California has long opposed noncompetition restrictions. In fact, Section 16600 of the California Business and Professions Code (CBPC) provides that "every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void." Except for a few narrow exceptions, California courts have refused to enforce post-termination covenants since they inhibit a person's ability to compete in the marketplace and earn a living.
Even though in-term covenants do not prevent a person from earning a living, California courts also have generally found them to be invalid under California law. One exception has been in-term covenants contained in franchise agreements. Until a recent decision by the U.S. Court of Appeals for the Ninth Circuit, in-term covenants had been enforced in the franchise context because of the unique and highly regulated nature of a franchise, in which the franchisor typically exercises substantial control over the franchisee.
In Comedy Club, Inc. v. Improv West Associates, 2007 WL 2556702 (9th Cir. Sept. 7, 2007), the Ninth Circuit concluded that an arbitrator's decision to uphold a broad in-term noncompetition restriction was contrary to California law. In that case, plaintiffs Comedy Club, Inc. and Al Copeland Investments, Inc. (collectively "CCI") entered into a Trademark License Agreement (which the Ninth Circuit characterized as a franchise agreement) that granted CCI an exclusive nationwide license to use Improv West's trademarks in connection with the opening and operation of Improv comedy clubs. As part of the Agreement, CCI was prohibited from opening any non-Improv comedy clubs during the term of the Agreement. In essence, the restriction prohibited CCI from opening any non-Improv comedy club anywhere in the United States for the remaining 14 year-term of the agrement.
CCI failed to meet its development schedule, which constituted a default of the Agreement, and Improv West terminated CCI's right to open more Improv comedy clubs. However, because CCI continued to operate comedy clubs under the Agreement, the Agreement itself had not been terminated. CCI sought a declaratory judgment that the in-term covenant was void under California law and that it had the right to open non-Improv comedy clubs.
The dispute ultimately went to arbitration, where the arbitrator found that the in-term covenant was valid and enforceable. Typically, an arbitrator's decision can be overturned only on limited grounds. Accordingly, it was not surprising when the decision was confirmed by the federal district court. On appeal, however, the Ninth Circuit found that enforcement of this in-term restrictive covenant would be in "manifest disregard of the law" because it foreclosed competition in a substantial share of the comedy club business. Consequently, the Ninth Circuit concluded that the covenant could be enforced only in those areas where CCI was operating an Improv comedy club.
Until this decision, the limited California case law had consistently enforced franchise agreement in-term restrictive covenants. For example, in Dayton Time Lock Service, Inc. v. Silent Watchman Corp., the California Court of Appeal considered the validity of a franchise agreement which prohibited the franchisee from competing with the franchisor during the term of the franchise agreement. 52 Cal. App. 3d 1 (1975). The court upheld that in-term noncompete, reasoning that "[e]xclusive-dealing contracts are not necessarily invalid. They provide an incentive for the marketing of new products and a guarantee of quality control distribution."
Subsequently, in Kelton v. Stavinski, a case involving a covenant not to compete signed by two partners, the California Court of Appeal clarified its holding in Dayton Time Lock, explaining that "[f]ranchising is a heavily regulated form of business in California . . . . [T]he franchisor retains some control over the franchisee." 138 Cal. App. 4th 941 (2006) The court stated further that "as part of that control, a franchisor may employ an 'exclusive-dealing contract' to promote and protect the franchise." Indeed, in Kelton, the California Court of Appeal explicitly stated that in-term restrictive covenants contained within franchise agreements are valid because of the unique and highly regulated nature of a franchise itself.
The Ninth Circuit took a different view of these cases, concluding that Dayton Time Lock and Kelton "make evident that under CBPC 16600 an in-term covenant not to compete in a franchise-like agreement will be void if it forecloses competition in a substantial share of a business, trade, or market." In other words, "in-term covenants not to compete cannot prevent a party from engaging in its business or trade in a substantial section of the market."
The Comedy Club court acknowledged that in-term covenants not to compete may be necessary in the franchise context "to protect and maintain the franchisor's trademark, trade name and goodwill." As a result, the court did not void the entire in-term covenant. Since the court considered the agreement between CCI and Improv West to be a franchise agreement, it weighed CCI's right to operate its business against Improv West's interest in protecting and maintaining its trademark, trade name and goodwill, and concluded that the covenant not to compete could be enforced only in areas where CCI was operating Improv comedy clubs under the Agreement. In all other areas, CCI could operate non-Improv comedy clubs.
Not surprisingly, Improv West has filed a petition for rehearing by the Ninth Circuit, along with a petition that all of the judges on the Ninth Circuit (and not just the three judges who initially heard the case) participate in the rehearing. The Court has yet to decide either motion.
Since many franchise agreements contain geographically broad in-term restrictions, if the Ninth Circuit fails to modify its decision, many franchisors will find it difficult to enforce their in-term restrictions in California, at least until California courts again address this issue.