Trade Secrets and Noncompete Blog : Non-Compete Lawyer & Attorney : Epstein Becker Green Law Firm : Trade Secrets & Confidentiality Agreements

Co-authored with Ted A. Gehring.

Except for very limited statutory exceptions (which do not apply to most employer/employee disputes), California courts will not enforce non-compete agreements, or any restrictive covenant by which anyone is restrained from engaging in a lawful profession, trade or business. Cal. Bus. & Prof. Code § 16600. Since § 16600 embodies a strong California public policy, California law is clear that a party cannot circumvent the § 16600 restrictions with a choice of law provision that designates a more non-compete friendly jurisdiction as the applicable law. The Application Group, Inc. v. The Hunter Group, (1998) 61 Cal.App.4th 881, 888-89.

It appears, however, based on rulings by two federal district courts last year that employers might get some traction in this area by including a choice of venue or forum selection provision in their employment contracts and – through that provision – have the case transferred to a jurisdiction that will be more likely to enforce a restrictive covenant.

In M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 15 (1972) (“Bremen”), the United States Supreme Court addressed forum selection clauses and held that a forum selection clause is unenforceable if: (1) it was the product of fraud, undue influence or overwhelming bargaining power; (2) the forum is so gravely difficult and inconvenient that the party challenging the clause will for all practical purposes be deprived of its day in court; or (3) the clause would contravene a strong public policy of the forum in which the suit is brought. Bremen, 407 U.S. at 15. A strong showing must be made to set aside the forum selection clause. Id. The California Supreme Court has set similar standards. Smith, Valentino & Smith, Inc. v. Superior Court, (1976) 17 Cal.3d 491, 496, (“We conclude that the forum selection clauses are valid and may be given effect, in the court’s discretion and in the absence of a showing that enforcement of such a clause would be unreasonable.”).

In both Hartstein v. Rembrandt IP Solutions, LLC, No. 12-2270 (N.D. Cal. July 30, 2012) and Hegwer v. American Hearing Aid Associates, No. C 11-04942 (N. D. Cal. Feb. 24, 2012), the Plaintiffs were former employees who had signed employment agreements containing restrictive covenants and which also contained, in part, forum selection clauses designating Pennsylvania as the appropriate forum. Both cases were filed in state court and removed to federal court. The Defendants filed motions to transfer or dismiss premised on the forum selection clause.

The Plaintiffs in each case argued, in part, that the motions should be denied because the more restrictive covenant friendly Pennsylvania courts would be more likely to enforce the non-compete which would, in turn, contravene a strong California public policy. Bremen, 407 U.S. at 15. Both federal district courts, however, focused on the reasonableness of the forum selection clause itself, rather than the reasonableness of the clauses’ effect. Both found that the possibility that a Pennsylvania court might enforce the non-compete was not a sufficient basis to invalidate the forum selection clause.

As such, employers that are based in jurisdictions more friendly to restrictive covenants (which would likely be any other state in the country), should consider including forum selection clauses designating the state of their corporate headquarters as the appropriate forum. Although these cases will no doubt be decided on a case by case basis depending on the particular factual circumstances, a forum selection clause will, in many instances, provide, at a minimum, more leverage for the employer in actual or threatened restrictive covenant litigation commenced in California.

The commencement and continued prosecution of a misappropriation of trade secrets action without objective evidence of actual misappropriation can result in the imposition of attorneys’ fees against the plaintiff if it does not prevail on that cause of action.  On April 17, 2012, we blogged about this issue in connection with a malicious prosecution action that was filed against Latham & Watkins after the unsuccessful prosecution of a trade secrets action on behalf of a client.

On July 11, 2012, in SASCO v. Rosendin Electric, Inc., 2012 WL 2826955 (Cal.App. 4 Dist.), the California Court of Appeal, Fourth Appellate District, provided more clarity on this issue and affirmed the trial court’s order awarding defendants almost $485,000 in attorneys’ fees and costs pursuant to California Civil Code § 3426.4 (the Uniform Trade Secrets Act). SASCO sued Rosendin Electric, Inc, another licensed electrical contractor and three individual defendants for misappropriation of trade secrets, among other things. SASCO identified a proprietary computer program to be one of its trade secrets. SASCO also alleged that the individual defendants contacted a third-party that had put out a competitive bid and encouraged it to ignore SASCO’s bid and to award the job to Rosendin. After the parties engaged in what the court described as “fierce discovery battles,” defendants filed a motion for summary judgment and after obtaining a continuance of the hearing to conduct additional discovery, SASCO voluntarily dismissed the action without opposing the motion for summary judgment. Defendants moved for attorneys’ fees.

The trial court accepted for the sake of argument that SASCO’s computer program was a trade secret. The court concluded, however, there was no evidence of misappropriation and that SASCO had sued defendants based on the suspicion that they must have misappropriated trade secrets because the individual defendants went to work for a competitor, which subsequently secured a contract for which both companies were competing. The trial court concluded that plaintiff engaged in bad faith pursuant to Civil Code § 3426.4, which consisted of both objective speciousness and subjective bad faith.

The appellate court affirmed and agreed that the claim was objectively specious because there was no evidence to support the claim. The plaintiff argued it should not be required to show actual evidence of misappropriation because the case was dismissed before trial and defendants allegedly withheld discovery. The plaintiff argued that the trial court should have looked to Code of Civil Procedure section 128.7 (which is comparable to Fed. R. Civ. P. Rule 11) which would preclude a finding of objective speciousness if the factual contentions were “likely to have evidentiary support, or …are likely to have evidentiary support after a reasonable opportunity for further investigation or discovery.” The appellate court refused to apply a standard that applied to a general pleading statute.

The appellate court also agreed with the trial court that continuing to prosecute the action without evidence of actual misappropriation constituted subjective bad faith.

Based on this decision, an employer has to be very careful before it commences a misappropriation of trade secrets action -- even if the departing employee was entrusted with trade secrets and that employee went to work for a competitor. If the employer is presented with evidence that no misappropriation occurred and continues to prosecute the case and loses or dismisses the case, the defendant’s application for attorney’s fees may be granted.
 

In Sybase, Inc. v. Superior Court of Alameda County, No. A132541, 2011 WL 5117117 (2011), the Court of Appeal of the State of California First Appellate District found, in an unpublished opinion, that the trial court abused its discretion when it ordered the production of a trade secret source code. The court found that the real party in interest did not meet the evidentiary burden imposed by the California Supreme Court in Bridgestone/Firestone, Inc. v. Superior Court, 7 Cal.App. 4th 1384 (1992) (“Bridgestone”) which set forth the standards governing whether a trade secret must be disclosed in litigation.

Plaintiff in the underlying action, Sybase, Inc. (“Sybase”), a developer of data management software, sued ANTs Software, Inc. (“ANTs”) for, among other things, breach of a written contract and unfair competition arising out of the alleged breach of an employee non-solicit provision.

Sybase sought damages based, in part, on the reduced functionality of its product due to the departure of the key engineer (Mathew) who was solicited. Sybase claimed that because of the engineer’s departure it would never be able to release the product it originally intended to develop and, therefore, it developed a different product (code named “Aries”), which it asserted was much less functional and drew less customer interest.

ANTs sought disclosure of the Aries source code, which the parties agreed was a trade secret, Sybase objected and ANTs moved to compel, claiming that it needed the Aries source code to defend against Sybase’s claims. ANTs supported its motion with, among other things, excerpts from the deposition transcripts of two Sybase engineers, which testimony indicated that certain integration issues were unrelated to Mathew’s departure. Sybase argued, in part, that it needed to examine the source code to determine whether the integration failure issues had anything to do with Mathew’s departure. The trial court issued an order compelling the production of the Aries source code, finding that ANTs could not adequately defend the case without access to the source code. The court subsequently entered a protective order, which set forth specific procedures to protect the source code.

Sybase filed a petition for writ of mandate with the Court of Appeal, which found that ANTs had not met the particularized showing required by Bridgestone. The court noted that in Bridgestone expert testimony showed a review of the trade secret formulas at issue would be “helpful” to the defense of the action, but the expert did not describe with precision how and why the formulas were a “predicate” to his ability to reach conclusions and disclosure was ultimately denied. The Court of Appeal found that ANTs likewise failed to establish with sufficient particularity that the disclosure of the trade secret was necessary for a fair resolution of the action.

 ANTs contended the source code was necessary to determine why its product was not integrated. The court rejected this argument because ANTs failed to demonstrate the source code for Aries would in fact provide the information it sought and because ANTs’ own evidence showed it would be able to obtain deposition testimony that addressed this issue.

The court also found that ANTs did not present sufficient evidence to show that the Aries source code would reflect the extent to which it incorporates or was influenced by another software product, and suggested that that expert testimony could have been submitted to establish that threshold question.

Finally, the court rejected ANTs’ theory that it needed to examine the Aries source code to refute or evaluate Sybase’s claim that the product it had ultimately brought to the market lacked the robust features and was less functional than an integrated product would have been. The court found that ANTs did not have to examine the product’s source code in order to defend against the allegation that the product itself was less functional and that an expert could reach any necessary conclusions about the product’s functionality by examining the product instead of the source code.

Importantly, the court declined ANTs’ request to remand to the trial court with directions, which would have allowed it to present specific expert declaration evidence to establish why the source code was necessary to its defense. The court stated that existing law reasonably identified the applicable standards and it would not grant “a second bite at the apple.”

The take away here is that before a litigant moves to compel trade secret information which it deems critical to its prosecution or defense of a claim, it must fully develop the trial court record and present particularized evidence to establish why the information is relevant and necessary. If it does not, it may not get a second opportunity to do so.
 

Co-authored by Betsy Johnson and Viktoria Lovei.

Contrary to popular perception, California law does not bar all restrictive covenants in the employment context. Rather, in certain very narrow circumstances (i.e., non-competes arising in connection with the sale or dissolution of certain businesses), non-competes are permissible under California law.

The General Prohibition of Non-Competes Under California Law

Under California Business and Professions Code § 16600, “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Cal. Bus. & Profs. Code § 16600 (2008). In Edwards v. Arthur Andersen LLP, 44 Cal.4th 937 (2008), the California Supreme Court confirmed the viability and breadth of section 16600 and expressly rejected a line of Ninth Circuit cases which had upheld sufficiently narrow restrictive covenants that only barred a party from pursuing a small or limited part of its business. Id. at 948-49. The California Supreme Court in Edwards held that “noncompetition agreements are invalid, even if narrowly drawn, unless they fall within the applicable statutory exceptions of section 16601, 16602, or 16602.5.” Id. at 955. These three exceptions are discussed below.

Non-Competes Arising From the Sale of a Business

The first exception arises in the context of the sale of a business entity. Section 16601 permits a party selling the goodwill or all of their ownership interest in a business to agree to refrain from competition within the business’s geographic area, so long as the buyer intends to carry on a like business therein. Cal. Bus. & Profs. Code § 16601. See Vacco Industries, Inc. v. Van Den Berg, 5 Cal.App.4th 34, 47 (1992) (upholding the enforceability of a non-compete agreement lasting as long as the employer conducted business in the area against shareholder/officer who sold all of his shares in the company pursuant to a stock sale). A merger agreement, whereby an employee sells his business interest in a company in exchange for shares of the newly merged company, is considered to be a transaction within the exception of section 16601. Hilb, Royal & Hamilton Ins. Services v. Robb, 33 Cal.App.4th 1812, 1824-1825 (1995) (upholding agreement entered into in conjunction with merger which prohibited competition in several countries for a 3-year period of time). Section 16601 thereby allows the buyer of a business to protect its investment by enforcing a covenant not to compete against the seller. However, this exception is only applicable to business owners (or persons who own at least a material portion of business); it would not, for example, be used to justify a non-compete for a seller (or selling employee) who only owns a very small percentage of a business entity. There is no “bright-line” definition for determining what is a material portion of the business.

Non-Competes Arising in Conjunction With the Dissolution Of Or Dissociation From a Partnership

 Section 16602, the partnership exception to California’s ban on non-compete agreements, permits, in the event of a dissolution of or dissociation from a partnership, an agreement that the departing partner not compete within the specified geographic area of the partnership’s business, so long as any other member of the partnership intends to carry on the business in the specified area. Cal. Bus. & Profs. Code § 16602. Unlike section 16601, there is no requirement under the partnership exception that compensation for goodwill in the partnership be transferred. South Bay Radiology Medical Associates v. Asher, 220 Cal.App.3d 1074, 1083 (1990). Section 16602 has been held applicable to partnerships involving accountants, attorneys, and physicians. See Swenson v. File, 3 Cal.3d 389 (1970); Howard v. Babcock, 6 Cal.4th 409 (1993); South Bay Radiology, 220 Cal.App.3d 1073. Courts have found that such covenants, rather than prohibiting competition, place a price on competition by, for example, permitting the departing partner to contract for compensation in return for refraining from engaging in competing business activity, or vice versa. Babcock, 6 Cal.4th at 417-24.

Non-Competes Arising in the Context of the Dissolution Of a Limited Liability Company

Like the partnership exception to California’s non-enforcement of covenants not to compete, section 16602.5 provides that in the event of the dissolution of a limited liability company, any member may agree not to carry on a similar business within the specified geographic area where the company’s business was transacted, so long as any other member intends to carry on the business in the specified area. Cal. Bus. & Profs. Code § 16602.5. Currently, there is no case law interpreting section 16602.5, which became effective in 2007. However, the section’s similarity to section 16602 indicates that it will be applied in a comparable manner by courts.

Despite California’s general hostility towards the enforcement of covenants not to compete in the employment context, these exceptions provide employers with valid methods under California law to protect their business interests from potential competitive harm caused by sellers and departing partners or members. Nevertheless, given the scarcity of case law interpreting these provisions, employers should proceed cautiously before relying on them. 
 

Co-authored by Ted A. Gehring.

On July 30, 2010, in Silguero v. Creteguard, Inc., the California Court of Appeal (2nd District) held that an employee could state a claim for wrongful termination against her subsequent employer when that employer terminated her after having been informed by her former employer that the employee was subject to a non-compete clause.  The decision will have important consequences for companies with California employees in industries where non-competition and non-solicitation agreements are common.

The plaintiff, Rosemary Silguero,  began employment with Floor Seal Technology Inc. (“FST”)  in 2003 as a sales representative.  In 2007, FST threatened to terminate her employment unless she signed a confidentiality agreement which contained a non-competition clause that prohibited her from all sales activities for 18 months following either her departure or termination from FST.  Silgureo's employment was subsequently terminated by FST.  She was then hired by Creteguard Inc.  FST contacted Creteguard requesting its cooperation in enforcing the confidentially agreement.  Creteguard then terminated Silguero’s employment, citing the non-competition clause.  Notably, in terminating her, Creteguard acknowledged the invalidity of the non-competition agreement, but noted it was terminating Silguero "to keep the same respect and understanding" with Creteguard's "colleagues" in the same industry.

Silguero filed suit against Creteguard, alleging wrongful termination.  She also sued FST in a separate lawsuit, alleging that FST had intentionally interfered with her contract with Creteguard.

Silguero contended that the non-competition agreement with FST was void under California Business and Professions Code Section 16600 and that her termination by Creteguard pursuant to that agreement was against public policy.   Creteguard demurred, arguing that that there was no clearly delineated public policy prohibiting an employer from honoring a non-competition agreement by an employee and a former employer.  Creteguard argued that if there was any violation of public policy, the violation was by FST.  The trial court granted Creteguard’s demurrer, finding it was not against public policy for a subsequent employer to honor a previous agreement entered into by an employee and former employer. Silguero appealed.

On appeal, the Court of Appeal reversed, holding that Silguero's allegations supported a claim for wrongful termination pursuant to Tameny v. Atlantic Richfield.  In reversing the ruling of the trial court, the Court held that Section 16600 was a clear legislative declaration of a fundamental public policy that forbid discharge based on a non-competition agreement.  The Court of Appeal did not address Silguero's claims against FST.

Creteguard argued that, notwithstanding the legislative policy against non-competition agreements, nothing in Section 16600 evidenced any legislative intent to impose third-party liability.  Imposing liability on Creteguard for a violation of Section 16600, Creteguard argued, went beyond the legislative intent evidenced by Section 16600.  The Court of Appeal disagreed, noting that California courts had previously rejected as unenforceable "no-hire" agreements between employees.  The Court of Appeal found that Creteguard's desire to keep an "understanding" with its competitors in the industry operated as a no-hire agreement.

Last week, we wrote briefly about EMC v. Donatelli, a case that is being litigated simultaneously in California and Massachusetts. On May 4, the Superior Court in Massachusetts ruled that EMC, a Massachusetts corporation, could obtain injunctive relief preventing Mr. Donatelli, who had been President of one of EMC’s major divisions, from starting a job at HP in California even though California has a statutory prohibition on covenants not to compete. The Court made some important findings in its decision which are summarized below.

Choice of Law - The court relied on the language of the agreement that Donatelli signed to find that Massachusetts law applied. Rejecting Donatelli’s argument that California’s fundamental policy against enforcement of non-competes made it futile for EMC to proceed in Massachusetts, the Massachusetts Court stated it “did not agree that California’s legislative policy, at least in this case, is somehow more ‘fundamental’ than, and therefore trumps, Massachusetts’ common law.”

Equitable Considerations - Donatelli also argued that Massachusetts should defer to California’s strong policy of protecting its workers. The Massachusetts Court rejected this argument as well, finding that Donatelli was not a California resident, and therefore not one of its workers. He was still a Massachusetts resident.  The Court also took Donatelli to task for “escaping” the obligations of the non-compete where the expectations of the parties were that he would be bound by it.

Enforceability of Covenant Under Massachusetts Law - The Court dealt with two issues that are of particular interest to practitioners in Massachusetts. The first is whether there was adequate consideration for the covenant even though it was signed 15 years after Donatelli started working at EMC. In ruling in favor of EMC, the Court found that even though the law in Massachusetts on this issue is somewhat unclear, under the facts of this case, continued employment constituted adequate consideration. However, regarding the breadth of the covenant, the Court allowed Donatelli to supplement the record to demonstrate that the covenant was broader than necessary to protect EMC’s interests.

The ball is now in the California Court. The Massachusetts Court was clear in ruling that California’s law against enforcement of non-competes did not trump Massachusetts’ common law in enforcing them, at least with respect to Massachusetts residents who move to California to escape the obligations of a Massachusetts non-compete. We will continue to follow this case as it no doubt progresses through the courts.
 

An executive’s resignation and intention to begin work for a competitor of his former employer has resulted in a bicoastal battle of lawsuits over the terms of a noncompete clause in his employment agreement.

On April 27, 2009, David Donatelli resigned his position as president of EMC Corp.’s storage division. That same day, Donatelli filed a lawsuit in California state court asking for a declaratory judgment voiding the noncompete clause in his employment agreement with EMC Corp. Donatelli’s attorneys are no doubt cognizant of California law’s hostility to noncompete clauses and sought to establish jurisdiction where the chances of enforcement of the noncompete are minimal. Donatelli intended to begin working at Hewlett Packard on May 5, 2009.

Placing a close second in the proverbial race to the courthouse, on April 28, 2009, EMC Corp. filed a suit in the Superior Court, Suffolk County, Massachusetts, alleging that Donatelli violated the noncompete in his employment agreement. EMC Corp. quickly moved for preliminary injunctive relief, and on May 4, 2009, Judge Stephen E. Neel issued a temporary injunction preventing Donatelli from starting his new position at Hewlett Packard as planned, pending a full hearing, noting: “Donatelli’s intention to work for HP in California, which has a statutory prohibition on covenants not to compete, does not warrant denial of EMC’s request for injunctive relief.”

It will be interesting to see if the California court renders a decision prior to the hearing in the Massachusetts court, and whether one court will defer to the other.
 

States vary widely in their willingness to enforce noncompetition agreements. Some states, such as California, are openly hostile and will not enforce them, while others will do so so, subject to varying degrees of judicial scrutiny.

My home state of Illinois, for example, will enforce a noncompetition agreement, but only after fairly rigorous judicial scrutiny. Notwithstanding such scrutiny, Illinois employers can draft enforceable noncompetition agreements. The attached article that I published in the April 2009 Illinois Bar Journal offers practical guidance on how to do so.