Ongoing Battles Regarding the Reach of California’s Prohibition of Covenants Not to Compete

Fourth Quarter 2010Newsletters California Update Employment Law

It is fairly well known by now that covenants not to compete are not enforceable in California. Business and Professions Code §16600 is said to contain a “strong public policy” in favor of allowing employees to depart and work for anyone else, including direct competitors of the original employer, even if the employee agreed in advance not to do so. Non-competition agreements are enforceable in many other states.

In an effort to hire out-of-state employees, some California companies have recently attempted to use B&P Code §16600 to nullify non-competition agreements between such employees and companies in states where those agreements are legal and enforceable. The companies attempting to nullify the out-of-state agreements are claiming standing to sue in their own right for “unfair competition” under B&P Code §17200. The case typically takes the form of an action in Superior Court for “declaratory relief.” The plaintiff company and the bolting employee ask the California court to declare the covenant between the employee and the original out-of-state employer “void” under California law. The out-of-state employer will likely counter with the argument that the suit seeks an unconstitutional, extraterritorial application of §16600 to citizens of other states, employees and companies alike. What’s a court to do? It depends.

The result will likely turn on the interpretation of Application Group, Inc. v. Hunter Group, Inc., 61 Cal.App.4th 881 (1998), a case that lay rather dormant for more than 10 years. Hunter Group was a Maryland corporation that provided computer consulting services for businesses, including customers in California. Hunter competed with Application Group, a California corporation, for projects. Hunter’s employees who resided outside of California, including employee Dianne Pike, had non-competition clauses in their employment agreements. Pike, a resident of Maryland, resigned from Hunter and went to work for its competitor, Application Group. Hunter filed a lawsuit in Maryland alleging that Pike had breached the covenant not to compete in her employment agreement and further alleging that Application Group had interfered with its contractual relationship with Pike. While that suit was pending, Application Group and Pike sued Hunter in California seeking a declaratory judgment that California law (B&P Code §16600), and not Maryland law, applied to Pike’s covenant not to compete. Hunter filed a motion to stay the California action based on inconvenient forum grounds. The California court granted Hunter’s motion and stayed the California action pending resolution of the Maryland litigation. The Maryland court subsequently granted Application Group’s motion for summary judgment because Hunter had failed to present evidence
of damage.

Application Group then filed an amended complaint in California seeking a declaratory judgment that:

(1) B&P Code §16600 and §17200, and not Maryland law, applied to Pike’s covenant not to compete;

(2) By including a non-competition provision in its employees’ contracts in Maryland, Hunter was engaging in “unfair competition” within the meaning of §17200;

(3) Pursuant to §16600 and §17200, Hunter was precluded from enforcing in California any out-of-state judgment or injunction it “might obtain” upholding the validity of its covenant not to compete; and

(4) §16600 and §17200 provided Application Group with a “privilege” to contact and recruit Hunter’s employees in Maryland regardless of the covenant not to compete in their employment agreements.

The California trial court ruled that §16600 and §17200 applied and that the covenant not to compete was unenforceable and a “contract to restrain trade,” which constituted “unfair competition.”

Hunter appealed, arguing that the trial court was wrong in its application of conflict of laws principles. The appellate court concluded that the trial court did not err in applying California law (§16600 and §17200), reasoning that California had a “greater interest” in application of its law to the dispute and that California's interests would be seriously impaired if its policy were subordinated to that of Maryland. Exactly why Maryland had a “lesser” interest in the matter was not fully explained.

Significantly, two other issues were not fully litigated in the Application Group case: (1) whether the California company could invoke standing under §16600, and (2) whether the extension of §16600 to out-of-state contracts is constitutional. On the issue of standing, §16600 itself does not on its face appear to confer standing upon a prospective employer. The question is whether §17200 can somehow be invoked to deem a covenant not to compete an act of “unfair competition” toward a prospective employer. On the issue of constitutionality, the U.S. Supreme Court has held that constitutional principles prohibit one state from imposing its laws on other states. Whether the Application Group case violates this doctrine by approving the seemingly “extraterritorial” use of §16600 remains to be seen. Sooner or later, two companies – one in California and one outside the state – will have enough at stake that the validity of Application Group will be tested.