In Comedy Club, Inc. v. Improv West Associates, 553 F. 3d 1277 (9th Cir. January 29, 2009), the Court recently held that in-term (during the term of contract/relationship) covenants not to compete in “franchise-like” agreements governed by California law are void if they foreclose competition in a substantial share of a business, trade, or market. The Court did not address whether broader covenants may be enforceable to the extent that they are necessary to protect trade secrets.

After obtaining a sweeping nationwide injunction from an arbitrator which enjoined licensee Comedy Club, Inc. (“CCI”) from opening any new comedy clubs nationwide until 2019, the Ninth Circuit modified the arbitrator’s injunction by significantly narrowing its scope and breadth. The arbitrator’s injunction was based on an in-term covenant not to compete in a trademark license agreement that prevented CCI and its affiliates (which included tangential relatives of CCI principals) from competing in the comedy club business anywhere in the U.S. until 2019. The Court narrowed the injunction’s scope and struck the inclusion of tangential relatives of CCI principals.

The Court found that the arbitrator’s injunction violated California Business & Professions Code Section 16600 (“CBPC § 16600”). CBPC § 16600 provides that “[e]xcept as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Regarding the injunction’s bar on affiliate competition, the Court found that “[p]recluding non-party relatives or ex-spouses from opening or operating improvcomedy- related businesses or restaurants violates CBPC § 16600. . . and that [b]y restricting non-party relatives and exspouses from engaging in a lawful business, the injunctions, with respect to those persons, exceed the arbitrator’s authority.”

Regarding the scope of the nationwide injunction, the Court stated that under California case law interpreting 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. According to the Ninth Circuit, California courts are less willing to approve in-term covenants not to compete outside the franchise context because the need to protect and maintain trademarks, trade names, and goodwill may not be present.

Under California case law, the franchisor-franchisee context was different from an employment or partnership context, said the Court. It found that CCI’s relationship with the licensor Improv West (“Improv”) was in essence a franchise agreement because CCI contracted with Improv to use Improv’s trademarks and open comedy clubs modeled on Improv’s clubs.  

After weighing CCI’s right to operate its business against Improv’s interest “to protect and maintain its trademark, trade name and goodwill”, the Court concluded that “this balance tilts in favor of Improv with regard to counties where CCI is operating an Improv club, but under the restraint of CBPC § 16600 California law does not permit an arbitrator to foreclose CCI’s competition in opening comedy clubs throughout the United States.” Accordingly, the Court upheld a more limited injunction that restricted competition by CCI and those persons in active concert or participation with CCI, but only in counties where CCI continued to operate comedy clubs using the licensed “Improv” name. Because the parties did not address its application, the Court did not address whether the in-term covenant could be upheld under the trade secrets exception to CBPC § 16600.  

The lessons from this important case are:  

  1. In-term covenants not to compete may be enforceable in the franchise context in California “to protect trademarks, trade names, and goodwill of a licensor” if they are narrowly tailored and do not foreclose a party from engaging in its business or trade in a substantial section of the market—the geographic scope should be the territory where the company or companies are doing business during the agreement. If franchisors can show that the in-term covenant is necessary to protect trade secrets, they may be able to support a broader covenant. Franchisors should review their agreements to ensure that they comport with the Court’s decision.  
  2. Businesses should use caution before utilizing any covenants not to compete in California and should assess whether the restriction on competition can be tied to one of the statutory exceptions to CBPC § 16600, to the protection of trade secrets, or the Court’s in-term “franchise” exception to section 16600. Businesses cannot assume that CBPC § 16600 does not have potential applicability to in-term covenants not to compete. However, employees still have a duty of loyalty to employers during employment.  
  3. Franchisors should not include overly broad definitions of “affiliates” in their franchise agreements in California. Courts will not enforce overly broad covenants that restrict non-party relatives from engaging in a lawful business because such covenants violate CBPC § 16600.  
  4. This decision can be used to support the position that in-term exclusive dealing contracts outside of the franchise context may be valid. However, such contracts will likely be held unlawful if they operate to foreclose competition in a substantial share of the affected business, trade, or market or are not necessary to protect genuine trade secrets.  
  5. This case highlights what the California Supreme Court made clear in a previous opinion: unless falling within one of few exceptions to CBPC § 16600, post-term covenants not to compete are invalid in California regardless of whether such covenants are narrowly drawn.
  6. The decision places an increased focus on trade secrets. The Court’s decision may be seen by some franchisees/ licensees/employees as allowing greater mobility, even where proprietary information is taken. Auditing your organization’s trade secret protections is a valuable first step toward protecting against this risk, ensuring that your organization’s intellectual capital is adequately protected.