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EXCLUSIVITY OF SERVICES, NONCOMPETITION

AGREEMENTS AND THE DEMAND FOR HIGHLY

SKILLED EMPLOYEES

Scott H. Dunham

Presented to

Institute for Corporate Counsel

Seventh Annual Seminar

March 1998

TABLE OF CONTENTS

Page

I. During Employment 3

A. Conduct not associated with preparing to compete 3

B. Preparing to leave 7

C. Unfair competition restrictions 13

II. Post-Termination 14

A. An employee's contract contains a covenant not to compete 14

B. Former employee has misappropriated trade secrets 19

C. Former employees are soliciting the employer's customers 19

D. Competitors are soliciting employer's former employees 22

E. Former employee is soliciting the employer's employees 22

F. Unfair competition 24

III. Remedies 24

A. Generally 24

B. Damages 24

I. During Employment.[1]

A. Conduct not associated with preparing to compete.

1. As a general matter, covenants not to compete during employment are enforceable. See Bach v. Curry, 258 Cal. App. 2d 676 (1968).

a. Since such a covenant only limits behavior during employment, it survives Cal. Bus. & Prof. Code § 16600, which states “any contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void.”

b. If the covenant is not expressly stated, employee’s activities will be limited under the unfair competition law. See “unfair competition,” page27.

c. In addition to any covenant not to compete, an implied covenant of good faith and fair dealing exists in every contract, which can establish the basis for a contract action. Bleecher v. Conte, 29 Cal. 3d 345, 350 (1981).

(1) In the context of employment contracts, an implied covenant of good faith and fair dealing does not give rise to a tort action in addition to a contract action. Foley v. Interactive Data Corp., 47 Cal. 3d 654 (1988); see also Hunter v. Up-Right, Inc., 6 Cal. 4th 1174 (1993).

d. For remedies available, see page 27.

2. Employee has breached the contract.

a. An affirmative covenant to perform personal services will not be specifically enforced unless “special circumstances” exist. Cal. Civ. Code § 2390.

(1) “Special circumstances” will be found to exist where:

(a) there is a written contract for personal services;

(b) with a minimum compensation of at least $9,000 for the first year of the contract[2], $12,000 for the second year of the contract, $30,000 for the fourth and fifth years of the contract and $45,000 for the sixth and seventh years of the contract;[3] and

(c) “where the promised service is of special, unique, unusual, extraordinary or intellectual character, which gives it peculiar value the loss of which cannot be reasonably or adequately compensated in damages in an action at law . . . .” Cal. Civ. Code § 3423.

(2) The rationale for such a provision is the “difficulty of supervision, the proscription of the Thirteenth Amendment of the Constitution against involuntary servitude, [and the] lack of mutual remedy."[4]

(3) Case law is unclear whether an injunction should only be granted to prevent breach of a negative covenant in a contract, leaving open the option for an employee to breach the contract and become idle. Briody, supra note 4, at 353.

(4) Case law is also ambiguous in defining “unique, unusual, extraordinary or intellectual services.” Briody, supra note 4, at 353.

(a) California cases seem to focus on degree of skill and replaceability of the employee. Id. at 353-54.

i) Examples include singers, ball players or actors. Id. at 354.

(b) A showing of irreparable damage may also be required. Id.

(5) Examples.

(a) A 10 year unilateral employment agreement, where, in the event of termination for any reason, the employee agreed not to become employed by any company in the same business, was unenforceable since it bound the employee for the 10 years, while the employer had no corresponding obligation to compensate him. Thompson v. Fish, 152 F. Supp. 779 (S.D. Cal. 1957).

(b) An employment contract where the employee was entitled to “service fees” for “so long as the contract remains in force” was valid since it tended to regulate the employee’s conduct only during the employment, not after termination. Bach v. Curry, 258 Cal. App. 2d 676 (1968).

(6) In Practice.

(a) Cal. Lab. Code § 2855 limits enforcement of a personal services contract to seven years from the commencement of service[5];

(b) employee’s unique services should be carefully defined and stipulated;

(d) side effects on other employment agreements already in force should be considered. Briody, supra note 4, at 355.

3. An employee has misappropriated trade secrets.[6]

a. A trade secret is defined as “information, including a formula, pattern, compilation, program, devise, method, technique, or process that:

“(1) Derives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use;"[7] and

“(2) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy."[8] Cal. Civ. Code § 3426.1(d).[9]

b. Either in the absence of an express agreement or in addition to one, a three year statute of limitations applies for misappropriation and misuse of trade secrets by a former employee. Id. § 3426.1(b)(2).

(1) This statute only applies where actual trade secrets are involved. Ingrassia v. Bailey, 172 Cal. App. 2d 117, 123 (1959) (“An agreement between the parties that something is a trade secret will not make of it a trade secret if in fact it is not”).

(2) Remedies available include injunctive relief and damages, including attorneys fees’ and exemplary damages. See remedies available, page27.

(3) The court is to take reasonable steps to preserve the confidential nature of trade secrets. Cal. Civ. Code § 3426.5.

c. Sanctions can also be imposed against those who induce, bribe, or reward an employer’s former employees to procure and turn over a trade secret that the employee obtained while working for that employer. Cal. Penal Code §499c(c).

d. A contract provision not to use trade secrets in competition with an employer is valid. Muggill v. Reuben H. Donnelly Corp., 62 Cal. 2d 239, 242 (1965).

(1) In the absence of a contract provision, trade secret law still protects the employer, but control over misappropriation is simpler if a contract establishes by agreement the definition of trade secrets and explicitly prohibits their use.

(2) Examples.

(a) “[A customer list] built up by ingenuity, time, labor and expense of the owner over a period of many years is property of the employer ... [and] [k]nowledge of such a list, acquired by an employee by reason of his employment, may not be used by the employee as his own property or to his employer’s prejudice."[10] Greenly v. Cooper, 77 Cal. App. 3d 382, 392 (1978); Morlife v. Perry, 66 Cal. Rptr. 2d 731, 735 (1997) (a list of prospective customers that took considerable time and expense to develop which was kept confidential, and which gave the employer an advantage over its competitors, is a trade secret that cannot be used by former employees to solicit customers). Accord Courtesy Temporary Service, Inc. v. Camacho, 222 Cal. App. 3d 1278, 288 (1990) (customer list that took a substantial amount of time and expense to create and which was kept reasonably confidential was a trade secret).

i) Computer programs and data compilations stored in computers are trade secrets. Cal. Penal Code § 499c.

(3) Drafting suggestions.[11]

(a) “Any employment agreement should itemize all confidential trade secrets and processes to which the employee will be exposed so that the employee is placed on notice that these matters are deemed to be confidential and the proprietary information of the company."[12]

(b) The agreement should also include a provision that allows for “the addition of new trade secrets and processes during the contract period."[13]

B. Preparing to leave.[14]

1. An employee is competitively soliciting employer’s customers.

a. Whether the employer is trying to restrain the solicitation under a tort or contract theory, one must first define “solicitation.”

(1) Solicitation “implies personal petition and importunity addressed to a particular individual to do some particular thing.” Aetna Bldg. Maintenance Co. v. West, 39 Cal. 2d 198, 203.

(a) Merely announcing to the employer’s customers that he/she is changing employment does not constitute improper solicitation. Id.

(b) An employee may also willingly discuss business at the invitation of another person without violating a prohibition against solicitation. Id.

(2) The difference between a solicitation and an announcement is not always clear.

(a) Mailed announcement comparing employee’s products or services and prices to the employer’s constituted improper solicitation and unfair competition since the employees had used the employer’s confidential customer list in connection with the mailings. Klamath-Orleans Lumber, Inc. v. Miller, 87 Cal. App. 3d 458, 466 (1978).

(b) Where employees, however, use customer names and addresses in the employer’s files, which were held not to be trade secrets, to mail announcements in violation of the employees’ employment agreements, the actions did not constitute improper solicitation. Moss, Adams & Co. v. Shilling, 179 Cal. App. 3d 124 (1986).

b. A typical nonsolicitation covenant[15] is valid during employment because it just requires an employee not to act to the employer’s detriment. Id.

(1) An antisolicitation clause of this type does not violate Cal. Bus. & Prof. Code §16600.

c. In the absence of an express covenant, unfair competition laws dictate. See “unfair competition,” page 27.

d. For remedies available, see page27.

2. Competitors or employees are soliciting employer’s employees.

a. Competitors are soliciting employer’s employees.

(1) Generally a business does not commit an actionable wrong by soliciting a competitor’s employees, or hiring away one or more of the competitor’s noncontractual employees, so long as neither the defecting employee nor the new employer uses deceptive or unfair methods. Diodes, Inc. v. Franzen, 260 Cal. App. 2d 244 (1968); Metro Traffic Control v. Shadow Traffic Network, 22 Cal. App. 4th 853, 859-60 (1992) (employer commits no actionable wrong by soliciting or hiring his or her competitor’s employees who are not under contract to the competitor so long as the inducement to leave is not accompanied by unlawful action).

(2) A competitor is also limited from soliciting employer’s employees under contract.

(a) The tort of interference with a contractual relationship has five elements: existence of valid contract; defendant’s knowledge of that contract; defendant’s intentional inducement of breach of that contract; actual breach or disruption of that contract; and damages. Pacific Gas & Elec. v. Bear Stearns, 50 Cal. 3d. 1118, 1125 (1990).

(3) For remedies available, see page27.

b. An employee is soliciting fellow employees for a competing company.

(1) An employee cannot solicit fellow employees to leave the employer and work for a competitor. Such action would constitute unfair competition[16] or a breach of fiduciary duty.[17] Breach of a confidential relationship or breach of an implied obligation may also be added to support the primary claims. Bancroft-Whitney Co. v. Glen, 64 Cal. 2d 327 (1966).

(a) See Bancroft-Whitney below, page 12.

(b) Laundry driver who solicited fellow employees to work for a competing laundry was terminated from employment for good cause. Puritan Laundry Co. v. Green, 15 Cal. App. 654 (1911).

3. Otherwise preparing to compete.

a. An employee is setting up a competing business.

(1) California law permits an employee to seek other employment and to take steps in preparation to compete before resigning, but the employee may not transfer his or her loyalty to a competitor during the employment period. Fowler v. Varian Assoc., Inc., 196 Cal. App. 3d 34, 41 (1987); Stokes v. Dole Nut Co., 41 Cal. App. 4th 285, 293-96 (1995) (employer can terminate employee who was preparing to establish a competing business).

(a) Examples.

i) An employer can terminate an employee who refuses to disclose information about his or her knowledge regarding prospective competition and claims an obligation to the competitor to remain silent. Fowler v. Varian Assoc., Inc, 196 Cal. App. 3d 34, 41 (1987).

ii) Writing announcements of future employment or the establishment of a new company, or leasing the necessary premises, have been held to be permissible preparatory actions.[18] See Sarkes Tarzian v. Audio Devices, Inc., 166 F. Supp. 250 (S.D. Cal. 1958); Southern California Disinfecting Co. v. Lomkin, 183 Cal. App. 2d 431 (1960).

(2) When a transfer of loyalty occurs.

(a) Statutory. See “unfair competition,” page14.

(b) Contracts.

i) “An employee may agree in advance not to take any preliminary steps to set up a competing business until after his employment expires. Thus, the employee may waive by contract his common law right to make preparation for a competing business as long as he stays on the payroll of his employer.” Browne, supra note 13 at 75.

ii) An agreement can be entered into which requires an employee to divulge any competitive plans “which he may have under consideration whether or not he intends to act upon them.” Browne, supra note 12, at 157.

i) A fiduciary relationship must exist between the employee and the employer. Generally, this means that at the time of the misappropriation of confidential information the employee must have been a director or officer of the employer’s company. Diodes, Inc. v. Franzen, 260 Cal. App. 2d 244, 255-56 (1968).

ii) In the leading case on fiduciary duty, corporate officers were found to have no general obligation to disclose prospective competitive plans unless the nondisclosure could result in harm to the corporation.[19] Bancroft-Whitney Co. v. Glen, 64 Cal. 2d 327 (1966).

iii) Examples of breaches of fiduciary duty.

a) President of a corporation breached his fiduciary duty by disclosing confidential salary information to a competitor, and by further assisting the competitor in negotiations to hire away some of the corporation’s best employees. Id. at 350-54.

b) An employee violated his fiduciary duty by setting up his own warehouse business, thereby interfering with his employer’s renewal of a business lease. Gower v. Andrew, 59 Cal. 119 (1881).