By Kurt Kappes and Jim McNairy
On August 20, 2009, the California Court of Appeal for the Fourth Appellate District issued an order certifying publication of its decision in The Retirement Group v. Galante, No. D054207, 2009 WL 2332008 (Cal. App. 4th July 30, 2009). In Galante, the Court analyzed the tension between California’s strong public policy favoring competition, as embodied in Business and Professions Code section 16600, and the longstanding body of law recognizing an employer’s right to guard against misappropriation of its trade secrets.
Under the facts presented, the Court concluded that an employer who seeks to prohibit a former employee from soliciting former customers to transfer their business away from the former employer to the employee’s new business, cannot specifically enforce a covenant not to compete without showing a tort. The employer must show more than that the former employee had access to customer lists that qualified as trade secrets while employed, and solicited customers once he left. Instead, the former employer must show that the former employee actually used the trade secret list to identify or facilitate the solicitation of existing customers.
In Galante, The Retirement Group (TRG), described as a business “association”, provided broker/dealer, investment advice, and securities sales services to customers on a fee for service basis. TRG provided these services through, among other things, the use of independent contractors, many of whom were registered investment advisors and registered representatives licensed to sell securities. Some of TRG’s customers used the registered representative to buy and sell securities through a third party broker/dealer known as Security Services Network, Inc. (SSN). TRG’s registered representative independent contractors also entered into independent contractor relationships with SSN.
TRG undertook extensive marketing efforts, including seminars. About 95% of TRG’s customers were obtained through this marketing. TRG’s list of customers and potential customers was maintained in a secure database designed to prevent copying of information in the database.
As a condition to allowing access to the secure database, TRG required execution of a Marketing and License Agreement (MLA). In pertinent part, the MLA defined TRG’s confidential information, and provided that (both during the term of the relationship and thereafter) the signing party would keep the information confidential and would not “disclose or use” the information, except as the MLA permitted.
After one of TRG’s principals left to form a competing business (Monarch) with several of the independent contractors who had worked for TRG, the independent contractors and Monarch allegedly began contacting TRG’s customers and asking them to switch their business to Monarch and Monarch’s new broker/dealer, SII Investments, Inc.
TRG filed suit, alleging among other things, misappropriation of TRG’s trade secret information contained on its database. TRG sought and obtained a preliminary injunction.
The preliminary injunction prohibited certain conduct, including:
“[d]irectly or indirectly soliciting any current TRG [customers] to transfer any securities account or relationship from TRG to [Advisors] or any broker-dealer or registered investment advisor other than TRG[.]”(“Non-solicitation Provision”); and
“[u]sing in any manner TRG information found solely and exclusively on TRG databases. [However,] [s]imilar information found on servers, databases and other resources owned and operated by other entities or businesses is excluded from the injunction[.]” (“Database Provision.”)
The Court of Appeal addressed the propriety of the Non-Solicitation Provision. In doing so, the Court analyzed (1) Bus. & Prof. Code section 16600 and the cases interpreting and applying it, and (2) trade secret case law providing that former employees may not misappropriate the former employer’s trade secrets to compete unfairly with the former employer.
In its analysis of Section 16600, the Court focused on the 2008 California Supreme Court decision in Edwards v. Arthur Andersen LLP, 44 Cal.4th 937 (2008). In Edwards, the Supreme Court held that covenants not to compete are void in California under Bus. & Prof. Code section 16600 unless permitted by a statutory exception. Section 16600 provides that “[e]xcept 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.”
After noting that Edwards “appears pivotal to resolution of this appeal,” the Galante Court highlighted that “[a]though Edwards reaffirmed the broad California rule that invalidates noncompetition agreements falling outside of the statutorily-prescribed exceptions, Edwards expressly stated it was not ‘[a]ddress[ing] the applicability of the so-called trade secret exception to section 16600.’” The Retirement Group, 2009 WL 2332008 at *5 (quoting Edwards, 44 Cal.4th at 946 n. 4).
In analyzing the trade secrets line of cases, the Galante Court started by noting “[a]n equally lengthy line of cases has consistently held former employees may not misappropriate the former employer’s trade secrets to unfairly compete with the former employer.” The Court continued, “in accordance with these principles, the courts have repeatedly held a former employee may be barred from soliciting existing customers to redirect their business away from the former employer and to the employee’s new business if the employee is utilizing trade secret information to solicit those customers.” Id. at *6, emphasis in original. The Court then concluded “[T]hus, it is not the solicitation of the former employer’s customers, but is instead the misuse of trade secret information, that may be enjoined.” Id. (emphasis in original).
Having analyzed section 16600 and the trade secrets line of cases, the Court concluded that :
“We distill from the foregoing cases that section 16600 bars a court from specifically enforcing (by way of injunctive relief) a contractual clause purporting to ban a former employee from soliciting former customers to transfer their business away from the former employer to the employee’s new business, but a court may enjoin tortious conduct (as violative of either the Uniform Trade Secrets Act and/or the Unfair Competition Law) by banning the former employee from using trade secret information to identify existing customers, to facilitate the solicitation of such customers, or to otherwise unfairly compete with the former employer. Viewed in this light, therefore, the conduct is enjoinable not because it falls within a judicially-created “exception” to section 16600’s ban on contractual nonsolicitation clauses, but is instead enjoinable because it is wrongful independent of any contractual undertaking." Id. (bolding added).
Applying this reasoning to the facts before it, the Court concluded that the Non-Solicitation Provision of the preliminary injunction facially violated Edwards and could not be viewed as limited in scope to only enjoining the misappropriation of TRG’s trade secrets.
The Court also rejected the argument that the Non-solicitation Provision could be upheld as an injunction designed to have the limited effect of protecting against the misappropriation of TRG’s trade secrets because the Database Provision of the injunction granted the full range of trade secret protections to which TRG was entitled. The Court further held that “[a]bsent the provisions of [the Non-solicitation Provision] [defendants] could compete with TRG for the business of TRG’s existing customers by employing all available resources and information except for those materials found ‘solely and exclusively on TRG’s databases,’” which constituted protectable trade secrets. Id. at * 7.
TRG’s argument regarding the so-called “trade secret exception” to section 16600 was also rejected by the Court. TRG argued that the conduct enjoined by the Non-solicitation Provision is outside the boundaries of Edwards because Edwards expressly excepted from its ruling noncompetition clauses falling within the trade secret exception to section 16600. Id. Significantly, the Galante Court noted that “[E]dwards did not approve the enforcement of noncompetition clauses whenever the employer showed the employee had access to information purporting to be trade secrets. Instead, Edwards merely stated it was not required to “address the applicability of the so-called trade secret exception to section 16600 [citation] because it was not germane to the claims raised by the employee.” Id.
Additional reasons for the Court holding that the Non-solicitation Provision was invalid included:
· TRG did not dispute that the names and contact information for existing customers were readily available to defendants from independent third party sources, thus negating that the names and contact information of existing customers constituted protectable trade secret information;
· Because the Database Provision already protected against defendants’ use of TRG’s trade secrets, the Non-solicitation Provision could not have any additional effect, except to bar solicitations not involving the use of trade secret information; and
· The Non-solicitation Provision was not enforceable as a mere “narrow restraint” on defendants because the “narrow-restraint” exception developed by 9th Circuit Court of Appeal was rejected in Edwards.
The Court ordered the trial court to vacate the preliminary injunction and enter a new injunction deleting the Non-Solicitation Provision.
The distinction that the Court drew between enforcing a contractual clause and enjoining tortious conduct, introduces new uncertainty whether a covenant not to compete in California explicitly tied to the protection of trade secrets is viable. Although future cases may address this issue, neither Galante nor Edwards expressly held that one cannot by contract prohibit conduct that is otherwise unlawful under one or more statutes.
The lessons from this case are:
1. Businesses should continue to use caution before utilizing any covenants not to compete in California and should carefully assess whether the restriction on competition can be tied to one of the statutory exceptions to section 16600 or to the protection of trade secrets. However, if tied to the protection of trade secrets, a covenant which seeks to restrict a former employee or contractor from competing against the former employer should be tied to the former employee’s/contractor’s actual misuse of trade secrets. Simply referencing prior access to trade secrets during the term of employment/contract alone is unlikely to address the misuse of that information.
2. This case highlights what the California Supreme Court made clear in its Edwards v. Arthur Andersen opinion: unless falling within one of few exceptions to CBPC § 16600, post-term covenants not to compete are invalid in California regardless of whether such covenants are narrowly drawn.