Management Alert

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 improv-

comedy-related businesses or restaurants violates CBPC § 16600. . . and that [b]y restricting non-party relatives and ex-

spouses 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.

March 2009•

Recent Ninth Circuit Decision Has Important Implications for Franchise and Other Exclusive Dealing Relationships In California

Management Alert

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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:

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.

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.

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.

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.

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.

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Attorney Advertising. This Management Alert is a periodical publication of Seyfarth Shaw LLP and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and you are urged to consult a lawyer concerning your own situation and any specific legal questions you may have. Any tax information or written tax advice contained herein (including any attachments) is not . (The foregoing legend has been affixed pursuant to U.S. Treasury Regulations governing tax practice.) © 2008 Seyfarth Shaw LLP. All rights reserved.

Management Alert

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.

For more information, please contact the Seyfarth attorney with whom you work, or any Trade Secrets, Computer Fraud &

Non-Competes or Franchise & Dealer Disputes attorney on our website.

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