The Ultimate Guide to Non-Competes in California

Non-competes in the state of California have been a topic of discussion for several years now. The status of California as the capital of modern technology and innovation in the United States makes the matter of non-compete clauses especially relevant as competition in all respects, including for qualified knowledgeable employees, in the state is fierce.

The business climate in California naturally created an environment in which the topics of fairness, validity and enforceability of non-compete clauses emerged and were eventually regulated by lawmakers and explained in detail by courts. However, to this day, questions regarding the enforceability of non-compete clauses in the state of California often arise when negotiating contracts with employees and business partners.

You may be thinking: why are we analyzing non-competes in California when, as covered in a number of our own articles, the most popular state for incorporation in the United States is Delaware? This is a good question – yes, most companies doing business in the United States, among which are most of our clients, are corporations and limited liability companies incorporated in the state of Delaware. It is not a secret, however, that those companies do not only do business in the state of Delaware. A significant number of Delaware corporations and limited liability companies, especially those engaged in businesses dealing with technologies and innovation, do business in the state of California, which often involves hiring employees and entering various business contracts in California. In such cases, the laws of the state of California, including rules regulating non-competes, cannot be overlooked.

Below we provide a summary of the most important points to keep in mind when considering a non-compete clause in an agreement governed by California law. Please mind that this article is neither legal advice nor should be treated as an exhaustive description of all applicable laws.

General Rule – Non-Competes in California are Unenforceable

Under the general rule in California, covenants not to compete are unenforceable. The rule set forth in California Business and Professions Code Section 16600 states that “except as provided in this chapter, 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 courts have consistently declared Section 16600 an expression of public policy to ensure that every citizen shall retain the right to pursue any lawful employment and enterprise of their choice (Strategix v. Infocrossing, 142 Cal.App.4th 1068 (Cal. Ct. App. 2006)). Therefore, in California, agreements containing non-compete clauses are generally void to the extent that they restrain anyone from engaging in a lawful profession, trade, or business of any kind.

Exception – Sale of Business

California Business and Professions Code Section 16601 sets for an exception to the general rule that allows non-compete covenants in connection with a sale of a business, more specifically stating that “any person who sells the goodwill of a business, or any owner of a business entity selling or otherwise disposing of all of his or her ownership interest in the business entity, or any owner of a business entity that sells (a) all or substantially all of its operating assets together with the goodwill of the business entity, (b) all or substantially all of the operating assets of a division or a subsidiary of the business entity together with the goodwill of that division or subsidiary, or (c) all of the ownership interest of any subsidiary, may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold, or that of the business entity, division, or subsidiary has been carried on, so long as the buyer, or any person deriving title to the goodwill or ownership interest from the buyer, carries on a like business therein”.

A similar rule is set forth in California Business and Professions Code Section 16602 and California Business and Professions Code Section 16602.5 stating, respectively, that non-compete covenants may be enforceable in case of a dissolution of a partnership (or dissociation of a partner from a partnership) and upon or in anticipation of a dissolution of, or the termination of a member’s interest in, a limited liability company.

The Section 16001 exception is aimed at protecting an acquired business’s goodwill. However, it must be kept in mind that under the exception, a non-compete covenant is only enforceable to the extent that it is reasonable and necessary in terms of time, activity and territory to protect the buyer’s interest (Monogram Industries, Inc. v. Sar Industries, Inc., 64 Cal.App.3d 692 (Cal. Ct. App. 1976)). Therefore, an overbroad non-compete clause agreed upon as part of a sale of business transaction in case of a dispute may need to be modified by court to be enforceable or may be considered void under Section 16600 regardless of the connection to the sale of business.

Additionally, it must be noted that a non-compete clause containing non-compete obligations after termination of an employment agreement is not necessarily enforceable if such employment agreement is entered as part of a sale of business transaction (Fillpoint, LLC v. Maas, 208 Cal.App.4th 1170 (Cal. Ct. App. 2012)). In other words, the fact that an agreement containing a non-compete covenant is entered as part of a sale of business does not guarantee the enforceability of such non-compete covenant under the Section 16601 exception.

As mentioned above, under appropriate circumstances, courts in California are empowered to modify contract provisions through reformation. California courts have reformed contracts and narrowly construed non-competition agreements if they appeared in the context of the sale of goodwill (Hill Medical Corporation v. Wycoff, 86 Cal.App.4th 895 (Cal. Ct. App. 2001)). However, if a non-compete clause entered as a part of a sale of a business is determined by a court to be too broad to fall under the Section 16601 exception, the court will not always opt to limit such non-compete clause to that which would be statutorily permissible (for example, by limiting the territory or scope of activities). In other words, if such non-compete clause cannot be easily limited to be compliant with the Section 16601 exception, the court may render the entire clause invalid without attempting to redraft it to something that the parties did not negotiate (Hecny Brokerage Servs. v. Sopko, A149111 (Cal. Ct. App. Feb. 4, 2020)).

Non-Competes in Business-to-Business Agreements

Even though the language of Section 16600 is very broad in stating 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”, it must be mentioned that this is not always the case in business contracts. The Supreme Court of California has recently explained in detail that a rule of reason applies to determine the validity of a contractual provision by which a business is restrained from engaging in a lawful trade or business with another business. The validity of such contractual provision under section 16600 must therefore be evaluated based on a rule of reason (Ixchel Pharma, LLC v. Biogen, Inc., 9 Cal.5th 1130 (Cal. 2020)). Therefore, a non-compete clause in a business-to-business agreement is not necessarily void and unenforceable.

When talking about business-to-business agreements and non-compete clauses, it must also be noted that a broad no-hire clause prohibiting one party to a business-to-business agreement from hiring the other party’s employees can also be declared void and unenforceable under Section 16600 due to the fact that it may present many of the same problems as covenants not to compete, and unfairly limit the mobility of employees (VL Systems, Inc. v. Unisen, Inc., 152 Cal.App.4th 708, 716 (Cal. Ct. App. 2007)). In other words, even though not exactly a non-compete clause, a broad no-hire clause in a business-to-business agreement can also be determined to be unenforceable under Section 16600 due to the fact that it restrains an employee from engaging in a lawful profession, trade, or business. However, a more narrowly drawn and limited no-hire or non-solicit provision, depending on specific circumstances, might be permissible under California law.

Non-Competes in California and Choice of Law Provisions

Finally, you may be thinking – if an entity registered in Delaware seeks to enter into an agreement with an individual based in California containing a non-compete clause, why not add a section agreeing on Delaware law as governing law and forget about the California laws prohibiting non-compete clauses altogether? The answer is, in short, that such governing law clause may not be enforceable either.

There has been a long developing trend among California courts of finding that Section 16600 represents a fundamental public policy interest in California that overrides contractual choice of law provisions, at least with respect to such restrictive covenants. For example, in Roadrunner Intermodal Servs., LLC v. T.G.S. Transp., Inc., No.: 1:17-cv-01207-DAD-BAM (E.D. Cal. Aug. 21, 2019) the court concluded that application of Delaware law as called for in the choice of law provision of the agreement in question would be contrary to a fundamental policy of California. Additionally, the court concluded that in the case, California’s interests were materially greater than those of Delaware and that California would have been more seriously impaired if its laws were not applied.

Additionally, it must be kept in mind that in January, 2017 California Labor Code Section 925 was amended to state that, among other things, an employer shall not require an employee who primarily resides and works in California, as a condition of employment, to agree to a provision that would require the employee to adjudicate outside of California a claim arising in California and/or deprive the employee of the substantive protection of California law with respect to a controversy arising in California, except for cases when such employee is in fact individually represented by legal counsel in negotiating the terms of an agreement to designate either the venue or forum in which a controversy arising from the employment contract may be adjudicated or the choice of law to be applied.

Conclusions

• Non-competes in California are generally unenforceable and any non-compete covenant contained in an agreement governed by California law is generally void, except for non-compete clauses entered into as part of a sale of business transaction.
• Not all non-compete clauses entered into as part of a sale of business transaction are enforceable in California. Non-compete covenants contained in employment agreements signed in connection with a sale of business may still be unenforceable depending on specific circumstances. Non-compete covenants entered into as part of a sale of business transaction are only enforceable to the extent that they are reasonable and necessary in terms of time, activity and territory to protect the buyer’s interest.
• Non-compete clauses in business-to-business agreements may be enforceable in California. Broad no-hire clauses in business-to-business agreements may not be enforceable in California. Each such clause is evaluated by the courts in California separately based on a rule of reason.
• Choosing a state other than California in the governing law or dispute resolution section in an agreement containing a non-compete covenant, which would generally fall under the laws of California, is not a way to circumvent the laws regulating non-competes in California.