Real Estate Law Alert: California Courts' Narrow Construction of Noncompetition Agreements
Can two parties enter into an agreement, separate from their partnership agreement, and agree not to compete with each other in their independent activities outside of the partnership? A recent California Court of Appeal panel found such an agreement unenforceable under California Business and Professions Code section 16600 as "contrary to California’s public policy of open competition." The case, Kelton v. Stravinski, 138 Cal. App. 4th 941 (2006) arose in the context of a real estate development partnership and is a timely reminder of the limitations that California law places on the enforcement of "non-compete" agreements in the context of an ongoing business, such as a partnership or limited liability company.
What Is Kelton About?
The facts of the case are straightforward. Michael Kelton and Peter Stravinski, and their affiliated companies, formed a general partnership to develop industrial warehouse projects. The partnership agreement was later amended to limit the partnership to the development of one or more of four specific warehouse properties. Concurrently with the execution of the original partnership agreement, Messrs. Kelton and Stravinski entered into a separate "covenant not to compete" agreement whereby Kelton agreed not to engage in the business of operating any warehouse and Stravinski agreed not to engage in the business of designing or building any warehouse. Ten years after their partnership was formed and five years after the amendment to their partnership agreement, Kelton discovered that Stravinski had built other warehouse projects (the decision does not disclose anything more specific about the competing projects) and asserted a one-half interest in those projects because they violated the non-compete agreement that the parties had entered into ten years earlier.
In response, Mr. Stravinski sued Mr. Kelton for declaratory relief seeking a judicial determination that the covenant not to compete was invalid and unenforceable or had been waived or mutually terminated (presumably based on the prior amendment to the partnership agreement). The trial court ruled in favor of Stravinski—the partner who had undertaken the competing warehouse projects. The court of appeal affirmed, holding that no exception existed to prevent application of California Business and Professions (B&P) Code section 16600’s prohibition against restraint of trade. The court stated that when a contract creates an illegal restraint of trade there is nothing the parties can do to "add to its validity," and therefore the parties’ agreement was void and unenforceable. The court reached this result despite the argument made by Kelton that the agreement should be enforced on equitable grounds because, since 1992, Kelton had asked Stravinski’s permission before independently pursuing any warehouse project, but that Stravinski had "secretly pursued warehouse projects" without involving Kelton, and had thereby been unjustly enriched.
What Non-Compete Agreements Are Enforceable Under California law?
California recognizes a strong public policy in favor of pursuing one’s choice of lawful employment and enterprise. The prohibition against non-compete agreements contained in B&P Code section 16600 has been the law in California since 1872.
While the Kelton decision underscores some of the uncertainties in drafting non-compete agreements, there are some bright-line safe harbors recognized under California law. California recognizes the enforceability of these provisions, if they are reasonably limited as to geographic area and type of business, when agreed to by a person in the following contexts:
- the person sells the goodwill of a business;
- the person sells all of his or her ownership interest in a business entity or a subsidiary thereof;
- the person sells all or substantially all of the operating assets and goodwill of a business entity or a subsidiary thereof;
- the person is a partner or member of a limited liability company and either disassociates from the entity or the entity is dissolved; or
- where the prohibition is necessary to protect an employer’s trade secrets.
In addition, some California appellate courts, and the federal courts in California when asked to apply California law, recognize a limited "narrow restraint" exception that enforces non-compete agreements that restrict someone from pursuing his or her profession in a "minor part of the market."
The Kelton court did not even discuss the "narrow restraint" exception, probably because the provision under review in that case was not even arguably reasonable (see discussion above noting that the covenant applied to "any" warehouse development). However, a strict reading of the Kelton case suggests that this court would not recognize this exception or any grounds for equitable enforcement.1
Although the Court’s reasoning in Kelton may be unclear, the Court’s holding is generally consistent with other California appellate decisions that have interpreted the "narrow restraint" exception more restrictively than federal courts applying California law. The Kelton court’s reasoning was recently upheld in another appellate court decision handed down after the Kelton opinion, this time by an appellate court panel in Los Angeles, which found unenforceable a non compete agreement that was limited in time and to specific clients. In that decision, the court stated that the "narrow restraint" exception followed by the federal courts was "a misapplication of California law when applied to an employee’s noncompetition agreement."2
What to Do
In light of Kelton, employers requiring such agreements of employees as a condition of employment should limit the agreements to the trade secret protections outlined in the Kelton and Arthur Andersen cases. In other contexts, The Kelton court’s decision makes clear that those seeking to enforce non-compete agreements in partnership or ongoing business relationships run the distinct risk of their unenforceability in California outside the recognized statutory exceptions. Drafters of non-compete agreements in these situations should consult with counsel to determine whether there is a basis for drafting the agreement narrowly to apply to a specific geographical area or trade (e.g., "all of California" may be unreasonably overbroad), for a limited duration (e.g., "ten years following termination" may be unreasonably long), and as to a narrow segment of the relevant market (e.g., restricting one from contacting specific customers to whom they were introduced or contracted with).
Another approach, if available, is to provide that the non-compete agreement be governed by the laws of another state that enforces such agreements (assuming that the state has some nexus to the parties or the subject matter of the contract). Finally, because federal courts have generally interpreted the statutory prohibition less broadly than California state courts, the parties should investigate whether there is an ability to structure the agreement so that a federal court can assert jurisdiction over the parties.3
Stoel Rives LLP
Natacha D. Allred
Stoel Rives LLP
(415) 617-8966 email@example.com
About Manuel Fishman and Natacha D. Allred
Manuel "Manny" Fishman is a partner of the firm who focuses his real estate transactional practice in the areas of office and industrial leasing, secured lending, the acquisition and sale of commercial properties, joint venture developments and the interface between landline and wireless telecommunications and Internet-based services with commercial real estate.
Natacha Allred is an associate in the firm’s Real Estate practice section in San Francisco. She works in all core areas of real estate, including leasing, financing, and purchasing. Natacha focuses her practice on retail shopping center leasing, representing both landlords and tenants. She has experience in representing lenders in both simple and complex lending
About Stoel Rives LLP
Stoel Rives LLP is a business law firm providing services throughout the western United States. With more than 350 attorneys, Stoel Rives is a regional leader in real estate, environment and natural resources, litigation, energy and corporate law. For more information about Stoel Rives’ offices in California, Oregon, Washington, Utah and Idaho, visit www.stoel.com.
1 "[T]he covenant not to compete was not executed as part of the sale of the goodwill of a business or dissolution of a partnership. Thus, no exception exists to prevent application of [Business and Professions Code] Section 16600." (Kelton, 138 Cal. App. 4th). The court also rejected Mr. Kelton’s equitable argument as "not compelling," and not "disproportionately harsh."
2 The case is Edwards v. Arthur Andersen (opinion issued on August 30, 2006, case number B178246).
3 There are many rules dictating whether a case may be brought before a federal court. Generally, unless there is an issue of federal law (and enforcement of a non- compete agreement is not a federal question), a party cannot bring a suit in federal court unless the parties are citizens of different states and the damages sought are greater than $75,000.