By Robert Milligan & Jim McNairy

After obtaining a sweeping nationwide injunction from an arbitrator that enjoined licensee Comedy Club, Inc. (“CCI”) from opening any new comedy clubs until 2019 pursuant to a trademark license agreement, licensor/competitor Improv West Associates (“Improv”) could not have been in the mood for laughs when the U.S. Court of Appeals for the Ninth Circuit modified the arbitrator’s injunction by significantly narrowing its scope and breadth. The decision is an important one for franchisors because the court indicated that in-term covenants not to compete in franchise like agreements will be void if they foreclose competition in a substantial share of a business, trade, or market.

The Ninth Circuit held in Comedy Club, Inc. v. Improv West Associates that an arbitrator’s injunction based on in-term covenant not to compete in a trademark license agreement, which precluded CCI and its affiliates (including tangential relatives of CCI principals) from competing in the comedy club business (apart from existing licensed “Improv” clubs that CCI continued to operate under the license agreement) until 2019, was not enforceable. Specifically, the court modified the nationwide scope and inclusion of tangential relatives of CCI principles in the arbitrator’s injunction.

The court found that the arbitrator’s injunction violated California Business & Professions Code Section 16600 (“CBPC § 16600”). With respect to the injunction barring affiliates from competing, the court stated:

Moreover, precluding non-party relatives or ex-spouses from opening or operating improv-comedy-related businesses or restaurants violates CBPC § 16600. . . . By 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 existing California case law that it was evident that under 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. The court also stated that California courts are less willing to approve in-term covenants not to compete outside a franchise context because there is not a need to protect and maintain the franchisor’s trademark, trade name and goodwill.

The court indicated that under existing California case law that the franchisor-franchisee context was different from an employment or partnership context. The court stated that CCI’s relationship with Improv was in essence a franchise agreement as CCI contracted with Improv to use Improv’s trademarks and open comedy clubs modeled on Improv’s clubs. Assessing the requirements of California law, the court weighed 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.

Lessons from this case include:

1. In-term covenants not to compete may be enforceable in the franchise context “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 is or companies are doing business during the agreement. If franchisors can show that the in-term covenant is necessary to protect trade secrets, then 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 California Business and Professions Code section 16600, to the protection of trade secrets, or the court’s in-term “franchise” exception to section 16600. These exceptions to California’s general prohibition against non-compete agreements were recognized by the court.

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 and ex-spouses from engaging in a lawful business because such covenants violate Business and Professions Code Section 16600.

4. The court’s decision highlights what the California Supreme Court made clear in its Edwards v. Arthur Andersen opinion: unless falling within one of few exceptions to Business and Professions Code Section 16600, post-term covenants not to compete are invalid in California regardless of whether such covenants are narrowly drawn.

5. The court’s decision places an increased focus on trade secrets. The court’s decision may be seen by some franchisees/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, and attempting to enforce a non-compete/non-solicit provision under the trade secrets exception to Business and Professions Code Section 16600.