California Business and Professions Code §16600 ("Section 16600") provides that except as otherwise provided, "every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void".

Twelve years ago, in Edwards v. Arthur Andersen LLP, the California Supreme Court applied the statute literally to invalidate a "limited" restriction imposed by a former employer where the former employee was purportedly restricted from performing services for certain enumerated clients for which the employee had performed services while in the employ of his former employer (as opposed to a broader restriction which might have purportedly restricted the former employee from providing any competitive services to any person).

On August 3, 2020, the California Supreme Court issued its opinion in Ixchel Pharma, LLC v. Biogen, Inc. The Court now considered whether Section 16600 should be applied literally to a restriction that did not involve an employee, but rather to a restriction agreed to between two companies.

Ixchel Pharma, LLC ("Ixchel") had a contract with Forward Pharma ("Forward") to jointly develop a drug which ultimately might have been competitive with a drug supplied by Biogen, Inc. ("Biogen"). The Ixchel-Forward contract was terminable without cause on sixty days' notice by either party. Forward had an unrelated business dispute with Biogen. As part of the settlement of that dispute, among other provisions, Biogen paid Forward a significant settlement; Forward granted certain patent licenses to Biogen; and Forward agreed to terminate its contract with Ixchel, and not to do further business with Ixchel.

After termination of the Ixchel-Biogen contract, Ixchel sued Biogen for tortious interference with contract and tortious interference with prospective economic advantage. Since the Ixchel-Forward contract was terminable without cause on sixty days' notice, the Court viewed the contract as similar to a situation where no contract existed; specifically, this required Ixchel, in order to move forward with its case, to show that Biogen had committed an independent wrongful act. Ixchel claimed that the independent wrongful act was a breach of Section 16600 committed by Biogen in connection with Biogen's having Forward agree to terminate the Ixchel-Forward agreement.

The Court acknowledged that the provisions of the Forward-Biogen settlement agreement did place a restriction on Forward's activities—so, if Section 16600 were applied literally, the restriction would be void. Nonetheless, the Court declined to apply Section 16600 literally as it had done in Edwards (although it did not overrule Edwards, pointing out that Edwards was a case where a former employee was subject to a restriction, and that such restrictions in the case of an employee ought to continue to be judged by a per se standard).

Rather, the Court held that the restriction placed on Forward in the Biogen-Forward settlement should be analyzed under a rule of reason approach, which is the approach taken to analyze antitrust violations under the Cartwright Act. That inquiry requires the Court to consider "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". Under a rule of reason approach, contracts with the purpose and effect of promoting trade and competition can be valid, even if their terms incidentally restrain commercial freedom in some way.

In applying a rule of reason approach, the Court stated that the case "presents an important question of California law, potentially affecting all contracts in California that in some way restrain a contracting party from engaging in a profession, trade or business"; and that it was "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". The Court pointed out that such a literal approach would jeopardize many commercial arrangements, such as franchise agreements, distributorship agreements, and requirements and output agreements, which typically include certain restrictions on the parties, but which promote competition. Such arrangements can help businesses leverage complementary capabilities; ensure stability in supply and demand; and protect research, development and marketing efforts from being exploited by contractual partners--thereby enabling businesses to effect long-term planning and a predictable market, reduced costs, stable long-term supply, incentives for the marketing of new products and a guarantee of quality-control distribution.

The upshot of this decision is that reasonable restrictions on activities in agreements between businesses (not in a employee context) will now be upheld—although a specific restriction could still be negated if a trier of fact (another court) views the restriction as anti-competitive, and consequently unreasonable.