With Limited Exceptions, Non-Compete Clauses Are Not Enforceable in California
California Has a Strong Policy in Favor of Open Competition
“California has a settled public policy in favor of open competition.” Kelton v. Stravinski, 138 Cal. App. 4th 941, 946 (2006). The general rule, as embodied in section 16600 of the California Business and Professions Code (“Section 16600”) is that, with limited exceptions, “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Section 16600 is “an expression of public policy to ensure that every citizen shall retain the right to pursue any lawful employment and enterprise of their choice.” Hill Medical Corp. v. Wycoff, 86 Cal. App. 4th 895, 900, 901 (2001); Morlife, Inc. v. Perry, 56 Cal. App. 4th 1514, 1520 (1997); see also Application Group, Inc. v. Hunter Group, Inc., 61 Cal. App. 4th, 881, 900 (1998) (observing that section 16600 reflects a “strong public policy” of California).
Non-Compete Clauses Are Enforceable in Very Limited Cases
One “narrow exception” to section 16600 is articulated in section 16601 of the California Business and Professions Code (“Section 16601”)[1]. Hill, 86 Cal. App. 4th at 901. “Pursuant to section 16601, in certain defined circumstances, persons who sell the goodwill of a business may agree to refrain from carrying on a similar business.” Hill, 86 Cal. App. 4th at 901 (citing Monogram Indus., Inc. v. Sar Indus., Inc., 64 Cal App. 3d 692, 698 (1976)). The logic is that “when the goodwill of a business is sold, it would be ‘unfair’ for the seller to engage in competition which diminishes the value of the asset he [or she] sold.” Id.
“[I]n order to uphold a covenant not to compete pursuant to section 16601, the contract for sale of the corporate shares may not circumvent California’s deeply rooted public policy favoring open competition. The transaction must clearly establish that it falls within this limited exception.” Id. at 903 (emphasis added). Otherwise, the non-compete agreement is void. Id.; Kelton, 138 Cal. App. 4th at 947. Moreover, “[t]here must be clear indication that in the sales transaction, the parties valued or considered goodwill as a component of the sales price . . . .” Hill, 86 Cal. App. 4th at 903. If a business (or shares in a business) are sold, but the sales price did not include goodwill, a non-competition provision that was executed as part of the sale is void. Id. (holding that the non-competition provision was unenforceable because the price of the shares did not include goodwill).
A non-compete may “literally” fall within section 16601, but it is still void if it is a sham to evade the public policy against such provisions. Bosley Medical Group v. Abramson, 161 Cal. App. 3d 284 (1984). In Bosley, a doctor was hired by a medical group and was required to purchase nine percent of the corporation’s shares. The agreement required him, upon termination, to resell his stock and prohibited from competing. The court refused to enforce the non-compete as a sham because the share purchase and sell-back provisions made little sense except as a device to prevent the doctor from competing. Id. Though the agreement literally fell under section 16601, a literal interpretation “would permit a major public corporation to require any employee to purchase one of several million shares and to enter into an agreement not to work for a competitor—an absurd result, and contrary to this state’s policy prohibiting such agreements.” Id.
“[A] covenant not to compete will be enforced [under section 16601] to the extent it is reasonable and necessary in terms of time, activity and territory to protect the buyer’s interest.” Monogram, 64 Cal. App. 3d 692, 698 (1976) (emphasis added). Section 16601 “permits a covenant not to engage in a business’ ‘similar’ to the one sold, in the area where the business sold has been carried on, so long as the buyer carries on a like business therein.” Id.(emphasis added). “Otherwise, a seller could be barred from engaging in its business in places where it poses little threat of undercutting the company it sold to the buyer.” Strategix, Ltd. V. Infocrossing West, Inc., 142 Cal. App. 4th 1068, 1073 (2006). “The territorial limits are coextensive with the entire area in which the parties conducted all phases of their business including production, promotional and marketing activities as well as sales.” Monogram, 64 Cal. App. 3d at 702. However, the area is limited to that in which competition “in fact” occurs, and not where there is only “insubstantial and infrequent or isolated transactions.” Id. at 698.
In enacting section 16601, the Legislature did not intend “to sanction restraints upon all business transactions of whatever character, regardless of their noncompetitive effect, their insubstantial nature, or their infrequent occurrence. Instead, . . . in using the words ‘carry on a similar business,’ the Legislature had in mind the direct or indirect transaction or solicitation of substantial business activities in competition with the covenantee [citation], rather than the occurrence of isolated, occasional transactions not substantially affecting the covenantee’s competitive position.” Swenson v. File, 3 Cal. 3d 389, 397 (1970); Roberts v. Pfefer, 13 Cal. App. 3d 93, 98 (1970).
In Swenson, an accounting partnership had offices in Pasadena and Azusa. One of the partners withdrew and opened offices in South San Gabriel and Arcadia. The issue was whether the withdrawing accountant carried on business in Pasadena and Azusa – the cities he had promised not to compete against the partnership. The record established that the accountant performed services in Pasadena for one client located there, whose business he had obtained when the client was located in Arcadia and whose billing amounted to only 1.2% of the accountant’s total billings. The accountant also serviced several other clients who had Pasadena addresses. These facts were held insufficient to conclude the partner carried on business in Pasadena: “The fact that some of defendant’s clients had Pasadena addresses would not, of itself, establish that proposition . . . Nor do we think that defendant carried on business in Pasadena merely by performing occasional services in that city for a single client whose plant was moved from Arcadia to Pasadena after it had retained defendant.” Id. at 397. These “isolated, occasional transactions” did “not substantially affect[] the [partnership’s] competitive position,” and therefore, the accountant did not carry on business in Pasadena. Id.
Overbroad Non-Compete Agreements May Be Completely Ignored
A non-compete agreement that is overbroad and exceeds the limitations in section 16601 may be declared void and unenforceable. Hill, 86 Cal. App. 4that 908 (refusing “to save the covenant not to compete by restructuring it”); Kelton, 138 Cal. App. 4th at 941, 946-47 (“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.”).
On the other hand, some “[c]ourts have ‘blue penciled’ noncompetition covenants with overbroad or omitted geographic and time restrictions to include reasonable limitations.” Strategix, 142 Cal. App. 4th at 1074; see Swenson, 3 Cal. 3d at 395 (holding that “the rule of severability may be invoked to uphold defendant’s covenant to the extent that it falls within the limits permitted by section 16602”); Edwards v. Mullin, 220 Cal. 379 (1934) (narrowing the geographic scope of the non-compete provision from Northern California to San Francisco).
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[1] Section 16601 states in part: [“[a]ny person who sells the goodwill of a business, or any owner of a business entity selling or otherwise disposing of all of his or her ownership interest in the business entity, or any owner of a business entity that sells (a) all or substantially all of its operating assets together with the goodwill of the business entity . . . may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold . . ., so long as the buyer, or any person deriving title to the goodwill or ownership interest from the buyer, carries on a like business herein.”