Franchise Update
April 2009

9th Circuit Allows Partial Restraint of Trade


The U.S. 9th circuit court of appeal recently issued an opinion which offers interesting guidance regarding the enforcement of arbitration awards and the permissible scope of non-compete covenants in California. Since many lawsuits involving California franchisees end up in federal court, the 9th circuit's decisions are relevant to California franchisees because they are binding on the federal courts in the state, even though they are not binding on California state courts.

Comedy Club, Inc., v. Improv West Associates, involved Comedy Club, Inc.'s ("CCI") challenge to an arbitration award. CCI had a trademark license agreement with Improv West, under which it agreed to open a specific number of "Improv" comedy clubs nationwide including four per year between 2001 and 2003. CCI did not satisfy the development schedule, and sued to preserve its right to continue using Improv West's trademarks at the clubs it had opened or was building. The matter was ordered to arbitration, and the arbitrator's ruling permitted CCI to continue operating its "at least seven" Improv clubs until the end of the license term. However, the award also enforced the non-compete covenant in the trademark agreement in two ways. First, it prohibited CCI from opening or operating any other comedy clubs for the remaining term of the trademark agreement, and it issued an injunction prohibiting CCI's "affiliates" including the relatives of the principals, from opening or operating comedy clubs. CCI appealed the order confirming the award.

The 9th circuit invalidated the injunction as applied to relatives of CCI's principals on two grounds. First, it held that such a broad injunction against competition violated California Business & Professions Code § 16600, which generally prohibits contracts in restraint of trade. Second, the court held it was an improper use of the equitable power of injunction to apply it to persons who were not parties to the trademark agreement.

The court's second, and more interesting ruling, involved the application of the covenant not to compete to CCI itself. CCI objected that the arbitrator's order prohibiting it from opening or operating any additional comedy clubs was in manifest disregard if the law (B & P Code § 16600) and thus should be overturned. The Federal Arbitration Act sets the standard for review of arbitration awards. Although arbitration awards are due great deference, the FAA includes several specific grounds, including the arbitrator's exceeding her authority or the award's "complete irrationality," upon which an award may be overturned. Manifest disregard of the law is not one of the statutory grounds for vacating an arbitration award. The court, however, held that asserting that an arbitrator's award was in manifest disregard of the law is shorthand for claiming that the arbitrator exceeded her authority.

The court found the order that CCI could only continue operating its seven clubs, but could not open any others, anywhere, to be a restraint of trade in violation of § 16600. The court noted that only a small number of cases discuss the application of § 16600 to covenants prohibiting competition during the course of a contractual relationship (so called "in-term covenants"). It held, based on its review of those few cases, that in-term covenants can be enforced, but only if they do not prevent a party from "engaging in its business or trade in a substantial section of the market." Here, the court found that prohibiting CCI from operating a comedy club anywhere in the United States prohibited it from engaging in its trade in too substantial a section of the market, since it operated only seven Improv clubs. The court thus vacated that portion of the award, to the extent it prohibited CCI from operating comedy clubs in any county in which it did not already operate an Improv club.

This case is important for several reasons. First, it confirms that in-term covenants against competition are judged by a different standard than covenants which prohibit competition after the end of the relationship. Second, the 9th circuit demonstrated its willingness to modify a covenant against competition to make it acceptable; California courts have traditionally refused to make such modifications, instead invalidating covenants against competition as against public policy, without regard to whether they could be made reasonable. Third, although the trademark agreement was not a franchise agreement, the court commented on its resemblance to a franchise, and further noted the need for the protections offered by non-compete covenants in the franchise context. In short, it appears that the 9th circuit and the federal courts obligated to follow its rulings, will take a more nuanced view of covenants not to compete, and may not just invalidate them as violations of California's law against restraints of trade. It is thus now unclear whether an arbitrator's award enforcing a covenant not to compete against a California franchisee would be held to exceed the arbitrator's authority.

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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