Business Tips After the CA Supreme Court
Voided Non-Complete Clauses
*

by
Dennis W. Chiu, Esq.
Founder
PRODIGY
LAW

This article is written to assist small business owners, who must protect themselves from training ticking time bomb employees, who can quit, possibly take their customer lists and innovative techniques, and give them to competitors as a result of the overly broad decision by the California Supreme Court in Edwards v. Arthur Andersen (2008) 44 Cal. 4th 937, voiding all non-compete clauses in employment relationships.

BACKGROUND

     In many industries, particularly in the technology and consulting areas, it has been relatively standard to include non-competition covenants in job requirements prior to hiring new employees.

     In Edwards, supra, the high Court dealt with the aftermath of the Enron collapse, where the once legendary, now defunct accounting firm, Arthur Andersen, disintegrated in the wake of the scandal over the shredding of documents to cover-up its auditing malfeasance. HSBC USA, Inc. (a New York based banking association) desired to hire Edwards. However, Arthur Andersen would not accept Edwards' resignation and allow him to join HSBC without signing a re-affirmation of his non-compete agreement, protecting Arthur Andersen's secrets and name from further tarnish, prior to being hired by HSBC. Edwards objected, and the Supreme Court found in favor of Edward's right to not be bullied by Arthur Andersen, by voiding all non-compete agreements in California employment relationships.

     This was not a knee-jerk reaction by the California Supreme Court. The California courts have been working up to banning non-compete clauses for some time. Non-competition provisions have been shunned in California Business & Professions Code § 16600 and by the court of appeals in California for decades. Finally, in August 2008, the California Supreme Court sounded the death knell for non-competition clauses in employment relationships by holding that they violated public policy, and are therefore unenforceable. See in general, Edwards v. Arthur Andersen (2008) 44 Cal. 4th 937. The public policy issues that the high Court invoked from their reading of Business & Professions Code §16600 were connected to protecting the freedom to enter into contracts, fair competition, restraint of trade, free markets, and the freedom to seek employment.

NON-COMPETITION AGREEMENTS ARE PROHIBITED & ARE NON-WAIVABLE

    Specifically, the California Supreme Court held: "We conclude that [Business & Professions Code] section 16600 prohibits employee noncompetition [sic] agreements unless the agreement falls within a statutory exception …" Edwards, supra, at p. 942 (according to legal dictionaries and non-legal dictionaries a hyphen is required in the spelling of "non-competition"). 

    California Business & Professions Code §16600 states: "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."

    Based on the holding in Edwards, supra, p. 951-952, non-compete clauses are so disdainful against public policy that contracting employers and employees cannot even waive the employees right to compete.

CASE LAW & STATUTORY EXCEPTION TO NON-COMPETE CLAUSE BAN

Judicial Exception (Trade Secrets)

    The California Supreme Court did leave the door open with regard to the so-called "trade secret" exception to the invalidation of non-compete clauses.

    Since the turn of the 20th century, the California Supreme Court has recognized a judicially created trade secret exception to the generally undesirability of non-compete clauses. In Edwards, the high Court ensured the trade secret exception's survival by noting, "We do not here address the applicability of the so-called trade secret exception to section 16600 …" Edwards, supra, p. 946 (footnote 4). The high Court had reiterated this exception over the years. See Muggill v. Reuben H. Donnelley Corp. (1965) 42 Cal. 2d 239, 242 (recognizing a trade secret exception to the general rule disfavoring non-compete clauses); see also Chamberlain v. Augustine (1916) 172 Cal. 2d 85, 288; Morris v. Harris (1954) 127 Cal.App.2d 476, 478; Gordon v. Landau (1958) 49 Cal. 2d 690, 694.

Statutory Exceptions

    According to the California Supreme Court and Business & Professions Code §16600, there are also statutory exceptions to the prohibition on non-competition clauses. However, the statutory exceptions are very limited.

Exceptions in Business & Professions Code § 16600 et sec.:

1.    Mergers & Acquisitions Exception. Non-compete clauses in acquisitions of other businesses (CA B & P § 16601) are valid.

2.    Partners & LLC Members Exception. Non-compete clauses for a partner in a partnership or a member in a limited liability company in a business are valid (CA B & P §§ 16602, 16602.5).

3.    Telephone Answering Service Exception. Non-compete clauses involving customer lists of a telephone answering service are trade secrets, and are valid (only applies to telephone answering services) (CA B & P § 16606).

4.    Employment Agency Exception. Non-compete clauses involving customer lists of employment agencies are trade secrets, and are valid. (Only applies to employment agencies) (CA B & P § 16607).
   
ALL NON-COMPETITION AGREEMENTS IN EMPLOYMENT ARE INVALID IN CALIFORNIA

     From reading the narrow list of exceptions, it is clear that all non-compete clauses in California in the employment area are invalid as a matter of law.

     The only known exclusions are the (a) trade secret exception, (b) M&A exception, (c) Partners & LLC Members exception, and (d) statutory trade secret exceptions for telephone answering services and employment agencies.

     Business can look no farther than to these exceptions to creating protections from the abolition of non-compete clauses in California.

Note on Non-Solicitation Clauses Preventing Use of Customer Lists: for the purposes of this white paper, non-solicitation clauses that prevent a former employee from soliciting clients of his or her former employer are treated the same as non-compete clauses.

Note on "No-Hire" Non-Solicitation Clauses:  non-solicitation agreements to prevent former employees from hiring employees from their former employer (i.e. "no-hire clauses") are not necessarily prohibited by Edwards, since the Court did not make a clear statement on this form of non-solicitation covenant.

CRITIQUE OF EDWARDS V. ARTHUR ANDERSEN

     I respectfully submit that the California Supreme Court's decision in Edwards was overly broad and thus wrongfully decided with regard to the total elimination of non-compete clauses in employment relationships. The Court was confronted with one employee against an enterprise-size business in Edwards, and the rights of individuals to seek work. In general, I applaud the Court for finding for David in his battle against Goliath.

     However, in my opinion, the Court failed to consider the disproportionate impact on small businesses, who have smaller profit margins, where the elimination of non-compete clauses would have a disproportionate effect, if information is leaked to competitors from former employees. The argument for small businesses to be treated differently under the law from enterprise size businesses is as simple as asking the question: "How can a small business protect its small competitive edge, if there is a high risk of training new employees, provide them all of the business' confidential information necessary to do their job effectively, only to have that employee leave for a competitor?" How can a small business' employees, in technology, consulting or other sophisticated industries, do their work properly without the small business' customer list and procedures? How can a small business' salesperson/account manager do his or her job without knowledge of the customer list?

     These scenarios set up an impossible situation for small businesses, since all customer lists, are not automatically protected as trade secrets. It depends on how the small business has handled its customer list, and in general, small businesses often cannot afford to have legal counsel providing advice on maintaining the secrecy of customer lists. Small businesses may also not have even known that their customer lists required specific actions to maintain the lists ability to be protected as trade secrets from terminated employees, since the lists were covered in non-competition and non-disclosure agreements. To be clear about the potential damage to small businesses, having been chief operating officer and general counsel for two small businesses, even the loss of a half-dozen customers is an enormous loss to a small business, who may rely on a total of 15-25 customers for their income. The midsized to large businesses, who can afford attorneys, will have their customer lists protected as trade secrets, leaving small businesses' largest customers ripe for the picking.

     Judicially legislating a restriction on the right of individuals and small businesses to negotiate a contract to include a fair and narrowly constructed non-competition clause helps neither individuals or the free market, since small businesses employ the vast majority of the workforce in California and are the heart of the free market. The U.S. Small Business Administration, in a 2008 publication, stated that in California, small businesses represented 99.2% of all employers in California in 2007, and created 87.6% of all new jobs between 2004 through 2005. "Small Business Profile: California," Office of Advocacy, U.S. Small Business Administration. So, by encouraging employee mobility with employees unjustly enriched with their former employer's valuable customer lists or hard earned know-how, larger businesses will hire employees of smaller businesses to take away the smaller business' biggest customers, thereby causing the eventual failure of many small businesses and consolidation of industries by larger size companies. This is simply anti-competitive, and simply bad for the economy, since the economy needs entrepreneurs, creating new small businesses that provide 99.2% of the jobs in California.

     The Court should have recognized a balancing test that weighed the size and industry of the business requesting the non-compete clause and the business sophistication of the employee, who signed or is required to sign a non-compete clause for employment. In the area of business consulting, legal consulting, technology consulting, political consulting or other high level professional consulting areas, the prospective employees are often very sophisticated individuals. Small businesses of under 20-25 employees (with 30% of the workforce clerical/administrative, 30% managers/ executives and 40% consultants) are not Goliaths, and could fail if as few as half a dozen customers are taken by a former employee to his or her new employer. Small businesses competing for customers in a difficult industry do not present the same public policy issues as the Court faced in Edwards. It is much closer to a David versus David situation without the inequity that the Supreme Court was attempting to eliminate.

     Additionally, the Court failed to fully comprehend the possibility that a former employee of a small business may attempt to set-up his or her own shop to compete with his or her former employer. But, the former employee starts out with a leg up and unclean hands by being unjustly enriched with a customer list, not purchased with the heart, sweat, and years of hard work, like his or her former employer used to earn each customer on the list. Each person does have a right to seek employment or start his or her own business, but there is no right to find employment or set up his or her own shop with ill-gotten gains.

     Hardly any employment and business subject is so two-dimensional that a blanket rule is wise. Competition in a free market system abhors theft of intellectual property, which is why copyrights, trademarks and patents have been protected since the birth of the nation (with historical traditions in the law for centuries). By voiding all non-compete covenants in the employment area in California, the Court has used a chainsaw, where a scalpel was necessary, at least from the point of view of the small business owner, who may not have properly protected their customer lists as trade secrets, due to their foolish and ignorant belief that their contracts and the laws would protect them. Of course, these business owners were not actually foolish for their beliefs and trust in the law; the California Supreme Court made them fools in the Edwards decision.

ENCOURAGE THE CALIFORNIA STATE LEGISLATURE TO AMEND BUSINESS & PROFESSIONS CODE SECTION 16600 ET SEC.

    Unless the Court overturns itself in part in Edwards, the California state legislature should step in and modify Business & Professions Code section 16600. Why should answering services and employment agencies receive special protection of their customer lists? These specific exceptions wreak of the power of certain interest groups, and not fairness on the whole for all businesses, who are disproportionately impacted by loss of its customer lists.

PROPOSED LEGISLATION

    Prodigy Law recommends that the California Legislature amend Business & Professions Code section 16600 to include a new provision, section 16608 to state:

"16608. (a) The customer list, including the names, addresses, and identity of customers, of any small business and consulting services company shall constitute a trade secret and confidential information of, and shall belong to, the consulting services company and/or its owner.

(b) For the purposes of this section 16608, 'small business' shall be defined as businesses employing fifty (50) employees or under, and 'consulting services company' shall be defined as any business, where fifty percent (50%) of the business' gross income is derived directly from consulting services in the industries of business, science, technology, information technology, network architecture, software, web design and web construction, nonprofit governance, and any other consulting field where businesses require assistance from individuals with specialized knowledge to guide them.

(c) No liability shall attach to, and no cause of action shall arise from the use of a customer list of a small business or consulting services company by a former employee, who starts his or her own business, or joins a competitor of his former employer, if use of the customer list begins more than one (1) year immediately following termination of his or her employment. If any customer of a former small business or consulting services company employer becomes the customer of the former employee's current company or employer, within one (1) year of termination of employment with the former employer, then the burden of proof shall shift to the former employee or his or her company or employer to prove that the customer of the former employer was not obtained by a violation of this section 16608 in any cause of action for intentional or negligent interference with a current or prospective business relationship."

      The proposed legislation is narrowly tailored to small businesses, whose primary business income is derived from consulting services, and where customer lists are protected for only one (1) year. Considering the devastating impact of losing clients, because a small business trained an employee to do his or her job is ridiculous. This legislation would also shifts the burden of proof to the former employee or his or her company or employer to preserve small business' ability to compete in the marketplace and prevent unfair competition.

      Nevertheless, since small businesses must operate in this post-Edwards decision, we have gathered some tips below to provide some security for your customer lists and valuable intellectual property.

STRATEGIES TO PROTECT SMALL BUSINESSES FROM INJURY CAUSED FROM EMPLOYEES LEAVING FOR A COMPETITOR AFTER THE CALIFORNIA SUPREME COURT'S ELIMINATION OF NON-COMPETE CLAUSES

      After analyzing the California Supreme Court's decision in Edwards, supra, there are some potential strategies for businesses to use to prevent their clients and secrets from walking out the door with a terminated employee.

1.    Customer Lists Can Be Protected As Trade Secrets. One way of preventing a terminated employee from approaching your customers is to protect the list of your customers as a trade secret. The California Court of Appeals for the Sixth District (covering most of the Silicon Valley) held in Loral Corp. v. Moyes (1985) 174 Cal. App. 3d 268, 275, "The misuse of trade secrets may include solicitation of an employer's customers when confidential information is employed." (internal citation omitted)

     The inclusion of customer lists as trade secret was not challenged or overruled by the California Supreme Court. In fact, the high Court cited Loral, supra, in Edwards to support another part of their holding. Edwards, supra, p. 954. Therefore, it is clear that the California Supreme Court knew of the decision in Loral, and left it untouched. In fact, as noted above, the Court made specific note that the validity of the trade secret exception would not be decided.

      In Jones v. Humanscale (2005) 130 Cal. App. 4th 401, 411, the California Court of Appeals for the Fourth District affirmed that "Section 16600 does not invalidate an employee's agreement not to disclose his former employer's confidential customer lists or other trade secrets or not to solicit those customers." (internal citation omitted)

     Cautionary Note: The fact that customer lists are available for protection as trade secrets, it does not mean that customer lists are trade secrets. To make your customer list a trade secret, your business must protect it from exposure to the public. Once information is public, such information cannot be a trade secret. So, the posting of your customer list on your business' website will eliminate its protection as a trade secret.

     The definition of a "trade secret" is a "formula, process, device, or item of information used by a business that has economic value because it is not generally known or easily discovered by observation or examination and for which reasonable efforts to maintain secrecy have been made". Merriam-Webster Dictionary of Law (1996 ed.)

      So, "trade secrets are only as good as the safeguards that protect them. If a business has valuable trade secrets, every effort should be made to secure and maintain the secrecy of information relating to them. Trade secret information should be accessible only on a 'need to know' basis, and then only if protections are in place to prevent further dissemination of the information." Melise R. Blakeslee. "Checklist for Trade Secret Protection," Advising Small Businesses, §35.4 (Thomson Reuters/West, 2008). Please seek the advice of a qualified attorney to understand all of the requirements necessary to establish a customer list as a trade secret.

2.    For Sensitive Job Positions – Hire a Contractor/Vendor. For employment positions that are appropriate for a contractor, Business may still protect their customer lists and other important business practices and intellectual property by signing an Non-Disclosure agreement. NDA should be narrowly drafted as to the uses that the confidential information provided to the contractor/vendor in the relationship can be used for only the purposes listed.

    The California Supreme Court's holding in Edwards was limited to the employer-employee relationship, not the business-contractor relationship where the parties are presumably more sophisticated to decide whether to accept the business as a customer of not.

Cautionary Note:  In California, be aware to not use contractors to create intellectual property for your business. The California State Labor Board has transmuted contractors into employees, if the contractors are required to assign all work product as a "work made for hire" under U.S. Copyright Law, and found it to be a violation of California Labor Code Section 3351.5(c) and California Unemployment Insurance Code Sections 621(d) & 686. Contractors or anyone subject to a "work made for hire" clause may be reclassified as an "employee" for unemployment and disability insurance purposes. California businesses would then be liable for failure to submit payroll deductions for the contractor's unemployment and disability insurance, possibly including late fees. Please consult with an experienced attorney, specializing in labor law, prior to using a contractor, who may be asked to create intellectual property.

3.    Finish Registering All Owned Intellectual Property To Protect Your Business. No matter what the California Supreme Court rules with regard to the importance of competition and allowing terminated employees rights to harm their former employers, the Court's decisions will always be secondary to federal intellectual property laws with regard to copyrights, trademarks and patents.

    This may seem obvious, but for small businesses, owners may not have actually sat down and looked around to see what is copyrightable, available for trademark, or is patentable. Other business owners may know, but, due to the press of daily business, have not yet devoted the time to hiring an attorney and making the appropriate applications to the U.S. Copyright Office or the U.S. Patent & Trademark Office.

     Just as a brief summary for those that find the different kinds of intellectual property confusing with regards to what should be copyrighted, trademarked and patented, we will briefly define each category of intellectual property. You should seek the advice of an experienced intellectual property attorney to verify how your writings, artwork, software, processes, inventions, writings, name, logo, and other intellectual property should be protected.

    Copyright is filed to protect the exclusive right of an author or creator of a literary or artistic property (such as a book, movie or musical composition) to print, copy, sell, license, distribute, transform to another medium, translate, record or perform or otherwise use (or not use) and to give it to another by will. Law.com Dictionary. In the business world, copyrightable material is not as glamorous as a novel, movie or hit song, but can include engineering consulting procedures to solve certain common problems, software code, your businesses brochure text, website text, and a host of other items that may be written or drawn. Copyrights are filed with the U.S. Copyright Office. Please note that copyright begins at creation of the copyrightable material. Filing with the U.S. Copyright Office allows businesses to bring suit for statutory damages, if their copyrighted material is plagiarized or stolen.

    Trademark can be obtained to protect a distinctive design, picture, emblem, logo or wording (or combination of each) affixed to goods for sale to identify the manufacturer as the source of the product. Law.com Dictionary. Trademark is to protect businesses that have developed, through hard work and money, a good reputation in their brand from imitators who attempt to pass off inferior products by stealing the goodwill developed by the original business' brand. Trademarks are commonly thought of as protecting consumers from being duped into buying products or paying for services that they believed are from the original business. Attorneys often refer to Trademarks as "Marks". Trademarks are filed with the U.S. Patent & Trademark Office.

    Patents are to protect inventions and to provide the right to exclude others from making, using, or selling said invention or products made by an invented process that is granted to an inventor and his or her heirs or assigns for a term of years. Please note that there are two basic types of patents. One is to protect a physical or mechanical items, and the other is to protect an invented process. For example, a new type of camera can be patented, but also the unique process to make the lens is patentable. Patents are filed with the U.S. Patent & Trademark Office.

4.    Create Contracts with Your Business Customers That Have Penalties For Soliciting Your Employees Who Worked on the Customers' Account. To prevent a customer from recruiting a valuable and expensively trained employee, ask your attorney to write in a liquidated damages clause or finder's fee (e.g. 30% of leaving employees new salary lump sum upon the occurrence.) Do not limit the employee's ability to find gainful employment, but charge the customer for training and finding them their new employee.

Cautionary Note: Such a clause is most likely only lawful, if the employee being stolen worked on the customer's account in a reasonably substantive manner (as opposed to an administrative employee, who only called the customer regarding late payment of an invoice).

SUMMARY

      In conclusion, small businesses need to be vigilant about protecting their businesses from competition from former employees. The California Supreme Court has decided that protecting terminated employees ability to find the work, even with your competitor, is more important then the months, years or decades that your small business spent gathering your customer base, and making innovations to be competitive. So, it is incumbent on your small business to protect your customer list and intellectual property.

     A former employee cannot transfer customer lists to a competitor, if the customer list is a trade secret. Consult an attorney specializing in protecting trade secrets and protect your customer list as a trade secret. Protect any writings or drawings by copyrighting them. Protect your logo and goodwill in your brand and name by trademarking them. Protect all of your mechanical inventions or innovative processes by patenting them.

     If possible, another techniques is to create non-employer-employee relationships that do not fall under the holding of Edwards by using contractors bound by NDAs to limit the use of confidential information from leaking to a competitor.

     Finally, prevent loss of your confidential information to a customer by charging the customer for hiring your business' employee away. There is nothing yet developed in the law that states two companies entering into an agreement cannot assess the costs and liability, if one company desires to hire away the other company's employee that has been working on their issues.

     Except for the discussion of federal intellectual property law registration, it is still too early to know whether all of the suggestions contained herein will be permitted by the California courts as they apply the Edwards decision. At the heart of defending business practices to keep customer lists confidential and other know-how or invention is to argue the public policy that these business practices do not truly impede a former employees ability to seek employment, and place no more limits on commerce than do trade secrets, copyrights, trademarks, and patents have for centuries. We hope this has provided a starting place to protect your business.

     In the longer term, small businesses should support legislation like the one suggested in this article to overturn the portion of the California Supreme Court's over-reaching decision in Edwards voiding all non-compete clauses in employment.


*PRODIGY LAW ARTICLES ARE CREATED BY DENNIS W. CHIU ARE FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY. ANY SUGGESTIONS CONTAINED IN THE ARTICLES IS ONLY THE GENERAL OPINION OF DENNIS W. CHIU. PRODIGY LAW ARTICLES ARE NOT WRITTEN WITH ANY SPECIFIC FACT PATTERN OR CASE IN MIND. THEY DO NOT REPLACE ORIGINAL LEGAL RESEARCH AND CONSULTATION WITH AN ATTORNEY REGARDING YOUR SPECIFIC MATTER OR CASE. PRODIGY LAW ARTICLES ARE PRESENTED "AS-IS", AND DO NOT GUARANTEE THE ACCURACY OF THE INFORMATION CONTAINED THEREIN, SINCE CASE LAW AND LAW CAN CHANGE RAPIDLY.