The Rule Of Reasonableness: Non-Compete Provisions In California Business Contracts

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The California Supreme Court in the 2008 case, Edwards v. Arthur Andersen LLP, ruled that a provision in an employment agreement that prevented an employee from competing with his former employer following the termination of his employment was an invalid restraint on trade in violation of section 16600 of the California Business and Professions Code.  The Court held that subject to certain statutory exceptions, i.e., to protect the value of goodwill in connection with the sale of one’s business interest, section 16600 invalidated all contractual provisions that constituted a restraint on an employee’s ability to practice his or her trade or profession.  What the Court has not addressed since that 2008 decision was whether provisions that acted as a restraint on trade in business contracts (i.e. exclusive distribution agreements, franchise agreements, etc.) would suffer a similar fate.    On August 3, 2020, the California Supreme Court issued its decision in Ixchel Pharma, LLC v. Biogen, Inc., and ruled that non-compete provisions in business to business contracts were not per se invalid, but rather subject to a rule of reasonableness.

Ixchel is a biotech company that develops drugs containing dimethyl fumarate (“DMF”) to treat certain neurodegenerative disorders.  Ixchel did not have the resources to develop these drug treatments independently so in 2016, it entered into a “Collaboration Agreement” with another biotech company, Forward.  Under the agreement, Forward and Ixchel would work together to develop and test a potential new drug and they eventually began developing a plan for a trial study.

During that same time, Forward was involved in a patent dispute with another biotech company, Biogen, that related to the use of DMF in certain drugs.  Biogen and Forward agreed to settle their dispute and enter into a settlement and license agreement. That agreement contained a provision (section 2.13) that required Forward to terminate its collaboration agreement with Ixchel and refrain from contracting with anyone to develop drugs with DMF. (Biogen was apparently worried that Forward’s work with Ixchel (and/or others) would lead to the development of competing pharmaceutical drugs).

After entering into the settlement with Biogen, Forward notified Ixchel that it was terminating the Collaboration Agreement.  Ixchel claimed that after Forward’s termination, it was unable to find a new partner to help with the development of its pharmaceutical drug.

As a result, Ixchel sued Biogen alleging a variety of claims in connection with Forward’s termination of the collaboration agreement.  The Federal district court granted Biogen’s motion to dismiss the complaint but granted Ixchel leave to amend its complaint.  Ixchel then amended its complaint to allege, among other things, that Biogen violated section 16600 of the Business and Professions Code by entering into the settlement agreement with Forward that contained section 2.13.  The district court again dismissed Ixchel’s complaint, ruling that section 16600 did not apply outside employment matters.  Ixchel appealed this decision to the Ninth Circuit which, after oral argument, asked the California Supreme Court to answer some legal questions about the state of California law in order to provide it guidance to rule on the matter.  One of these questions that the Ninth Circuit certified to the California Supreme Court: “Does section 16600 of the California Business and Professions Code void a contract by which a business is restrained from engaging in a lawful trade or business with another business?”

Ixchel claimed that section 2.13 of the Forward/Biogen settlement agreement violated section 16600 which provides:  “Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void.”  The California Supreme Court began by reframing the question that had been certified to it by the Ninth Circuit.  It determined that the question as framed of whether section 16600 applied to contracts in the business context was not really in dispute.  In fact, Biogen had acknowledged as much at oral argument before the Ninth Circuit.  Rather, the issue that the California Supreme Court felt needed to be addressed was whether “contractual restraints on business operations or commercial dealings are subject to a reasonable standard under section 16600” or were per se in valid as in the employment context following the Edwards decision.

Biogen urged the California Supreme Court to apply the rule of reason similar to what is used to analyze antitrust violations in considering section 2.13 of the settlement agreement.  The California Supreme Court recognized that this analysis focuses on “whether an agreement harms competition more than it helps” and requires courts to look at the following factors: (1) the facts peculiar to the business in which the restraint is to be applied; (2) the type of restraint at issue and its effects; (3) the history of the restraint; and (4) the reason for the restraint’s adoption by the parties.

Ixchel, on the other hand, argued that the Court should not apply a reasonableness standard but rather to extend the Court’s 2008 Edwards decision “and hold that any contract in restraint of trade is per se void.”  The California Supreme Court recognized that reading section 16600 “in isolation” might support such an argument. However, the Supreme Court cautioned that when considering statutes, the Court was required to analyze the statute by considering “the statutory framework as a whole in order to determine its scope and purpose.”  In doing so, the Supreme Court recognized that “section 16600 is best read not to render void per se all contractual restraints on business dealings, but rather to subject such restraints to a rule of reason.”

The Court turned its attention to the history of section 16600 recognizing that its predecessor, Civil Code section 1673, had been enacted in 1872 “against the back drop of well-established common law prohibitions against restraints of trade.”  In fact, section 16600’s predecessor should be considered in connection with another antitrust statute, California’s Cartwright Act, which the Court had previously “construed to permit reasonable restraints of trade.”  Thus, the Court believed that it would be consistent to apply a reasonableness standard in considering business contracts under section 16600 similar to agreements that could raise antitrust issues under the Cartwright Act.

The Court also looked at the legislative history to section 16600 and its predecessor, Civil Code section 1673.  In enacting section 1673 in 1872, the legislature “did not go so far as to say that Civil Code former section 1673 categorically replaced the common law standard of reasonableness with a per se [invalid] rule.”

In addition, the Court recognized that during the next half century, it had never invoked a per se invalidity rule on contractual restraints on business operations and commercial dealings.  Rather, throughout this time, the Court had “generally declared agreements in this context valid if the restraints they imposed were reasonable.”  In those cases where the Court invalidated a contractual provision that restricted trade, it did so after conducting a reasonableness inquiry and finding the contracts “to be invalid when their purpose was to restrain trade by creating a monopoly, restricting supply, or fixing prices.”

The Court noted that although it had gradually evolved to evaluate contractual restraints in business contracts under a reasonableness standard, it had “often interpreted the statute more strictly when it came to agreements not to compete after the termination of employment or the sale of interest in a business.”  This line of cases culminated with the Court’s 2008 decision in Edwards.  In declining Ixchel’s invitation to extend Edwards beyond the employment context to commercial contracts, the Court reasoned, “it is axiomatic that language in a judicial opinion is to be understood in accordance with the facts and issues before the Court” in a particular case.  Furthermore, the Court’s rationale in Edwards was focused largely on issues relating to employee mobility and competition in the marketplace.  Thus, the California Supreme Court concluded that its holdings in Edwards and prior employment-specific cases should not be extended to similar restrictions in commercial dealings.

The California Supreme Court was also aware that if it adopted Ixchel’s argument, this could have severe consequences and require it “to invalidate all contracts that limit the freedom to engage in commercial dealing.”  The Court noted that businesses often engage in legitimate partnerships and exclusive dealing arrangements or franchise arrangements “which limit the parties’ freedom to engage in commerce with third parties.”  These types of arrangements allow businesses to maximize their complimentary capabilities; ensure stability and supply/demand; and protect R&D and marketing efforts from being exploited by their contractual partners.  The Court recognized that such arrangements “can have pro-competitive effects” by allowing for “long term planning, giving protection against price fluctuations and offer predictable marketplaces.”  Faced with the potential consequences of adopting Ixchel’s reasoning, the California Supreme Court concluded, “We decline to construe section 16600 to call such arrangements into question simply because they restrain trade in some way.”

Thus, under California law, non-compete provisions in an employment contract/context will continue to be struck down unless they fall within one of the statutory exceptions to section 16600 such as the protection of the value of goodwill in connection with the sale of a business interest.  However, restrictive covenants in commercial contracts, such as exclusive distributorship or franchise agreements, will be enforced provided they pass the rule of reasonableness.

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.

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