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Will California enforce your franchise contract’s non-compete provisions?

A Common Non-Compete Scenario

Let’s say Jim is a franchise owner of Goldy’s Gym, in Palmdale.  At some point during the term of the franchise agreement, Jim realizes he doesn’t want to pay the exorbitant franchise fees, as “Jim’s Gym” would be a much better brand for his business anyways.  So Jim terminates his franchise agreement.  The problem — the Goldy’s Gym franchise agreement includes a 3 year non-compete provision which expressly precludes Jim from opening another gym within a 500 mile radius of Palmdale.  But all of Jim’s client relationships are in Palmdale, so of course that’s where he is going to open Jim’s Gym.  The question then becomes, can Goldy’s Gym Inc. enforce their non-compete and force Jim’s gym out of Palmdale?

The Enforceability of Non-Compete Provisions in California

Since this is a California operation, Jim is in luck.  Non-competition clauses are typically void in California, meaning you can ignore the scary language in the contract and proceed to compete with your jerk of an ex-employer, even by opening a shop up right next door, with no repercussions.  California wants to promote free competition and disfavors any contract enforcements that abridge employee (or former employee) rights. But before Jim opens up shop, he should be mindful of

The Franchise Exception

In franchise cases, 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.  So say Jim is using Goldy Gym’s equipment, client lists, exercise classes, etc., all of which he learned and gained access to as a result of the franchise relationship with Goldy’s Gym, for the Jim’s Gym launch.  This is the type of scenario where certain aspects of a non-compete WOULD BE enforceable.  Now Jim can mitigate his exposure here if he purchased the equipment from Goldy’s Gym outright and refused to utilize any trade secrets in the launch of his new gym, but he still may forced to move out of Palmdale if a court determines that the new gym utilized Goldy’s trade secrets in the operation of Jim’s Gym.  Jim should take solace however in the fact that the franchisor has the burden of proving the existence of its trade secrets and the franchisee’s use of its trade secrets.  And even if the franchisor meets its burden, the courts will not enforce the non-compete provision if it is deemed to be unreasonable.  So what is reasonable?  That’s a question better left for your attorney, as the answer depends on a number of factors specific to your particular case.  As for Jim, a 10 year non-compete in all of California is unlikely to be considered reasonable, however a 3-year non-compete in the county just might be enforced.  Case law supports findings both ways, so again it is best to consult an attorney before you elect to proceed under similar circumstances as Jim here.

Does it matter whether Jim intends to compete during term of franchise agreement or afterwards?

Post-term non-competes are generally acknowledged as unenforceable unless the trade secrets exception (above) applies.   California courts seemingly tend to use fluctuating standards in this determination.  For example, some California courts have held that an in-term non-compete provision 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 over-broad 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.  This is bad news for Jim if he wants to stay in Palmdale.

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. So proceed with caution Jim, and call your Franchise attorney today!

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