Franchise Non-Competition Agreements in California
By Matt Dickstein
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Franchise agreements almost always have non-competition covenants. [Note: Non-competition covenants go by a number of names, including “restrictive covenants” and “no-competes.”] A franchisor uses a non-compete agreement to stop the franchisee from competing against the franchisor. To give you my conclusion up-front, CA law generally voids a non-compete agreement, but permits the franchisor to use trade secret protections to stop the franchisee’s unfair competition.
California Law Generally Voids Non-Compete Agreements
The law of non-competes in California is simple on its face – a contract by which one is restrained from engaging in a lawful trade or business is to that extent void (CA B&P §16600). That is, a contract is void if it prohibits one from engaging in a particular industry.
In-Term and After-Termination Non-Competes
A non-compete can be effective during the term of a franchise (“in-term”), and/or after termination of a franchise (“after-termination”). CA law is slightly different for in-term and after-termination non-competes.
In-Term. CA law on in-term non-competes is as clear as mud. CA courts will void an in-term non-compete in a franchise agreement if it cuts off competition in a “substantial share of a business, trade or market.” This is a fact-driven determination and it is impossible to predict the outcome of any given case.
After-Termination. Most non-compete cases occur after-termination when the franchisee defaults on the franchise but tries to stay in the industry on his own. CA law will void nearly every non-compete that applies after termination of a franchise relationship.
Your franchise agreement likely has a choice-of-law provision that requires use of the franchisor’s home state law. Although CA is rarely the chosen law in the franchise agreement, still, CA courts apply CA law to the non-compete provision in the contract. That is, so long as the franchisee operates in CA, CA courts generally use CA law when deciding on the non-compete. CA courts protect CA residents. If the franchisor sues in its home state, however, the home state court has the power to apply its home law, not CA law. Each state has different policies on choice of law – home law vs. CA law.
Don’t Be Too Aggressive
Franchisors frequently tell me they want the non-compete in their franchise agreement to scare the franchisee, even though the franchisor knows it’s unenforceable. This is not smart. CA courts have permitted punitive damages against companies that are overly aggressive in their use of non-competes.
The Big Backdoor – Trade Secrets
When your non-compete fails, use trade secret law for protection. Even though CA courts void non-competes, they protect trade secrets. Franchisors can use trade secret law to stop the franchisee’s unfair competition, that is, prevent the franchisee from using your business methods and other secret information to compete against the franchise system.
A trade secret is information that is secret and that has competitive value. Any information can be a trade secret so long as it meets these two requirements – secrecy and value. The formula for Coca-Cola is the classic example of a trade secret. Other information can be a trade secret too, for example, a customer list. A customer list can be a trade secret if the information is not easily obtained from public sources (e.g. a phone book) and contains valuable information developed through effort and expense (such as customer preferences and purchasing tendencies).
If your franchisee plans to compete against the franchise, he might use your trade secrets to do so. It might be hard for the franchisee to start over completely from scratch. This is especially true if you taught the franchisee how to do business in the first place or you introduced the franchisee to all the important contacts in the industry. CA law will stop the franchisee from using your trade secrets against you. This in turn will help prevent the franchisee from unfairly competing against you.
I’ve tried to make this article as simple as possible. California law on non-competes and trade secret protection is very complex, however. You need a competent franchise attorney to help you. If you want to read more about franchising, try my main page Franchise Attorney. From there you can link to other pages and articles of interest.