Choice of law and choice of forum provisions in franchise agreements: jurisdictional differences in enforcing the covenant not to compete

The importance of choice of law and choice of forum clauses in franchise agreements is clearer than ever in the wake of two recent arbitration decisions involving Paul Green School of Rock Music Franchising (“School of Rock”). One of those decisions was recently affirmed by the U.S. Court of Appeals in Paul Green School of Rock v. Smith, underscoring the necessity to make choice of law and forum decisions carefully and strategically.

The two cases involved disputes between School of Rock and two of its franchisees—Smith and the Giammarrusco’s, who together conspired to repudiate their franchise agreements to start a competitor, Rock Nation (the “Smith” and “Rock Nation” cases respectively). The cases share largely identical facts. Each involved California franchisees, breach of the respective franchise agreements, and similar claims including non-payment of royalties to School of Rock. Both cases also involved franchise agreements that contained arbitration and non-compete clauses. The major difference between them is that the franchise agreement in Smith provided for arbitration in Pennsylvania pursuant to Pennsylvania law, while the franchise agreement of the Giammarrusco’s in Rock Nation required arbitration in California under California law.

Unlike Pennsylvania law, California law considers covenants not to compete to violate public policy—an important distinction between the two states. California law generally prohibits such covenants, and California courts rarely enjoin competition, doing so only when necessary to protect trade secrets.

The Smith case proceeded to arbitration in Pennsylvania. Ultimately, the arbitrator ruled that Smith must pay $401,743 in damages including attorneys fees and future lost profits to School of Rock, and that he was bound by the non-compete clause in the franchise agreement. The arbitrator was not bound by the prohibition on restrictive covenants found in California. In contrast to Smith, School of Rock’s arbitration award in Rock Nation awarded $100,000 in damages for unfair competition with no damages for future lost profits. The arbitrator also refused to uphold the non-compete clause as against California’s public policy but is increasing the award to add costs and counsel fees.

These cases provide franchisors with an important guide for constructing franchise agreements for use in California. However, the extent to which clauses choosing non-California law are enforceable in California franchise disputes is not completely clear. Prior to the arbitration in Smith, Smith objected to the choice of law and forum provisions in a California court, arguing that the provisions were unconscionable. However, the court found that, since Smith’s California rights would be recognized in Pennsylvania, the provisions should be enforced. Notably, not all California cases since Smith have been similarly decided. Recently, in Bridge Fund Capital Corp. v. Fastbucks Franchise Corp., the court refused to follow Smith. The court found that the choice of forum and law provisions in the franchise agreement, which designated Texas and Texas law, were not enforceable since there was no evidence that the franchisee’s California-based rights would be recognized in Texas.

Regardless of the uncertainty created by Fastbucks, Smith still provides a useful guide on how to avoid California’s prohibitions of non-compete covenants, and for how franchisors in California can obtain the greatest possible protection if disputes arise. Smith and Rock Nation prove that strategically choosing the governing law and forum can make all the difference in franchise dispute resolution results, and selecting non-California law in the franchise agreement will likely provide better protection to franchisors.

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Nixon Peabody Franchise Law Alert, August 20, 2010.
Reprinted with permission.