciated in the California Business and Professions Code, such covenants are typically unenforceable. The rules against enforceability are broad: “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void” (California Business and Professions Code §16600). The California Supreme Court reinforced those rules in a case called Edwards v. Arthur Andersen LLP, by definitively stating that such covenants are not enforceable even if written clearly and narrowly (Edwards v. Arthur Andersen LLP (2008), 44 Cal. 4th 937). The rule against covenants cannot be overridden by choosing another state’s laws.
The policy reason for the unenforceability of covenants not to compete is to ensure citizens have the right to pursue any lawful employment and enterprise of their choice. Even though covenants not to compete are almost always unenforceable, the California Court of Appeals stated that the policy is not “absolute” (SingerLewak LLP v. Gantman (2015), 241 Cal.App.4th 610, 624).
Courts sometimes have authority to change agreements that include covenants not to compete. This is called a “blue pencil agreement.” Blue penciling is not allowed in employment contexts, but can occur in circumstances that fall under the first exception, discussed below (agreements in the context of the sale of a business) (Monogram Indus., Inc. v. Sar Indus., Inc. (1976), 64 Cal. App. 3d 692).
There are three main circumstances in which covenants not to compete are permitted and could be enforced.
Exception #1: Sale of a Business or Business Interest
The first and most common exception is when covenants not to compete are signed in connection with the sale of a business or interest in a business (California Business and Professional Code §16601). “Business” entities include limited partnerships, limited liability partnerships, limited liability companies, and corporations. The “sale” of a business includes where the business entity sells (1) all ownership interest in the business entity or subsidiary, or (2) all or substantially all of the operating assets and goodwill of the business entity or subsidiary. The covenant not to compete may be enforced in these circumstances, but only to prevent the seller from carrying on a similar competing business and in a specified geographic area.
The duration and geographic size of the covenant not to compete under the exceptions must be limited. The duration is usually viewed as reasonable if the covenant operates as long as the same buyer or one of their partners is carrying on the same business. The geographic area must be limited to the zone where the business was being conducted, and cannot be larger than the state where the company was operating. For example, if the business was only operating in one California county, the covenant not to compete must be limited to that one county (Alliant Ins. Servs., Inc. v. Gaddy (2008), 159 Cal. App. 4th 1292). This exception therefore plays the policy role of protecting the value of a business for the buyer by preventing the seller from competing within a geographic area.
Exception #2: Partnership Dissolution
The second exception is where a partner signs a covenant not to compete when the partnership dissolves or a partner dissociates from the partnership (California Business and Professional Code §16602).
Exception #3: Limited Liability Company Withdrawal or Dissolution
And finally, the third exception is where a member signs a covenant not to compete when ending any interest in a limited liability company or the company dissolves (California Business and Professional Code §16602.5).
Covenants designed to protect trade secrets are enforceable. Trade secrets are defined as “information, including a formula, pattern, compilation, program, device, method, technique, or process, that … [d]erives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use” (California Civil Code §3426.1).
Even if an exception applies, enforcing a covenant not to compete may still be difficult. The California Court of Appeals has stated that if a covenant not to compete ever becomes an issue before the court, evidence will be interpreted in favor of the party that is being restrained, such as the former employee (Fillpoint, LLC v. Mass (2012), 208 Cal.App.4th 1170, 1177).
Not only are covenants not to compete generally unenforceable, but employers can be found liable for attempting to enforce a covenant not to compete. In California employers have been successfully restrained for attempting to enforce a covenant based on a violation of unfair competition law (California Business and Professional Code §17200 et seq.) and for the tort of invalid discharge for refusing to sign an invalid covenant (Thompson v. Impaxx, Inc. (2003), 113 CA4th 1425). Employers who fire an employee for breaching a covenant not to compete with a former employer can also be liable (California Business and Professional Code §16600; Silguero v. Creteguard, Inc. (2010), 187 CA4th 60).
California has increasingly narrowed situations in which a covenant not to compete will be enforceable. However, covenants not to compete are still commonly used and litigated. As such, partners, sellers of businesses, and employers and employees should be aware of their legal responsibilities when drafting, signing, or enforcing covenants not to compete.
Simantob Law Group is a law firm of business attorneys and real estate lawyers. We have represented the business and real estate legal needs of individuals and companies, from start-ups to regional and national US corporations for over 20 years. Please contact us at 310.281.0041 or complete our online contact form to discuss covenants not to compete or other legal issues or legal documentation needs.