In situations where employers also make their employees, or certain employees, agree to restrictive covenants, particularly noncompetes, companies expect the same uniformity and predictability regarding their enforceability as to each employee, regardless of where the employee works or lives. Employees, on the other hand, often expect (as we learned through a recent case) that even with another state’s choice of law provision, they will still be afforded the protection of the laws of their own state. This disconnect is no clearer than where non-California headquartered companies hire California residents as employees and require them to sign noncompetes governed by another state’s law. In California, noncompete agreements are generally unenforceable (with some limited exceptions). This is well-known, particularly by California residents. So, what happens in this situation if the California employee violates their noncompete?
California Prohibits Employers From Enforcing Noncompetes
To back up a little, noncompete agreements are a form of restrictive covenant entered into between an employee and employer in which the employee agrees not to enter into competition with the employer for a period of time (usually one or two years) after employment. Under a more than decade old California law, these agreements are unenforceable.
The California Business and Professions Code 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.” California is one of the most, if not the most “employee-friendly” states in this regard, and rarely enforces non-compete agreements governed by California law. Other states that take a hostile view towards non-competes are Nevada, Rhode Island, North Dakota and Oklahoma. California’s policy works when a California court is applying California law, but what about when the noncompete of a California citizen is governed by another state’s choice of law?
Noncompete Agreements Entered Into Before Jan. 1, 2017
For years, companies evaded California’s prohibition on noncompete agreements by inserting both forum selection clauses and choice of law provisions that governed the enforcement of noncompetes. In situations where there was a choice of law provision that provided for application of non-California law, courts, even California courts, generally honored the intent of the contracting parties and enforced choice of law provisions in contracts executed by them. This led to noncompetes being enforced against California residents even in their own courts, see, Synthes v. Knapp, 250 F.Supp.3d 644 (E.D. Cal. 2017).
Pennsylvania, for example, like the vast majority of states, follows the choice of law test provided by Section 187 of the Restatement (Second) of Conflict of Laws (1971) (restatement), known as the “most-significant-contacts” approach. The restatement provides that the law of the chosen state (if there is one) will be applied unless either (a) the chosen state has no substantial relationship to the parties or the transaction and there is no reasonable basis for the parties’ choice, or (b) application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in determining the particular issue. If either subsection (a) or (b) of Restatement Section 187 are not satisfied, the applicable law relating to the enforcement of a noncompete often turns on an analysis of where the agreement was made.
The analysis under subsection (a) is easy, and companies should know they cannot select just any state’s law to govern its contracts. California companies, for example, cannot avoid their own state’s laws by arbitrarily choosing the laws of another state. The analysis under subsection (b) is often more applicable. Under subsection (b), where a Pennsylvania choice of law provision governs a California citizen’s non-compete, the first inquiry would be whether California has a materially greater interest than Pennsylvania. See, e.g., Coface Collections North America v. Newton, 430 F. App’x 162, 167 (3d Cir. 2011). If it is determined that California has a materially greater interest, then it must be determined whether application of Pennsylvania law would be contrary to a fundamental public policy of California.
Pennsylvania state and federal courts have routinely upheld choice of law provisions applying the law of the state in which a party is incorporated or headquartered, particularly where the company’s payroll department, primary decision making, and location of corporate officers and operations are also in that state and even though doing so eviscerates California law. See, e.g., Synthes v. Emerge Medical, 2012 WL 4205476 (E.D. Pa. Sept. 19, 2012); Synthes USA Sales v. Harrison, 83 A.3d 242 (Pa. Super. 2013); Britton v. Whittmanhart, 2009 WL 2487410 (E.D. Pa. Aug. 13, 2009). The U.S. Court of Appeals for the Third Circuit is not unique in this regard. This is because courts recognize that companies, “regardless of a state’s interest in the transaction of its citizens,” “have an interest in uniformity in dealings with their locations throughout the country,” as in Select Medical v. Hardaway, 2006 WL 859741 (E.D. Pa. Mar. 24, 2006).
A collection of “Synthes cases,” a few of which are cited above, highlight a (at least then-existing) loophole to California’s ban on non-compete agreements. To close this loophole, California enacted a new law.
Noncompete Agreements Entered into After Jan. 1, 2017
Recently, California enacted California Labor Code Section 925, which is not retroactive, and governs only agreements entered into, modified, or extended on or after Jan. 1, 2017, and provides that an employer shall not require an employee who primarily resides and works in California to agree to a provision that would either: require the employee to adjudicate a claim outside of California that arose in California; or deprive the employee of the substantive protection of California law with respect to a controversy arising in California.
So far, no Pennsylvania state or federal court has addressed California’s Section 925, particularly as to whether it now gives California a “materially greater” interest than Pennsylvania companies under the “most-significant-contacts” approach to a conflict of laws analysis.
Section 925 does include an important carve-out in subsection (e) which exempts from the ban on importing another state’s law those agreements where the “employee … is in fact individually represented by legal counsel in negotiating the terms of an agreement to designate either the venue or forum in which a controversy arising from the employment contract may be adjudicated or the choice of law to be applied.” The Delaware Court of Chancery recently relied on this carve-out provision to uphold the parties’ choice of Delaware law and forum. See NuVasive v. Miles, 2018 WL 4677607 (Del. Ch. Sept. 28, 2018).
Challenges to Section 925 remain in their infancy, and until Pennsylvania courts provide guidance on its application, companies might be operating in the unknown. There are, however, a few things companies can do to protect themselves during this time. First, they can rely on the carve-out in Section 925(e) by making sure employees are represented by counsel during the negotiation of their employment contracts.
Second, companies can use permissive (as opposed to mandatory) choice of law and forum selection clauses, as a California court held that Section 925 does not apply to permissive forum-selection clauses. Farrar v. Cupcake Digital, 2017 WL 395311, *3 n.1 (C.D. Cal. Jan. 26, 2017). Third, since Section 925 only applies when an employee is required to sign such an agreement “as a condition of employment,” employers can condition the agreement on something other than employment. For example, companies can condition non-compete agreements with choice of law and forum selection provisions on an employee’s receipt of optional benefits or compensation.
Looking Ahead
Right now, there is a trend, which began under the Obama administration, in limiting the enforceability of noncompete agreements. On Nov. 27, 2017, legislators in Pennsylvania proposed legislation to ban noncompete agreements in what is known as the Freedom to Work Act (House Bill No. 1938). Similar legislation has been proposed in many other states, including New Jersey (Senate Bill S3518; Assembly Bill NJ A5261), Massachusetts (House Bill 4419), and Vermont (House Bill 566). If this trend continues and this legislation is passed, the issue outlined herein could become moot.
Edward T. Kang is the managing member of Kang Haggerty LLC. He devotes the majority of his practice to business litigation and other litigation involving business entities. He gave a CLE presentation titled “Emojis Speaking Louder than Words” at the 2018 Annual Meeting of National Association of Minority and Women Owned Law Firms (NAMWOLF) in Chicago, Illinois.
Kandis L. Kovalsky, an associate at the firm, focuses her practice on representing both corporate and individual clients in a broad range of complex commercial litigation matters in Pennsylvania and New Jersey state, federal and bankruptcy courts.
Reprinted with permission from the November 8 edition of “The Legal Intelligencer” © 2018 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.