Uniquely California: Non-competes and fiduciary obligations

The California Court of Appeal recently clarified two significant unsettled issues for business owner non-competition provisions and fiduciary obligations:

• A contractual restraint on competition is evaluated under a reasonableness standard, and is not void per se, where a business owner sells less than is or her entire interest; and
• Members of a manager-managed LLC can be subjected to fiduciary obligations by the company’s operating agreement.

California’s legislative policy on contractual non-compete clauses favors open competition and employee mobility. “Under [Business and Professional Code section 16600]’s plain meaning … an employer cannot contract to restrain a former employee from engaging in his or her profession, trade, or business unless the agreement falls within one of the exceptions to the rule.” Edwards v. Arthur Anderson, LLC., 44 Cal.4^th 937, 949-947 (2008). The policy intent is clear, “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” (Bus. & Prof. Code, 16600, subd. (a)). Thus, historically noncompetition agreements related to employment have been deemed voided per se.

In recent years, the California Supreme Court has revised section 16600 to determine whether it applied outside the employment context between businesses. Ixchel Pharma, LLC v. Biogen, Inc., 9 Cal. 5^th 1130, 1159 (2020). Concluding section 16600 applies beyond employment relationships to other business contracts, the Court identified two standards to determine if a contractual restraint on competition is void. Non-competition agreements are either (1) void per se or (2) evaluated under a reasonableness test. In line with California policy, the per se standard applies to restraints from “termination of employment or the sale of interest in a business.” Id at 1159. However, the reasonableness standard applies to “contractual restraints on business operation and commercial dealings.” Id. In applying the reasonableness standard, courts consider “the facts peculiar to the business in which the restraints is applied, the nature of the restraint and its effects and the history of the restraint and the reasons for its adoptions." Id at 1150. 

Thus, when a business is completely sold, much like when an employee stops working at a company, the per se void standard applies to noncompetition agreements. However, it remained unclear which standard applies to a partial sale of an interest in business. Recently, in Samuelian v. Life Generations Healthcare, LLC, this question was addressed by the Court of Appeals. The facts of Samuelian are straight forward, Robert and Stephen Samuelian (“Samuelians”) co-founded Life Generations Healthcare, LLC (“LGH”) with Thomas Olds, Jr. (“Olds”). The Samuelians owned half the business and sold a portion of their interest while still remaining owners. During the sale, LGH adopted a new operating agreement that prohibited owners from competing with LGH.

The Samuelians proceeded with arbitration to challenge the enforceability of the noncompetition provision. Thereafter, the arbitrator found the noncompete provision arose from the sale of a business interest and concluded it was per se invalid. On appeal, LGH admitted that the per se standard applies to noncompetition restraints arising from the sale of an entire business interest, but not a partial sale.

The Court held that the per se standard does not apply to noncompetition restraints arising from the partial sale of a business interest. Instead, the reasonable standard applies. Because of the potential procompetitive benefits when owners only partially sell their interest in a company, such noncompetition provisions are invalid under section 16600 only if unreasonable in light of the seller’s connection to the company.

In discussion as to why the reasonableness standard applies, the Court explained that selling owners may still owe their company a duty of loyalty that prohibits them from competing with it, thus a per se standard to noncompetition restraints could interfere with such fiduciary duties.

The Court also held that while the California Revised form Limited Liability Company Act (RULLCA) does not impose fiduciary duties on members in a manger-managed company, it does not bar an operating agreement from imposing such duties on members.

Thus, under California law, an operating agreement can impose fiduciary duties on members in a manager-managed company. If a noncompetition restriction is included in these fiduciary duties, it should be evaluated under the reasonableness standard.

These considerations are often fact-specific and require a nuanced understanding of the applicable law. The commercial team at Kennedys stands ready to assist you and your business with these concerns.