ALERT: California Supreme Court Rejects the Narrow-Restraint Exception and Invalidates Noncompete Agreement

Many states permit employers to enter into reasonable and limited noncompetition agreements that prevent departing employees from working for a competitor after the end of an employment relationship. California is not one of those states. California has a long-established public policy ensuring that employees retain the right to pursue lawful employment after leaving their employer, even if the new employment is with a direct competitor. California’s public policy is embodied in California Business and Professions Code Section 16600, which states: “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Of course, there are exceptions to Section 16600. Some of those exceptions are statutory, such as noncompetition agreements that are permitted under the California Business and Professions Code in connection with the sale of a corporation or the dissolution of a partnership. Other exceptions to Section 16600 have been judicially created.

On August 6, 2008, the California Supreme Court decided Edwards v. Arthur Andersen and limited the already minimal, judicially created exceptions to Section 16600. In Edwards, the Court held that the “narrow-restraint” exception, which some courts used to justify enforcing noncompetition agreements that were narrowly tailored to prevent an employee only from working for a direct competitor, and left a substantial portion of the market available to the employee, is not a recognized exception to Section 16600. In rejecting the narrow-restraint exception, the Court invalidated the noncompetition agreement used by Arthur Andersen to prevent departing employees from performing services for the company’s clients at a new employer. However, as we will explain below, the California Supreme Court did not invalidate the myriad other agreements California employers use to protect their trade secrets and prevent departing employees from soliciting their coworkers.

Case Facts

The plaintiff, Raymond Edwards II, was a tax manager working in Arthur Andersen’s Los Angeles office. While employed by Arthur Andersen, Edwards signed an employment agreement that prohibited him from, among other things: (1) rendering any professional services to any of Arthur Andersen’s clients for 18 months following the end of his employment; and (2) soliciting any of Arthur Andersen’s clients for 12 months following the end of his employment.

In the wake of the Enron scandal in 2002, Arthur Andersen ceased its accounting practices in the United States and sold its Los Angeles tax practice to HSBC. In July 2002, HSBC offered Edwards a job, but did so on the condition that Arthur Andersen release Edwards from his noncompetition agreement. In turn, Arthur Andersen agreed to release Edwards from his noncompetition agreement, but only if Edwards signed an agreement releasing all claims he might have against the company. Edwards refused to sign the release, and Arthur Andersen refused to release Edwards from his noncompetition agreement. Thereafter, HSBC withdrew Edwards' offer of employment. Edwards then sued Arthur Andersen for, among other things, interference with prospective economic advantage. Edwards argued that Arthur Andersen required him to sign an unenforceable noncompete agreement that violated California law, and forced HSBC to withdraw its employment offer. Edwards also argued that Arthur Andersen’s requirement that he release “any and all claims” violated California law by forcing him to release “nonwaivable” indemnification rights concerning employee expenses under California Labor Code section 2802.

Arthur Andersen prevailed on Edwards’ claims at trial. The trial court determined that, as a matter of law, Edwards’ noncompetition agreement fell within the narrow-restraint exception and did not violate Section 16600 because it was narrowly tailored and did not deprive Edwards of the right to pursue his profession. The trial court also concluded that Arthur Andersen’s release agreement was lawful because it did not specifically purport to require that Edwards waive his right to indemnification under the California Labor Code. Edwards appealed the trial court’s decision, which eventually led him to the California Supreme Court.

The California Supreme Court Rejects the Judicially Created Narrow-Restraint Exception

In its recently published decision, the California Supreme Court rejected Arthur Andersen’s argument that its noncompetition agreement was enforceable under California law. The Court found that Section 16600 evinces a legislative policy in favor of open competition and employee mobility. The Court also found that, unless the noncompetition agreement fell within one of the statutory exceptions to Section 16600, it would generally violate California law. Further, the Court rejected Arthur Andersen’s claim that the narrow-restraint exception, which was developed primarily by the Ninth Circuit Court of Appeals, was a valid exception to Section 16600:

Contrary to Andersen’s belief, however, California courts have not embraced the Ninth Circuit’s narrow-restraint exception. Indeed, no reported California state court decision has endorsed the Ninth Circuit’s reasoning, and we are of the view that California courts “have been clear in their expression that section 16600 represents a strong public policy of the state which should not be diluted by judicial fiat. . . . We reject Andersen’s contention that we should adopt a narrow-restraint exception to section 16600 and leave it to the Legislature, if it chooses, either to relax the statutory restrictions or adopt additional exceptions to the prohibition-against-restraint-rule under section 16600.

Consistent with this reasoning, the Court found that Arthur Andersen’s attempt to contractually prohibit Edwards from performing services for its clients or soliciting those clients violated Section 16600 because it did not fall within a statutory exception created by the California legislature.

However, the California Supreme Court refused to comment on or overrule the line of California cases holding that an employer is permitted to impose reasonable restraints on former employees – including agreements prohibiting the solicitation of clients – to the extent necessary to protect trade secrets. Indeed, the California Supreme Court cited with approval the 1965 case Muggill v. Reuben H. Donnelley Corp, which held that contracts prohibiting an employee from working for a competitor violated Section 16600 “unless they are necessary to protect the employer’s trade secrets.” The California Supreme Court also refused to invalidate the line of California cases starting with Loral Corp v. Moyes,which hold that employers may impose reasonable restrictions that prohibit former employees from soliciting certain of their coworkers.

The California Supreme Court Confirms the Validity of Agreements Releasing “Any And All Claims” Against Employers

In addition, the California Supreme Court sided with Arthur Andersen in finding that the company’s release agreement was lawful. On this issue, the Court concluded that the language releasing Arthur Andersen from “any and all” claims, including “claims that in any way arise from or out of, are based upon or relate to [Edwards’] employment” with Arthur Andersen did not purport to release Edwards’ nonwaivable right to indemnification under California Labor Code section 2802 for expenses he incurred on Arthur Andersen’s behalf. The Court came to this conclusion in large part based on the fact that Arthur Andersen’s release agreement did not expressly reference Edwards’ indemnity rights under the California Labor Code and, accordingly, could not be construed to implicate a waiver of those rights.

Steps to Take in Light of Edwards

To a large degree, the Edwards decision does not change the legal landscape for California employers. For years, California courts have refused to enforce traditional “noncompete” agreements by which employers attempt to outright prevent their former employees from working for a competitor or otherwise engaging in a lawful occupation. On the other hand, California courts have sanctioned an employer’s use of limited restrictions when it comes to departing employees. For example, California courts have held that agreements prohibiting the solicitation of clients do not run afoul of Section 16600 to the extent necessary to protect trade secrets. Similarly, California courts have enforced tailored agreements prohibiting a departed employee from soliciting their former coworkers. In light of the Edwards decision, employers seeking to ensure best practices should consider taking the following actions:

  • Employers should review their employment agreements and other nondisclosure/proprietary information agreements applicable to California employees to ensure that they do not contain prohibited noncompetition clauses. Employers should not require their California employees to sign agreements containing noncompetition provisions in the hope that such agreements may have a “deterrent effect.” The Edwards Court specifically held that forcing an employee to sign an unenforceable agreement may provide employees with an affirmative claim against their employer. 
  • To the extent an employer’s agreement contains restrictions that apply to former employees, employers should ensure that those restrictions are necessary to protect trade secrets or concern solicitation of employees. 
  • Employers with California employees should review their release agreements to ensure that they do attempt to specifically release claims that are nonwaivable, such as expense reimbursement claims.

For further information, please feel free to call your Jones Day contact or:

George Howard
12265 El Camino Road, Suite 200
San Diego, CA 92130-4096
Tel: 1.858.314.1168
Fax: 1.858.314.1150

Mark Kemple
555 South Flower Street, 50th Floor
Los Angeles, CA 90071-2300

Donna Mezias
555 California Street, 26th Floor
San Francisco, CA 94104
Tel: 1.415.875.5822
Fax: 1.415.875.5700

Steven Zadravecz
3 Park Plaza, Suite 1100
Irvine, CA 92614-2592 
Tel: 1.949.553.7508 
Fax: 1.949.553.7539

This alert is intended to provide a brief synopsis of recent developments in the law and should not be construed as legal advice. For more information, please contact your Jones Day contact, Jacqueline Holmes or Sarah McClure, at 1.202.879.3939.