Franchisor 101: Taking the Red Pill on Non-Competes

Lewitt HackmanFranchisors and franchisees in California have long conducted themselves based on precedent that voids post-termination covenants against competition in a franchise agreement in California. Recently, a franchisor’s ability to enforce such covenants in California may have changed dramatically.

The California Supreme Court faced the question of what standard determines whether California Business and Professions Code Section 16600 voids a contract that restrains a business from engaging with another business. The plaintiff, Ixchel Pharma, Inc. (“Ixchel”) had an agreement with a third party, Forward Pharma (“Forward”), for the creation of a new drug. Forward terminated the agreement with Ixchel and entered into a new, exclusive agreement with defendant Biogen, Inc. (“Biogen”). In the new agreement, Forward agreed to avoid new partnerships with companies dealing in similar biotech products. Ixchel sued Biogen in California federal court alleging the Forward/Biogen agreement was an unenforceable non-compete agreement under Section 16600. Ixchel claimed it restrained Forward and Ixchel from engaging in future business.

Section 16600 states: “Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Prior case law held that such restraints are automatically unlawful, unless an exception applies.

Prior holdings upheld reasonable restrictions in commercial contract cases and, therefore, departed from a strict reading of the statute. The court held that in analyzing whether a covenant between businesses is valid or void, the proper inquiry is “whether an agreement harms competition more than it helps by considering the facts peculiar to the business in which the restraint is applied, the nature of the restraint and its effects, and the history of the restraint and the reasons for its adoption.” Thus, restrictive covenants between businesses should be reviewed under a “rule of reason” which considers various interests and asks if the challenged conduct promotes or suppresses competition.

The court used exclusive dealing provisions in franchise agreements as an example of potentially enforceable restrictions. It acknowledged such provisions are often part of a franchise agreement or distributorship contract. In exchange for the right to sell the franchisor’s products, franchisees often agree to buy from a particular supplier or operate in a particular geographic area and franchisees are often prohibited from selling a third party’s products. Recognizing possible procompetitive effects of such provisions, the court would not “call such arrangements into question simply because they restrain trade in some way.”

The door is open for argument that a franchise agreement’s covenants against competition, whether in-term or post-term restrictions, are enforceable, if shown to be limited and supported by procompetitive commercial interests. Franchisors should expect franchisees with prior experience in the type of franchised business to negotiate the nature and scope of such covenants before entering into a franchise agreement. Franchisors who once shied from enforcing such covenants against California franchisees, should stay abreast of future case developments on this subject.

Ixchel Pharma, LLC v. Biogen, Inc., No. S256927 (Cal. Aug. 3, 2020)

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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