California Business and Professions Code § 16600

On April 13, 2015 we blogged about the decision of the Ninth Circuit in Golden v. California Emergency Physicians Medical Group, 782 F.3d 1083 (9th Cir. 2015). There, the Ninth Circuit considered whether, under California law, an employee could be ordered to sign a settlement agreement that included language that restricted him, inter alia, from future employment with his former employer.

Dr. Golden is an emergency-room doctor who sued California Emergency Physicians Medical Group (“CEP”), among others, regarding his loss of staff membership at a medical facility.  His lawsuit was based on various state and federal causes of action, including racial discrimination.  The parties orally agreed in open court to settle the case and the settlement terms included “a substantial monetary amount,”  dismissal of the action, a release of CEP and a waiver of any and all rights to employment with CEP or at any facility that CEP may own or with which it may contract in the future (the “no-employment provision”).  Dr. Golden refused to sign the written agreement and attempted to have it set aside.  His attorney moved the court to withdraw as counsel, moved the court to intervene and further moved the court to enforce the settlement agreement so he could collect his contingency fee. In further proceedings, a magistrate judge recommended that Dr. Golden be ordered to sign an amended agreement, and that recommendation was adopted by the district court judge who concluded the settlement agreement was not within the ambit of Business and Professions Code § 16600, which makes unlawful in California (with limited exceptions) any contract to the extent it restrains someone from engaging in a lawful trade, business or profession.  Dr. Golden refused to sign the agreement and filed a notice of appeal.

On appeal, the Ninth Circuit Court of Appeals reversed the district court’s enforcement of the settlement agreement and remanded the case to the district court to determine whether a no employment provision in the agreement is a “restraint of substantial character” to the Plaintiff’s medical practice.

On remand, the district court again ordered Dr. Golden to sign the settlement agreement, concluding that the no-employment provision was not a restraint of substantial character. Dr. Golden again appealed.

In its July 24, 2018 decision, the Ninth Circuit surveyed California law and noted first that a contractual provision imposes a restraint of substantial character if it significantly or materially impedes a person’s lawful profession, trade, or business.  The Ninth Circuit noted that a provision need not completely prohibit the business or professional activity at issue, nor need it be sufficient to dissuade a reasonable person from engaging in that activity.  Rather, the “restraining effect must be significant enough that its enforcement would implicate the policies of open competition and employee mobility that animate Section 16600.”  The Court noted that it “will be the rare contractual restraint whose effect is so insubstantial that it escapes scrutiny under Section 16600.”

Looking to the provision in the settlement agreement at issue, the Ninth Circuit noted that it impeded Dr. Golden’s ability to practice medicine in three ways.

First, the settlement agreement prohibited Dr. Golden from working or being reinstated at any facility owned or managed by CEP.

Second, the settlement agreement prohibited Dr. Golden from working at any CEP-contracted facility.

Third, the settlement agreement provided that if CEP contracts to provide services to, or acquires rights in a facility where Dr. Golden is currently working as an emergency room physician or hospitalist, CEP has the right to terminate his employment with no liability.

The Ninth Circuit held that the first provision, which barred Dr. Golden from future employment at facilities owned or managed by CEP did not impose a substantial restraint on his medical practice. The Ninth Circuit further held, however that the second and third provisions did substantially restrain Dr. Golden’s practice of medicine and were therefore barred by Section 16600.  These two provisions limited employment with third parties based merely on whether CEP contracted with them. As a result, if Dr. Golden was employed by a hospital that later contracted with CEP to provide, for example, anesthesiology services, Dr. Golden would be ineligible for employment with the hospital.

Given the size of CEP’s business in California—it staffs 160 facilities in the state and handles between 25% and 30% of the state’s emergency room admissions, these provisions were a substantial restraint on Dr. Golden’s trade.

The Ninth Circuit’s ruling may leave open whether a provision in a settlement agreement that permits an employer to terminate the employment of an employee where it acquires the employee’s new employer will pass muster under Section 16600.  The provisions at issue in Golden were extremely broad: Plaintiff was prohibited from employment with entities with which CEP contracts to provide services to, or “acquires rights” in.  A different, more limited provision that prohibited employment at entities as to which the employer acquires outright may be held not to impose a substantial restraint on trade.  Further, the Ninth Circuit relied in part on CEP’s broad reach in the state of California.  This leaves open that smaller employers may be able to impose restrictions that larger employers with more market share may not.

Co-authored by Betsy Johnson and Viktoria Lovei.

Contrary to popular perception, California law does not bar all restrictive covenants in the employment context. Rather, in certain very narrow circumstances (i.e., non-competes arising in connection with the sale or dissolution of certain businesses), non-competes are permissible under California law.

The General Prohibition of Non-Competes Under California Law

Under California Business and Professions Code § 16600, “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Cal. Bus. & Profs. Code § 16600 (2008). In Edwards v. Arthur Andersen LLP, 44 Cal.4th 937 (2008), the California Supreme Court confirmed the viability and breadth of section 16600 and expressly rejected a line of Ninth Circuit cases which had upheld sufficiently narrow restrictive covenants that only barred a party from pursuing a small or limited part of its business. Id. at 948-49. The California Supreme Court in Edwards held that “noncompetition agreements are invalid, even if narrowly drawn, unless they fall within the applicable statutory exceptions of section 16601, 16602, or 16602.5.” Id. at 955. These three exceptions are discussed below.

Non-Competes Arising From the Sale of a Business

The first exception arises in the context of the sale of a business entity. Section 16601 permits a party selling the goodwill or all of their ownership interest in a business to agree to refrain from competition within the business’s geographic area, so long as the buyer intends to carry on a like business therein. Cal. Bus. & Profs. Code § 16601. See Vacco Industries, Inc. v. Van Den Berg, 5 Cal.App.4th 34, 47 (1992) (upholding the enforceability of a non-compete agreement lasting as long as the employer conducted business in the area against shareholder/officer who sold all of his shares in the company pursuant to a stock sale). A merger agreement, whereby an employee sells his business interest in a company in exchange for shares of the newly merged company, is considered to be a transaction within the exception of section 16601. Hilb, Royal & Hamilton Ins. Services v. Robb, 33 Cal.App.4th 1812, 1824-1825 (1995) (upholding agreement entered into in conjunction with merger which prohibited competition in several countries for a 3-year period of time). Section 16601 thereby allows the buyer of a business to protect its investment by enforcing a covenant not to compete against the seller. However, this exception is only applicable to business owners (or persons who own at least a material portion of business); it would not, for example, be used to justify a non-compete for a seller (or selling employee) who only owns a very small percentage of a business entity. There is no “bright-line” definition for determining what is a material portion of the business.

Non-Competes Arising in Conjunction With the Dissolution Of Or Dissociation From a Partnership

 Section 16602, the partnership exception to California’s ban on non-compete agreements, permits, in the event of a dissolution of or dissociation from a partnership, an agreement that the departing partner not compete within the specified geographic area of the partnership’s business, so long as any other member of the partnership intends to carry on the business in the specified area. Cal. Bus. & Profs. Code § 16602. Unlike section 16601, there is no requirement under the partnership exception that compensation for goodwill in the partnership be transferred. South Bay Radiology Medical Associates v. Asher, 220 Cal.App.3d 1074, 1083 (1990). Section 16602 has been held applicable to partnerships involving accountants, attorneys, and physicians. See Swenson v. File, 3 Cal.3d 389 (1970); Howard v. Babcock, 6 Cal.4th 409 (1993); South Bay Radiology, 220 Cal.App.3d 1073. Courts have found that such covenants, rather than prohibiting competition, place a price on competition by, for example, permitting the departing partner to contract for compensation in return for refraining from engaging in competing business activity, or vice versa. Babcock, 6 Cal.4th at 417-24.

Non-Competes Arising in the Context of the Dissolution Of a Limited Liability Company

Like the partnership exception to California’s non-enforcement of covenants not to compete, section 16602.5 provides that in the event of the dissolution of a limited liability company, any member may agree not to carry on a similar business within the specified geographic area where the company’s business was transacted, so long as any other member intends to carry on the business in the specified area. Cal. Bus. & Profs. Code § 16602.5. Currently, there is no case law interpreting section 16602.5, which became effective in 2007. However, the section’s similarity to section 16602 indicates that it will be applied in a comparable manner by courts.

Despite California’s general hostility towards the enforcement of covenants not to compete in the employment context, these exceptions provide employers with valid methods under California law to protect their business interests from potential competitive harm caused by sellers and departing partners or members. Nevertheless, given the scarcity of case law interpreting these provisions, employers should proceed cautiously before relying on them.