California Supreme Court Clarifies Standards for B2B Non-Competition Agreements and Disputes in California

This week, on August 3, 2020, the California Supreme Court issued its opinion in Ixchel Pharma, LLC v. Biogen, Inc.[1], which resolved two questions regarding the standards to be applied for non-competition agreements and disputes between businesses in California. The first was whether a plaintiff in a dispute between businesses is required to plead an independently wrongful act in order to establish a claim for tortious interference with a contract that is terminable at-will, to which the court responded, yes. The second question was what is the proper standard for determining whether California Business and Professions Code section 16600 (Section 16600) voids a non-competition agreement between two businesses, to which the court responded, the Rule of Reason.

In addressing the first issue, the court noted that in Reeves v. Hanlon, 33 Cal.4th 1140 (2004), it had held that a plaintiff was required to plead independent wrongfulness to a state a claim for interference with a specific category of at-will contracts: employment contracts. In Ixchel, however, the court declined to limit Reeves solely to the employment context, noting that “the broader logic underlying the decision is persuasive with respect to other spheres of economic relations.” Agreeing with the district court, the court reasoned that a claim for tortious interference with an at-will contract is more closely analogous to a claim for tortious interference with “prospective relations,” which requires a showing of an independently wrongful act, than to a claim for tortious interference with contractual relations, which does not require a showing of an independently wrongful act.[2] 

In addressing the second issue, the court acknowledged arguments that Section 16600 did not apply outside of the employment context, but then conclusively held that Section 16600 applies to contracts between businesses as well.  In doing so, the court explained that the business exceptions included in the statute, such as the exception for noncompetition agreements upon the sale of goodwill or ownership interest in a business, would be unnecessary if the statute did not apply to businesses. The court proceeded to find, as had the district court, 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.”[3] The court expressly declined to hold that non-competition agreements between businesses were per se unenforceable under Section 16600 (as with non-competition agreements in the employment context)[4]. The court opined that in certain circumstances, contractual limitations on the freedom to engage in commercial dealings can promote competition, and in multiple points in the unanimous opinion noted the principle of fostering commercial activity and limiting any chilling effect on legitimate business competition.  

Background

Plaintiff Ixchel Pharma, LLC (Ixchel), a biotechnology company, entered into a Collaboration Agreement in 2016 with Forward Pharma (Forward) to jointly develop a drug with dimethyl fumerate (DMF) as an active ingredient for the treatment of Friedreich’s ataxia. That agreement was terminable at any time upon 60 days’ advance notice. Forward subsequently entered into a settlement and licensing agreement with Defendant Biogen, Inc. (Biogen), that among other things required Forward to stop collaborating with Ixchel or any other entity, to the extent the engagement was related to the development of any pharmaceutical product having DMF as an active ingredient for the treatment of human diseases, including Friedreich’s ataxia.  Per its agreement with Biogen, Forward agreed to terminate its contract with Ixchel.

Ixchel sued Biogen in federal court, alleging that Biogen tortiously interfered with its contractual and prospective economic relationship with Forward and that the non-compete provision in its settlement and licensing agreement with Biogen effectively prohibiting Forward from engaging in its entire business or a substantial part of it in violation of Section 16600.

B2B At-Will Contracts Less Protected Than B2B Contracts for a Definite Term

As outlined in the court’s opinion, the interest in maintaining open competition is stronger than the expectation of future business relations. Therefore, absent an independent, wrongful act, a business can induce another business to sever its at-will agreement with a third party and it will not be found liable for tortious interference with contractual relations. In particular, the court observed that at-will contracts do not involve the same cemented economic relationships as contracts of a definite term, stating:

The contracting parties presumably bargained for these terms, aware of the risk that the relationship may be terminated at any time. At-will contractual relations are thus not cemented in the way that a contract not terminable at will is. The interest in protecting the contract from interference more closely resembles the interest in protecting prospective economic relationships than the interest in protecting a contractual relationship that, by its terms, is expected to continue on pain of breach.

Highlighting the potential threat to lawful competition, the court stressed that “allowing interference with at-will contract claims without requiring independent wrongfulness risks chilling legitimate business competition.”[5] 

B2B Non-Competes Enforceable Under Section 16600 Subject to Rule of Reason

In Ixchel, the court confirmed 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.”[6] The rule of reason inquiry asks 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.[7]

The court reasoned that “[b]usinesses 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.”[8]

The court did not reach a determination on the reasonableness of the restraint in this case, leaving that issue for lower court resolution.

Takeaways

• The court confirmed that non-competes between businesses are not held to the same standard as non-competes with employees under Section 16600. Employment non-competes are per se invalid, whereas businesses can enter into non-compete agreements with each other that will be deemed valid by the courts provided they are reasonable in scope.
• The court declined to decide whether the specific non-compete in Ixchel was reasonable enough to be enforced, so trial courts retain discretion in determining what B2B restraints are deemed reasonable.
• Ixchel may signal a greater willingness to permit restrictive covenants that promote competition. For example, the court discussed approvingly a previously upheld restraint that required a business agree to purchase whiskey exclusively from another whiskey distillery in exchange for being the sole merchant of that particular whiskey in California.[9] 
• It will be interesting to see if COVID-19 and its economic ramifications factor into any court determination of what restraints may be reasonable going forward. 
• Similarly, while the non-compete at issue in Ixchel in the B2B context, it remains to be seen how it may impact the enforceability of non-competition, non-solicitation, and no hire agreements in the employment context.

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

[2]Id. at *19 (emphasis added).

[3] Ixchel at *18.

[4] Noting that the question of whether noncompetition agreements outside the employment context were per se invalid had not been presented in Edwards v. Arthur Andersen LLP, 44 Cal.4th 937 (2008).

[5] Ixchel. at *8.

[6] Id. at *10 (emphasis added).

[7] Id.

[8] Id. at 17.

[9] Discussing Great Western Distillery Products v. John A. Wathen Distillery Co., 10 Cal.2d 442 (1937) (applying the predecessor statute to Section 16600).