Labor and Employment

Readers of this blog will note that we frequently remind them that California law generally prohibits non-compete agreements. There are very limited exceptions to this general rule, one being that the seller of goodwill in a business can be bound by a valid non-compete agreement to protect the goodwill that is being purchased. Sometimes, the buyer of a company will want to continue to employ certain key employees, who can also be the sellers of the goodwill of the former company. We have seen instances where the purchasing company gets creative and subjects the seller/key employee to two covenants not to compete, one in the purchase agreement and the other in an employment agreement. Last week, a California appellate court shut the door on this approach in the case Fillpoint, LLC v. Maas.

Maas was an employee and stockholder in a video game company. In 2005, Handleman (which was later acquired by Fillpoint) purchased the video company pursuant to a purchase agreement. Under the terms of that purchase agreement, Maas agreed to a covenant not to compete for three years after the closing date of the transaction. At about the same time, Maas signed an employment agreement by which he agreed to work for the acquiring company for three years. That employment agreement had a separate covenant not to compete which prohibited Maas from working in the video game industry for one year after the termination of his employment.

After working for the new company for three years, Maas resigned and six months later joined a competitor. Fillpoint sued Maas for breach of contract for violating the one year non-compete in his employment agreement (and also sued his new employer for interference with contractual relations). At the time of trial, Maas filed a motion for non-suit stating that the one year non-compete set forth in his employment agreement was unenforceable under California law. The trial court agreed and dismissed the lawsuit.

In affirming the court’s dismissal, the appellate court began by recognizing that Business and Professions Code section 16600 prohibits any contract “by which anyone is restrained from engaging in a lawful, profession, trade or business,” except as otherwise provided under California law. Section 16601 makes an exception in the case where the non-compete is necessary to protect a buyer’s purchase of a company’s goodwill. The court noted, “section 16601’s exception serves an important commercial purpose by protecting the value of the business acquired by the buyer. ‘In the case of the sale of the goodwill of the business, it is ‘unfair’ for the seller to engage in competition which diminishes the value of the asset he sold.’” Thus, the Court had no problem recognizing the validity of the three year non-compete provision that was contained in the purchase agreement.

However, the Court noted that the non-compete provision in the employment agreement was a bit different than the one contained in the purchase agreement. Although the Court held that both agreements had to be read together since they were part of the same transaction, the non-compete in the employment agreement would only be enforceable if it satisfied the “goodwill” exception under section 16601. The Court held that it did not.

The Court reasoned that the non-compete in the purchase agreement was reasonably necessary to protect the value of the goodwill that was being purchased. This complied with section 16601. However, the one year non-compete in the employment agreement was clearly intended to affect Maas’s rights to be employed in the future after the expiration of the three year non-compete period in the purchase agreement. The Court concluded: “The purchase agreement’s covenant was focused on protecting the acquired goodwill for a limited period of time. The employment agreement’s covenant targeted an employee’s fundamental right to pursue his or her profession.” Thus, the Court held that the additional one year non-compete provision in the employment agreement was unenforceable.

The Fillpoint decision continues the trend in California for courts to heavily scrutinize restrictive covenants to ensure that they meet the spirit of section 16600 and its prohibitions against restraining an employee’s mobility. Businesses that are acquiring other companies and want to employ key employees who happen to be selling shareholders need to consult with legal counsel to ensure that the structure of the deal, including any non-compete provisions, is enforceable under California law.

As this blog frequently reminds its readers, California state courts take a hard look at arbitration agreements in the employment context. The recent case: Sparks v. Vista Del Mar Child & Family Services, from the Second Appellate District of California provides additional support for why employers need to be extra careful in establishing enforceable arbitration provisions.

Mr. Sparks was hired as Vista Del Mar’s controller in April 2007 and was terminated three years later. He claimed he was fired in retaliation for complaints he had made about various employment practices. After filing his complaint in state court, Vista Del Mar filed a petition to compel arbitration of the dispute citing a provision in its employee handbook that all employment matters were subject to binding arbitration. The trial court denied the petition and refused to order the matter to arbitration. The California appellate court affirmed this decision (by a split 2-1 vote).

After Mr. Sparks was hired, he received a 2006 employee handbook and signed an acknowledgement that he had received and reviewed the handbook and agreed to abide by its terms. An arbitration provision appeared on pages 35 and 36 of the handbook in the same font and style as the other provisions in the handbook. The employee handbook contained language that it was not intended to create a contract of employment and both the handbook and acknowledgement stated that the employer was free to change, rescind or add to the policies, benefits or practices described in the handbook.

Mr. Sparks was later provided a 2009 employee handbook but (for some reason) was not asked to sign a new acknowledgement. The arbitration provision was nearly identical in the 2009 handbook as the 2006 handbook but provided additional language that the employee, in acknowledging receipt of the handbook, would also be agreeing to the inclusion of the arbitration provision.

The appellate court began by recognizing that “[a]rbitration is recognized as a matter of contract and a party cannot be forced to arbitrate something in the absence of an agreement to do so.” Although the subject arbitration clause provided for the application of the Federal Arbitration Act (“FAA”), the appellate court ruled that California state law would determine whether there was a binding contract to arbitrate and not the FAA.

In holding that the arbitration policy in the 2006 handbook was unenforceable, the Court found the following facts persuasive:

• The arbitration provision was not prominently distinguished from the other clauses nor was there any place for the employees to acknowledge it in writing;

• The acknowledgement of receipt of the handbook made no reference to the arbitration provision (unlike the later 2009 handbook);

• The handbook was “distributed” to all employees with language that suggested it was informational rather than contractual;

• The arbitration provision was “illusory” in that the employer could unilaterally modify the handbook, including the arbitration provision, at any time;

• The rules of the American Arbitration Association which were referred to in the arbitration policy were never provided to Mr. Sparks;

• There was no evidence that the arbitration provision was subject to negotiation nor did it provide any express provision for discovery rights should arbitration be ordered.

The Sparks case is a reminder to employers that they need to be extra careful when presenting employees with arbitration clauses and must take care to ensure that the employee’s acceptance of the arbitration policy is properly documented. Merely relying on the fact that an employee handbook has an arbitration provision is unlikely in itself to allow an employer to compel an employee’s lawsuit into arbitration.