Introduction

Every business owner and employer makes careful decisions on how to best invest in and protect their business interests. Without detailed planning, investments may not grow into the returns the owner hoped for. Perhaps the most significant investment a business owner will make is in their employees. Hiring, training, and retaining employees consumes a large portion of a small business’ resources.

In 2022, small businesses spent an average of 70% of their revenue on labor. Paycor. The last thing a small business owner wants to happen upon making such an investment is to have employees leave to join a competing business, taking with them the experience and training they gained at the expense of their small business employer. Business owners may think that a simple solution is to have their employees sign non-compete agreements. But as we will discuss in this article, in addition to the fact that California renders them unenforceable in most circumstances, the National Labor Relations Board (“NLRB”) has now recently taken the stance that non-compete agreements are unenforceable in most circumstances, nationwide. The NLRB joins Congress and other federal agencies in now signaling disapproval of non-compete agreements.

Despite the shift in public policy against non-compete agreements, in some circumstances described below, non-competes may still be used in California in specific situations.

Non-Compete Agreements and Their Enforceability In California

A non-compete agreement is a contract between an employer and employee in which the employee agrees not to work for a competing business after their employment ends. Non-compete agreements usually have limitations for their duration and geographic reach. For example, a non-compete agreement may say that an employee may not work for a competitor in the same industry upon termination, within a 25-mile radius of the former employer’s offices and for two years after leaving the company.

Most states restrict non-compete agreements so that only those with reasonable limits on duration and scope are enforceable. Nevada is one such state. In California, however, by statute non-compete agreements are unenforceable except where one of only a few exceptions apply.

Non-compete agreements are generally unenforceable because Business & Profession Code § 16600 voids any contract that restrains anyone from “engaging in a lawful profession, trade, or business of any kind. . . .” A contract that prevents an employee from working in a specific field for a set period of time is deemed to unlawfully restrain their engagement in a lawful profession, in violation of this statute.

California’s strict position on non-compete agreements is result of the public policy determination that workers’ freedom of movement between employers benefits the economy by encouraging competitive wages. Another concern is that by preventing employees from sharing their ideas, non-compete agreements prevent new businesses from forming, stifle entrepreneurship, and slow novel innovation.

Generally, choice of law provisions in contracts are not honored by California courts if the application of the other state’s law would result in enforcement of a non-compete agreement in California, thus contradicting California’s public policy determination that such agreements should not be enforced, particularly in cases involving California-based businesses and other residents. See, e.g., Application Grp., Inc. v. Hunter Grp., Inc., 61 Cal. App. 4th 881, 895-96 (1998); Non-Compete Laws: California, Practical Law State Q&A 1-505-9117. For example, a California court might not honor a contract calling for Virginia law to apply if it would mean that a non-compete agreement would be enforced in California despite none of the California law exceptions described below being applicable.

California Exceptions to Prohibition of Non-Compete Agreements

California only allows non-compete agreements in specific circumstances and prohibits them in all others. These exceptions are as follows:

Dissolution of Partnership

Non-compete agreements may be enforceable when a partnership is being dissolved or a partner is exiting the partnership, against the former partner.

Limited Liability Company

A non-compete agreement may be upheld where a member of a limited liability company terminates their interest in the company, against the departing member.

Sale of Business or Stock

A non-compete agreement in a contract for the sale of a business may be enforceable, against the seller, when all the of the following conditions are met:

The business owner is selling all their ownership interest in the business entity or a substantial portion of the business’s or subdivision’s operating assets together with the goodwill;
The business owner promises not to conduct a similar business within a specific geographic area for a period of time after the sale (i.e. there are limitations on duration and geographic scope); and
The buyer of the business actually continues in the same or a similar business in the geographic area.

The purpose for enforcing non-compete agreements in these scenarios is to promote stability in contracts. For example, buying businesses would be riskier if the seller could turn around after selling their business and immediately open up the same kind of business next door. The buyer would be left with a business worth less than for what it was purchased because there would be a new direct competitor that did not exist before the purchase.

Protection of Trade Secrets

Although California statutes do not have provisions for using non-compete agreements to protect a business’s trade secrets, California courts have granted preliminary injunctions to stop employees from competing against their former employer by using trade secrets they misappropriated from that employer. To see whether an injunction should be granted, courts weigh the likelihood the plaintiff will succeed in bringing a suit for misappropriation of trade secret against the harm the parties would suffer if the injunction were granted.

Still, a better option for employers wanting to protect their trade secrets is to incorporate robust written non-disclosure of trade secret provisions into their employee agreements rather than solely relying on non-compete agreements which may be invalidated by a court.

Non-Compete Enforcement Outside of California

Companies located in states where non-compete agreements are enforceable may sue to enforce the agreement in their home state, to stop an employee who has signed a non-compete agreement from working for a California competitor. However, that employee and company may sue in California to invalidate the non-compete agreement. The result is a “race to judgement” where the first final judgement to either enforce or invalidate the non-compete agreement will be enforced in the other state.

The NLRA And The NLRB

Passed in 1935, the National Labor Relations Act (“NLRA”) established the National Labor Relations Board (“NLRB”), an independent federal agency that protects employees from unfair labor practices and protects the right of private sector employees to join together, with or without a union, to improve wages, benefits, and working conditions. The NLRB is governed by a five-person Board and a General Counsel. The General Counsel, appointed by the President, is independent from the Board and is responsible for the investigation and prosecution of unfair labor practice cases and for the general supervision of the NLRB field offices in the processing of cases.

Besides establishing the NLRB, the NLRA contains statutory provisions making clear policy of the United States to encourage collective bargaining by protecting workers’ full freedom of association. The NLRA protects workplace democracy by providing employees in private-sector workplaces the fundamental right to seek better working conditions and designation of representation without fear of retaliation. Two important sections of the NLRA are Sections 7 and 8. Section 7 lays out the rights for employees to self-organize, form and join unions, and “engage in other concerted activities” for the purpose of collective bargaining. Section 8 lists unfair labor practices and prohibits employers from interfering with employees’ rights described in NLRA Section 7.

Figure 1: President Franklin Delano Roosevelt signing the NLRA into law, July 5, 1935. Source.

Recent NLRB Memo On Non-Compete Agreements

On May 30, 2023, current NLRB General Counsel Jennifer Abruzzo issued a memorandum in which she outlined how non-compete agreements violate the NLRA by violating Section 8 (a)(1) and are therefore unenforceable except in a few situations.

First, Abruzzo points out that non-compete agreements are overbroad and chill employees’ Section 7 rights, as a general matter, because they cut off employees’ access to other employment opportunities. She states that non-compete agreements are overly broad because they “could reasonably be construed by employees to deny them the ability to quit or change jobs by cutting off their access to other employment opportunities that they are qualified for based on their experience, aptitudes, and preferences as to type and location of work.”

Second, Abruzzo describes how non-compete agreements chill employees from engaging in five specific types of activity protected by Section 7 of the NLRA:

Right to concertedly threaten to resign to demand better working conditions. The memo states that non-compete agreements “discourage such threats because employees would view the threats as futile given their lack of access to other employment opportunities” and because employees would fear retaliation from their employers.
Right to carry out concerted threats to resign. Although not explicitly recognized by NLRB’s interpretation of Section 7 of the NLRA, the memo notes that a right to concertedly resign from employment logically follows caselaw and is consistent with the US Constitution and other federal law.
Right to concertedly seek employment at competitor to get better work conditions. This would include an employee’s acceptance of a job with a competitor after concertedly resigning or threatening to resign.
Right to solicit coworkers to work for competitors as part of larger concerted effort. The memo notes that employees would not be able to solicit without breaching a non-compete agreement and because the solicitors may fear retaliation.
Right to seek employment to carry out workforce organization efforts. The memo states that non-compete agreements would discourage employees from changing jobs for the specific reason of organizing labor or carrying out other protected activities at another employer.

Abruzzo notes that non-compete agreements may be enforceable in “limited circumstances.” However the memo is silent as to which circumstances would allow for non-compete agreements.

Future Developments

In addition to the NLRB’s May 30 memo, there has been recent movement in the arena of non-compete law from other establishments.

In January of this year, the Federal Trade Commission (“FTC”) proposed the Non-Compete Clause Rule that would prevent the formation of non-compete agreements between employers and employees. To justify the proposed rule, the FTC points to research that “has shown the use of non-compete clauses by employers has negatively affected competition in labor markets, resulting in reduced wages for workers across the labor force—including workers not bound by non-compete clauses. This research has also shown that, by suppressing labor mobility, non-compete clauses have negatively affected competition in product and service markets in several ways.”

A month after the FTC proposed its rule, a bipartisan group of US senators introduced the Workforce Mobility Act of 2023. It would make non-compete agreements all but unenforceable except for in narrowly defined situations. The Act describes non-compete agreements as “blunt instruments that crudely protect employer interests and place a drag on national productivity by forcing covered workers to either idle for long periods of time or leave the industries in which the workers have honed their skills altogether.”

At least 13 states have statutes restricting the use of non-compete agreements in some way. The several states that allow non-compete agreements do so only if they are reasonably limited in duration and scope. There is general reservation about the use of non-compete agreements because of the effects they may have on the labor market and workforce mobility. The California Legislature has considered various bills this session that would solidify the existing prohibition of non-competes; make their use constitute unfair competition (see Bus. & Prof. Code § 17200 et seq.) as a matter of statute, with the attendant liability associated therewith; and/or expand upon the potential remedies available to employee for employer’s use of such unenforceable contracts. See A.B. 1076, S.B. 699.

Current Status of Non-Compete Law In Flux

If the Workforce Mobility Act of 2023 were to become law, the mere formation of a non-compete agreement would be prohibited unless a recognized exception applied. The viability of California’s exceptions identifying circumstances in which non-competes are considered valid could be in question if federal law to the contrary is passed. Fortunately, some of California’s non-compete exceptions seem to fall in line with exceptions contained within the Act, as currently proposed.

The impact of the NRLB’s memo on the use of non-competes in California, in the limited circumstances they are permitted to be used, remains to be seen. To whatever extent the circumstances in which California permits use of non-competes do not implicate the concerns noted by Abruzzo in the memo, the impact on non-compete law in our golden state may be lessened. The state of the law may remain unclear in this regard until a court takes up the matter or the federal legislature takes further action.

Conclusion

California employers should be aware that in addition to potentially running afoul of the NLRA, maintaining unenforceable non-compete terms or provisions in their employment agreements is not without risk even if no enforcement measures are taken. Such a practice could likely be considered by a court to give rise to liability pursuant to Bus. & Prof. Code § 17200 et seq., see Application Group, Inc. v. Hunter Group, Inc., 72 Cal.Rptr.2d 73, 89 (1998), and is technically subject to misdemeanor fines under the California Labor Code.

The law governing non-compete agreements is in a state of flux across the country. The NLRB’s memo follows seemingly nationwide trend toward eliminating non-competes as an option for employers except in very limited situations. To ensure full compliance with the law, make sure your agreements are properly drafted and consistent with both California and federal law.