California has a strict code section that declares that covenants not to compete are unlawful except in limited circumstances.California Business and Professions Code Section 16600:

“Except 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.”

Section 16600 has some statutory exceptions (e.g., qualifying sale of a business (Section 16601)), but often operates as a per se rule against noncompete clauses in contracts.

In Comedy Club, Inc. v. Improv West Associates, 553 F.3d 1277 (9th Cir. January 29, 2009), the plaintiff sought a declaration that an exclusive dealing provision in a trademark licensing agreement prevented it from pursuing a lawful business in violation of section 16600. The Ninth Circuit followed a California Court of Appeal decision, Dayton Time Lock Service, Inc. v. The Silent Watchman Corp., 52 Cal.App.3d 1, 6-7 (1975), in rejecting the application of per se illegality to the exclusive dealing provision. Instead, the court employed a Rule of Reason type of analysis to uphold the covenant/exclusive dealing provision in part.

Plaintiff Comedy Club, Inc. (“CCI”) entered into a Trademark License Agreement with Improv West Associates (“Improv West”). Improv West granted CCI an exclusive license for the lower 48 States to use the “Improv’ mark for newly opened comedy clubs. CCI was obligated to open four such clubs each year in 2001 through 2003. The contract contained a covenant that prohibited CCI from opening any non-Improv comedy clubs in the lower 48 States for the 19-year term of the contract. CCI opened some Improv clubs, but not the number required by the contract. Improv West then terminated the contract in large part except that it permitted CCI to continue to operate the Improv clubs that it had already opened. Improv West insisted that the covenant not to compete remained in effect in all respects.

CCI sued for a number of declarations, including one that the prohibition against CCI opening other, non-Improv comedy clubs violated Section 16600. The case reached the Ninth Circuit as an appeal from a district court’s affirmance of an arbitration award that enforced the exclusive dealing, or noncompete, provision nationwide for nineteen years. The arbitrator had held that Section 16600 and Dayton Time Lock, 52 Cal.App.3d 1, did not apply. Comedy Club, 553 F.3d at 1293.

The Ninth Circuit held that it could review the merits because the arbitrator had acted “with manifest disregard of the law” in refusing to apply Section 16600 and Dayton Time Lock, and reversed in part. Comedy Club, at 1292-1293. The court noted the “dramatic geographic and temporal scope” of the covenant not to compete. Id. at 1292. “The arbitrator’s award effectively quarantines CCI from engaging in its business in forty-eight states until 2019 and does not follow well-established California law.” Id. at 1293.

The court did not hold the covenant unlawful altogether, but instead “blue penciled” the covenant and gave it a limited application: CCI remained enjoined from opening or operating non-Improv clubs in those counties where it currently owned or operated Improv clubs. Comedy Club, 553 F.3d at 1293-1294 ("CCI may not open or operate any non-Improv clubs in those counties where it currently owns or operates Improv clubs"). That arbitrator’s injunction was to remain in effect to that extent for the entire 19 years called for by the trademark agreement. However, the covenant not to compete was held not to apply to any other counties in the country, and so that aspect of the arbitrator’s injunction was vacated. Id. at 1293.

The Ninth Circuit stated that it was following the market foreclosure analysis set forth in Dayton Time Lock: “[U]nder [Cal. Bus. & Prof. Code] § 16600 an in-term covenant not to compete in a franchise-like agreement will be void if it ‘foreclose[s] competition in a substantial share’ of a business, trade or market. Dayton Time Lock, 52 Cal.App.3d at 6 . . .” Comedy Club, 553 F.3d at 1292. The court in Dayton Time Lock, applying Section 16600, stated that a Rule of Reason type of analysis applied to exclusive dealing agreements:  

“Exclusive–dealing contracts are not necessarily invalid. They provide an incentive for the marketing of new products and a guarantee of quality-control distribution. They are proscribed when it is probable that performance of the contract will foreclose competition in a substantial share of the affected line of commerce. A determination of illegality requires knowledge and analysis of the line of commerce, the market area and the affected share of the relevant market.”

Dayton Time Lock, 52 Cal.App.3d at 6-7 (citations to U.S. Supreme Court cases omitted) (holding that plaintiff had made no showing of illegality).

There may be a difference between a standard Rule of Reason analysis and a Section 16600 analysis with regard to the definition of the type of injury that Section 16600 proscribes, or what constitutes "foreclos[ing] competition in a substantial share of the affected line of commerce." Dayton Time Lock, supra, at 6. In an antitrust case in which a covenant not to compete was being challenged, a court might determine legality by whether competition, not just the plaintiff, was injured due to a particular plaintiff being excluded from the market. See, e.g., Bhan v. NME Hospitals, 929 F.2d 1404, 1414 (9th Cir.) (exclusion of one nurse anesthetist not sufficient to demonstrate injury to competition), cert. denied, 502 U.S. 994 (1991). In contrast, under Section 16600, the courts may look only at the effect on an individual competitor’s ability to compete without regard to whether the exclusion of plaintiff from the marketplace has any overall effect on competition.

Comedy Club is consistent with the application of the common law doctrine of "partial" restraints, also referred to as "ancillarity." See, Mitchel v. Reynolds, 24 Eng. Rep. 347 (K.B. 1711); M. Handler, Changing Trends In Antitrust Doctrines: An Unprecedented Supreme Court Term -1977, 77 Colum. L. Rev. 979, 980 n.6 (1977); D. Ghirardelli Co. v. Hunsicker, 164 Cal. 355, 361 (1912) (RPM minimum price contract lawful where there were many competing substitutes available to consumers: "others may and do manufacture and sell such chocolate in considerable quantities").

In the context of exclusive dealing and related restraints, a Rule of Reason analysis applies, which requires that we characterize and test a geographic and product relevant market. See, Roth v. Rhodes, 25 Cal.App.4th 530 (1994). But as to geographical areas where a party has never conducted nor was contemplated to conduct its business, a form of truncated rule of reason under Section 16600 may shorten the qualitative analysis. Cf. Cel-Tech Communications, Inc. v. L.A. Cellular Telephone Co., 20 Cal.4th 163 (1999) (adoption in California of the antitrust injury requirement, citing the dicta in Brown Shoe Co. v. United States, 370 U.S. 294 (1962), that the antitrust laws are designed to protect competition, not competitors).