Recent Developments in California Law: Restraint of Trade and California Business & Professions Code, § 16600

Rule of Reason

California Business and Professions Code § 16600 says that “[e]very contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void.” 

In a 2008 decision, the California Supreme Court held that § 16600 rejected the common law “rule of reasonableness” and appeared to rule that all contracts (other than those excepted by statute) restraining trade were invalid per se—no matter how reasonable they appeared to be. As a result, for the past several years, California courts have used § 16600 to invalidate non-compete and non-solicit provisions in agreements between employees and employers, or buyers and sellers of a business.

However, in August, the California Supreme Court decided Ixchel Pharma, LLC v. Biogen, Inc., in which it somewhat retreated from its earlier absolute view. In that case, the Court held that, in fact, a rule of reasonableness did apply to contractual restraints on business operations and commercial dealings.

The Ixchel Case

The plaintiff, Ixchel Pharma, was a biotechnology company that was developing a drug containing the active ingredient dimethyl fumarate (DMF) to treat a disorder called Friedreich’s ataxia (spinocerebellar degeneration).

Ixchel signed an agreement with drug company Forward Pharma to jointly develop a drug for the treatment of this rare genetic disease that causes difficulty walking, a loss of sensation in the arms and legs, and impaired speech. The drug development went according to plan until Forward withdrew from the agreement, which was permitted in the contract.

Pursuant to a settlement with another biotechnology company, defendant Biogen (Ixchel’s competitor), Forward agreed to terminate its contract with Ixchel. Ixchel then sued Biogen in federal court for tortiously interfering with its contractual and prospective economic relationship with Forward and claimed that Biogen did so in violation of California Bus. & Prof. Code, § 16600.

The U.S. Court of Appeals for the Ninth Circuit certified two questions to the California Supreme Court, asking it to answer whether § 16600 voids a contract by which a business is restrained from engaging in a lawful trade or business with another business? And whether a plaintiff is required to plead an independently wrongful act in order to state a claim for intentional interference with a contract that can be terminated by a party at any time?… or does that requirement apply only to at-will employment contracts?

An Independently Wrongful Act Must Be Alleged

Associate Justice Goodwin Lui of the California Supreme Court wrote that “California has traditionally recognized two economic relations torts: interference with the performance of a contract […] and interference with a prospective economic relationship.”

The two torts are related but distinct, he explained. Tortious interference with contractual relations requires:

  • The existence of a valid contract between the plaintiff and a third party;
  • The defendant’s knowledge of that contract;
  • The defendant’s intentional acts designed to induce a breach or disruption of the contractual relationship;
  • Actual breach or disruption of the contractual relationship; and
  • Resulting damage.

It’s generally not required that the defendant’s conduct be wrongful apart from the interference with the contract itself.

However, tortious interference with prospective economic advantage doesn’t depend on the existence of a legally binding contract. In that situation, a plaintiff must show that the defendant knowingly interfered with an “economic relationship between the plaintiff and some third party, [which carries] the probability of future economic benefit to the plaintiff.”

Justice Lui explained, citing an earlier case that “[t]he purpose of the independent wrongfulness requirement in economic interference torts is to ‘balance between providing a remedy for predatory economic behavior and keeping legitimate business competition outside litigative bounds.’”

Justice Lui and the Supreme Court held that to state a claim for interference with an at-will contract by a third- party, the plaintiff must allege that the defendant engaged in an independently wrongful act. Because the plaintiff alleged that the defendant interfered with its at-will contract, it must allege that the defendant did so through wrongful means.

As a result, in this case, the Court held that Ixchel couldn’t sue Biogen for tortiously interfering with the at-will contract that existed between Ixchel and Forward without the required independently wrongful act.

The Rule of Reason Applies

The Court also held that a rule of reason applies to determine the validity of a contractual provision by which a business is restrained from engaging in a lawful trade or business with another business. The contract between Biogen and Forward was in fact a restraint “because it prevented the drug company from collaborating with plaintiff or any other partner in the development of treatments containing the active ingredient DMF. Its validity under Bus. & Prof. Code, § 16600, must therefore be evaluated based on a rule of reason.”

Therefore, the Court held that in the commercial context—as distinguished from the employment context—a “rule of reason” applies to determine the enforceability of a restrictive covenant such as the one at issue in the Ixchel case.

The broader logic underlying the Court’s earlier decision is persuasive with respect to other spheres of economic relations, Justice Liu wrote.

In adopting a rule of reason, the Supreme Court limited its earlier decision to the application of noncompetition agreements following the termination of employment or sales of interests in a business.

Takeaway

The California Supreme Court clearly stated that the state’s prohibition on restraints of trade isn’t restricted to only the employment context, but rather also applies to contractual restraints on business operations.

However, the Court expressly stated that contractual limitations on a business’s freedom to engage in commercial dealings are still valid so long as they satisfy the “rule of reason” standard by promoting competition overall. The Supreme Court “declined to categorically invalidate all agreements limiting the freedom to engage in trade.”

As a result, business agreements, such as partnerships, exclusivity contracts, supply contracts, franchise agreements, and output contracts will not conflict with California law because they restrain trade in some manner.

Questions on the Case and How It Applies to Your Business?

Contact the experienced attorneys at Eanet, PC to learn more about the changes to the law and the effect it may have on your business. Our experienced California employment law and business and commercial litigation attorneys can help your business with all your employment issues and business questions, including confidentiality and non-solicitation agreements.

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