Non-Disclosure & Non-Competition Issues

  1. The Basic Approach in California.

    With some exceptions involving sales of businesses and the like, California law prohibits non-competition provisions. On the other hand, California law protects trade secrets and the vast majority of confidentiality provisions.

  2. Non-Competition Provisions.

    1. Prohibition. In California (and this is NOT true in many other states), non-competition provisions are void except for very limited situations.

      1. Business & Professions Code Section16600: "Except 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."

      2. While it has been argued that Section 16600 applies only in the employer-employee relationship, that interpretation is not supported by the language of the statute and it has been rejected by the courts. In other words, Section 16600 protects independent contractors as well.

    2. Exceptions. Non-competition provisions are allowed with the following types of owners in the following situations:

      1. Sole Proprietors. Any person who sells the goodwill of a business.

      2. Shareholders. Any shareholder of a corporation selling or otherwise disposing of all his shares in said corporation, or any shareholder of a corporation which sells (a) all or substantially all of its operating assets together with the goodwill of the corporation, (b) all or substantially all of the operating assets of a division or a subsidiary of the corporation together with the goodwill of such division or subsidiary, or (c) all of the shares of any subsidiary.

      3. Partners. A partner upon or in anticipation of (a) a dissolution of the partnership, (b) dissociation of the partner from the partnership, or (c) a sale or other disposition of the partner's interest in a partnership.

      4. Limited Liability Company Members. Any member, upon or in anticipation of a dissolution of a limited liability company or a sale of his or her or its interest in a limited liability company.

      All of these exceptions require that a geographic area be established by naming "a specified county or counties, city or cities."

    3. Token Ownership: The courts have held that giving token amounts of stock etc. to employees will not allow these exceptions to apply.

    4. Governing Law: California will uphold the prohibition even if another state’s law is designated as governing the agreement IF the chosen state has no substantial relationship to the parties or the transaction. The Courts have held that the prohibition applies to a California employer hiring out-of-state employees.

      1. When hiring out-of-state employees in particular, it is important to find out whether the employee signed a non-competition provision and what its terms are; otherwise you may find yourself defending against a lawsuit in another state.

    5. Stock Option Plans: A Court has held that an employee stock-option plan did not violate Section 16600 even though it included a provision that the employee would return any profits from the stock options if he worked for a competitor within six months after he exercised his options.

    6. Limited Restrictions: One case has held that a provision barring one party from courting a specifically named customer, as opposed to a significant part of the industry, does not violate Section 16600. Obviously, there can be disputes over what constitutes a significant part of an industry.

      1. Though this is a federal case, there is older California case law stating that a partial restraint on competition is allowed "where one is barred from pursuing only a small or limited part of the business, trade or profession." (Boughton v. Socony Mobil Oil Co. (1964) 231 Cal.App.2d 188, 192.)

      2. Caution: adding a "savings" clause that states the restriction, if found invalid, is to be narrowed rather than removed, will be ignored IF the restriction is blatant.

      3. In fact, a blatantly invalid non-compete clause may well void the entire agreement. As a result, if you are going to use a non-compete provision, place it in an entirely separate agreement so that confidentiality and ownership provisions are not at risk.

    7. Forcing Employees to Sign Invalid Provisions. A California case found the employer liable for terminating an employee who refused to either sign a non-competition agreement (preventing the employee from working in the health-care field in the same state for six months after termination) or accept work in a different part of the company. The Court held that the employer’s action violated public policy and upheld a $1.2 million judgment against the employer.

      1. Still, this was an obvious violation. If the agreement had been restricted to one or two key clients, it might have worked.

      2. On the other hand, since California does not give the same sort of rights to prospective employees as it does to existing employees, make sure each prospective employee signs a confidentiality agreement as a condition of getting the job.

    8. Clauses in Customer Agreements. Courts have already held that an employer cannot evade the non-competition restrictions by putting clauses in its contracts with its clients that prohibit the clients from hiring the employer’s former employees.

      1. Clauses that state that the client will not solicit the employer’s employees while they are working for the employer are valid though.

      2. Also, an employer may be able to place a provision in its agreements with its clients stating that the work that the employer performs for the client is a trade secret and, although the client can use it, it will not divulge the trade secrets to any of employer’s former employees or consultants. Since the former employee or consultant would not be able to continue the same work, this makes him/her much less attractive to the client.

  3. Trade Secrets and Non-Disclosure Agreements.

    1. NDA’s. Non-disclosure agreements (also known as confidentiality agreements or NDA’s) protect trade secrets.

    2. "Trade secret" means information, including a formula, pattern, compilation, program, device, 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; and

      2. Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy. (Civil Code 3426.1(d), part of California’s version of the Uniform Trade Secrets Act.)

    3. If No Agreement. The Uniform Trade Secrets Act ("UTSA") protects a trade secret even if there is no written agreement if, among things, the information was acquired under circumstances giving rise to a duty to maintain its secrecy or limit its use. Employees, officers and directors owe duties of confidentiality to their company, but a written agreement provides more secure–and often broader–protection.

    4. Inevitable Disclosure. On the other hand, California has rejected the "inevitable disclosure" doctrine, which allows an injunction if it is "inevitable" that the employee will have to use the former employer’s trade secrets in order to do the new job.

    5. Reasonable Efforts. To show reasonable efforts to maintain secrecy, have signed non-disclosure agreements with the employees and principals of your company as well as with independent contractors and other businesses where appropriate.

    6. Specific Definition. Be certain that your definition of what constitutes confidential material is specific enough to identify the confidential information without disclosing it. Vague or overly broad definitions of what constitutes proprietary material may nullify non-disclosure agreements.

      1. Employees with prior experience who are coming on board may require exceptions for knowledge they already have.

  4. Exceptions

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    You cannot make something a trade secret by contract. If your definitions are too broad, you risk invalidating the protection. For this reason, make sure that you include the usual exceptions: information in the public domain, information the employee acquired before taking the job, information obtained legitimately from a third party under no obligation of confidentiality.

    1. Consideration. Have your confidentiality agreements with employees signed at the time when they first start work, and give existing employees additional consideration such as small amounts of stock or money–or a bottle of wine (but be sure to document it!)--as consideration for signing the agreement. If existing employees are not given additional compensation to sign, the agreement may well not be enforceable.

      1. When hiring a new employee, be sure to ask if he/she has signed any non-disclosure agreements with former employers–and make a record of the response.

    2. Use of Memory. It is misappropriation to use trade secret information from memory; no taking of paper or electronic information is required.

    3. Customer Lists and Preferences. Confidentiality agreements can protect customer preferences and sometimes customer lists. If the former employee develops a customer list from other legitimate sources, though, it is not a violation, even though there is a great deal of overlap between the lists.

    4. Solicitation. Although one case has questioned the distinction, in general California courts have held that contract provisions may validly prohibit former employees from soliciting (raising the issue of doing business with) the former employer’s customers–but not prohibit announcements. In other words, the former employee is entitled to send an announcement (including to some of the employer’s customers) stating that the former employee is with another business and giving contact information, even if trade-secret information is involved.

    5. Outsiders.

      1. Ideally, have outsiders sign a non-disclosure agreement (or letter agreement with a place for them to sign and accept) BEFORE giving them confidential information. However, many large companies will refuse to do this.

      2. If you can’t get a signed non-disclosure agreement, second best is sending a letter PRIOR to disclosing the confidential information stating that you will be providing confidential information and expect the other side to keep it confidential.

      3. Even a post-meeting letter–confirming that you disclosed confidential information and expect the recipient to keep it confidential–is better than nothing.

      In all of these cases, be sure to describe the confidential material sufficiently to identify it.

  5. Other Allowed Provisions. It is permissible to state in an employment agreement that the employee will not:

    1. Divert the employer’s customers during the period of employment.

    2. Organize a competing business during the period of employment.

    3. Solicit the company’s employees to work elsewhere–whether during or after the period of employment.

  6. Ownership Issues.

    1. Employee Inventions. If you are in California, your agreements with employees regarding inventions must comply with California Labor Code Section 2870. This means that inventions developed entirely on an employee’s own time without using the company’s equipment, supplies, facilities, or trade secret information must NOT be assigned to your company unless they relate to your business. Making invention-assignment clauses too broad will nullify the agreement. On the other hand, failure to use an invention-assignment agreement with employees may mean an employee owns the invention.

    2. Independent Contractors. If you do not have a written agreement with an independent contractor, the work developed will be owned by that contractor–and you will have only a non-exclusive license to use it. In addition, you need to make sure that your "work for hire" agreements with independent contractors (such as programmers and Web designers) also include an assignment of ownership rights in the resulting product to your company. "Work for hire" clauses alone may not be sufficient.

    3. Patents.

      1. Utility patents cover inventions that are novel and non-obvious, among other things.

      2. Novelty deals with timing. With potentially patentable ideas, be sure to contact an attorney early enough so that a patent application can be filed within one year of the earlier of a) the publication of the invention in any patent or printed publication anywhere in the world by anyone and b) anyone placing the invention in public use or on sale. Otherwise patent rights are lost.

      3. "Non-obvious" means not obvious at the time the invention was made to a person having ordinary skill in the art.