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Noncompetes a Nonstarter in California? Think Again

Corporate Counsel

Until 2008, the scope of California’s statutory prohibition against noncompetition agreements, codified in California Business Code §16600, was subject to widely varying interpretations. California’s federal courts regularly enforced narrow restraints on trade, such as nonsolicitation provisions, which can have similar practical effects to general noncompetition provisions. In 2008, however, the California Supreme Court slammed the door shut on these employer-friendly interpretations, and held unequivocally that §16600 prohibits all restraints on trade, including nonsolicitation provisions. See Edwards v. Arthur Anderson, 44 Cal. 4th (2008).

In the aftermath of the Edwards decision, commentators observed that companies doing business in California would have to live with a new reality: California employees, unlike employees in other states, were off limits for restrictive covenant agreements. Many employers drafted new agreements tailored to their California employees, which prohibited only the use of trade secrets—the one restraint that remains legal under California law. As a practical matter, these agreements afforded few additional protections beyond what were already available under the California Uniform Trade Secrets Act.

Over the last few years, however, employers headquartered outside of California have had some success enforcing noncompete agreements against California-based employees through the use of well-crafted choice of law and forum selection clauses. If your company has written off its California employees as “untouchable” when it comes to noncompete agreements, it may be time to take another look.

Choice of Law Rules

State and federal courts apply the choice of law rules of the forum state in which they sit. Most states have adopted the provisions of the Restatement (Second) of Conflict of Laws, §187, which provides in relevant part:

  1. The law of the state chosen by the parties to govern their contractual rights and duties will be applied if the particular issue is one which the parties could have resolved by an explicit provision in their agreement directed to that issue. 
  2. The law of the state chosen by the parties to govern their contractual rights and duties will be applied, even if the particular issue is one which the parties could not have resolved by an explicit provision in their agreement directed to that issue, unless either (a) the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties’ choice, or (b) application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue and which … would be the state of the applicable law in the absence of an effective choice of law by the parties.

Despite its widespread adoption, different jurisdictions have widely varying views about how §187 applies in noncompete cases. California courts have concluded that California has an overriding interest in the application of its law to noncompete disputes involving California-based employees, and that applying another state’s law to enforce a restrictive covenant would be contrary to California’s fundamental policies expressed in §16600. Accordingly, if an employer files a noncompete case in California, it is almost certain to lose.

This fact has not been lost on California employees looking to avoid restrictions in their noncompete agreements. Employees regularly file declaratory judgment lawsuits in California immediately upon their resignation—or sometimes even before they resign—in hopes that a California court will apply California law.

Choice of Law and Forum Selection Clauses Make a World of Difference

Rather than retreat from California’s legal minefield, some employers headquartered outside of California have used another arrow in their quiver to enforce restrictive covenants against California-based employees: choice of law and forum selection clauses.

Unlike in California, courts in New York, Pennsylvania, Massachusetts, Michigan, Oregon, Washington and Kansas have applied their choice of law rules to uphold choice of law clauses in noncompete agreements with California-based employees, including where the chosen law favors enforcement. These courts have taken different paths to reach this conclusion. Some have held that California does not have a “materially greater interest” in the dispute than the employer’s home state. Others have concluded that California’s protection of trade secrets undermines any claim that noncompetes run afoul of California’s fundamental policies. Still other courts have avoided application of Restatement §187(2) altogether by concluding that, in the absence of fraud or illegality, the parties’ choice of law should be upheld. Whatever the reason, employers should seriously consider using choice of law clauses selecting their home state’s law in noncompete agreements with employees nationwide, including employees based in California.

But what about those declaratory judgment actions that employees file in California to ensure that California choice of law rules (and California law) apply to their agreements? Thankfully, there are solutions for that, too. The easiest way to avoid the application of California’s choice of law rules (and California law) is to include in the noncompete agreement an exclusive forum selection clause selecting the federal or state courts in the employer’s home state. The U.S. Supreme Court recently held in Atl. Marine Const. v. U.S. Dist. Court (2013) that exclusive forum selection clauses between contracting parties must be honored and enforced except in rare circumstances. Accordingly, California courts regularly dismiss declaratory judgment actions when the noncompete agreement contains an exclusive forum selection clause selecting a forum outside of California. Even in the absence of a forum selection clause, however, employers can respond to employee declaratory suits by filing their own actions in the forum of their choice, and then moving to dismiss the declaratory action under Brillhart v. Excess Ins. Co. of America, 316 U.S. 491 (1942), which provides district courts with discretion to dismiss declaratory actions when the dispute can better be settled in a pending state court proceeding. California courts have displayed a willingness to dismiss declaratory suits in favor of later-filed actions brought in the employer’s home state. See, e.g., Harrison v. Synthes USA Sales, No. 2:12-CV-02704-GEB-AC, 2013 WL 1007662, at *2 (E.D. Cal. Mar. 13, 2013).

Key Takeaways

There are a few key considerations before attempting to enforce a non-compete against a California-based employee. Most important, familiarize yourself with choice of law rules of the state law that you would like to govern your agreement. Although New York, Pennsylvania, Massachusetts, Michigan, Oregon, Washington and Kansas have been willing to enforce non-competes against California employees, not all courts have been so favorable to their home-state employers. Courts in Delaware, Illinois, Ohio and Texas have concluded that, at least under certain circumstances, California law may override a choice of law clause in a noncompete agreement with a California-based employee. Most other states have not yet decided the issue.

Second, if the employer’s state is one with favorable choice of law rules, the employer should consider adding a choice of law and forum clause that selects the law of the state in which the employer is headquartered. These clauses will ensure uniform application of the law to their agreements with employees throughout the country, including in California.

Finally, to help ensure the enforceability of the choice of law clause (and ultimately the noncompete), it is important to establish that the employee had a meaningful connection to the chosen state during his or her employment. In determining which state’s law should apply, courts often analyze contacts with the relevant forums, including where the noncompete agreement was drafted, signed and stored by the parties, and how often the employee visited the chosen state. For example, having an employee attend training at company headquarters may help justify enforcement of the choice of law clause. Moreover, setting forth these contacts with the forum in an “acknowledgment” section of a noncompete agreement may be particularly useful in the event of future litigation.

In sum, if your company has assumed that its California employees are off limits for noncompete agreements, it may be time to reconsider your approach. The adoption of effective choice of law and forum clauses may afford you the protections your company desires, even in states that have traditionally been hostile to such agreements.

“Noncompetes a Nonstarter in California? Think Again,” by Anthony B. Haller and Andrew B. Cohen was published in Corporate Counsel on January 6, 2016. To read the article online, please click here.

Reprinted with permission from the January 6, 2016, edition of Corporate Counsel © 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382, reprints@alm.com or visit www.almreprints.com.