By Dale C. Campbell

The Ninth Circuit recently considered the enforceability of non-competition covenants contained in franchise-like agreements.  (Comedy Clubs, Inc. v. Improv West Associates (9th Cir. January 29, 2009; WL 205046.)


The plaintiff Comedy Club, Inc. (“CCI”) entered into a trademark license with Improv West Associates (“IMPROV”). CCI owned and operated restaurants and comedy clubs across the nation. The license agreement provided that IMPROV granted CCI an exclusive nationwide license to use the IMPROV marks; that CCI would open four IMPROV clubs a year in 2001 through 2003; and CCI would not operate any non-IMPROV clubs during the term of the license.


CCI failed to meet its obligation to open four new IMPROV clubs a year. IMPROV notified CCI that, in accordance with the terms of the license, CCI had forfeited its right to open and use the IMPROV mark in connection with any new club. IMPROV did not terminate the license, but only terminated CCI’s right to open new clubs using the mark. The license, including the non-competition covenant, was to continue in place until the year 2019.

CCI filed a complaint seeking declaratory relief that the non-competition covenant was void under California Business and Professions Code section 16600. The matter was ordered to arbitration. The arbitrator found that the trademark license was not canceled but, as a result of CCI’s failure to comply with the build-out schedule, CCI’s right to use the mark with new clubs was terminated. The arbitrator found that the non-competition covenant remained in full force and effect through 2019.


The District Court affirmed the arbitrator’s award. On appeal, CCI argued that the arbitration award was irrational because it simultaneously revoked its license to open IMPROV clubs yet prevents it from opening any other comedy clubs throughout the United States until at least 2019.


The Ninth Circuit Court of Appeals reviewed the arbitration award to determine whether the arbitrator’s ruling constituted a “manifest disregard of the law,” justifying vacatur of the award.

Business and Professions Code section 16600 establishes that covenants not to compete are void unless they involve the sale of “goodwill of a business [or] where a partner agrees not to compete in anticipation of dissolution of a partnership,” see Kelton v. Stravinski, 138 Cal.App.4th 941, 964, “or where they are necessary to protect . . . trade secrets,” see Whyte v. Sladge Law Company, 101 Cal.App.4th 1443, 1462.


None of those well-established exceptions applied to CCI facts. California cases dealing with section 16600 generally involve post-contract or post-employment covenants not to compete. The covenant not to compete in this case was part of a continuing contractual relationship and, as such, the Court evaluated the enforceability of an “in-term covenant not to compete.”


The Ninth Circuit looked to two California court of appeal decisions which address in-term covenants not to compete – one in the context of an exclusive dealing contract and the other in the context of a partnership agreement. The Court in Dayton Time Lock Service found that “[e]xclusive-dealing contracts are not necessarily invalid,” but “[t]hey are proscribed when it is probable that performance of the contract will foreclose competition in a substantial share of the affected line of commerce.” (Dayton Time Lock Service v. Silent Watchman Corp. (1975) 52 Cal.App.3d 1, 6.)

In Kelton v. Stravinski, the Court of Appeals struck down an in-term covenant not to compete in the context of a partnership agreement. However, the Court noted that even in connection in the franchise context, a covenant not to compete is still invalid if it forecloses competition in a substantial share of the affected line of commerce. (Kelton v. Stravinski, 138 Cal.App.4th 941, 947-48.)


The Ninth Circuit Court of Appeals interpreted the IMPROV trademark license to be akin to an exclusive dealing or franchise agreement. The Court found that, under Dayton Time Lock Service and Kelton, “an in-term covenant not to compete in a franchise-like agreement will be void if it ‘foreclose[s] competition in a substantial share’ of a business trade or market.” (Comedy Club, Inc. v. Improv West Associates at p. 11.)  The Court noted the 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 a franchisor’s trademark, trade name, and goodwill.


The Ninth Circuit found that the grounds stated by the arbitrator to disregard Dayton Time Lock Service were fundamentally incorrect. “Even under the permissive standard with which we view arbitral positions, the economic restraint . . . on competition is too broad to be countenanced in light of the clear prohibition of section 16600 as interpreted by the California courts.” (Id. at p. 12.) The Ninth Circuit then balanced IMPROV’s interest to protect and maintain its trademark, trade name, and goodwill against CCI’s right to compete under section 16600. Rather than strike the overbroad in-term non-competition covenant in full, the Court restricted the covenant to apply only in those counties where CCI currently operates IMPROV clubs. In blue-penciling the in-term non-competition covenant, the Court noted that “overbroad covenants not to compete may be restricted temporally and geographically,” citing General Paint Corp. v. Seymour, 124 Cal.App. 611, 614-15. To be enforceable, the in-term covenant not to compete must not prevent a party from engaging in its business or trade in a substantial section of the market. That is fact-driven determination, which, if the contracting parties get it wrong, at least the Ninth Circuit has indicated a willingness to restrict its scope.


The Comedy Club decision is also important for the Court’s analysis of circumstances under which an arbitrator’s ruling can be vacated under the Federal Arbitration Act.  The Comedy Club decision provides limited guidance as to when an award can be vacated as a result of a “manifest disregard of the law” as compared to simple legal error, which is not grounds to vacate the award.  A careful reading of the decision does not provide any clear factors to distinguish one from the other.