(Contracts) Non Compete Agreements: With limited exceptions, non compete agreements are invalid in California
Non-competition provisions and their implications have long been misunderstood by both lawyers and non-lawyers alike for many years. I want to say right off the top, that with few exceptions, non-compete provisions and non-compete agreements are not enforceable in California. This article will explore those exceptions. But make no mistake about it, with the filing of its decision in the case of Raymond Edwards II v. Arthur Anderson LLP on August 7, 2008, the California Supreme Court was very clear: unless the facts of the case fit within one of the exceptions, a non-compete agreement will not be enforced.
To commence our exploration of the exceptions, I begin with the following sentence taken from the California Supreme Court’s opinion in the above case: “Noncompetition agreements are invalid under section 16600 (of the California Business and Professions Code – all further references are to the Business and Professions Code) in California even if narrowly drawn, unless they fall within the applicable statutory exceptions of sections 16601, 16602, or 16602.5.” That is it folks. If the noncompetition agreement does not fall within one or more of section 16601, 16602, or 16602.5, it is invalid under section 16600.
Section 16600 states: “Except as provided in this chapter (i. e., one of the exceptions), every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void.” So what are the exceptions? Let’s have a look.
Exception No 1/ Section 16601: Sale of goodwill of a business or an ownership interest in or operating assets of a business entity or division or a subsidiary thereof.
Section 16601 states that if you are selling (i) the goodwill of a business, or (ii) an ownership interest in a business, or (iii) the operating assets of a business entity, or (iv) the operating assets of a division of a business entity, and/or (v) the operating assets of a subsidiary of a business entity, then the seller may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold has been carried on, so long as the buyer carries on a like business within the specified geographic area.
This seems only fair. If Jones buys a hardware business from Smith, Jones will not want Smith to open a new hardware business within the geographic area served by the business Smith just sold to Jones. So, Jones will be within her rights to include a non-compete provision in the parties’ agreements. In short, if a seller of a business interest agrees not to compete with the buyer of the business interest in the geographic area where the business sold had been carried on, then such a non-compete provision will be enforceable. In fact it is often the case in such sales and purchases of business interests that the seller’s promise not to compete with the buyer is among the most important “assets” being purchased by the buyer. I might offer you $10x to buy your business if I know you will end up competing with me, whereas I might offer you $20x to buy your business if you will agree to the non-compete. Such deal structures happen all the time.
Exception No 2/ Section 16602: Dissolution or disassociation of a partnership.
Section 16602 states that any partner may, upon or in anticipation of (i) a dissolution of the partnership or (ii) disassociation of the partner from the partnership, agree that he or she will not carry on a similar business within a specified geographic area where the partnership business has been transacted, so long as any other member of the partnership carries on a like business within the specified geographic area.
In other words partners can agree (a) that when the partnership dissolves, or (b) a partner leaves the partnership, that a partner will not carry on a similar business within the geographic area where the partnership business had been conducted, so long as any other partner carries on a similar business within the specified geographic area. Scenario (b) may seem clear because it involves a partner leaving a partnership that continues to operate. Scenario (a) may seem less clear.
Sometimes dissolution of a partnership can take place over a protracted period of time rather than all at once. Therefore, one or more partners will continue with the “dissolving” partnership, staying on to actively guide the partnership as it goes through the steps required to dissolve, while some of the other partners will leave the dissolving partnership early on. This is what is addressed in scenario (a). Scenario (a) says that so long as the partnership continues to operate, albeit only for the purpose of winding up its affairs and finally dissolving, the earlier departing partners cannot compete with the partnership as it winds down and proceeds towards final dissolution.
Let’s assume Smith, Jones, and Dagwood form a partnership to operate a bottle manufacturing business. Their written partnership agreement includes a non-compete provision. The non-compete provision states that if any of them leave the partnership, the leaving partner cannot compete with the business in the specified geographic area where the business has been conducted so long as any of the other partners continue to operate the business in the specified geographic area. Dagwood decides he wants to open a sandwich shop and leaves the partnership. After a couple of years, Dagwood realizes he is not meant for the sandwich shop business and decides to return to what he knows. He tries to open a bottle manufacturing business in the specified geographic area. Smith and Jones learn of Dagwood’s plan and remind him in a letter that the written partnership agreement he signed had a non-compete provision that prevents him from operating a bottle manufacturing business in the specified geographic area. Such an agreement is enforceable. This is scenario (b).
Now let’s assume that the partners decide to dissolve the partnership because they can no longer get along. They agree that Dagwood will leave immediately and find other employment, but Smith and Jones will continue to operate the partnership to sell the remaining inventory, furnishings, fixtures and equipment to generate as much revenue as possible to pay off creditors. Because of the nature of the business and a difficult economy, it takes almost two years for Smith and Jones to “wind down” the business, sell the remaining inventory, etc., pay off the partnership’s creditors, and finally “dissolve” the partnership. Dagwood has a hard time finding other employment and decides once again to return to what he knows. Dagwood tries to open a bottle manufacturing business in the specified geographic area. Smith and Jones learn of Dagwood’s plan and remind him in a letter that the written partnership agreement he signed had a non-compete provision that prevents him from operating a bottle manufacturing business in the specified geographic area for as long as it takes for Smith and Jones to “wind down” the business and finally “dissolve.” Such an agreement is enforceable. This is scenario (a).
Exception No 3/ Section 16602.5: Dissolution or sale of a limited liability company.
Section 16602.5 is essentially the same as Section 16602, but adapted to limited liability companies. If you substitute the term “member” for the term “partner” in Section 16602, and similarly substitute the term “limited liability company” for the term “partnership” in Section 16602, you essentially end up with Section 16602.5.
That is pretty much it folks. If the non-compete agreement does not fall within the exceptions discussed above, it is invalid. Is there a way around these exceptions you may ask? Well not directly, but an “end-run” is from time to time attempted by aggressive plaintiffs by disguising the lawsuit as a violation of the plaintiff’s trade secrets. But don’t get me started. Trade secret violations deserve their own feature article.