Notes & Comment
Vol. 2007, No. 2
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Business Law
Broad "No-Hire" Clauses Sent Packing
A common feature in many business contracts today is a "no-hire", or non-solicitation clause. This provision seeks to protect an employer's investment in its skilled work force by restricting a second company it's doing business with (a vendor, client or customer) from getting a "free look" at its valuable, trained employees and hiring them away without consequence. "No-hire" provisions with liquidated damage formulas are an accepted device often written into contracts between, for instance, professional service companies and their clients.
Two recent California Court of Appeal decisions from the same appellate panel cast doubt on the enforceability of all but the narrowest no-hire clauses in California. Striking down broad non-solicitation provisions in different contexts, these two decisions set aside conventional wisdom that freely negotiated no-hire clauses between companies are presumptively valid. VL Systems, Inc. v. Unisen, Inc. (Civ. No. G037334, California Court of Appeal, Fourth Appellate District (June 25, 2007)); Strategix, Ltd. v. Infocrossing West, Inc., 142 C.A.4th 1068 (California Court of Appeal, Fourth Appellate District (September 11, 2006)).
The VL Systems Case
VL Systems, Inc. (VL), a technology consulting firm, signed a consulting agreement with Star Trac (Client) in which the Client promised not to hire away any VL employees for 12 months after the contract's termination unless the Client paid VL liquidated damages. The relationship was good, VL satisfactorily completed the work and the consulting contract was eventually terminated.
Thereafter, the Client hired away an employee of VL. He'd only worked for VL a short time, wasn't employed by VL when the VL-Client contract was signed or when VL performed work for the Client, and he'd applied to the Client in response to an Internet job posting - the Client hadn't solicited him. When VL learned he'd been hired away, it sent the Client an invoice for liquidated damages according to the no-hire provision of the consulting contract. The Client refused to pay and VL sued for breach of contract. The trial court enforced the no-hire clause but reduced the amount of liquidated damages awarded to VL. On appeal, the court reversed, holding that the no-hire provision was unenforceable.
California strictly forbids most "non-compete" covenants between employees and employers as against public policy. Citing cases from Wisconsin and South Dakota, the court here extended this principle to broad no-hire provisions such as between VL and the Client. If enforced, the provision in this case would prevent VL's ex-employee from taking a job with the Client, even though he had no prior dealings with the Client on behalf of VL. In fact, he wasn't even employed by VL when the no-hire contract was signed or when VL did work for the Client.
While freedom of contract, including the right of companies to bargain for no-hire clauses, is an important commercial interest, the court rejected a no-hire clause that "seriously impact[s] the rights of a broad range of third parties." Though courts have approved "narrowly drawn [no-hire] provisions which might limit the employment mobility of nonparties", the provision in this case, wrote the court, "goes far beyond what is necessary to protect [VL's] legitimate interests and results in a situation where the opportunities of employees are restricted without their knowledge and consent." This no-hire clause was deemed unenforceable, and the award of liquidated damages to VL was vacated.
The Strategix Case
Strategix and related companies (Strategix) agreed to sell assets, including good will, to SMS, and the parties signed an asset purchase agreement and a consulting agreement. The contracts included a non-solicitation provision that barred Strategix (the seller) from offering jobs to SMS's (the buyer's) employees for one year after the consulting agreement ended. The relationship then fell apart, Strategix terminated both agreements, and litigation followed. The trial court enjoined Strategix from soliciting SMS's employees, as the contract said, and Strategix appealed. The appellate court reversed.
In California, covenants not to compete are enforceable as part of a sale of good will; this principle prevents a seller from immediately setting up a new business to compete with the buyer. Further, a no-hire clause is appropriate when it's designed to stop that same seller from hiring away employees of the business it just sold.
In the Strategix case, however, the no-hire provision applied to all employees of SMS, not just employees of the business that Strategix just sold. It covered SMS's employees who didn't even work in the Strategix business. Since it affected the job mobility of SMS employees unrelated to the Strategix business that SMS had bought, the no-hire provision agreed to between Strategix and SMS was unenforceable.
Summary and Conclusion
In most contract negotiations, the parties usually don't stop to craft a narrowly drawn no-hire clause. Such provisions are often mutual, broad in scope and intended to prevent poaching by one company of any skilled employees of the other. Promoting the individual interests of each company's respective employees is rarely a consideration.
The VL Systems and Strategix cases, however, demonstrate that when California courts construe no-hire provisions in the future, the clauses' impact on particular employees will be taken into account and their individual interests may be given more weight than the freedom of two companies to contract for such provisions. If a no-hire provision narrowly protects a business buyer by barring a business seller from poaching employees just of the sold business (Strategix), or narrowly applies just to those employees of a service provider who worked on the poaching customer's account (VL Systems), the no-hire clause may be enforceable even if it forecloses job opportunities to some. If, on the other hand, such a provision indiscriminately applies to all employees of a company, not just those working in the sold business (Strategix), or also applies to employees who weren't employed when the no-hire contract was signed and/or never worked on the relevant customer account (VL Systems), the no-hire provision may be unenforceable as a violation of public policy in California.
These two cases don't hold that no-hire/non-solicitation provisions are always unenforceable or are fundamentally contrary to public policy. Instead, they perhaps suggest that companies wishing to impose enforceable no-hire clauses on their commercial partners must give such provisions careful thought, and, at least in California, that companies should draft targeted and focused no-hire clauses impacting a specific category of employees, not broad, far-reaching ones impacting tangential personnel.
© Matthew Joseph 2007. Law Offices of Matthew Joseph, San Mateo, California, practices in the areas of intellectual property licensing, commercial real estate leasing, and corporate and business transactions. No legal advice is intended by the information provided herein and recipients should independently consult counsel before taking any action related to this subject matter.