IN-TERM AND POST-TERM NON-COMPETITION CLAUSES
If you are an employee, employer, franchisee, franchisor or simply a party to a contract involving a non-compete clause that restricts your rights to engage in a lawful profession, trade or business of any kind in California either during the term of the contract or for a period of time after the contract expires or is terminated for any reason, you need to understand your rights.
GENERALLY NON-COMPETE CLAUSES IN CALIFORNIA CONTRACTS ARE VOID:
California has a well settled public policy in favor of open competition. [See Hill Medical Corp. v. Wycoff (2001) 86 Cal.App.4th 895, 900] Accordingly, the general rule in California is that covenants not to compete are void. (Id. at p. 901.) This public policy has been codified in California Business and Professions Code §16600 which embodies this prohibition against restraints on trade and states:
B&P Code §16600. Unauthorized contracts – Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.
Two exceptions exist: B&P Code §16601 (Sale of Business/Goodwill) and §16602 (Partnership Dissolution or Disassociation). B&P Code §§16601 and 16602 permit businesses to enforce broad covenants not to compete under the following conditions:
- Where the individual(s) sell the goodwill of a business to another and as part of the sales agreement, agree not to compete with the buyer;
- Where a business partner agrees not to compete with his other business partner(s) in anticipation of dissolving the partnership. (See Kolani v. Gluska (1998) 64 Cal.App.4th 402, 407.)
In Kelton v. Stavinski, (2006)138 Cal. App. 4th 941, 946, a case involving a covenant not to compete signed by two partners, you would expect the court to enforce the covenant. The California Court of Appeal affirmed the determination that the covenant was actually unenforceable. You see, although B&P Code §§16601 and 16602, permit covenants not to compete in connection with the sale of the goodwill of a business or the anticipated dissolution of a partnership, the challenged covenant (not to compete) in this agreement was not executed as part of the sale of the goodwill of a business or the dissolution of a partnership. Thus, it is not sufficient for the partners simply to agree not to compete; the partnership must also be dissolving for the exception to exist. No dissolution, no exception to prevent the application of the general rule in B&P Code §16600, that covenants not to compete are void. The existence of an ongoing business relationship between the parties did not give rise to an exception.
Thus, covenants not to compete in contracts, other than for the sale of a business’ and its goodwill or the dissolution of a partnership, are void. Moreover, when a contract creates an illegal restraint on trade, there is nothing that the parties can do that will in any way add to its validity. If the contract is void, it cannot be ratified either by right or by conduct. [See South Bay Radiology Medical Associates v. Asher (1990) 220 Cal. App. 3d 1074, 1080]
“Every contract which contains a covenant restraining any person from engaging in a lawful business is to that extent void, including franchise agreements.” [See Scott v. Snelling & Snelling, Inc., 732 F. Supp. 1034, 1041 (N.D. Cal. 1990)]
In the Scott case, the plaintiffs entered into various franchise agreements with the defendant, but subsequently, during the term of the Franchise Agreement, formed competing businesses. Plaintiffs brought suit upon termination of the agreements and the parties filed cross-motions for partial Summary Judgment on the enforceability of the non-compete provisions. The Scott Court held that the non-compete clauses violated a strong California public policy against enforcement of restrictive covenants and that covenants restricting competition in franchise agreements were barred as a matter of law by B&P Code §16600 The Court further held that although the choice of law provisions were given deference, the non-compete clauses violated a strong California public policy against enforcement of restrictive covenants and that covenants restricting competition in franchise agreements were barred as a matter of law by B&P Code §16600. The Court further found that the plaintiffs were not using trade secrets as the defendant’s customer lists, temporary employee lists and business forms and procedures were not trade secrets under Cal. Civ. Code §3426.1(d) (California’s Uniform Trade Secrets Act, “UTSA”). Despite the parties covenant not to compete, its enforcement violated a strong California public policy embodied in statute, and did not fall within any exception to the B&P Code §16600.
In Aussie Pet Mobile, Inc. v. Benton, (2010 U.S. Dist. LEXIS 65126, 17 (C.D. Cal. June 28, 2010) involving a pet grooming franchise, the U.S District Court for the Central District of California held that the Exclusive Relationship Clause contained within the Franchise Agreement prohibited the signatory, any affiliate, “any shareholder, member or partner,” and “any member of the immediate family” from having “any direct or indirect interest as a disclosed or beneficial owner in any similar business located anywhere.” The broad language and lack of restrictions on the scope of the Exclusive Relationship Clause showed that the intent was not merely to protect trade secrets, but to restrict competition. [See Applied Latona v. Aetna U.S. Healthcare, Inc., 82 F. Supp. 2d 1089, 1095 (C.D. Cal. 1999) (applying California law, invalidating non-solicitation clause that was “neither narrowly tailored nor limited to protecting trade secrets”]. The Court held that the Exclusive Relationship Clause was too broad and therefore unenforceable under California Law.
Finally, in Comedy Club, Inc. v. Improv West Assocs., (2009) 553 F.3d 1277, the Ninth Circuit held that under B&P code §16600 an in-term covenant not to compete in a franchise-like agreement was found to be void if it foreclosed competition in a substantial share of a business, trade, or market.” In other words, “in-term covenants not to compete cannot prevent a party from engaging in its business or trade in a substantial section of the market.”
In Comedy Club, the district court confirmed an arbitrator’s award under which the licensee lost its exclusive right to operate new comedy improv clubs. The arbitrator’s award effectively quarantined plaintiff from engaging in its business in forty-eight states until 2019 and did not follow well-established California law against non-compete clauses. The Ninth Circuit held that the arbitrator’s ruling was not narrowly tailored, was invalid, ignored B&P Code §16600 and was in manifest disregard of the law.
“However, we do not void the entire in-term covenant not to compete. Kelton stressed that the franchisor-franchisee context was different from an employment or partnership context. CCI’s relationship with Improv West is in essence a franchise agreement as CCI contracted with Improv West to use Improv West’s trademarks and open comedy clubs modeled on Improv West’s clubs. (See Kelton, 138 Cal. App. 4th at 947-48 (discussing franchising under California law)) Assessing the requirements of California law, we weigh CCI’s right to operate its business against Improv West’s interest” to protect and maintain its trademark, trade name and goodwill.” Id. at 948. This balance tilts in favor of Improv West with regard to counties where CCI is operating an Improv club, but under the restraint of B&P Code§16600. California law does not permit an arbitrator to foreclose CCI’s competition in opening comedy clubs throughout the United States.” (Emphasis added)
“Therefore, we hold that the district court should vacate the arbitrator’s injunctive relief as to any county where CCI does not currently operate an Improv club, but uphold §9.j. in those counties where CCI currently operates Improv clubs. [See Armendariz v. Found. Health Psychcare Servs., Inc. (2000) 24 Cal. 4th 83, 123 (stating that “overbroad covenants not to compete may be restricted temporally and geographically” (citing Gen. Paint Corp. v. Seymour, (1932) 124 Cal. App. 611, 614-15)]. Nationwide CCI may open and operate non-Improv comedy clubs in all those counties where it does not currently operate an Improv club. However, CCI may not open or operate any non-Improv clubs in those counties where it currently owns or operates Improv clubs.
The Comedy Club court in essence acknowledges that in-term covenants not to compete may be necessary in the franchise context” to protect and maintain the franchisor’s trademark, trade name and goodwill.” As a result, the Court would not void the entire in-term covenant not to compete. Since the Court considered the agreement between CCI and Improv West to be a Franchise Agreement, it weighed CCI’s right to operate its business against Improv West’s interest in protecting and maintaining its trademark, trade name and goodwill, and concluded that the covenant not to compete could be enforced only in those areas where CCI was operating Improv comedy clubs under the Agreement. In all other areas, CCI could operate non-Improv comedy clubs.
TRADE SECRETS AND CONFIDENTIAL INFORMATION PROTECTIONS:
A non-competition clause designed to protect the businesses’ trade secrets and confidential information is more likely to be enforced by the Courts. However, broad non-compete clauses that seek to limit competition are less likely to be enforced based on the public policy prohibiting non-compete clauses in California Business and Professions Code§16600. Trade secrets are defined by the common law trade secrets and the statutory Uniform Trade Secrets Act.
VIOLATIONS OF THE NON-COMPETE CLAUSE THROUGH BACKDOOR ALLEGATIONS OF UNFAIR COMPETITION AND ILLEGAL USE OF TRADE SECRET(S) AND CONFIDENTIAL BUSINESS INFORMATION:
Even though your former employer franchisor or other contracting party may not be able to enforce the post term non-compete clauses and may be limited in their ability to enforce in-term non-compete clauses you must anticipate that they will most likely seek to keep you from competing with them by alleging that you are using their trade secrets and confidential business information to compete which the California Court’s consider to be an exception to B&P 16600 and is seen as Unfair Competition.
In order for an employer or franchisor or other party to succeed with an unfair competition allegation, they must show that they own a trade secret(s) like client lists, proprietary software, pricing formulas, product formulas, etc., that the information is not generally known to the public and that the information is maintained in secrecy. Moreover, they will have to show that because of your prior working relationship, you had access to this information and that you are using the information to help you compete and take away business from your former employer, Franchisor or other party. The first step in analyzing your potential exposure to a claim of unfair competition is to determine if your former employer, Franchisor and/or other party has any trade secret(s). If so, you cannot be using them in your competing business.
THE UNIFORM TRADE SECRETS ACT:
Under the Uniform Trade Secret Act, a trade secret is any information that derives independent economic value from not being generally known, either to the public or to other persons who can obtain economic value from its disclosure or use. [See C.C. §3426.1(d)(1)] The independent economic value may be either actual or potential. [C.C. §3426.1(d)(1)]
The existence of economic value can be established by evidence that a trade secret owner expended effort and money in developing the information. A trade secret owner proved that his information had economic value when he showed that he spent over $500,000 to develop the information. [See Cybertek Computer Prods., Inc. v. Whitfield (1977) 203 USPQ 1020, 1977 Cal App LEXIS 2140] A software company failed to meet its burden of showing that allegedly misappropriated source code met the definition of a trade secret because the evidence did not establish that the code had significant economic value, inter alia, because it did not play a pervasive role in competing program. [See Yield Dynamics, Inc. v. TEA Systems Corp. (2007)154 CA 4th 547]
The information must also be a secret and must not be generally known to the public or a matter of general knowledge in the trade or business. [See CC §3426.1(d)(1)] Widespread, anonymous publication over the Internet can destroy the existence of a trade secret unless the Internet publication is sufficiently obscure or transient so as not to become generally known to those who would derive economic value from obtaining the information. [See DVD Copy Control Assn., Inc. v. Bunner (2004) 116 CA4th 241, 251] The information disclosed by a product available in the open market, as well as any other information that its owner does not keep secret, does not qualify as a trade secret. [See Vacco Indus., Inc. v. Van Den Berg (1992) 5 CA4th 34, 50]
The information is only a trade secret if it is “the subject of efforts that are reasonable under the circumstances to maintain its secrecy“. [See CC § 3426.1(d)(2)] Reasonable efforts are sufficient if physical access to a plant is controlled through use of security guards, employee identification badges, visitor escorts, and special sign-in procedures. [See People v. Gopal(1985) 171 CA3d 524, 538] Use of locked cabinets, safes, logging and identification of materials, availability of materials at only a few sites worldwide, electronic sensors attached to documents, locked briefcases for transporting works, alarms, photo identifications, security personnel, and confidentiality agreements for all those given access to the materials were all reasonable steps under the circumstances to protect trade secrets as well. [See Religious Tech. Ctr. v. Netcom On-Line Communication Servs. (ND Cal 1995) 923 F Supp 1231, 1250]
THE COMMON LAW TRADE SECRET:
Under the common law, California Courts apply the Restatement of Torts definition of trade secret, which provides that a trade secret must be used in one’s business and may consist of a formula, pattern, device, or compilation of information. The information must give an economic advantage to the business over its competitors who do not know or use it. [See Uribe v. Howie (1971) 19 CA3d 194, 208] One consideration in making this determination is the amount of money or effort expended by the business to develop the information. [See Futurecraft Corp. v. Clary Corp. (1962) 205 CA2d 279, 289]
Moreover, the business must have a need for the continued use of the information to maintain a competitive advantage over others. If the information is only useful for a single transaction, for example, the information does not constitute a trade secret under common law. [See Cal Francisco Inv. Corp. v. Vrionis (1971) 14 CA3d 318, 322,] the information must also be adequately kept secret. Courts determine whether information was adequately kept secret by considering the following factors:
- The extent to which the information is known outside the business;
- The extent to which the information is known to employees and others involved in the owner’s business;
- The extent of measures taken by the owner to guard the secrecy of the information; and
- The ease or difficulty with which others could properly acquire or duplicate the information. [See Futurecraft Corp. v. Clary Corp. (1962) 205 CA2d 279, 289]
Information cannot be a trade secret unless it is capable of being kept secret by its creator. Information is not deemed a trade secret if a casual inspection of an item reveals the information. However, if it would take time and expense to examine the item to figure out how it was made, the information may be considered a trade secret. [See Sinclair v. Aquarius Elecs., Inc. (1974) 42 CA3d 216, 226]
Regardless of whether the plaintiff or the defendant developed the information during the course of the employment relationship, the Court generally protects information that is so special and integral to the business that it may be deemed confidential or secret information. If information was supplied by a plaintiff employer to a defendant former employee, the Court is more likely to regard the information as a trade secret if the plaintiff can show that the information was highly refined and that the plaintiff took great time and expense to develop it. [See California Intelligence Bureau v. Cunningham (1948) 83 CA2d 197, 203]
Under the UTSA, a customer list may be a trade secret. California courts recognize that a customer list satisfies the requirement that a trade secret be “information”. [See, e.g., American Paper & Packaging Prods., Inc. v. Kirgan (1986) 183 CA3d 1318, 1324] A former employee who contacts trade secret customers to announce new employment does not misappropriate the trade secret information. [See American Credit Indem. Co. v. Sacks (1989) 213 CA3d 622, 636-637]
This article has focused on issues related to an employer, Franchisor or other contractual party’s ability to enforce the non-compete clauses against your present or future competing business. This article provides detailed information regarding the available defenses under California’s Business and Professions Code §16600 to claims of violations of non-compete clauses in employment, Franchise or other contractual agreements. In summary, an employer or Franchisor could attempt to enforce these clauses, by seeking an injunction and damages, against your future business by claiming that you are operating a “Competitive Business” in violation of the non-compete clauses in the agreement or that you have violated California’s Unfair Competition law by stealing trade secrets and/or confidential business information to give yourself a unfair advantage. However, as set forth above, California Courts are extremely skeptical and cautious about enforcing overly broad non-compete provisions and there are considerable defenses available to you under California law for claims of Unfair Competition and illegal use of trade secrets and/or confidential business information.
AL MOHAJERIAN/MOHAJERIAN LAW CORP
Filed Under: Franchise & Distribution, Labor & Employment, Litigation, Trade Secrets, Unfair Competition
Tagged With: MOHAJERIAN REVIEW, NON-COMPETITION CLAUSES
A shareholder has the right to petition the court for the removal of a corporation’s director if that director is acting in bad faith and not in the best interests of the corporation and its shareholders. A lawsuit seeking the removal of a corporate director is an equitable remedy and the party bringing such an action must do so with clean hands. [See DeGarmo v. Goldman (1942) 19 Cal. 2d 755, 759-761] This means that the party seeking the director’s removal must not be guilty of any wrong doing or bad faith himself. The act of having a corporate director removed from the Board of Directors constitutes a derivative action and the process by which the shareholder(s) must go through are specific and must be followed precisely otherwise the shareholder(s) will lack standing in Court to pursue the relief sought.
A derivative suit is also an action in equity and the party bringing the lawsuit must come to court with clean hands. [See Rosenfeld v. Zimmer (1953) 116 Cal. App. 2d 719, 722,] In a derivative suit, the shareholder(s) who files the action(s) against the corporation’s director stands in the place of and represents the corporation as a whole. There are two basic elements that encompass a shareholder derivative lawsuit: First there must be some recognized injury to the corporation or to the whole body of its stockholders; Second, the corporation (Board of Directors) or the responsible official(s) within the corporation have failed or refused to act. [See Starbird v. Lane (1962) 203 Cal. App. 2d 247, 255] Lastly, the corporation itself must have a legal cause of action against the director whose removal is sought. [See McDermott v. Bear Film Co. (1963) 219 Cal. App. 2d 607, 611,]
A shareholder derivative suit is in essence a lawsuit that seeks to recover for the benefit of the corporation and all of its shareholders when the injury is caused to the corporation. The shareholder(s) brings the action because other options are not available due to the corporation’s intentional or negligent failure to act to remove said director. Although the corporation is a named defendant in the lawsuit, the corporation is the real plaintiff as the shareholder(s) stands in its place and it is the corporation alone that benefits from the judgment. [See Jones v. H.F. Ahmanson & Co. (1969) 1 Cal. 3d 93, 106-107]
If you are shareholder in a corporation and are considering filing a derivative action seeking the removal of a member or members of the Board of Directors, there are specific pleading and proof requirements under California Corporation Code §800(b)(2) that you must follow. California Corporation Code §800(b)(2) states:
“(b) No action may be instituted or maintained in right of any domestic or foreign corporation by any holder of shares or of voting trust certificates of the corporation unless both of the following conditions exist:
(2) The plaintiff alleges in the complaint with particularity plaintiff’s efforts to secure from the board such action as plaintiff desires, or the reasons for not making such effort, and alleges further that plaintiff has either informed the corporation or the board in writing of the ultimate facts of each cause of action against each defendant or delivered to the corporation or the board a true copy of the complaint which plaintiff proposes to file.” [See Bader v. Anderson (2009) 179 Cal.App. 4th 775, 796, (no exception to demand requirement in instances in which underlying wrong concerns alleged misrepresentations or omissions in proxy statement)] (Emphasis added.)
An exception to the above stated pleading requirements exist if you can show facts that demonstrate that a demand on the corporation pursuant to Corp. Code §800(b)(2) would have been futile. [See Koshaba v. Koshaba (1942) 56 Cal. App. 2d 302, 308,] A demand on the Board of Directors is deemed unnecessary if you allege that the Director you are seeking to be removed and/or the Board of Directors as a whole are guilty of conspiracy, fraud, or criminal conduct. [See Reed v. Norman (1957) 152 Cal. App. 2d 892, 898]
However, conclusionary allegations like “that further demand as stockholder would be futile” are insufficient to meet the pleading requirements of Corp. Code §800(b)(2). [See Shields v. Singleton (1993) 15 Cal. App. 4th 1611, 1621-1622; Fairchild v. Bank of America (1961) 192 Cal. App. 2d 252, 259] The test for proving that the demand on the corporation is futile, is whether the facts alleged show a reasonable doubt that (1) the Directors are disinterested and independent, and (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. [See Oakland Raiders v. National Football League (2001) 93 Cal. App. 4th 572, 587] You should also keep in mind that the demand futility rule is not a mere pleading requirement that drops out of the case once a derivative suit survives a demurrer. [See Oakland Raiders v. National Football League (2001) 93 Cal. App. 4th 572, 584-586 (rejecting contention that trial court erred by considering demand futility as element of derivative claims that is subject to proof)]
The clearest way to determine if the lawsuit you intend to file is derivative is to see if the injury is to the corporation and/or to the whole body of its stock and property without any severance or distribution among the individual shareholders, or if your Complaint seeks to recover assets for the corporation or to prevent the dissipation of its assets. For example, in an action for breach of fiduciary duty arising from alleged management improprieties and the attendant decline in the corporation’s stock value, the gravamen of the complaint was harm to the corporation and thus the action was a derivative action that the plaintiff lacked standing to pursue [See Schuster v. Gardner (2005) 127 Cal. App. 4th 305, 309, 312-315 (affirming judgment of dismissal entered after trial court sustained demurrers without leave to amend)] Similarly, in a case in which plaintiffs’ allegations regarding mismanagement amounted to a claim of injury to the corporation itself, the court of appeal held that the trial court properly dismissed the shareholders’ complaints [See Avikian v. WTC Financial Corp. (2002) 98 Cal. App. 4th 1108, 1115-1117] Furthermore, in a case in which causes of action for fraudulent transfer of a company’s assets were brought by members of LLC, the court held that the action could be brought only as a derivative action on behalf of the LLC [See Paclink Communications International, Inc. v. Superior Court (2001) 90 Cal. App. 4th 958, 964-965]
NONDERIVATIVE SHAREHOLDER SUITS
A shareholder’s suit is deemed nonderivative or an individual right of action when it is brought to enforce the shareholder’s personal and individual rights against the corporation, director(s) and/or officer(s). The alleged wrong to the shareholder necessary to support the lawsuit does not have to be unique to that specific/individual shareholder or group of shareholders but can affect a substantial number of the corporation’s shareholders. What this means is that if the injury is not incidental to an injury to the corporation, an individual cause of action exists. [See Jones v. H.F. Ahmanson & Co. (1969) 1 Cal. 3d 93, 107-108; Vega v. Jones, Day, Reavis & Pogue (2004) 121 Cal. App. 4th 282, 296-297 (plaintiff’s action was individual, not derivative, because in alleging defendant had deceived him into exchanging valuable stock in acquired corporation for worthless stock in acquiring corporation, he sought recovery for injury to himself); Denevi v. LGCC (2004) 121 Cal. App. 4th 1211, 1223 (LLC member entitled to bring individual claim for fraudulent representations that induced him to transfer real estate purchase rights to LLC, notwithstanding facts that he had already successfully prosecuted derivative claim on behalf of LLC and damages awards in the two suits might be overlapping or duplicative); Jara v. Suprema Meats, Inc. (2004) 121 Cal. App. 4th 1238, 1258 (minority shareholder’s claim that majority stockholders paid themselves excessive compensation, thus depriving him of his proportionate share of corporate profits, came “within the scope of allowable individual actions”); Nelson v. Anderson (1999) 72 Cal. App. 4th 111, 124-126, 84 Cal. Rptr. 2d 753 (minority shareholder as individual had no standing to bring action for breach of fiduciary duty against majority shareholder, but should have brought derivative action, when all acts allegedly causing injury constituted misfeasance in managing corporate business)] For a shareholder to obtain a personal right of action there must be a relationship between the shareholder and the Corporation, Director and/or Officer independent of those which the shareholder derives through his or her interest in the corporate assets and business. [See Shenberg v. DeGarmo (1943) 61 Cal. App. 2d 326, 333]
The significance of the distinction between a derivative and a nonderivative shareholder suit is that the pre-filing conditions and security requirements prescribed by Corp. Code §800 apply exclusively to derivative lawsuits. [See Hagan v. Superior Court (1960) 53 Cal. 2d 498, 501-503 (writ of prohibition may be used to restrain trial court from requiring plaintiff to post security in nonderivative suit)]
AL MOHAJERIAN – MOHAJERIAN APLC
Filed Under: Corporate, Litigation
Tagged With: Board of Directors, MOHAJERIAN REVIEW