by Stephen W. Pearson, ESQ
California business owners have struggled for many years to protect their businesses from competition by departing employees. Disputes over the scope and enforceability of covenants not to compete are commonplace.
There are few areas of the law which result in more acrimonious litigation than disputes over the right of an employer to limit competition by former employees. Naturally, a business owner has a strong negative reaction to his or her employees taking information and skills the employees have learned and developed on the job, often after years of training, and expected employee loyalty, which information and skills are then used by the departing employee in direct competition with the former employer.
Employees, fearful of not being able to work in a business field in which they have become knowledgeable, effective and sophisticated participants, are often aggressive in pushing the boundaries of competition and using information they have learned or acquired at the their former place of employment. The disputes and litigation resulting from these competing interests are common, expensive and unpleasant; and the outcome of these disputes is often difficult to predict.
This article discusses briefly the intersection between covenants not to compete, limitations on competition, and how limits on the use of trade secrets and confidential information may help protect an employer from unfair competition by a departing employee.
The law on restricting competition varies from state to state. A number of states allow employers to extract covenants not to compete from their employees. In states in which this is permissible, the employee is bound not to compete and the covenant is enforceable.
California, however, has long been a strong protector of open and free competition in the employment market. The California Legislature and California courts have repeatedly supported California’s strong public policy to prevent any restriction on lawful employment. This policy is enshrined in statute [Business & Professions Code section16600] which has been in effect for many years. The Legislature has provided in section 16600 that every contract by which any person is restrained from “engaging in a lawful profession, trade or business of any kind . . . is void”. This means that an employer cannot limit an employee’s rights to compete with the employer after the employee leaves employment. A contract which attempts to do so is unenforceable and will be disregarded by the court if an employer attempts to enforce such a contract or to limit a former employee’s competing against his former employer.
Moreover, an employer cannot require an employee to sign a non-competition agreement when taking a position with the employer. Likewise, an employer cannot force an employee to agree not to compete at the time of the employee’s termination or voluntary departure, even if the employee pays for the employee’s agreement not to compete. In fact, if an employer disciplines or fires an employee who refuses to sign a covenant not to compete, the employer is violating California law and can be successfully sued for wrongful termination and other claims.
Many employers and their imaginative legal advisors have attempted over the years to avoid the law’s prohibition of non-compete agreements. Nevertheless, many direct or indirect methods, techniques or schemes to limit competition have been unceremoniously tossed out by California courts.
However, competition can be limited or prohibited in one important circumstance: A business owner, including officer and employee owners, who sells his or her interest in a business enterprise can be lawfully prohibited from direct or indirect competition with the buyer of the business by requiring the seller sign a covenant against future competition.
The seller of stock in a corporation, the seller of goodwill in a business on departure, the seller of an interest in a California limited liability company or the seller of an interest in a partnership all can lawfully agree not to compete against the business enterprise in which they have sold an interest. Under this exception to section 16600, an agreement not to compete is enforceable. The buyer of the business enterprise can enforce the non-compete agreement in California courts; can recover damages from the wrong-doing competitor; and often can obtain an injunction against future competition, so long as the injunction follows terms of the non-compete agreement as to time and geographic limits.
This exception to section 16600 has been permitted by the Legislature for a specific reason: to allow the purchaser of a business to protect the newly-acquired business. This exception recognizes that if a seller could immediately compete with the purchaser, there would be little value to the purchaser remaining after the sale. The limit on competition prevents the seller from reducing or destroying the value of the business acquired by the purchaser, and depriving the purchaser of the value of what was purchased: a going concern, with its valuable assets, it business and relational contacts, its reputation and its good will.
However, even enforceable covenants not to compete must be somewhat limited in scope. An enforceable covenant may prohibit competition within a carefully specified geographic region. For instance, a seller of a business could agree not to compete within the 3-4 counties in which the business operates; or could agree not to compete within the state of California if the company operates throughout the state. The courts will look at whether the geographic region specified in the covenant is reasonable under all the circumstances, and has a reasonable relationship to the area in which the business operates as of the date of the covenant. The larger the geographic region selected, the more risk is assumed by the buyer that the covenant will not be enforceable.
A covenant not to compete must be also limited to a reasonable length of time. The rationale for a time limitation on competition is that it permits the purchaser of a business to transition the business to the buyer without competition from the seller. The longer the time period in the covenant not to compete, the more risk that a court will find the covenant to be unenforceable. Usually, for most small and medium-size businesses, a reasonable time to restrict competition would be 3 to7 years, but it can be longer if appropriate under the factual circumstances in which the non-compete agreement is signed.
In summary, the employer who as a part of the sale of some or all of an owner’s interests in a business enterprise, attempts to limit employee competition against a former employer will end up with an agreement which is generally void and unenforceable.
While covenants not to compete which restrict employees and former employees from future competition with an employer are not effective, a California employer can protect its trade secrets and confidential information, and thus limit the departing employee’s ability to compete, using that information. No employee or former employee is entitled to use his employer’s protected confidential information and trade secrets to compete with his former employer. Therefore, by preventing the disclosure and use of its trade secrets and confidential information, the employer can protect itself from future competition by a former employee, regardless of the fact that this will have the effect of limiting the departing employee’s future employment. The employer’s right to protect trade secrets and confidential information is not limited to an employee who sells his or her interest in the business; it is available any time an employee leaves to work for another.
What is a “trade secret”? California has adopted a version of the Uniform Trade Secrets Act. California Civil Code section 3426 et seq. That legislation provides that a trade secret includes information, formulas, patterns, compilations, programs, devices, methods, techniques or processes that have “independent economic value”; are not “generally known to the public”; and which have been “subject . . . to . . . [reasonable] efforts . . . to maintain [the asset’s] secrecy.” Civil Code section 3426.1(a). While the question of whether something is a “trade secret” is a question of fact, generally an asset will be found to be a trade secret if it consists of information or a technique which is valuable because it is unknown to others (especially to competitor), and the owner has kept the information or technique “secret”.
Assets which have been determined by courts to be trade secrets include customer lists; information about special needs or requirements of a customer; proprietary credit application processing systems; the existence of confidential business negotiations; manufacturing processes; machines and patterns; treatments and preservation of goods and materials; and strategic and marketing plans. In all these instances, the courts determined factually that the trade secret was valuable, not known to the public, and that the owner made substantial efforts to protect the secrecy of the trade secret.
Employees in California are prohibited from misappropriating trade secrets. Misappropriation includes acquiring a trade secret “by improper means” or disclosure or use of a trade secret without consent of the owner. A party who uses a trade secret improperly may be enjoined from use or disclosure of a trade secret by a restraining order. The improper use of trade secrets can also result in the award of damages, including punitive damages. And finally, an employer whose trade secrets are improperly used or disclosed may be awarded attorneys’ fees and costs which are spent to enforce the employer’s rights to protect its trade secrets and confidential information.
An employer which owns trade secrets should be careful to provide in writing that an employee shall not, while employed or upon departure from employment, disclose trade secrets or use trade secrets when working for other employers or for him or herself. Requiring a prospective employee to agree in writing before he starts work that he will not disclose or use any trade secret or confidential information is a good first step. The agreement should also provide the employee’s acknowledgement that an injunction against disclosure is a proper legal remedy to protect an employer’s trade secrets and confidential information. An important second step is making sure that the employees manual or company- wide written policies and procedures confirm and reinforce that the employer’s trade secrets and confidential information are company property, and are not to be used or disclosed to any outside party, and may not be used in competitions with the employer. When an employee leaves the business, he should be asked to acknowledge in writing that he is not taking, using, disclosing, or planning to take, use or disclose any of his employer’s trade secrets or other confidential information.
Not only is it important to obtain the agreement of an employee to guard and protect trade secrets and confidential information, it is also important that the employer takes steps to protect confidential information and trade secrets from disclosure. In determining whether information is a trade secret or is confidential, it will be important to be able to demonstrate to a court that the employer has taken all necessary steps to protect confidential information from disclosure. The more broadly information is known within a company, the less likelihood the information will be protectable as a trade secret. Thus, guarding the trade secret or confidential information with passwords, limiting disclosure to a small number of employees, and requiring those with access to trade secrets or confidential information all are important indicators the trade secrets and confidential information is in fact secret and not disclosable.
The employer owner of the trade secret is entitled to protect trade secrets and confidential information by injunctions against disclosure and use; and to recover damages if the trade secret has been disclosed or used by a former employee. The new employer is also exposed to claims that it improperly obtained and used trade secrets and confidential information when hiring away an employee from another company.
Therefore, when hiring a new employee, a prospective employer should take steps to protect itself from a claim by the prospective employee’s former employer. The prospective employee should be asked to certify in writing that he is not taking any trade secrets or confidential information with him when he leaves his current employment. And he should be advised to leave the office “bare”, without any information of any kind, including that contained in any device, disk, electronic data, or in tangible form which is or might be a trade secret or confidential information. These steps will help defend against any future litigation brought by the former employer, claiming that the employee and his new employer are using the former employer’s trade secrets or confidential information. Not only would litigation name the former employee; it would also include the new employer as a defendant.
Covenants not to compete are enforceable only under limited circumstances. Business owners should be aware of the strict limits the California legislature and California courts have placed on enforcing covenants not to compete. Because of the complexity of California law relating to covenants not to compete and trade secret protection, consulting with legal counsel will be important to ensure that proper steps are taken to protect and defend your business’s position and to ensure that lawful and enforceable restrictions on competition are in place before a dispute arises.
Business owners should not attempt to obtain covenants against competition from its employees. However, when buying out a business owner, the buyer should insist on a properly limited covenant against competition.
Business owners should take all appropriate steps to identify and protect trade secrets and confidential information. They should insist on written acknowledgement by their employees that they will not disclose or use trade secrets or confidential information.
And finally, when hiring an employee from a competitor, business owners should carefully document that the new employee is not going to bring a time bomb into his new employer’s business. The new employee must leave “bare” of any information that could be a trade secret or confidential information; and must also acknowledge that he is not bringing or planning to use his former employer’s trade secrets or confidential information.
This article is intended to address topics of general interest and should not be construed as legal advice.