Court Watch

Ninth Circuit Reforms CA Covenant Not to Compete; CA Supreme Court Will Consider 'Narrow Restraint' Exception

Section 16600 of the California Business and Professions Code provides that '[e]very contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.' There is little dispute that this provision nullifies post-term covenants not to compete in franchise agreements except in very limited circumstances, such as the statutory exceptions for a covenant in an agreement for the sale of a business or in connection with the dissolution of a partnership or a limited liability company. See, e.g., Scott v. Snelling and Snelling, Inc., 732 F.Supp. 1034 (DC Cal. 1990).

Over the years, at least two judicially created exceptions to '16600 have been formulated: A covenant not to compete will be enforced to the extent necessary to prevent unfair competition and protect trade secrets, see, e.g., ReadyLink Healthcare v. Cotton, 126 Cal.App.4th 1006 (2005); and a covenant will be enforced if it only amounts to partial or narrow restraint on the covenantor's exercise of its profession, see, e.g., General Commercial Packaging v. TPS Package, 114 F.3d 888 (9th Cir. 1997). The few California state intermediate appellate court opinions that discussed an exception to '16600 based on the limited scope of the covenant involved based their decisions on narrow factual situations. See, e.g., Dayton Time Lock Service, Inc. v. Silent Watchman Corp., 52 Cal.App.3d 1 (1975) (exclusive dealing contract in franchise agreement); Broughton v. Socony Mobil Oil Co., 231 Cal.App.2d 188 (1964) (challenge to term in deed to property prohibiting use of property for sale of petroleum products).

In Comedy Club, Inc., et al, v. Improv West Associates, et al, Nos. 05-55739 and 05-56100, 2007 WL 2556702 (9th Cir. Sept. 7, 2007), the U.S. Court of Appeals for the Ninth Circuit vacated part of a district court's confirmation of an arbitration award in which an arbitrator upheld a nationwide prohibition against competition following the termination of a trademark licensee's expansion rights on the basis that since the license agreement remained partially in effect following the loss of the licensee's expansion rights, the noncompetition covenant was a valid in-term covenant allowed by California law.

In this case, Comedy Club, Inc. and Al Copeland Investments, Inc., as licensees, were granted exclusive nationwide development rights for comedy clubs using marks belonging to Improv West Associates, the licensor. In order to maintain their development rights, the licensees were required to open a certain number of clubs using the marks over a specified period of time. The license agreement provided that in the event of a default under the opening schedule, further development rights would be lost, but the agreement would remain in effect as to clubs then open or under construction. The licensees did not meet their development schedule, and the licensor terminated the licensees' right to develop additional clubs.

The agreement also contained a provision prohibiting the licensees from opening any comedy clubs during the term of the agreement other than those allowed by the agreement. Therefore, under the contract, once the licensees' development rights were lost, the licensees were limited to operating the clubs they had open or that were under construction at the time of the termination and were prohibited from opening any further comedy clubs in the United States until 2019, when the agreement was due to end.

Since the trademark license contained an arbitration provision, the validity of the noncompetition convenant was arbitrated. The arbitrator issued an injunction against the licensees' opening additional comedy clubs in the United States, finding that since the license agreement was still in effect as to the clubs then open, the concerned provision was valid as an in-term noncompetition covenant. The district court confirmed the arbitration award.

On appeal, the Ninth Circuit reviewed the confirmation de novo. The licensees attacked the arbitration award on various grounds, including that the nationwide covenant against competition violated '16600 of the California Business and Professions Code. The circuit court found that the concerned clause did not fall within the sale of the goodwill of a business exception, the partnership or LLC dissolution exception, or the trade secret exceptions to '16600. It did find, however, that, while a total prohibition against competition would be too broad, a partial restraint would be valid. For this proposition the court relied primarily on Dayton Time Lock, supra, which upheld, using antitrust analysis, an exclusive dealing arrangement in a franchise agreement. It also cited Kelton v. Stravinski, 138 Cal.App.4th 941 (2006), which analogized the Dayton Time Lock exclusive dealing arrangement to a covenant not to compete and then sought to limit its reach to franchise agreements. The Ninth Circuit held that the arbitrator's upholding the nationwide prohibition on opening comedy clubs by the licensees was a manifest disregard of settled California law by the arbitrator since the trademark license agreement was analogous to a franchise agreement and that, therefore, the rule of Dayton Time Lock, as further massaged by Kelton, applied. The court held that the licensor's interests could be protected by limiting the covenant against competition to the counties in which the licensees operate their clubs and remanded the matter to the district court to vacate the arbitrator's injunction as to the counties where the licensees have no clubs.

There are two principal arguments in California in favor of the enforcement of an in-term covenant against competition in franchise agreements: that the covenant is necessary to protect the trade secrets of the franchisor, an exception that has been judicially endorsed; and that the covenant is allowable as a limited restraint on a franchisee's ability to engage in a trade, business, or profession. Under the clause providing only a limited restraint, the franchisee is allowed to engage in any business, trade, or profession except one competing with the franchised business ' assuming the absence of a 'full time and best efforts'-type clause in the franchise agreement. However, since the partial restraint exception is based primarily on the antitrust analysis of Dayton Time Lock and not on a clear holding by a California state court based on '16600, its validity, despite Comedy Club and other federal court cases, may be shaky. The California Supreme Court has yet to pass on the partial restraint exception but that may be about to change.

The 'partial restraint' exception to '16600 of the California Business and Professions Code may be about to be reviewed, and possibly revised, by the California Supreme Court. That court has granted review in Edwards v. Arthur Andersen LLP, 142 Cal.App. 4th 603 (2006) (an opinion now vacated as a result of the pending review). In that case, Edwards, an employee of the Arthur Andersen accounting firm, signed a noncompetition agreement not to solicit, or do work for, certain of Arthur Andersen's clients for a specified period after the end of his employment. Arthur Andersen went out of business and sold its practice to various entities. In order to be hired by the entity to which Andersen sold its Los Angeles tax practice, Edwards, as a condition of being released from his noncompetition agreement with Andersen, was required to sign an agreement releasing all claims he had against Andersen. He refused ' the noncompetition agreement remained in effect, and he was not hired. The trial court found that since the noncompetition agreement was valid under the limited restraint exception to '16600, Andersen's requiring a release as a condition of terminating the agreement was not an intentional interference with Edwards' prospective advantage.

On appeal, a California intermediate appellate court held that unless a covenant against competition falls within the statutory exceptions or the judicially recognized 'trade secret exception,' it is not enforceable since California state courts have not recognized the 'narrow restraint' exception propounded by the federal courts in California. In Edwards, the California Supreme Court should decide whether the only judicially recognized exemption to '16600 is the trade secret exception, or whether California will recognize the limited restraint exception.

It will be interesting to see whether the California Supreme Court follows the federal line of cases upholding the exception or limits exceptions to '16600 to those expressly found in the statutes and the trade secret doctrine. While this is not a case involving an in-term covenant or a franchise agreement, the consequences of the court's decision may affect the availability of the limited restraint exception to justify in-term, as well as post-term, noncompetition covenants in California franchise agreements.

As of press time, Edwards has been fully briefed but a date for oral argument has not yet been set.

Charles G. Miller and Darryl A. Hart are members of Bartko, Zankel, Tarrant & Miller in San Francisco. Miller can be reached by e-mail at [email protected], and Hart can be reached by e-mail at [email protected]. They can be reached by phone at 415-956-1900.

Ninth Circuit Reforms CA Covenant Not to Compete; CA Supreme Court Will Consider 'Narrow Restraint' Exception

Section 16600 of the California Business and Professions Code provides that '[e]very contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.' There is little dispute that this provision nullifies post-term covenants not to compete in franchise agreements except in very limited circumstances, such as the statutory exceptions for a covenant in an agreement for the sale of a business or in connection with the dissolution of a partnership or a limited liability company. See, e.g., Scott v. Snelling and Snelling, Inc ., 732 F.Supp. 1034 (DC Cal. 1990).

Over the years, at least two judicially created exceptions to '16600 have been formulated: A covenant not to compete will be enforced to the extent necessary to prevent unfair competition and protect trade secrets, see, e.g. , ReadyLink Healthcare v. Cotton , 126 Cal.App.4th 1006 (2005); and a covenant will be enforced if it only amounts to partial or narrow restraint on the covenantor's exercise of its profession, see, e.g., General Commercial Packaging v. TPS Package , 114 F.3d 888 (9th Cir. 1997). The few California state intermediate appellate court opinions that discussed an exception to '16600 based on the limited scope of the covenant involved based their decisions on narrow factual situations. See, e.g., Dayton Time Lock Service, Inc. v. Silent Watchman Corp ., 52 Cal.App.3d 1 (1975) (exclusive dealing contract in franchise agreement); Broughton v. Socony Mobil Oil Co., 231 Cal.App.2d 188 (1964) (challenge to term in deed to property prohibiting use of property for sale of petroleum products).

In Comedy Club, Inc., et al, v. Improv West Associates, et al, Nos. 05-55739 and 05-56100, 2007 WL 2556702 (9th Cir. Sept. 7, 2007), the U.S. Court of Appeals for the Ninth Circuit vacated part of a district court's confirmation of an arbitration award in which an arbitrator upheld a nationwide prohibition against competition following the termination of a trademark licensee's expansion rights on the basis that since the license agreement remained partially in effect following the loss of the licensee's expansion rights, the noncompetition covenant was a valid in-term covenant allowed by California law.

In this case, Comedy Club, Inc. and Al Copeland Investments, Inc., as licensees, were granted exclusive nationwide development rights for comedy clubs using marks belonging to Improv West Associates, the licensor. In order to maintain their development rights, the licensees were required to open a certain number of clubs using the marks over a specified period of time. The license agreement provided that in the event of a default under the opening schedule, further development rights would be lost, but the agreement would remain in effect as to clubs then open or under construction. The licensees did not meet their development schedule, and the licensor terminated the licensees' right to develop additional clubs.

The agreement also contained a provision prohibiting the licensees from opening any comedy clubs during the term of the agreement other than those allowed by the agreement. Therefore, under the contract, once the licensees' development rights were lost, the licensees were limited to operating the clubs they had open or that were under construction at the time of the termination and were prohibited from opening any further comedy clubs in the United States until 2019, when the agreement was due to end.

Since the trademark license contained an arbitration provision, the validity of the noncompetition convenant was arbitrated. The arbitrator issued an injunction against the licensees' opening additional comedy clubs in the United States, finding that since the license agreement was still in effect as to the clubs then open, the concerned provision was valid as an in-term noncompetition covenant. The district court confirmed the arbitration award.

On appeal, the Ninth Circuit reviewed the confirmation de novo. The licensees attacked the arbitration award on various grounds, including that the nationwide covenant against competition violated '16600 of the California Business and Professions Code. The circuit court found that the concerned clause did not fall within the sale of the goodwill of a business exception, the partnership or LLC dissolution exception, or the trade secret exceptions to '16600. It did find, however, that, while a total prohibition against competition would be too broad, a partial restraint would be valid. For this proposition the court relied primarily on Dayton Time Lock, supra, which upheld, using antitrust analysis, an exclusive dealing arrangement in a franchise agreement. It also cited Kelton v. Stravinski , 138 Cal.App.4th 941 (2006), which analogized the Dayton Time Lock exclusive dealing arrangement to a covenant not to compete and then sought to limit its reach to franchise agreements. The Ninth Circuit held that the arbitrator's upholding the nationwide prohibition on opening comedy clubs by the licensees was a manifest disregard of settled California law by the arbitrator since the trademark license agreement was analogous to a franchise agreement and that, therefore, the rule of Dayton Time Lock, as further massaged by Kelton, applied. The court held that the licensor's interests could be protected by limiting the covenant against competition to the counties in which the licensees operate their clubs and remanded the matter to the district court to vacate the arbitrator's injunction as to the counties where the licensees have no clubs.

There are two principal arguments in California in favor of the enforcement of an in-term covenant against competition in franchise agreements: that the covenant is necessary to protect the trade secrets of the franchisor, an exception that has been judicially endorsed; and that the covenant is allowable as a limited restraint on a franchisee's ability to engage in a trade, business, or profession. Under the clause providing only a limited restraint, the franchisee is allowed to engage in any business, trade, or profession except one competing with the franchised business ' assuming the absence of a 'full time and best efforts'-type clause in the franchise agreement. However, since the partial restraint exception is based primarily on the antitrust analysis of Dayton Time Lock and not on a clear holding by a California state court based on '16600, its validity, despite Comedy Club and other federal court cases, may be shaky. The California Supreme Court has yet to pass on the partial restraint exception but that may be about to change.

The 'partial restraint' exception to '16600 of the California Business and Professions Code may be about to be reviewed, and possibly revised, by the California Supreme Court. That court has granted review in Edwards v. Arthur Andersen LLP , 142 Cal.App. 4th 603 (2006) (an opinion now vacated as a result of the pending review). In that case, Edwards, an employee of the Arthur Andersen accounting firm, signed a noncompetition agreement not to solicit, or do work for, certain of Arthur Andersen's clients for a specified period after the end of his employment. Arthur Andersen went out of business and sold its practice to various entities. In order to be hired by the entity to which Andersen sold its Los Angeles tax practice, Edwards, as a condition of being released from his noncompetition agreement with Andersen, was required to sign an agreement releasing all claims he had against Andersen. He refused ' the noncompetition agreement remained in effect, and he was not hired. The trial court found that since the noncompetition agreement was valid under the limited restraint exception to '16600, Andersen's requiring a release as a condition of terminating the agreement was not an intentional interference with Edwards' prospective advantage.

On appeal, a California intermediate appellate court held that unless a covenant against competition falls within the statutory exceptions or the judicially recognized 'trade secret exception,' it is not enforceable since California state courts have not recognized the 'narrow restraint' exception propounded by the federal courts in California. In Edwards, the California Supreme Court should decide whether the only judicially recognized exemption to '16600 is the trade secret exception, or whether California will recognize the limited restraint exception.

It will be interesting to see whether the California Supreme Court follows the federal line of cases upholding the exception or limits exceptions to '16600 to those expressly found in the statutes and the trade secret doctrine. While this is not a case involving an in-term covenant or a franchise agreement, the consequences of the court's decision may affect the availability of the limited restraint exception to justify in-term, as well as post-term, noncompetition covenants in California franchise agreements.

As of press time, Edwards has been fully briefed but a date for oral argument has not yet been set.

Charles G. Miller and Darryl A. Hart are members of Bartko, Zankel, Tarrant & Miller in San Francisco. Miller can be reached by e-mail at [email protected], and Hart can be reached by e-mail at [email protected]. They can be reached by phone at 415-956-1900.