Just a few days ago, the Southern District of Ohio issued a decision in a non-compete case that reads like a treatise on non-compete agreements, choice of law and conflicts of law. Let’s take a look:
In 1987, Patrick Porter started a business called Positive Changes Hypnosis Centers. As the name suggests, Positive Changes was a sort of self-help center that offered hypnosis therapy. Strangely enough, Positive Changes was wildly successful. Eventually, Porter had a network of franchises, a radio talk show, and a television show. In 2003, Porter sold the business to An Ohio-based company called Lifestyle Improvement Centers. Fast forward several years. Patrick Porter and his wife Cynthia are now living in California. They have a new company called East Bay Health, which operates in a similar self-improvement market space. In 2011, Lifestyle reaches out to the Porters seeking their help with a struggling Positive Changes franchise located in Pleasanton, California. As it turns out, the Porters are interested in purchasing that franchise. The parties enter a deal: The Porters acquire the struggling Positive Changes franchise from Lifestyle. The Porters’ company, East Bay, enters both a franchise agreement and a separate non-compete agreement with Lifestyle. Under the terms of the non-compete agreement, East Bay agrees that it will not compete with Lifestyle in the hypnosis business for two years after the termination of their relationship.
After a year spent trying to turn around their Positive Changes franchise, the Porters conclude that it is a lost cause. The Porters write to Lifestyle and inform them that they will be shutting the franchise down. Over the next several months, the Porters wind down the Positive Changes operation and convert the Pleasanton location into something they call The Smart Body Institute, operated through their East Bay Health LLC. Smart Body provides a variety of health services including chiropractic care and detox treatments. Eventually, Smart Body expands into the hypnosis market. In late April 2013, Smart Body starts running advertisements in local newspapers offering hypnosis therapy.
Lifestyle, which is based in Ohio, brings suit in Ohio state court. They allege a breach of the Positive Changes franchise agreement and a breach of the Lifestyle/East Bay non-compete agreement. Both the franchise agreement and the separate non-compete agreement contain Ohio choice of law provisions. We can see where this is headed: The Porters – and East Bay – argue that, in spite of the choice of law provisions contained in the agreements, California law should apply.
In every non-compete case that involves any connection to California, the defendants will push for the application of California law. Sometimes, the potential defendants will even strike first by running into California court and seeking a declaratory judgment holding that California law applies and that the non-compete agreement is unenforceable. The basis for this strategy is obvious: Non-compete agreements are generally unenforceable under California law. This strategy has met with varying degrees of success depending on both (1) the specific facts of the case at issue and (2) the law of the forum state. In this case, here’s how it went down:
Conflicts of Law 101
First principal: A federal court sitting in diversity applies the choice of law rules of the forum state. In this case, Plaintiff filed suit in Ohio state court and the case was removed to Ohio federal court on diversity. As a result, the court applies Ohio law.
Ohio, like many other states, has adopted some part of the Restatement (Second) of Conflict of Laws § 187. The first section of the Restatement provides, “The law of the state chosen by the parties to govern their contractual rights and duties will be applied if the particular issue is one which the parties could have resolved by explicit provision in their agreement directed to that issue.”
First, the court held that Ohio had not adopted the § 187 in its entirety. But the court went on to explain that even under 187(1) of the Restatement, Ohio law does not automatically apply. Recall the specific language of 187(1): The choice of law applies if “the particular issue” is one that the parties could have resolved by contractual agreement. Here, the issue is the enforceability of a covenant not to compete. The parties could not have resolved that issue – enforceability – via agreement. As the court notes, “Stating . . . that the non-compete provision was valid under Ohio or California law would not have made it so.” In other words, parties cannot accomplish via choice of law what they cannot accomplish by contract. The court provided an excellent example via reference to a law review article about choice of law and franchise agreements written by a former Boies, Schiller colleague of mine, George Carpinello: A franchisor cannot “evade the public policy of the franchisee’s state by designating the law of a state which would embrace the contract as written.” Testing the Limits of Choice of Law Clauses: Franchise Contracts as a Case Study, 74 Marq. L.Rev. 57, 72 (1990). Consistent with these principles, the court held that even under 187(1), Ohio law would not necessarily apply.
The court then moved to 187(2), which provides that the parties’ choice of law will be enforced except where:
(a) the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties’ choice, or
(b) application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue and which, under the rule of s 188, would be the state of the applicable law in the absence of an effective choice of law by the parties.
In practice, the inquiry under 187(2) involves (1) Determining the state law that would apply absent a choice of law provision (2) Determining whether application of the chosen law would violate fundamental policy of the otherwise applicable state law and (3) Determining whether the state whose law would apply absent a choice of law provision has a materially greater interest.
The first determination – which state law would normally apply – turns on the application of various factors listed in Restatement (Second) Conflict of Laws § 188: Law Governing in Absence of Effective Choice by the Parties. Those factors include things such as the place of contracting, place of performance, location of the subject matter of the contract, place of incorporation of the business, etc. Applying the factors listed in 188, the Court reasoned that this test pointed to California law. Remember – turning back to the actual subject matter of the case – the dispute hinged on the operation of a franchise located in California.
Having determined that California law would apply absent a choice of law provision, the Court next addressed whether application of Ohio law would offend fundamental public policy of California. The comments to 187 indicate that “a fundamental policy may be embodied in a statute which makes one or more kinds of contracts illegal.” This principle is directly applicable to the instant case: California Business & Professions Code § 16600 essentially prohibits the use of non-compete agreements. This is fundamental California public policy and the application of Ohio law would offend that policy.
Finally, the court concluded that California had a materially greater interest in regulating the activities of a business located in California that provides services to California consumers. Bottom line: The Ohio choice of law provision must be discarded and California law applies.
Applying California law, the court found the non-compete agreement unenforceable, denied the plaintiff’s motion for a preliminary injunction and granted summary judgment in favor of the defendants.
The takeaway: State laws that govern non-compete agreements vary widely throughout the country. When faced with a non-compete dispute that involves parties in different states or ties to different states, it is imperative to have a clear view of the differences between the laws of those states. Even when faced with a choice of law provision, if the law of another state plausibly could apply, and that law is more favorable to your position, make the conflicts of law argument. Sometimes it works. The case is Lifestyle Imp. Centers, LLC v. E. Bay Health, LLC, 2013 WL 5564144 (S.D. Ohio Oct. 7, 2013).
Jonathan Pollard is a trial lawyer and litigator based in Fort Lauderdale, Florida. He focuses his practice on competition, particularly cases involving non-compete, trade secret and antitrust disputes and represents clients in Florida and throughout the country. He is licensed in all Florida federal and state courts and routinely represents clients in Fort Lauderdale, Miami, West Palm Beach, Boca Raton, Fort Myers, Tampa, Orlando, Jacksonville, and Sarasota. His office can be reached at 954-332-2380.