California Supreme Court Clarifies Pleading Requirements for Claims of Tortious Interference with At-Will Contracts

Called upon by the Ninth Circuit in Ixchel Pharma, LLC v. Biogen, Inc. to answer two key questions concerning the validity of a settlement provision requiring a party’s termination of a collaboration agreement with a third-party, the California Supreme Court unanimously held:

to state a claim for tortious interference with an at-will contract, a plaintiff must allege that the defendant engaged in an independently wrongful act, and
in determining the validity of a competitive restriction in a business-to-business agreement under Business and Professions Code section 16600, the rule of reason applies and such restriction is not per se void.

The Court’s decision will impact how companies contracting under California law decide to set up their contracts and whether they will agree to the at-will termination of such contracts. The decision also provides some clarity for businesses that include competitive restraints with their other companies in their commercial dealings, such as exclusive dealing and collaboration agreements, licenses, leases, and franchise agreements, as such restraints are not per se void under Section 16600 but subject to a rule of reason analysis.

The Ixchel-Forward Collaboration Agreement

Assuming the truth of the allegations in Ixchel’s complaint, the Court observed that Ixchel Pharma, LLC and Forward Pharma entered into a Collaboration Agreement in 2016. The purpose of the Collaboration Agreement was to develop a drug using dimethyl fumarate (DMF) to treat Friedreich’s ataxia, a rare neurodegenerative disorder. Under the terms of the Collaboration Agreement, Ixchel assigned certain patent rights to Forward in exchange for Forward’s assistance in investigating and funding clinical trials for the drug and, depending on the success of the trials, manufacturing and commercializing the drug. Importantly, the Collaboration Agreement permitted Forward to terminate the agreement “at any time” with 60 days’ advance notice to Ixchel, and permitted Ixchel to terminate the agreement if Forward would not conduct clinical trials or failed to timely submit an application to the Food and Drug Administration. Forward confirmed the feasibility of conducting clinical trials in October 2016 and began planning a trial study.

The Forward-Biogen Settlement

During this time, Forward was also in the process of resolving a patent dispute with Biogen, Inc., involving the use of DMF (the same active ingredient being used under the Collaboration Agreement with Ixchel) to treat multiple sclerosis. Forward and Biogen eventually reached a settlement, pursuant to which Biogen agreed to pay Forward $1.25 billion for a license to certain of Forward’s patents “and other intellectual property.” The settlement and license agreement further required Forward to “terminate any and all existing, and not enter into any new, Contracts or obligations to Ixchel Pharma LLC ... related to the development ... of any pharmaceutical product having dimethyl fumerate ... for the treatment of a human for any indication, including Friedreich’s ataxia.” Following the settlement, Forward provided Ixchel 60 days’ notice of termination as required under the Collaboration Agreement.

Biogen’s Motion To Dismiss

Without Forward or a suitable replacement partner, Ixchel was unable to develop the drug, and filed suit against Biogen in the Eastern District of California, asserting federal and state antitrust violations under 15 U.S.C. § 1 and Bus. & Prof. Code §§ 16700, et seq., tortious interference with contractual relations, intentional and negligent interference with prospective economic advantage, and violations of California’s unfair competition law (Bus. & Prof. Code §§ 17200, et seq.). The district court granted Biogen’s motion to dismiss as to each of Ixchel’s claims.

More specifically, the district court concluded that Ixchel “had failed to state a claim for interference with prospective economic advantage [or with contractual relations] because Ixchel did not plead that Biogen engaged in an independently wrongful act” and because the contract at issue was one terminable at will. Ixchel Pharma, LLC v. Biogen, Inc., No. 2:17-cv-00715-WBS-EFB, 2017 WL 4012337, at *4-5 (E.D. Cal., Sept. 12, 2017). Ixchel later amended its complaint to allege that Biogen’s independently wrongful act was restraining trade (via the settlement with Forward) in violation of Bus. & Prof. Code Section 16600. The district court again dismissed the complaint, finding that the Forward-Biogen Agreement must be analyzed under the antitrust rule of reason and that Section 16600 does not apply outside the employment context. Ixchel appealed, and the Ninth Circuit certified the underlying issues to the California Supreme Court.

Analysis

The Court began its analysis with a detailed examination of the history of California law on tortious interference claims.

Interference with at-will contracts and the independent wrongfulness requirement

The Court first noted that “[w]e have long recognized that interference with at-will contracts is actionable as an economic tort.” (Citing Pacific Gas & Elec. Co. v. Bear Stearns & Co., 50 Cal. 3d 1118, 1127 (1990)). However, the Court acknowledged that whether interference with an at-will contract “more closely resembles” a claim for interference with contractual relations, or one for interference with prospective economic advantage remains a separate question, which the Court had partially addressed in Reeves v. Hanlon, 33 Cal. 4th 1140, 1145 (2004). In Reeves, the Court held that a plaintiff must plead independent wrongfulness to state a claim for interference with at-will employment contracts, based on the rationale that such a requirement promotes the public policies supporting the right of at-will employees to pursue opportunities for economic betterment and the right of employers to compete for talented workers. Reeves at 1145-51; see also Della Penna v. Toyota Motor Sales, U.S.A., Inc., 11 Cal. 4th 376, 392 (1995).

Extending its reasoning in Reeves, the Court compared at-will contracts to both existing contracts and prospective economic relations. Although the Court recognized that parties to an at-will contract have somewhat greater interests than those without a contract at all, it concluded that parties to at-will contracts ultimately have “no legal basis to expect the continuity of the relationship or to make decisions in reliance on the relationship.” See Rest. 2d Torts § 766, com. g, § 768, com. i (“One’s interest in a contract terminable at will is primarily an interest in future relations between the parties, and he has no legal assurance of them. For this reason, an interference with this interest is closely analogous to interference with prospective contractual relations. If the defendant was a competitor regarding the business involved in the contract, his interference with the contract may not be improper.”) (Emphasis added). The Court stated that from the perspective of third parties, there is no legal basis in either case to expect the continuity of the relationship or to make decisions in reliance on the relationship. The Court further reasoned that allowing interference with at-will contract claims without requiring independent wrongfulness risks chilling legitimate business competition.

When is a competitive restriction in a contract between businesses void under Section 16600 (and therefore an independently wrongful act)?

The Court then addressed the issue of what standard to apply when evaluating competitive restrictions in business-to-business contracts under Section 16600, similarly beginning its analysis with a detailed discussion of historical interpretation.

As an initial matter, though not disputed by the parties, the Court held that Section 16600 applies to competitive restrictions in contracts between businesses. Then, taking into account the history of Section 16600 and its predecessor, Civil Code former section 1673, the Court concluded 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. See Great Western Distillery Prods. v. John A. Wathen Distillery Co., 10 Cal. 2d 442, 446 (1937) (“[I]t may be stated as a general rule that courts will not hold to be in restraint of trade a contract between individuals, the main purpose and effect of which are to promote and increase business in the line affected, merely because its operations might in some theoretical way incidentally and indirectly restrict trade in such line.”). The Court stated that its decisions interpreting Civil Code former section 1673 gradually evolved to evaluate contractual restraints on business operations and commercial dealings based on a reasonableness standard but often interpreted the statute more strictly when it came to agreements not to compete after the termination of employment or the sale of an interest in a business.

Since Civil Code former section was repealed and replaced with Section 16600, the Court stated that it has had occasion to construe section 16600 only in relation to contracts restraining competition after the termination of employment or the sale of interest in a business and that these cases have followed its earlier decisions by strictly construing the prohibition on restraint of trade in such contexts. The Court rejected Ixchel’s contention that under Edwards v. Arthur Andersen LLP, 44 Cal. 4th 937 (2008), any contract in restraint of trade is per se void: “[i]n context, 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 ... this court has interpreted section 16600 and its Civil Code predecessor on numerous occasions, and we have declined to categorically invalidate all agreements limiting the freedom to engage in trade.”

The Court explained that a rule of reason standard is not inconsistent with Edwards, which was “limited” to the context of employee non-competition agreements, and policy considerations “specific to employment mobility and competition”; “[n]othing about Edwards indicates a departure from that precedent to also invalidate reasonable contractual limitations on business operations and commercial dealings.” The rule of reason standard asks “whether an agreement harms competition more than it help 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.”

The Court indicated that its survey of its precedent reveals that it has long applied a reasonableness standard to contractual restraints on business operations and commercial dealings. The Court stated that it does not disturb the holding in Edwards and other decisions strictly interpreting section 16600 to invalidate noncompetition agreements following the termination of employment or sale of interest in a business. The Court, however, found that those cases do not call into doubt the applicability of a reasonableness standard to contractual restraints on business operations and commercial dealings.

The Court indicated that a rule of reason standard is further supported by Section 16600’s broader statutory context, given its shared “statutory purpose” and “doctrinal heritage” with the Cartwright Act (Bus. & Prof. Code §§ 16700, et seq.). The Court stated it is mindful of the consequences of strictly interpreting the language of section 16600 to invalidate all contracts that limit the freedom to engage in commercial dealing, reasoning that:

“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.”

Finally, according to the Court, a rule of reason standard balances the antitrust concerns underlying Section 16600 and 16700 against the benefits of “legitimate partnership and exclusive dealing arrangements” and potential procompetitive effects, e.g., “enable[ing] long-term planning on the basis of known costs, giv[ing] protection against price fluctuations, and ... offer[ing] the possibility of a predictable market.” In demonstrating the application of the rule of reason standard, the Court used examples of exclusive dealing arrangements, including such provisions in distribution and franchise agreements: “Franchise agreements often prohibit the franchisee from selling a third party’s products; requirements and output contracts restrain buyers and sellers respectively from doing business with third parties.” The Court stated that it declined to construe Section 16600 to call such arrangements into question simply because they restrain trade in some way. In reaching its conclusion, the Court stressed the importance of harmonizing the Cartwright Act and Section 16600, stating that they should be interpreted together. The Court did not reach the ultimate question of whether the settlement agreement at issue is invalid because the case is on appeal at the pleading stage. Upon remand, the Court indicated a determination of its validity under Section 16600 must be evaluated based on a rule of reason.

Takeaways

The California Supreme Court’s holding in Ixchel offers some reassurance for businesses that use competitive restrictions with other companies, e.g. exclusive dealing, distributorships, leases, collaboration agreements, licenses, and franchise agreements. While the Court rejected the per se approach advocated by Ixchel, and reiterated that it would not “categorically invalidate all agreements limiting the freedom to engage in trade,” businesses should carefully weigh the legitimate business interests of such restrictions with any anti-competitive effects (e.g. weigh the relative procompetitive vs. countervailing or anticompetitive effects of any relevant arrangements, and consider the potential impact of the arrangement on the market more broadly). The Court’s decision also opens the door as to whether some post-termination non-competition covenants in franchise agreements and similar business arrangements may be permissible in California.[1]

In addition, the Ixchel ruling provides guidance for businesses seeking to pursue claims for interference with at-will contracts, as the Court has expressly predicated liability on pleading (and proving) some independent wrongfulness. Businesses will want to carefully consider whether they want to have contracts that are terminable at will or want to have long term contractual arrangements.

[1] In Scott v. Snelling & Snelling, Inc., 732 F. Supp. 1034 (N.D. Cal. 1990), a district court in California held that post-termination covenant against competition contained in a franchise agreement relating to a California franchise unit was void under Section 16600.