California Appellate Court Holds Post-Term Noncompete Not Enforceable against Franchisee Following Franchise Transfer

At a Glance

• The California Court of Appeal held that a post-term noncompete covenant in a franchise agreement was void under Business & Professions Code section 16600 because it restrained an individual's ability to engage in a lawful trade after the conclusion of a business relationship — regardless of whether the relationship was characterized as employment or a franchise.
• The court held that the rule-of-reason framework established in Ixchel Pharma, LLC v. Biogen, Inc. applies only to contractual restraints governing ongoing business relationships, not to post-term restrictions that take effect after the relationship has ended.
• The court rejected the franchisor's argument that the section 16601 sale-of-business exception applied to the noncompete in the franchise agreement because the sale of goodwill was between the franchisee and buyer, not the franchisor.
• Franchisors should continue to monitor state law developments regarding noncompletes, particularly since the Federal Trade Commission (FTC) abandoned a universal ban on noncompete agreements and states (including Tennessee, Washington, and Virginia) have stepped into the gap to advance their own restrictions.

Since the FTC abandoned its attempt at a universal ban on post-employment noncompetes, many states have advanced their own noncompete restrictions. Recently, Virginia amended its Retail Franchising Act to prohibit post-term noncompete provisions in franchise agreements, with an exception preserving the ability to restrict a former franchisee from competing if it sells the franchise to a third party or back to the franchisor.

California remains one of the most stringent states, banning most noncompete agreements with only limited and narrowly construed exceptions. A recent unpublished decision from the California Court of Appeal, CBD Franchising, Inc. v. One Day Doors & Closets, Inc., addresses whether a post-term noncompete covenant in a franchise agreement is enforceable under California law.

Background of CBD Franchising, Inc. v. One Day Doors & Closets, Inc.

CBD Franchising, Inc. (CBDF) is a franchisor of "Closets By Design" businesses that specialize in custom closets and home organizers. In 2013, CBDF entered into a franchise agreement with William and Mary Conway that contained a post-term noncompete provision prohibiting the Conways from competing within 75 miles of any CBDF territory across the country.

CBDF terminated the franchise agreement in April 2015 for the Conways' failure to comply with franchise obligations, but granted the Conways a limited license to continue operating the franchise in order to facilitate a sale. CBDF consented to the Conways' transfer of their franchise rights to DenMatt Industries, LLC. The asset purchase agreement between the Conways and DenMatt contained a narrower noncompete provision prohibiting the Conways from competing within five miles of DenMatt's business. Shortly thereafter, Mr. Conway began engaging in a competing door replacement and closet business, signing an exclusive licensing agreement with One Day Doors & Closets, Inc. (One Day).

After CBDF initially obtained an injunction against the Conways in New Jersey state court, the court dismissed the action when the Conways invoked a California forum selection clause in the franchise agreement. CBDF then re-filed claims in California state court asserting tortious interference with contractual relations and violation of California's unfair competition law (Bus. & Prof. Code, § 17200 et seq.) against One Day. Both claims were predicated on One Day doing business with the Conways while they were operating in alleged breach of the CBDF post-term noncompete. One Day moved for summary judgment, arguing the noncompete was unenforceable under section 16600; and the trial court granted the motion.

What the Court Decided

Section 16600 Prohibits Post-Term Noncompete Covenants in Franchise Agreements

CBDF acknowledged that California has a strong policy against enforcement of noncompete agreements in the employment context, but contended that California Supreme Court precedent required a more liberal approach to noncompete provisions in business contracts, such as franchise agreements. Relying on Ixchel Pharma, LLC v. Biogen, Inc., 9 Cal. 5th 1130 (2020), CBDF advocated for application of a rule-of-reason approach to noncompete provisions in franchise agreements. The California Court of Appeal rejected this argument.

The court explained that Ixchel concerned restrictions governing ongoing business relationships, not restrictions on what individuals could do following the conclusion of a business relationship. The court held that the franchise agreement's post-term noncompete bore no resemblance to the exclusivity covenant in Ixchel because it served only to prevent the Conways from competing with CBDF after their relationship had ended. As such, it served none of the "salutary functions" (such as leveraging complementary capabilities, ensuring stability in supply or demand, or protecting research and development efforts) that the Ixchel court identified as warranting deference.

According to the court, although the Conways were not CBDF's employees, the effect of the post-term noncompete was the same as what section 16600 flatly prohibits: restraining an individual's ability to engage in trade after the conclusion of a business relationship.

Section 16601 Exception Did Not Apply

CBDF also argued that the post-term noncompete was exempted from section 16600's noncompete ban by section 16601, which permits noncompete agreements in connection with the sale of business goodwill, relying on CBDF's sale of the goodwill of its business to a third party. The court disagreed, holding that section 16601 applies to agreements between the seller of goodwill and its buyer. The court rejected CBDF's argument that the franchise agreement, the asset purchase agreement between the Conways and a third party, and the 2016 assignment formed a single integrated transaction. Even if the documents did form an integrated transaction, because the Conways never sold the goodwill of any business to CBDF, section 16601 did not apply.

The court also noted that CBDF was not saved by the clause in the franchise agreement that provided that all goodwill associated with CBDF's proprietary marks belonged to CBDF. The court found that this provision "suggests no goodwill was transferred" either to or from CBDF in the Conways' sale to DenMatt, and so CBDF could not invoke the sale-of-business exception.

The court further noted that the Conways and DenMatt separately agreed to a noncompete provision in their asset purchase agreement that was narrower than the noncompete in the franchise agreement, but it declined to opine on whether that noncompete would be enforceable.

What This Means for You

1. Franchisors with California connections should be aware that California courts may decline to enforce post-term noncompete agreements and may refuse to apply the sale-of-business exception to the noncompete ban where the franchisee sold its franchise rights to a third party. Franchisors should work with franchise counsel to understand California limitations on restricting a former franchisee from competing in its former territory.
2. In California, although in-term franchise noncompete agreements may still be enforceable under the rule-of-reason framework that applies to restraints governing ongoing business relationships (such as exclusive dealing arrangements), that framework does not apply to post-term noncompetes that restrict what parties can do after the relationship ends.
3. Noncompete agreements between a former franchisee and a third-party buyer may be enforceable under California law and provide some protection against competition.
4. Location matters. Under Virginia law, even while banning post-term noncompetes in franchise agreements, the legislature expressly provided an exception for the sale of the franchise back to the franchisor or to a third party. But in California, under the reasoning of CBD Franchising, post-term noncompetes are not permitted even in the transfer context. Franchisors should consider how they approach noncompete agreements in the transfer context as part of their 2027 franchise renewals.
5. These legal developments reinforce that franchisors should take other steps to protect their businesses, including by reviewing and enhancing trade secret protections and focusing on reducing franchisee turnover.

Noncompetes will continue to be challenged. Monitoring state law developments in noncompete law — legislation and judicial decisions — is more important than ever.