United States: Employment Law Commentary

How Far Can Employers Go To Protect Their Trade Secrets And Other Proprietary Information?

Over the past few months, employers have been creating more jobs and hiring more employees. With more employment opportunities available, employees are more mobile than they have been in recent years. However, as employee mobility increases, so do employer concerns about the possible disclosure of trade secrets when employees leave to join other companies.

To address these concerns, many employers outside California rely on post-termination restrictive covenants that restrict employees’ competitive activities. California employers, however, have much less discretion when it comes to restricting an employee’s post-employment competitive activities. This Commentary explores the options available to California employers in restricting an employee’s post-employment activities.

It is well established that covenants not to compete are generally unenforceable in California. California Business & Professions Code Section 16600 ("Section 16600") provides " … every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void." This notion is reinforced by two recent California Court of Appeal decisions, Thompson v. Impaxx, Inc., 113 Cal. App. 4th 1425, 1428 (2003) and D’Sa v. Playhut, Inc., 85 Cal. App. 4th 927, 934 (2000).¹ These two decisions not only reaffirm California’s fundamental public policy against restrictive covenants, but also state that employers may be held liable for wrongful termination if they terminate an employee who refuses to sign an unenforceable restrictive covenant.

There are a few exceptions to Section 16600’s broad prohibition of non-competition agreements. For example, non-competition agreements may be valid if they are obtained in connection with the sale of a business or the dissolution of a partnership. Cal. Bus. & Prof. Code §§ 16601, 16602. In addition, California courts have created an exception that permits the enforcement of non-competition agreements, when necessary to protect an employer’s trade secrets. Metro Traffic Control, Inc. v. Shadow Traffic Network, 22 Cal. App. 4th 853, 859 (1994); Muggill v. Reuben H. Donnelley Corp., 62 Cal. 2d 239, 242 (1965). This exception, however, is not as expansive as many employers would like, since it can only be used to protect trade secrets.

One common misconception among many employers is that "trade secret" includes all the information encompassed within the definition of proprietary and confidential information as those terms are broadly defined in standard non-disclosure agreements. On the contrary, by statute, a trade secret is more narrowly defined. A trade secret must derive "independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use" and be "the subject of efforts that are reasonable under the circumstances to maintain its secrecy." California Civil Code § 3426.1(d). For example, customer lists that contain information not readily available to competitors through general sources have been found to be trade secrets by California courts. See MAI Syst. Corp. v. Peak Computer Inc., 991 F.2d 511, 521 (1993); Morlife, Inc. v. Perry, 56 Cal. App. 4th 1514 (1997); American Paper & Packaging Prods., Inc. v. Kirgan, 183 Cal. App. 3d 1318, 1325 (1986). Conversely, employees’ talents, qualities, and characteristics are not considered trade secrets. Metro Traffic Control, Inc. v. Shadow Traffic Network, 22 Cal. App. 4th 853, 861-62 (1994).

Even if the information is clearly a trade secret, proving that a former employee has disclosed trade secrets to a new employer can be difficult. Some federal courts outside California have adopted a theory commonly referred to as the "inevitable disclosure" doctrine. Under this doctrine, the former employer need not show that trade secret information has actually been disclosed, but rather, that the new position would necessarily require the former employee to rely on trade secret information. PepsiCo, Inc. v. Redmond, 54 F.3d 1262 (7th Cir. 1995). In those jurisdictions in which the doctrine has been adopted, employers have successfully relied on it to prevent a former employee from working for a direct competitor.

Until recently, the availability of the inevitable disclosure doctrine in California was in doubt. Over the past few years, however, several state and federal courts in California have consistently rejected this doctrine as being inconsistent with California law, as embodied in Section 16600. Whyte v. Schlage Lock Co., 101 Cal. App. 4th 1443, 1460 (2002); see also GlobeSpan, Inc. v. O’Neill, 151 F. Supp. 2d 1229, 1231 (C.D. Cal. 2001); Bayer Corp. v. Roche Molecular Sys., 72 F. Supp. 2d 1111, 1120 (N.D. Cal. 1999). Therefore, a California employer must be prepared to demonstrate an actual or threatened misappropriation of its trade secrets if it wants to prevent an employee from working for a competitor.

A few older California court and recent federal court decisions have enforced restrictive covenants "where one is barred from pursuing only a small or limited part of a business, trade or profession." Boughton v. Sacony Mobil Oil Co., 231 Cal. App. 2d 188, 192 (1964); King v. Gerold, 109 Cal. App. 2d 316 (1952); see also General Commercial Packaging, Inc. v. TPS Package Eng’g, Inc., 126 F.3d 1131 (9th Cir. 1997). However, those cases involved a business relationship between two commercial parties, as opposed to an employment relationship between an employer and employee.

In 1997, however, the Ninth Circuit extended the "small or limited part" exception to an employment relationship when it enforced a non-competition clause in a stock option agreement. Bajorek v. IBM, 191 F. 3d 1033 (9th Cir. 1999).² In Bajorek, the employee-plaintiff was subject to a non-competition agreement that required him to forfeit the profits from his stock options if he worked for a competitor within six months following the exercise of his options. The plaintiff eventually left IBM, exercised his stock options, and then went to work for a competitor. Pursuant to the non-competition clause, IBM rescinded his stock options and demanded repayment of the profits.

The Ninth Circuit found that IBM’s non-competition clause did not violate Section 16600 because it only restrained individuals from engaging in a "small or limited part" of the trade or profession. Specifically, the plaintiff was only prohibited from working for one competitor and only for six months, which was a "small or limited part" of his profession.

Since Bajorek, the Ninth Circuit has applied the "small or limited part" exception in one unpublished case, Corporate Express Document & Print Mgmt. v. Coons, 2000 U.S. Dist. LEXIS 22243 (C.D. Cal. 2000). In that case, the Ninth Circuit upheld a covenant that restricted an employee’s ability to solicit or do business with any customers that he serviced in the preceding two years because the covenant did not "completely restrain" the employee from engaging in his trade.

It is unclear whether California courts will follow the Ninth Circuit’s lead and extend the "small or limited part" exception to an employment relationship. To date the California courts have applied the "small or limited part" exception in only a few commercial cases, and none of those cases involved a restrictive covenant between an employer and its employees.

Furthermore, at least one unpublished decision indicates that California courts would not be receptive to adopting this exception in the context of an employer-employee relationship. In Arrowhead Fin. Group v. Welty, 2002 Cal. App. Unpub. LEXIS 11100 (2002), a California Appeals Court rejected the "small or limited part" exception. While doing so, the court ruled that contractual restraints on an employee’s ability to compete with his/her former employer are valid only if they are limited to protecting the employer’s property rights under the law of unfair competition, including the misappropriation of the employer’s trade secrets.

Many employers believe that non-solicitation covenants, which are a less restrictive type of covenant, fall outside the scope of Section 16600. While these types of covenants may, in fact, be less restrictive, California courts have been reluctant to enforce those that prohibit the solicitation of customers, unless they are necessary to protect an employer’s trade secrets. Indeed, several courts have refused to enforce covenants restricting the solicitation of customers where the identities of customers were not trade secrets. See, e.g., Moss, Adams & Co. v. Shilling, 179 Cal. App. 3d 124, 130 (1986); American Paper & Packaging v. Kirgan, 183 Cal. App. 3d 1318, 1326 (1986). When determining whether a customer list is, in fact, a trade secret, the courts will examine whether a customer list contains information that is not readily available to competitors through general sources. American Paper & Packaging Products, Inc., 183 Cal. App. 3d at 1325. Also important is whether a company has expended time and effort identifying customers with particular needs or characteristics. Morlife v. Perry, 56 Cal. App. 4th 1514, 1521-22 (1997).

Recently, a California Court of Appeal addressed the enforceability of a non-solicitation clause in the context of a wrongful termination case. Thompson v. Impaxx, Inc., 113 Cal. App. 4th 1425 (2003). The Thompson case arose when Impaxx fired Daniel Thompson for refusing to sign an agreement that restricted his ability to "call on, solicit, or take away" its customers for a period of one year after his employment ended. Thompson sued Impaxx for wrongful termination in violation of public policy, and claimed the non-solicitation clause was an unenforceable restrictive covenant that violated Section 16600. The trial court dismissed Thompson’s claims, and found the non-solicitation clause to be enforceable. However, the California Court of Appeal reversed this decision. In its decision, the California Court of Appeal held that Impaxx’s non-solicitation clause was enforceable only if it was necessary to protect the company’s trade secrets, and directed the trial court to determine whether Impaxx’s customer list was, in fact, a trade secret.

The Thompson case, in other words, reinforced the notion that non-solicitation covenants that restrict the solicitation of customers are enforceable only when necessary to protect an employer’s trade secrets. More importantly, however, the court also indicated that an employer may be sued for wrongful termination if it fires an employee who refuses to sign an unenforceable non-solicitation covenant.

In Loral Corp. v. Moyes, 174 Cal. App. 3d 268 (1985), the California Court of Appeal upheld an agreement that restrained former employees from disrupting, damaging, impairing, or interfering with the former employer’s business by "raiding" its employees, presumably referring to solicitation of a large number of employees. In upholding the anti-raiding clause, the court reasoned that Section 16600 invalidates an agreement penalizing a former employee for obtaining employment with a competitor. However, according to the court, Section 16600 does not affect an agreement limiting how the former employee can compete. Such clauses do not restrain trade because the former employee is not restricted in finding employment and current employees may seek employment with the former employee’s new employer. In the words of the court, "[e]quity will not enjoin a former employee from receiving and considering applications from employees of his former employer, even though the circumstances be such that he should be enjoined from soliciting their applications."

Still unresolved by Loral is whether the case stands for the general proposition that agreements prohibiting the solicitation of employees in California are valid or whether it is simply another "raiding" case. On the one hand, Loral dealt with a prohibition against interfering with a company’s business by raiding employees. On the other hand, the reasoning of the Loral court did not limit itself only to raiding cases. Instead, it broadly rejected the argument that an agreement prohibiting solicitation of employees is unenforceable under Section 16600.

However, at least one court has questioned Loral’s holding in this regard in an unpublished opinion. In Liberty Mutual Insurance Company v. Gallagher & Company, No. C94-3384 MHP, 1994 U.S. Dist. LEXIS 18412 (N.D. Cal. Dec. 19, 1994), the federal district court analyzed California law and concluded that Section 16600 prohibits enforcement of all restrictive covenants, including non-solicitation clauses. The court found that the only exception to that broad prohibition is when the challenged activity constitutes unfair competition, such as the unauthorized use of trade secrets or confidential information. This finding is consistent with other California cases that have addressed non-solicitation covenants that apply to customers, including the recent Thompson case discussed above.

Because of the fundamental public policy embodied in Section 16600, California courts have repeatedly refused to enforce non-competition covenants, even when the covenant is governed by a choice-of-law clause that selects the laws of another state. Application Group, Inc. v. Hunger Group, Inc., 61 Cal. App. 4th 881, 901 (1998). At the same time, California courts cannot enjoin a party from proceeding with an out-of-state action to enforce a non-competition covenant. Advanced Bionics Corp. v. Medtronic, Inc., 29 Cal. 4th 697 (2002). In the Medtronic case, a California trial court issued a temporary restraining order to prevent Medtronic from proceeding with a Minnesota action to enforce a non-competition agreement against a former employee who went to work for a competitor in California. However, the California Supreme Court overturned this decision, and held that the trial court exceeded its jurisdiction in issuing the restraining order. While doing so, the California Supreme Court acknowledged California’s strong public policy against non-competition agreements, but found that policy was outweighed by principles of judicial restraint and comity.

While the Medtronic decision does not change existing law in California, it leaves open the possibility that employers may enforce non-competition covenants in other jurisdictions outside of California. Accordingly, non-California employers should continue to use choice-of-law and choice-of-venue provisions that select jurisdictions other than California when drafting non-competition covenants.

Entering into restrictive covenants with employees raises a host of legal questions that are not readily answered by existing case law. Many employers nonetheless find such agreements useful for protecting company assets and discouraging unfair competition by disgruntled former employees. However, entering into unenforceable agreements is of little benefit to California employers.³ Thus, employers should keep the following points in mind when drafting restrictive covenants.

• Covenant Not To Compete. A covenant not to compete in California is unenforceable under Business & Professions Code Section 16600. Any clause in an employment agreement restricting post-employment activities should be narrowly tailored to protecting trade secrets. An aggressive option would be to require an employee not to compete for a reasonable period of time following termination of employment unless the employee can prove that such competition would not involve use or disclosure of trade secrets. An employer should be aware, however, that such a clause has yet to be tested in a California court (as opposed to California federal courts), and a state court may well find that it constitutes a restraint on trade in violation of Section 16600.

• Non-Solicitation of Customers. A clause prohibiting solicitation of customers is generally enforceable under Section 16600 when the identities of customers are trade secrets. Whether a customer list constitutes a trade secret depends entirely on the facts of the particular company and its market. Although many employers may wish to have employees sign non-solicitation clauses, even when a trade secret is not involved, employers should not require employees to sign such clauses as a condition of employment, in light of the Thompson case.

• Non-Solicitation of Employees. Given the broad reasoning in the Loral opinion, there is a strong argument that clauses restricting solicitation of employees — not just "raiding" of employees — are enforceable and do not run afoul of Section 16600. However, inclusion of such a clause in an employment agreement may be of limited value to an employer. As stated in the Loral decision, a clause prohibiting the solicitation of employees does not restrain current employees from contacting, seeking employment with, or being employed by the former employee’s new employer.

In sum, the law in this area is subject to rapid change, and employers should make sure that any restrictive covenants in agreements that employees are expected to sign are up to date.