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December 15, 2021 Articles

Recent Developments in Restrictive Covenants in California: What Is Allowed?

The Golden State is widely known for its hostility to restrictive covenants, but its Supreme Court offers clarifications that this hostility does not extend to every agreement involving competitive restrictions.

By Robert Milligan and Sierra J. Chinn-Liu

While California is widely known for its hostility to restrictive covenants, the California Supreme Court recently clarified that this hostility does not extend to every agreement involving competitive restrictions. Certain competitive restrictions may nonetheless be permissible as terms of a business-to-business arrangement.

Specifically, the court was called upon by the Ninth Circuit in Ixchel Pharma, LLC v. Biogen, Inc. to answer key questions concerning the validity of a settlement provision that required one party’s termination of a collaboration agreement with a third party. 9 Cal. 5th 1130, 1151–52 (2020). The court unanimously held that (1) to state a claim for tortious interference with an at-will contract, a plaintiff must allege that the defendant engaged in an independently wrongful act, and (2) in determining the validity of a competitive restriction in a business-to-business agreement under California Business and Professions Code section 16600, such a restriction is not per se void; rather, it is subject to the less stringent “rule of reason.”

This clarification provides key insight for companies contracting under California law, as it affects how companies should design their contracts with one another, and it sets forth consequences to consider when agreeing to the at-will termination of such contracts. The decision further provides clarity for businesses that include competitive restraints with other companies in their commercial dealings, such as exclusive dealing and collaboration agreements, licenses, leases, and franchise agreements, as such restraints are not per se void under section 16600; rather, they are subject to a rule of reason analysis.

A more detailed breakdown of the court’s reasoning in Ixchel is below.

The Ixchel-Forward Collaboration Agreement

Assuming the truth of the allegations in Ixchel’s complaint, the court observed that Ixchel Pharma, LLC, and Forward Pharma entered into a collaboration agreement in 2016. The purpose of the agreement was to develop a drug using dimethyl fumarate (DMF) to treat Friedreich’s ataxia, a rare neurodegenerative disorder. Under the terms of the collaboration agreement, Ixchel assigned certain patent rights to Forward in exchange for Forward’s assistance in investigating and funding clinical trials for the drug and, depending on the success of the trials, manufacturing and commercializing the drug. Importantly, the collaboration agreement permitted Forward to terminate the agreement “at any time” with 60 days’ advance notice to Ixchel, and permitted Ixchel to terminate the agreement if Forward would not conduct clinical trials or failed to timely submit an application to the Food and Drug Administration. Forward confirmed the feasibility of conducting clinical trials in October 2016 and began planning a trial study.

The Forward-Biogen Settlement

During this time, Forward was also in the process of resolving a patent dispute with Biogen, Inc., involving the use of DMF (the same active ingredient being used under the collaboration agreement with Ixchel) to treat multiple sclerosis. Forward and Biogen eventually reached a settlement, pursuant to which Biogen agreed to pay Forward $1.25 billion for a license to certain of Forward’s patents “and other intellectual property.” The settlement and license agreement further required Forward to “terminate any and all existing, and not enter into any new, Contracts or obligations to Ixchel Pharma LLC . . . related to the development . . . of any pharmaceutical product having dimethyl fumerate . . . for the treatment of a human for any indication, including Friedreich’s ataxia.” Following the settlement, Forward provided Ixchel 60 days’ notice of termination as required under the collaboration agreement.

Biogen’s Motion to Dismiss

Without Forward or a suitable replacement partner, Ixchel was unable to develop the drug and filed suit against Biogen in the Eastern District of California, asserting federal and state antitrust violations under 15 U.S.C. § 1 and California Business and Professions Code section 16700 et seq., tortious interference with contractual relations, intentional and negligent interference with prospective economic advantage, and violations of California’s unfair competition law (Bus. & Prof. Code §§ 17200 et seq.). The district court granted Biogen’s motion to dismiss as to each of Ixchel’s claims.

More specifically, the district court concluded that Ixchel “had failed to state a claim for interference with prospective economic advantage [or with contractual relations] because Ixchel did not plead that Biogen engaged in an independently wrongful act” and because the contract at issue was one terminable at will. Ixchel Pharma, LLC v. Biogen, Inc., No. 2:17-cv-00715-WBS-EFB, 2017 WL 4012337, at *4–5 (E.D. Cal. Sept. 12, 2017). Ixchel later amended its complaint to allege that Biogen’s independently wrongful act was restraining trade (via the settlement with Forward) in violation of California Business and Professions Code section 16600. The district court again dismissed the complaint, finding that the Forward-Biogen agreement must be analyzed under the antitrust rule of reason and that section 16600 does not apply outside the employment context. Ixchel appealed, and the Ninth Circuit certified the underlying issues to the California Supreme Court.

The court began its analysis with a detailed examination of the history of California law on tortious interference claims.

Interference with At-Will Contracts and the Independent Wrongfulness Requirement

The court first noted that “[w]e have long recognized that interference with at-will contracts is actionable as an economic tort.” Ixchel, 9 Cal. 5th at 1143 (citing Pacific Gas & Elec. Co. v. Bear Stearns & Co., 50 Cal. 3d 1118, 1127 (1990)). However, the court acknowledged that whether interference with an at-will contract “more closely resembles” a claim for interference with contractual relations or one for interference with prospective economic advantage remains a separate question, which the court had partially addressed in Reeves v. Hanlon, 33 Cal. 4th 1140, 1145 (2004). In Reeves, the court held that a plaintiff must plead independent wrongfulness to state a claim for interference with at-will employment contracts, based on the rationale that such a requirement promotes the public policies supporting the right of at-will employees to pursue opportunities for economic betterment and the right of employers to compete for talented workers. Reeves, 33 Cal. 4th at 1145–51; see also Della Penna v. Toyota Motor Sales, U.S.A., Inc., 11 Cal. 4th 376, 392 (1995).

Extending its reasoning in Reeves, the court compared at-will contracts to both existing contracts and prospective economic relations. Although the court recognized that parties to an at-will contract have somewhat greater interests than those without a contract at all, it concluded that parties to at-will contracts ultimately have “no legal basis to expect the continuity of the relationship or to make decisions in reliance on the relationship.” See Restatement (Second) of Torts § 766 cmt. g, § 768 cmt. i (“One’s interest in a contract terminable at will is primarily an interest in future relations between the parties, and he has no legal assurance of them. For this reason, an interference with this interest is closely analogous to interference with prospective contractual relations. If the defendant was a competitor regarding the business involved in the contract, his interference with the contract may not be improper.”). The court stated that from the perspective of third parties, there is no legal basis in either case to expect the continuity of the relationship or to make decisions in reliance on the relationship. The court further reasoned that allowing interference with at-will contract claims without requiring independent wrongfulness risks chilling legitimate business competition.

When Is a Competitive Restriction in a Contract Between Businesses Void under Section 16600 (and Therefore an Independently Wrongful Act)?

The court then addressed the issue of what standard to apply when evaluating competitive restrictions in business-to-business contracts under section 16600, again beginning its analysis with a detailed discussion of historical interpretation.

As an initial matter—though not disputed by the parties—the court held that section 16600 applies to competitive restrictions in contracts between businesses. Then, taking into account the history of section 16600 and its predecessor, former section 1673 of the California Civil Code, the court concluded that a rule of reason applies to determine the validity of a contractual provision by which a business is restrained from engaging in a lawful trade or business with another business. See Great W. Distillery Prods. v. John A. Wathen Distillery Co., 10 Cal. 2d 442, 446 (1937) (“[I]t may be stated as a general rule that courts will not hold to be in restraint of trade a contract between individuals, the main purpose and effect of which are to promote and increase business in the line affected, merely because its operations might in some theoretical way incidentally and indirectly restrict trade in such line.”). The court stated that its decisions interpreting former section 1673 of the Civil Code gradually evolved to evaluate contractual restraints on business operations and commercial dealings based on a reasonableness standard but often interpreted the statute more strictly when it came to agreements not to compete after the termination of employment or the sale of an interest in a business.

Since former section 1673 of the Civil Code was repealed and replaced with section 16600, the court stated that it has had occasion to construe section 16600 only in relation to contracts restraining competition after the termination of employment or the sale of interest in a business and that these cases have followed its earlier decisions by strictly construing the prohibition on restraint of trade in such contexts. The court rejected Ixchel’s contention that under Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008), any contract in restraint of trade is per se void:

In context, section 16600 is best read not to render void per se all contractual restraints on business dealings, but rather to subject such restraints to a rule of reason. . . . [T]his court has interpreted section 16600 and its Civil Code predecessor on numerous occasions, and we have declined to categorically invalidate all agreements limiting the freedom to engage in trade.

The court explained that a rule of reason standard is not inconsistent with Edwards, which was “limited” to the context of employee noncompetition agreements, and policy considerations “specific to employment mobility and competition”; “[n]othing about Edwards indicates a departure from that precedent to also invalidate reasonable contractual limitations on business operations and commercial dealings.” The rule of reason standard asks “whether an agreement harms competition more than it helps by considering the facts peculiar to the business in which the restraint is applied, the nature of the restraint and its effects, and the history of the restraint and the reasons for its adoption.”

The court indicated that its survey of its precedent reveals that it has long applied a reasonableness standard to contractual restraints on business operations and commercial dealings. The court stated that it does not disturb the holding in Edwards and other decisions strictly interpreting section 16600 to invalidate noncompetition agreements following the termination of employment or sale of interest in a business. The court, however, found that those cases did not call into doubt the applicability of a reasonableness standard to contractual restraints on business operations and commercial dealings.

The court indicated that a rule of reason standard is further supported by section 16600’s broader statutory context, given its shared “statutory purpose” and “doctrinal heritage” with the Cartwright Act (Bus. & Prof. Code §§ 16700 et seq.). The court stated it is mindful of the consequences of strictly interpreting the language of section 16600 to invalidate all contracts that limit the freedom to engage in commercial dealing, reasoning that

contractual limitations on the freedom to engage in commercial dealings can promote competition. Businesses engaged in commerce routinely employ legitimate partnership and exclusive dealing arrangements, which limit the parties’ freedom to engage in commerce with third parties. Such arrangements can help businesses leverage complementary capabilities, ensure stability in supply or demand, and protect their research, development, and marketing efforts from being exploited by contractual partners.

Finally, according to the court, a rule of reason standard balances the antitrust concerns underlying sections 16600 and 16700 against the benefits of “legitimate partnership and exclusive dealing arrangements” and potential procompetitive effects, e.g., “enable[ing] long-term planning on the basis of known costs, giv[ing] protection against price fluctuations, and . . . offer[ing] the possibility of a predictable market.” In demonstrating the application of the rule of reason standard, the court used examples of exclusive dealing arrangements, including such provisions in distribution and franchise agreements: “Franchise agreements often prohibit the franchisee from selling a third party’s products; requirements and output contracts restrain buyers and sellers respectively from doing business with third parties.” The court stated that it declined to construe section 16600 to call such arrangements into question simply because they restrain trade in some way. In reaching its conclusion, the court stressed the importance of harmonizing the Cartwright Act and section 16600, stating that they should be interpreted together. The court did not reach the ultimate question of whether the settlement agreement at issue is invalid because the case was only on appeal at the pleading stage. Upon remand, the court indicated a determination of the agreement’s validity under section 16600 must be evaluated based on a rule of reason.

Post-Ixchel Restrictive Covenants in California

The Ixchel ruling opens the door to revisiting and raising further questions concerning post-termination noncompetition covenants in franchise agreements and similar business arrangements, and whether they are permissible in California. See, e.g., Scott v. Snelling & Snelling, Inc., 732 F. Supp. 1034 (N.D. Cal. 1990) (determining that a post-termination covenant against competition contained within a franchise agreement for a franchise unit in California was void under section 16600).

Indeed, many courts have already applied and construed the California Supreme Court’s guidance in Ixchel since the decision was issued. For instance, the court ordered briefing deferred in Quidel Corp. v. Superior Court of San Diego County, 57 Cal. App. 5th 155 (2020), pending its decision in Ixchel, after which it directed the appellate court to vacate its previous opinion and “reconsider the case” in light of Ixchel. See Quidel, 57 Cal. App. 5th at 165–66 (observing, in light of Ixchel, that “the per se ban on noncompetition clauses outlined in Edwards is limited to employment agreements” and that the exclusive dealing agreement at hand “falls outside the confines of Edwards because it does not address an individual’s ability to engage in a profession, trade, or business”). The court in Quidel also included a brief discussion of the differing considerations for in-term, as opposed to post-term, restrictions. See id. at 169 (narrowly concluding that “in-term covenants not to compete in exclusive dealing agreements are not per se invalid”); see also Sandler Partners, LLC v. Masergy Commc’ns, Inc., 848 F. App’x 798, 799 (9th Cir. 2021) (“As the Court [in Ixchel] explained, businesses routinely enter into contracts that limit their ability to conduct business. . . . In light of Ixchel, the non-compete provision in [the business-to-business contract at issue] must be evaluated under the rule of reason.”); Whitewater West Indus., Ltd. v. Alleshouse, 981 F.3d 1045, 1057 (Fed. Cir. 2020) (“Those are not the employment-agreement circumstances for which § 16600 prescribes a strict approach, as the California Supreme Court has recently confirmed; indeed, [those] circumstances are more akin to the business-to-business dealings for which Ixchel holds that § 16600 prescribes a much less strict approach.”); but see NuLife Ventures, Inc. v. AVACEN, Inc., No. 20-cv-2019-BAS-KSC, 2020 WL 7318122, at *11 (S.D. Cal. Dec. 11, 2020) (distinguishing from the restriction upheld in Ixchel, finding that “[t]he non-compete clauses at issue here [while contained in a business-to-business agreement] do not have the purpose and effect of promoting competition. To the contrary, similar policy considerations behind prohibiting anticompetitive employment contracts under section 16600 . . . apply here. Much like employment non-compete clauses, the contract at issue here prohibits former NuLife [partners] from soliciting business from NuLife’s customers or [other partners]”).

Ultimately, the California Supreme Court’s holding in Ixchel offers some reassurance for businesses that use competitive restrictions with other companies, e.g., exclusive dealing, distributorships, leases, collaboration agreements, licenses, and franchise agreements. While the court rejected the per se approach advocated by Ixchel and reiterated that it would not “categorically invalidate all agreements limiting the freedom to engage in trade,” businesses should carefully weigh the legitimate business interests of such restrictions with any anticompetitive effects (e.g., weigh the relative procompetitive effects against countervailing or anticompetitive effects of any relevant arrangements) and consider the potential impact of the arrangement on the market more broadly. The court’s decision also offers further guidance for businesses seeking to pursue claims for interference with at-will contracts, as the court expressly predicated liability on pleading (and proving) some independent wrongfulness. From a pre-litigation standpoint, businesses should carefully consider whether they want to have contracts that are terminable at will or more long-term contractual arrangements.

Robert Milligan is a partner and Sierra J. Chinn-Liu is an associate in the Los Angeles, California, office of Seyfarth Shaw LLP.

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