California employment practice has been much in the news lately. First, Hewlett Packard sued its former chief executive officer Mark Hurd to prevent him from taking a job as co-president of Oracle. HP had previously fired Hurd over expense account indiscretions and allegations of sexual harassment and paid him a hefty severance in HP stock. The theory of the lawsuit was that Hurd would inevitably use or disclose HP trade secrets in his work for Oracle. Another news item was the Justice Department’s Antitrust Division charge that six big tech companies — Apple, Google, Intel, Adobe, Intuit, and Disney/​Pixar — colluded not to recruit each other’s employees via cold calls.

Both cases have now been settled. But what is puzzling is that they arose in the first place. A simple non-compete agreement would have been enough to prevent Hurd from going to work for Oracle or to prevent cross-border workforce raids. Did the lawyers whiff? And why is that other tech giant, Microsoft, curiously absent from the list of offending companies?

Good for tech? | The answer to this puzzle is that, under California law, a non-compete agreement is unenforceable because of a statute the state adopted shortly before it joined the Union in 1850. (The only other state that bans such agreements is North Dakota.) So instead of contractually binding Hurd not to go to work for one of HP’s competitors, HP was forced into the fallback position of arguing that the courts should block Hurd’s joining Oracle because, if he were to do so, he would disclose HP trade secrets to his new employer.

There is nothing new about this tactic. California firms have sought to end-run the law in this way many times. They seldom succeed.

It may seem odd that California — a state whose economy depends on intellectual property and the home of Silicon Valley — would have prospered under such a law. How can a business hope to succeed if employees are free to come and go with the know-how they acquire on the job?

Ironically, it seems the law may be quite good for business — especially the technology business. Arguably, the law prohibiting non-compete agreements was a major factor in the rise of Silicon Valley (and possibly the demise of Boston’s Route 128 technology corridor). The techie tendency to job-hop may have led to sharing information and know-how that facilitated more rapid innovation than would otherwise have been possible. (For more, see “Should Noncompetes Be Enforced?” p. 6.)

Moreover, and perhaps even more important, California companies have had to find other ways to keep their employees from running off with the competition. It turns out that equity compensation is a far better way to assure the loyalty of employees than a non-compete agreement. An employee who receives stock or options as part of his compensation package usually cannot sell until a year or more has elapsed. In addition, stock and options are forfeit in most cases if the employee leaves the company.

Needless to say, this system works fine as long as the employees think the company will prosper. But if the employees have no faith that the business will succeed, equity compensation will do little to keep them around. One might see this as a shortcoming of equity compensation. With a non-compete agreement, a struggling business can keep its employees from abandoning ship by preventing them from joining the competition. But what is the sense in that? Do we not want employees to exit unpromising ventures sooner rather than later, thus allocating human resources more quickly and efficiently? This may be uniquely important in the computer industry where there is danger of developing a technology that is obsolete before it even gets to market. But it makes sense for all business.

This is not to say that the only effect of equity compensation is to induce the rats to leave a sinking ship. Equity compensation is just as likely to lead rats onto a ship that can be saved if the prospect of gain is significant. Indeed, one might prefer to sign on with a company whose stock price is depressed. If the business has promise, they will come — or stay. Equity compensation induces an employee to focus on how his efforts will contribute to the success of the business. Moreover, it induces employees to keep an eye on each other. If the value of my options depends on how you do your job, peer pressure is likely to rise. And when employers understand that it is important for employees to have faith in the firm, it even induces employers to listen to employees.

But wait. There’s more.

Equity compensation saves cash and thus permits startups to compete for talent more vigorously than would otherwise be possible. In contrast, an employee who must agree to a non-competition agreement must in effect invest more of his human capital in the venture and thus will insist on more pay.

In addition, equity compensation forces the company to seek liquidity. If a company does not go public or get sold, employees cannot ever cash out. One might argue that it is not necessarily a good thing to start a business with the primary goal of selling it. But one cannot sell a business unless it produces something of value. So the need to plan for liquidity keeps a business focused on what matters.

Some critics have suggested that technology companies have used equity compensation too liberally, arguing that few employees can have much effect on stock price. But is it not a bigger problem when employees cannot have much effect on stock price? Yet another advantage of equity compensation is that it induces firms to maintain an efficient size. If a firm grows too large, too diversified, or too unfocused, equity compensation will become less attractive for employees who see less connection between their work and the bottom line. Thus, equity compensation will tend to induce spin-offs and other divisive transactions when they make sense.

In the end, a non-compete agreement simply cannot compete with equity compensation. A carrot always beats a stick.

End run | Although the ban on non-compete agreements has served California well, it has not stopped California companies from seeking to handcuff employees using the trade secret theory as an end run. Although business prospers if all agree to eschew non-compete agreements, it is thus all the more in the interest of an individual employer to restrain his own employees if he can. So law matters here. Employers would never agree to forgo the supposed benefits of non-compete agreements. And if they did, they would have every incentive to cheat.

To be fair, HP had little choice but to sue Hurd. For the HP board of directors to do nothing would have been seen as a breach of fiduciary duty. Moreover, HP may really possess specific trade secrets that need protection. But if so, HP could have insisted that Hurd agree not to work for specified competitors, as did Carly Fiorina when she left HP. That agreement was probably enforceable under California law, which bans only contracts that prohibit an employee from engaging in a lawful profession, trade, or business in any capacity.

Fortunately, the California courts have had little difficulty seeing the inevitable disclosure theory for what it is: an after-the-fact agreement not to compete that restricts employee mobility and that constitutes a threat to a public policy that has served the state well since 1850. Nevertheless, to mangle Oliver Wendell Holmes, the Hurd case threatened to make some bad law. If HP had prevailed, it could have set a precedent that other employers could use at will.

Non-compete partnership? The Justice Department case against the six big tech companies was an equally important victory for the cause of innovation. The defendant companies argued that without an agreement not to cold call competitor employees, it would have been impossible to enter into various joint ventures. It may also be that, as partners, the companies assumed a duty to each other not to take advantage of the situation.

It is unlikely that the Justice Department would have been much impressed by that argument given the recent Supreme Court decision in American Needle that seems to limit the single entity defense, such as in the production of hats and other logowear. In other words, the big six could have argued that since it was legal for them to form partnerships with competitors for the purpose of developing new products, it should also be legal to agree not to compete with each other for employees. If indeed they were partners, then they would owe a fiduciary duty to each other that might have precluded them from raiding each other’s work force. If they did owe each other such a duty, then presumably a contract that spells out a duty that already exists would be permissible. But maybe not. That was essentially the argument that the Supreme Court rejected in American Needle. That the teams comprising the National Football League need to collaborate to produce football games does not imply they are free to restrain trade in other ways where it may not be necessary to do so.

Still, the case against the six big tech companies illustrates the worrisome possibility that, even in California, employers may try to avoid the law against non-compete agreements simply by agreeing not to hire competitor employees. In contrast, Microsoft, which is based in Washington state, can and does require its employees to sign a non-compete agreement. So Microsoft has no need to collude with competitors about hiring, though it would probably be legal for Microsoft to do so anyway. After all, every (legal) contract is a restraint of trade. So no harm, no foul.

The bottom line is that California and the cause of innovation dodged a couple of bullets. As we all know, California is different. Let us hope it stays that way. To mangle another Wendell — Phillips, in this case — eternal vigilance is the price of being different.