IN BRIEF
- The California appellate court erred in a recent decision by failing to let the fraud cause of action drop.
- The opinion goes off track in its discussion of California Business and Professions Code section 16600.
- If you are in one of the many states that are considering legislation similar to section 16600, ensure that it addresses with appropriate carve-outs all relationships that should be protected by a covenant not to compete.
A recent California appellate court decision, Techno Lite, Inc. v. Emcod, LLC, et. al, (Cal. Ct App. 2d Dist. Jan. 21, 2020), involves the common law duty of loyalty of an employee to the employer, and the statute that voids most covenants not to compete.[1]
In this case, the only thing the “suspenders” (as in belt and suspenders) held up was an award of punitive damages, but I believe the court got it wrong and should have let the fraud cause of action drop.
The facts and procedural history of the case are both complex. For purposes of this analysis, I am limiting the background to the salient facts and law that focus on what became an award of punitive damages to the employer based upon the employees’ promise that, if they were allowed to conduct a side business selling the same products as those they were hired to sell for the employer, they would not do so in a manner that would compete with the employer’s business. It does not appear from the opinion that this promise was in a written document.
By way of further background, in the year I turned one year old, two major events happened (in addition to my first birthday party): the Japanese bombed Pearl Harbor, dragging the United States into WWII, and the California legislature passed a law that was signed by the governor and subsequently codified as Business and Professions Code section 16600: “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.” That seems pretty clear, unambiguous, and easy to understand, even for lawyers. What is “excepted” are, as explained by the California Supreme Court: “noncompetition agreements in the sale or dissolution of corporations (§ 16601), partnerships (ibid. § 16602), and limited liability corporations (sic) (§ 16602.5).”[2]
What I refer to as the “belt” in this article is the California common law doctrine of an employee’s duty of loyalty to his or her employer. Many cases focus on this duty, and a good number of them are cited to in the Techno Lite opinion in section A.1. of the discussion portion of the opinion captioned: “A Promise Not to Compete with an Employer While Employed Is Not Void.” California Labor Code section 2863 is the only codification I could find that partially addresses the employee duty of loyalty, and it provides: “An employee who has any business to transact on his own account, similar to that intrusted to him by his employer, shall always give the preference to the business of the employer.”[3]
As noted above, sometime after their employment began with Techno Lite, the three employees began a separate limited liability company (defendant Emcod, LLC) that was engaged in essentially the same business of selling lighting fixtures as Techno Lite. When Techno Lite’s owners learned of this activity, they obviously were concerned. This led to serious discussions that culminated in the three employees’ “agreement” that they would not conduct Emcod’s business in a way that would compete with Techno Lite. This subsequent agreement is what I refer to as the “suspenders” because the obligation to avoid competing with the employer was already an important part of their employment agreement which, by law, incorporates both the common law duty of loyalty and Labor Code section 2863.
Despite their promise that they would not compete with Techno Lite through the Emcod business, the employees not only did compete, but also diverted to Emcod customer inquiries directed to Techno Lite. Eventually this led to litigation, with Techno Lite suing the employees for a host of causes of action, and in an amended complaint adding causes of action for fraud and unfair business practices. The trial court found the three employees liable for fraud and unfair competition. On appeal, the employees argued that they could not be guilty of fraud (when they allegedly agreed to a covenant not to compete) because that agreement was void under section 16600. Without a finding of fraud, there was no basis for the trial court to impose punitive damages in the original amount of $625,926, but subsequently reduced to $29,321 each, for a total award of $87,963.[4]
Where the appellate opinion in Techno Lite goes off track is in its discussion of section 16600. For instance:
[S]ection 16600 has consistently been interpreted as invalidating any employment agreement that unreasonably interferes with an employee’s ability to compete with an employer after his or her employment ends. However, the statute does not affect limitations on an employee’s conduct or duties while employed.
(Citation omitted; emphasis in original.) And later, referring to the Edwards v. Arthur Anderson opinion: “Edwards did not address—much less invalidate—agreements by employees not to undermine their employer’s business by surreptitiously competing with it while being paid by the employer.” That last sentence is absolutely true. What is also true is that the Edwards court was not addressing a covenant not to compete that was effective during the person’s employment. The Edwards opinion, to the extent it pertains to section 16600, is limited to considering whether the Ninth Circuit’s “narrow restraint”[5] exception to section 16600 was the law of California. In addition, the court concluded it was not. One can deduce that the Supreme Court was reading the statute’s unambiguous language—“every contract” imposing a covenant not to compete, other than the three statutory exceptions, is void. A “narrow restraint,” and presumably a “current employee” exception, is inconsistent with that language.
This analysis presents yet another puzzling question. It would seem that the combination of the employee’s duty of loyalty with Labor Code section 2863 imposes, at the very least, a narrow restraint on the employee’s ability to engage “in a lawful profession, trade, or business”. The employee cannot work for a competitor of her employer. Each employment arrangement is based upon a written, oral, or implied contract between the employer and the employee. What is the logical reasoning that exempts employment contracts from the unambiguous language of section 16600? With this disconnect between the employment laws discussed above and section 16600, it would seem that the only way to avoid litigation over the confusing state of the law would be for the legislature to create a fourth exception to section 16600. The following is proposed for that exception: “Section 16602.6: Section 16600 does not apply to any employer-employee agreement, whether written or oral, during the period of the employee’s active employment.”
However, that simple clarification runs smack into another confounding California innovation: AB5. This new law, effective January 1, 2020, mandates that any worker who cannot be shown to be outside the law’s ABC test[6] must be treated as an employee in California, irrespective of the intent of the hiring entity and the worker with regard to their relationship. AB5 has already generated massive litigation concerning truckers, “gig” workers such as Lyft and Uber drivers, stringers for publications, singers, dancers, etc. Assuming it applies to Uber and Lyft, for example, tens of thousands of those drivers will be classified as employees of both companies. Does that give either company the right to demand adherence to the duty of loyalty? Alternatively, consider the highly skilled winemaker who works for three or four different wineries. As an independent contractor, he or she has no obligation to refrain from working for a competitor of one of his or her winery clients; as an employee, there is that duty of loyalty that can create a messy and unintended situation.
Taking this issue to the level of the absurd (but why not, we are in California), how does a literal reading of section 16600 square with the duties of partners to one another? How does it not make void any provision in a partnership agreement such as: “Each partner shall devote his or her full time and attention to the conduct of the Firm’s business and account to the Firm for any compensation or payment received from any person if the work performed is within the scope of the Firm’s usual business activities.”? If you are in one of the many states that are considering legislation similar to section 16600, as has been reported in recent legal publications, it will behoove you to ensure that the statute actually adopted addresses these issues with appropriate carve-outs for all relationships that business people believe should be allowed to be protected by a covenant not to compete.
[1] Niesar & Vestal LLP. The author acknowledges the valuable contributions to this article made by Carolina Juvin, Esq., associate with Niesar & Vestal LLP.
[2] Edwards v. Arthur Anderson LLP, 44 Cal. 4th 937, 946 (2008).
[3] Forgive the rather dated language; this section was added to the Labor Code in 1937.
[4] In 1988, a California court of appeal held that there is no cause of action for “tortious breach of contract,” which had been used in lower courts to establish a basis for awarding punitive damages in a breach of contract action. Pugh v. See's Candies, 203 Cal. App. 3d 743, 250 Cal. Rptr. 195 (1988) (review denied).
[5] The restrictive covenant in Edwards would have prevented him from: (a) working for any client he had worked for while at his employer, for a period of 18 months following end of employment; and (b) soliciting any client of the employer to whom he had been assigned, for a period of 12 months post-employment. The services were advising wealthy clients on financial matters. The trial court determined, in ruling that the restrictions were a permitted “narrow restraint”: “There were more than enough of these wealthy folks . . . in L.A. for all CPAs to do the kind of work [Edwards] was doing. . . . There wasn’t even perhaps a minimal restriction on his ability to work.”
[6] The worker will be a statutory employee if he or she fails to satisfy any one of the following tests: (a) the worker is free from control and direction from the hiring entity; (b) the work performed is outside of the usual course of the hiring entity’s business; and (c) the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.