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The Enforceability of Non-Compete Agreements in California

The Enforceability of Non-Compete Agreements in California

Franchise agreements often contain a prohibition against competition. If the franchisee operates in California, or if California Law otherwise applies to a franchise agreement, then the franchisee may not be bound by the onerous restrictions of the non-compete. Both franchisor sand franchisees should be aware of the nuances of (and certain lack of clarity in the application of) California law.

Non-Competes, Generally

In California, non-competition clauses are typically void regardless of whether they are reasonable under California law. In franchise cases, however, the California Supreme Court has recognized an exception, and will enforce a non-compete where it is necessary to protect a franchisor’s trade secrets or proprietary information. The franchisor has the burden of proving the existence of its trade secrets and the franchisee’s use of its trade secrets. Even if the franchisor meets its burden, the courts will not enforce unreasonable non-competes.

Post-Term vs. In-Term

“Post-term” refers to non-competes that purport to apply after an agreement terminates or expires. “In-term,” by contrast, refers to non-competes that purport to apply during the term of the agreement.

Post Term is Unenforceable, In-Term May be Enforced

Post-term non-competes are generally acknowledged as unenforceable unless the trade secrets exception (above) applies.

California courts may use a different standard to determine whether an in-term non-compete is enforceable. For example, some California courts have held that an in-term non-compete in a franchise agreement is void if it forecloses competition in a substantial share of a business, trade or market. Determination of this requires knowledge and analysis of the line of commerce, the market area and the affected share of the relevant market. This test was first set forth in 1975 in a California Court of Appeal case, Dayton Time Lock Service, Inc. v. Silent Watchman Corp., but was recently applied, in 2009, in a Ninth Circuit U.S. Court of Appeals case, Comedy Club Inc. v. Improv West Associates. This is important, because Ninth Circuit cases are binding on California district courts.

Applying the Dayton standard, the Comedy Club court, held that an overbroad in-term non-compete would “foreclose competition in a substantial share” of the comedy club business, and thus, was unenforceable. However, despite finding the provision unenforceable, the court did not invalidate it altogether, and, instead, revised the non-compete and partially enforced it (a practice known as “blue penciling”). Accordingly, the court held that franchisor in that case could prohibit the franchisee from operating in a county where that franchisee currently operated, but could not prohibit the franchisee from operating or opening a competing club in counties where it did not currently operate.

Complicating matters somewhat, some district courts in California have declined to follow the Comedy Club case, and, instead, have applied the same test to in-term non-competes as post-term non-competes (that they are unenforceable unless the trade secrets exception applies). The courts that have declined to follow Comedy Club do not say that Comedy Club is wrong or “bad law” (in fact, these lower courts cannot overturn a decision by a higher court), but, instead, have specifically rejected the underlying Dayton case that the Comedy Club decision relied upon. (At least one district court case has followed the Comedy Club decision.)

Accordingly, with respect to post-term non-competes, they are generally not enforced unless the trade secrets exception applies. As to in-term non-competes, however, California case law is somewhat unclear and will depend on which line of cases the court opts to follow.

Einbinder & Dunn is available to consult on any issues related to the enforcement of non-competes in California and other states.

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