California Appellate Court Determines that Business and Professions Code Section 16600 Does Not Apply To Non-Compete Agreement During

On January 21, 2020, the California Court of Appeal, Second Appellate District, in the case of Techno Lite, Inc. v. EMCOD, LLC, 2020 Cal. App. LEXIS 41, in the portion of the decision certified for publication, upheld the trial court and rejected the defendants’ contention that they could not be liable for fraud because their false promise not to compete against their employer while employed was void because the noncompete agreement violated section 16600 of the California Business and Professions Code prohibiting restraints of trade.

The legal dispute grew out of a promise by two employees of Techno Lite not to compete with Techno Lite. When Techno Lite appeared to be failing, those two employees formed EMCOD, LLC as a vehicle for conducting similar business in case Techno Lite closed its doors. Other members of management of Techno Lite learned of the formation of EMCOD and required confirmation by those two employees that they would not use EMCOD to do what they could not do themselves (compete with Techno Lite) and would operate EMCOD on their own time.  The two employees agreed.

Techno Lite survived its financial challenges and later learned that EMCOD was conducting business in competition with Techno Lite. Negotiations ensued for a buy-out of Techno Lite, but those did not result in an agreement.  The two employees who had formed EMCOD thereupon resigned from Techno Lite.

Litigation eventually ensued, and Techno Lite alleged, among other claims, that the two employees and EMCOD had stolen Techno Lite’s customers, breached their fiduciary duty, and committed fraud. After trial, the lower court found the defendants liable on a variety of claims, including fraud.

On appeal, the defendants argued that the fraud liability should be overturned because the covenant not to compete was contrary to public policy and the express provisions of section 16600. Section 16600 provides that “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.” There are statutory exceptions in sections 16601, 16602 and 16602.5 for noncompete provisions relating to sales of businesses, dissolutions of partnerships or dissociations of a partner from a partnership, and a dissolution of a limited liability company or a termination of a member’s interest in a limited liability company. In support of their argument, the defendants quoted from the California Supreme Court decision in Edwards v. Arthur Andersen LLP (2008) 44 Cal. 4^th 937: “Noncompetition agreements are invalid under section 16600 in California even if narrowly drawn, unless they fall within the applicable statutory exceptions of sections 16601, 16602, or 16602.5.”    Not surprisingly, the appellate court rejected the defendants’ argument, finding that section 16600 has been interpreted by courts to strike down noncompete provisions in employment contracts that apply post-employment, not during employment, and that no public policy would be served by permitting an employee, while employed by the employer, to violate the duty of undivided loyalty by competing against the employer. The court concluded that section 16600 “is not an invitation to employees to bite the hand that feeds them.”

This e-Bulletin was prepared by William Ross, of counsel to Hirschfeld Kraemer LLP. Mr. Ross is a member and past co-chair of the Corporations Committee of the Business Law Section of the California Lawyers Association