Publications

Can One Ever Restrict A Partner, Member or Director

Alan S. Petlak and Linda M. Donner
California Real Estate Journal
January 8, 2007

In forming a partnership, limited liability company or corporation, parties often enter into a covenant intended to prevent a partner, member or director from engaging in a competing business. These covenants are commonly referred to as “covenants not to compete.” A California Court of Appeal recently invalidated one such covenant between partners of a partnership formed to develop industrial warehouses on the grounds that the covenant at issue was an unenforceable restraint on trade under California Business and Professions Code Section 16600. Section 16600 provides that “every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void.” This article will discuss the recent case of Kelton v. Stravinski and consider the impact of Section 16600 on entities doing business in California.

The Kelton Decision

In Kelton v. Stravinski (2006, 138 Cal. App. 4th 941), the parties entered into a partnership for the purpose of developing industrial warehouses. The original partnership agreement explicitly allowed each partner to engage in other real estate activities, whether competitive with the partnership or otherwise. Subsequently, by way of a letter agreement, however, the partners agreed that they would not build, develop or operate a warehouse without including the other. Years later, Kelton claimed a one-half interest in various projects completed by Stravinski on the ground that these projects violated the covenant not to compete. Stravinski responded that, among other grounds, the covenant not to compete was invalid and unenforceable. In the resulting dispute between the partners, the appellate court held that the partners’ agreement not to build, develop or operate a warehouse without the other was an unenforceable restraint on trade. The court stated that California has a “settled public policy in favor of open competition” and a covenant which restricts open competition is void under Business and Professions Code Section 16600.

Is Every Covenant Not to Compete Unenforceable in California?

  • The Statutory and Common Law Framework

Section 16600 makes restraints that preclude one from engaging in a lawful profession, trade or business illegal, unless the restraint falls within the statutory or "trade secret" exceptions to the statute. Sections 16601 and 16602 permit broad covenants not to compete in two narrow situations, i.e. where a person sells the goodwill of a business and where a partner agrees not to compete in anticipation of dissolution of a partnership. Section 16602.5 similarly provides that a member of a limited liability company may, upon or in anticipation of dissolution of the company, agree not to carry on a similar business within a specified geographic area. Additionally, it has long been recognized that section 16600 does not invalidate covenants not to compete where necessary to protect an employer's trade secrets such as a customer or price list.

The courts in California are split as to whether Section 16600 invalidates all covenants not to compete that are not expressly permitted by statute or otherwise designed to protect a company's trade secrets. The Ninth Circuit Court of Appeals has held that a covenant not to compete is void only when it acts to restrain a party completely from engaging in a lawful profession, trade or business. When a party is barred from pursuing only a small or limited part of a business, trade or profession, the Ninth Circuit has held that such limited restraint is valid and enforceable. For example, the Ninth Circuit Court of Appeal upheld a provision in a stock option plan that prohibited an executive employee from working for a competitor for six months following the exercise of stock options. The Ninth Circuit held that such a provision did not completely restrain trade as it was limited to six months and to a competitor, i.e., the employee was free to work in his trade and even in the same industry, so long as he did not work for a competitor.

The California Court of Appeal for the State of California, however, disagrees with the Ninth Circuit's "narrow restraint exception" and has held that any restraint on trade is unenforceable. Therefore, under the California state court standard, any covenant not to compete that this not expressly permitted by statute or designed to protect a trade secret is unenforceable.

  • Choice of Law Issues

To avoid a result like Kelton, parties may contractually agree that disputes shall be governed by laws of a state like Delaware that enforces covenants not to compete. In determining whether to enforce a contractual choice of law provision, a California court looks to the following two factors: (1) whether the chosen state has a substantial relationship to the parties or their transaction, or (2) whether there is any other reasonable basis for the parties’ choice of law. If either factor is met, the court next determines whether the chosen state’s law is contrary to a fundamental public policy in California.

With respect to covenants not to compete, California courts have held that there is a “settled public policy in favor of open competition,” which justifies the enforcement of Business and Professions Code Section 16600. Indeed, in two reported decisions—one case relating to an employment contract and the other relating to a franchise agreement—California appellate courts have held that Section 16600 applied notwithstanding the existence of a choice of law provision providing that the law of another state should apply.

A separate, but related, question is whether a foreign entity doing business in California with a covenant not to compete will be able to enforce the agreement in California under the internal affairs doctrine. The internal affairs doctrine is a common law choice of law principle that provides internal corporate relationships are governed by the laws of the state of incorporation. Internal affairs are commonly described as the relationships of the corporation to its stockholders, directors and officers in matters of internal corporate governance. The doctrine is applicable to partnerships, limited liability companies and corporations.

No California case has addressed whether a covenant not to compete constitutes an “internal affair” of an entity. Even if a covenant not to compete is deemed an “internal affair,” it is unlikely whether that this in itself would compel a California court to apply the state law of a foreign entity in deciding whether this covenant not to compete is enforceable. While courts in other states, such as Delaware, have held that application of the internal affairs doctrine is mandated by constitutional principles, California courts have not followed this holding. In fact, one California appellate court has held, in dicta, that the internal affairs doctrine has never been followed blindly in California, but is merely a factor in the balancing test used to resolve conflict of law problems.

Conclusion

Because of California's settled public policy in favor of competition, it is questionable whether any covenant not to compete which restrains a partner, member or director from engaging in a competing business that is not expressly authorized by statute or designed to protect a trade secret will be held enforceable in California. Moreover, because of this strong public policy, it is unlikely that a California court will apply the law of another state in interpreting a covenant not to compete based upon a contractual provision or the internal affairs doctrine. Therefore, caution must be exercised in California whenever attempting to limit a partner, member or director from entering into a competing business through a contract.