Industry News 3/4/2008

New California Case on Non-Competition and Non-Solicitation Agreements

New California Case on Non-Competition and Non-Solicitation Agreements
By Michael Orlando, attorney at Sheppard Mullin Richter & Hampton LLP

A new California Court of Appeals case published February 7, 2008 adds more clarity to when non-competition and non-solicitation agreements can be enforced against former employees in California.  The case of Alliant Insurance Services, Inc. v. Gaddy concerned a large insurance brokerage company (Alliant) that purchased the stock of another insurance brokerage company (GWC).  The majority shareholder (Gaddy) entered into non-competition and non-solicitation of customer covenants in both the stock sales agreement and in his new employment agreement (Gaddy was hired on by Alliant as part of the deal).  These covenants prevented him from competing with Alliant in all of the State of California for 5 years and from contacting former GWC clients, or customers of Alliant that he meets in his new employment, for 3 years.  The Court upheld both of these covenants.

Non-Competition Agreements

To understand why the Gaddy case is important, one needs a brief understanding of non-competition covenants in California.  California general prohibits non-competition agreements as being contrary to public policy.  The one exception is that under California Business and Professions Code Section 16601, non-competition agreements are generally valid when done in connection with the sale of a business (e.g., sale of all the person’s shares in a corporation, or sale of substantially all the assets and goodwill of a corporation).  The statute further requires that the covenant only extend to a “specified geographic area” and only as long as the new business owner “carries on a like business” in the specified area.  Cases dealing with the scope of the geographic area have held that it needs to be reasonable, but have varied on what is considered to be reasonable in scope. 

The Gaddy case adds understanding to what is considered reasonable for the geographic scope of a non-competition covenant.  Gaddy argued that he should only be prevented from competing in the 4 counties of Northern California where GWC had clients.  The Court, however, disagreed, relying on another case that states that “[t]he territorial limits are coextensive with the entire area in which the parties conducted all phases of their business including production, promotional and marketing activities as well as sales.”  The Court explained that both the location of existing and prospective customers are important in determining where GWC does business and that it is not just where GWC’s products were sold, but also where they were procured, that constitutes the geographic area where it does business.  The lesson of this case is that although geographic limits must still be reasonable, an analysis of where the company does business may extend to areas where it markets or to where it has important supplier relationships.

Non-Solicitation Agreements

The Gaddy case also provides further understanding on the scope of non-solicitation agreements.  Gaddy had contacted “[h]alf a dozen to a dozen” former clients of GWC.  His agreement with Alliant prohibited him from soliciting former clients, and also broadly prohibited him from soliciting Alliant’s customers.  Gaddy argued that the non-solicitation clause was too broad because it extended to Alliant’s customers.  The Court disagreed, because the basis for enforcing the non-solicitation with respect to the former GWC clients was the sale of the business, but the basis for enforcing the non-solicitation of Alliant’s customers was Gaddy’s new employment agreement with Alliant.  The Court cited the 2006 case of Strategix, Ltd. v. Infocrossing West, Inc. that held that prohibitions against soliciting former customers are valid in connection with the sale of a business.  The Court then cited the 2003 case of Thompson v. Impaxx, Inc. that held that covenants prohibiting the solicitation of an employer’s clients on termination of employment may be valid if needed to protect the employer’s trade secrets.  Gaddy makes it clear that when buying a business, if the seller becomes an employee of the buyer, the buyer can obtain a broad non-solicitation agreement that encompasses former clients and new clients, as long as it is necessary to protect actual trade secrets.