Revisiting Restrictive Covenants in a Commercial Setting: The California Supreme Court Applies a Less Aggressive Approach

Littler
Contact

Littler

California is known for having the most aggressive approach among the states regarding restraints on profession, trade, and business. Specifically, California Business and Professions Code section 16600 codifies this approach: “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”

Prior case law examining section 16600 in the employment and sale of business context has unequivocally held that such restraints are unlawful per se unless one of the exceptions set forth in sections 16601, 1602, and 1602.5 applies. On August 3, 2020, however, the California Supreme Court issued a decision in Ixchel Pharma, LLC v. Biogen, Inc.1 examining the application of section 16600 to an agreement entered into by two businesses in a business-to-business collaboration context. In this scenario, the court used a different standard applicable in the antitrust setting—the rule of reason. In Ixchel, the court departed from a strict reading of section 16600, and instead held that when analyzing whether a collaboration agreement between businesses was void pursuant to section 16600, the inquiry is “whether an agreement harms competition more than it helps by considering the facts peculiar to the business in which the restraint is applied, the nature of the restraint and its effects, and the history of the restraint and the reasons for its adoption.”2

Because the rule of reason is a detailed factual inquiry and has been considered a vague3 standard in the antitrust setting, the Ixchel decision creates uncertainty as to how lower courts will apply the standard when analyzing agreements between businesses. Nonetheless, the Ixchel decision creates an opening for California businesses to revisit the use of restrictive covenants in their commercial dealings.

Background

The Ixchel case concerns a dispute between Plaintiff Ixchel Pharma, Inc. (“Ixchel”) and Defendant Biogen, Inc. (“Biogen”). Ixchel had an agreement with Forward Pharma (“Forward”) to collaborate in the creation of a drug treatment, using dimethyl fumurate (“DMF”) to treat a disorder known as Friedreich’s ataxia.  Under this “Collaboration Agreement,” Forward could terminate at any time so long as it provided Ixchel 60 days’ advance notice. While Ixchel and Forward were working together pursuant to the Collaboration Agreement, Forward and Biogen were in negotiations to settle a patent dispute. The negotiations between Forward and Biogen resulted in a settlement and license agreement with Biogen (“Forward-Biogen Agreement”), in which Biogen agreed to pay settlement money to Forward in an exchange for a license to certain Forward patents and other intellectual property. The Forward-Biogen Agreement also stated that Forward was required to terminate any and all existing agreements and not enter into any new agreements with Ixchel for the development of any pharmaceutical product using DMF for the treatment of a human condition, including Friedreich’s ataxia. As a result, Forward terminated its relationship with Ixchel under the Collaboration Agreement. Ixchel lost its ability to develop its Friedreich’s ataxia treatment and was unable to find another collaboration partner.

Ixchel filed suit against Biogen in federal district court, asserting: (1) violations of the federal and state antitrust laws (15 U.S.C. § 1; Bus. & Prof. Code, § 16700 et seq.); (2) tortious interference with contractual relations; (3) intentional and negligent interference with prospective economic advantage; and (4) violations of the unfair competition law (UCL) (Bus. & Prof. Code, § 17200 et seq.). The district court dismissed Ixchel’s complaint after Biogen moved to dismiss on several grounds, including on the grounds that Ixchel failed to plead that Biogen engaged in an independently wrongful act in support of its interference claims.

Ixchel then filed a second amended complaint against Biogen pleading interference claims and this time, Ixchel alleged that Biogen had committed the wrongful act of violating section 16600’s prohibition against restraints on trade. The district court again dismissed the second amended complaint, ruling that section 16600 must be analyzed under the antitrust rule of reason and section 16600 did not apply outside the employment context.

Ixchel sought review of its tort and UCL claims, and after oral argument, the Ninth Circuit certified two questions for the California Supreme Court, which the court rephrased and reordered as follows:

(1) Is a plaintiff required to plead an independently wrongful act in order to state a claim for tortious interference with a contract that is terminable at will?

(2) What is the proper standard to determine whether section 16600 voids a contract by which a business is restrained from engaging in a lawful trade or business with another business? 

As to the first question, the court held that an independently wrongful act is required to state a claim for tortious interference with a contract that is terminable at will, such as the Collaboration Agreement.

As for the second question, the court held that the rule of reason is the correct standard to determine whether section 16600 voids a contract by which a business is restrained from engaging in a lawful trade or business with another business. In its analysis, the court first reconfirmed that section 16600 is applicable to contracts between businesses and is not limited to contracts pertaining to the employment or sale of business setting.

In analyzing the proper standard under section 16600 for an agreement that restricts business and/or trade, the court acknowledged that when read in isolation, section 16600 suggests that any part of an agreement restraining a party from engaging in a trade, profession, or business is per se invalid unless certain exceptions apply. This is consistent with the Ninth Circuit Court of Appeals’ ruling in Golden v. California Emergency Physicians Medical Group,whereby the court rejected the “rule of reasonableness.” Here, however, the court departed from a strict reading of the statute and instead analyzed the statute “in context of the statutory framework as whole in order to determine the scope and purpose.” After conducting a detailed analysis of section 16600’s predecessor statute, Civil Code section 1673, repealed and reenacted as Business and Professions Code section 16600 in 1941, the court stated that it had only construed section 16600 in relation to contracts restraining competition after the termination of employment or in the sale of interest in a business. The court found that its pervious decisions, including Edwards v. Arthur Andersen, LLP,5 whereby the court rejected that a rule of reason standard applies to non-compete agreements in the employment setting, were not applicable to this type of collaboration contract between businesses. The court therefore differentiated the Ixchel case from Edwards based on this pure business-to-business arrangement, leaving Edwards intact.

The court ultimately held that when analyzing whether an agreement between businesses violates section 16600, the proper standard is the rule of reason in the antitrust setting. The rule of reason asks whether the challenged conduct promotes or suppresses competition. The court stated:

In certain circumstances, contractual limitations on the freedom to engage in commercial dealings can promote competition. Businesses engaged in commerce routinely employ legitimate partnership and exclusive dealing arrangements, which limit the parties’ freedom to engage in commerce with third parties. Such arrangements can help businesses leverage complementary capabilities, ensure stability in supply or demand, and protect their research, development, and marketing efforts from being exploited by contractual partners.

The decision demonstrates that the court was attempting to strike a balance between California’s public policies supporting employee mobility and competition with public policies promoting business competition, which may be enhanced with the ability to enter into collaboration agreements with contractual limitations.  

The court did not making any findings as to whether the Forward-Biogen Agreement requiring the termination of the Collaboration Agreement actually violated section 16600 pursuant to the rule of reason.  

What Does Ixchel Mean for Businesses?

The Ixchel decision has huge ramifications for a variety of business agreements, such as licensing, franchisee/franchisor, collaboration, and joint venture agreements since the agreements that restrict trade and business will not be void per se. This decision clears the way for businesses to enter into such agreements so long as the restraints promote competition and do not violate the rule of reason. Nonetheless, given the rule of reason has been criticized as a vague and amorphous standard, it remains to be seen how California courts will apply the standard to the business setting and if creative agreements that restrict employees will be allowed. It also remains to be seen whether future analysis by California courts of the Ixchel decision will stray into the substantial body of case law interpreting the rule of reason under the federal Sherman Act to address the multitude of possible business-to-business agreements and their effects on free market competition.  Moreover, while the focus in this context is on market power, the door is seemingly open to more and varied commercial collaborations with accompanying restraints on trade, which no doubt will require greater scrutiny on their economic justification to balance against worker mobility and wage competitiveness.  Regardless, it is unlikely that Ixchel will allow the recruiting and staffing industry to enter into no-poach agreements, as those agreements will most likely not satisfy the rule of reason based on the guidance issued by the Federal Trade Commission and U.S. Department of Justice.

Employers considering such restraints should first consult with counsel.

 

Footnotes

1 Ixchel Pharma, LLC v. Biogen, Inc., No. S256927, 2020 WL 4432623 (Cal. Aug. 3, 2020).

2 Id. at *10 (citing Cipro Cases I & II, 61 Cal.4th 116, 146 (2015)). 

3 Maurice E. Stucke, Does the Rule of Reason Violate the Rule of Law?, 42 U.C. DAVIS L. REV. 1375, 1379 (2009).

4 782 F.3d 1083 (9th Cir. 2015).

5 44 Cal. 4th 937, 945 (Cal. 2008).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Littler | Attorney Advertising

Written by:

Littler
Contact
more
less

Littler on:

Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
- hide
- hide

This website uses cookies to improve user experience, track anonymous site usage, store authorization tokens and permit sharing on social media networks. By continuing to browse this website you accept the use of cookies. Click here to read more about how we use cookies.