Franchise Update
March 2007

California Continues To Invalidate Covenants Not To Compete


Two recent Court of Appeal cases have re-confirmed California's historic hostility toward covenants not to compete. Neither of the cases involved a franchise agreement, but their broad language is potentially relevant to the franchise context.

In Strategix, Ltd. v. Infocrossing West, Inc., a contract for the sale of a business's goodwill and assets contained non-competition covenants prohibiting the seller (Strategix) from soliciting the buyer's customers or employees for one year. Both parties alleged breaches of the sale agreement, and the buyer obtained a temporary restraining order and preliminary injunction prohibiting Strategix from soliciting its customers or employees. Strategix appealed, and the appellate court overturned the injunction on the basis of Business & Professions Code ( 16600, the statute which codified California's strong public policy supporting "a person's right to pursue the lawful occupation of his or her choice."

Even though B & P Code ( 16601 specifically permits a non-compete covenant in an agreement for the sale of a business, the Strategix, Ltd. court found that this agreement went too far. The court held that the purpose of the exception is to allow the meaningful sale of goodwill, by prohibiting the Seller from immediately competing with the buyer for "the sold business's employees and customers." This agreement, however, extended the ban to all of the buying business's employees and customers, which necessarily included persons with whom the seller had no prior relationship. The court held this was too broad, thus invalid.

Significantly, the court refused to "blue pencil," or interpret the agreement to apply more narrowly, in order to satisfy the statute.

The court in the second case, Edwards v. Arthur Andersen, LLP, applied similar reasoning to an extremely convoluted set of facts. Edwards arose from the breakup of the accounting firm Arthur Andersen following its criminal conviction in the Enron matter. Andersen had made certain high level employees sign non-compete agreements when they were hired. As the firm broke up, those employees were unable to take other jobs without receiving a waiver of the non-compete agreement from Andersen. In exchange for freeing them from the non-compete agreement, Andersen required former employees to sign a document which released all claims they might have against Andersen. After Edwards refused to sign the release and therefore lost a job opportunity, he sued Andersen.

The non-compete clause prohibited Edwards from working for clients for whom he had worked while at Andersen. The appellate court held this clause "restricted Edwards's ability to practice his profession" and was therefore void under ( 16600. As in Strategix, the Edwards court also found that the prohibition was too broad - here, it applied even if the clients sought Edwards out without his soliciting them.

The trial court had initially held the non-compete agreement to be valid under the "narrow restraint" exception, under which some (mainly federal) courts have permitted restraints of trade so long as their effect is "limited and leaves as substantial portion of the market available to the employee." The Edwards court held that the narrow restraint exception is "a misapplication of California law" and that the only exceptions to the general rule are the two created by statue (for the sale of a business and between partners), and the long established judicial exception for the protection of trade secrets. Since none of these applied, the non-compete was void.

The court's final holding was that requiring an employee to sign a non-compete covenant as a condition of employment violates California's public policy. Thus, Arthur Andersen's insistence on receiving a release of claims against it in return for agreeing to release Edwards from an invalid agreement was a wrongful act. The Edwards decision was accepted for review by the California Supreme Court, and it will be interesting to see whether that court adopts the Edwards decision's firm position against enforcing non-compete agreements, and its rejection of the narrow restraint exception.

Although neither of these cases involved a franchise agreement, their hostility to non-compete provisions should give terminating franchisees confidence that California courts will not enforce the non-compete covenants found in most franchise agreements. Modern franchise agreements use multiple provisions to restrain former franchisees from competing: not only non-compete covenants, but also provisions permitting the franchisor to purchase the business's assets for depreciated value, require assignment of the telephone number or premises lease, and asserting ownership of the client list. These cases demonstrate that California courts are willing to look carefully at any claimed exception, and to invalidate true restraints of trade.

This update is only a summary. The attorneys at Singler, Napell & Dillon, LLP can help you understand the full impact this law may have on your business. If you have any question, please contact Bruce Napell at (707) 823-8719 or BJN@singler-law.com.


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