How Far Can Employers Go To Protect Their Trade Secrets and Other Proprietary Information?
Also in this issue:
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.
Business And Professions Code Section 16600 Prohibits Restraints On Trade, Unless Necessary To Protect Trade Secrets
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).[fn1] 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.
Is A Limited Restriction On Competition Permitted In California?
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).[fn2] 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.
Agreements Not To Solicit Customers Are Enforceable To The Extent Needed To Protect 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.
Agreements Prohibiting "Raiding" Of Employees Are Enforceable
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.
Choice of Law Considerations
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.
Drafting Post-Employment Restrictions
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.[fn3] 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.
European Union – English Law: Trade Secrets and Proprietary Information
By Ann Bevitt and Simeon Spencer
The approach to protection of trade secrets and proprietary information in the European Union varies widely between Member
States. The following is a brief outline of the English law position.
English law allows wide confidentiality and similar obligations, protecting the employer's intellectual property rights and
confidentiality, during the course of employment. It is usual for the employment contract to contain a clause defining the
rights that are protected and prohibiting the employee from using or disclosing them, except so far as necessary for work.
It is more difficult to prevent a former employee from abusing confidential information. Restrictions on an employee after
employment has ended are against public policy and unenforceable unless:
- reasonable in the interests of the contracting parties; and
- reasonable in the interests of the public.
There are two stages in assessing reasonableness:
- Legitimate interest of the employer in obtaining protection — three main categories: customer connection, trade secrets (or
other confidential information), and the stability of the workforce;
- Overall reasonableness of the restraint — i.e. not too wide in scope (geographically and subject-matter) and not excessive
in duration.
The usual forms of restrictive covenant found in the UK are:
Non-solicitation
Prohibiting solicitation of customers. These should be limited to those with whom the employee dealt personally within a defined
and reasonable period. The more senior the employee, the wider the permissible pool.
Prohibiting dealing with customers, regardless of whether the employee initiated the approach. The restriction can be wider
than the non-solicit.
Non-Competition
Prohibiting engaging in a competing activity. Typically — but not always — these are drafted by reference to geographic area.
This particular type of prohibition will be upheld if the employee has access to confidential information.
Non-solicitation of other employees
Prohibiting poaching of senior employees, usually limited to colleagues known personally to the employee.
Factors taken into account in deciding whether a restraint is reasonable include:
- the nature of the employee's job;
- whether the employee is prevented from earning a living in his chosen field.
Normally, if the restraint is unreasonable, the entire restraint is unenforceable — the court will not apply a more limited
version of it.
Enforcement
The usual remedy against a defaulting employee is an injunction. This can be obtained at very short notice. Damages can also
be awarded.
Upcoming Labor Seminar
A company's trade secrets and proprietary information are its most valued assets. Regardless of whether a company's workforce
is domestic or global, protecting its confidential information raises a host of legal issues.
Morrison & Foerster will be holding a series of seminars throughout
California to discuss these issues and the strategies an employer can utilize to protect its trade secrets and proprietary
information against misuse by current and former employees. For more information, including how to register, please follow
the link below to the session you would like to attend.
Los Angeles, April 20
Newport Beach, April 21
San Diego, April 22
San Francisco, April 29
Palo Alto, April 29
Footnotes
1: Our January 2001 Employment Law Commentary discusses the D'Sa v. Playhut case in more detail.
2:See also our October 1999 Employment Law Commentary, "Can California Employers Include Non-Competition Clauses in Their Stock Option Agreements?" which discusses the Bajorek case in more detail
3:It is also important to note that section 432.5 of the California Labor Code prohibits an employer from requiring its employees
to sign an agreement that it knows to be unenforceable. With the passage of the Labor Code Private Attorneys General Act of
2004, employers need to exercise caution regarding the documents they expect employees to sign. See our March 2004 Employment Law Commentary for an example of the usage of section 432.5 in litigation.
