Implementing and Enforcing Covenants Against Competition in The Franchise Context: Part 1

Share Button

Dunne_Anne Color Hi Res

Skelton_John BW Hi Res

 

 

Weibust_Erik Color Hi Res

I.          Introduction

Covenants against competition—oftentimes referred to as non-competition covenants or, more colloquially, as “non-competes”—are an important means for companies to defend against misappropriation or misuse of confidential information and trade secrets, and to protect the company’s goodwill.  Although they are not a failsafe for the reasons discussed in this article, covenants against competition do provide important protections and can be a valuable tool in a more comprehensive toolbox. Franchisors, in particular, should consider including such provisions in their franchise agreements, as franchisees are oftentimes, by necessity, given access to confidential information.  To some degree, moreover, the fate of a franchisor’s brand is placed in the hands of its franchisees who serve as the “face” of the brand.  In addition, franchisors need to be able to protect the integrity of their franchise networks and other franchisees. This article seeks to demystify covenants against competition and to provide basic information about their enforceability in the franchise context.

II.        Non-Compete Basics 

Regardless of the context—employer/employee, sale of a business, franchisor/franchisee, etc.—covenants against competition must all meet certain basic threshold criteria to be enforceable.  First, they must protect a legitimate business interest.  Broadly speaking, legitimate business interests include trade secrets and confidential information, as well as goodwill.  Preventing ordinary competition is not a legitimate business interest. Second, covenants against competition must be reasonable in time, geographic reach, and scope of proscribed activities.  Reasonableness is a highly fact-intensive inquiry, regardless of the context, and the same covenant may be found reasonable in one instance and unreasonable in another.

Context matters. So does bargaining power. In the employment context, a court is more likely to enforce a covenant against competition against a senior-level executive than a rank-and-file employee.  It is also more likely to enforce such a covenant where the employee had access to sensitive information. Covenants against competition entered into between the buyer and seller of a company, on the other hand, are more likely to be enforceable than between an employer and employee, because the seller is ostensibly a sophisticated party who can negotiate appropriate consideration for his or her agreement not to compete.  In the franchise context, it is not as clear cut. Oftentimes franchisees are less sophisticated than franchisors, English may be their second language, franchises can be one-person operations (e.g., a tax preparer or financial advisor), and similar to employees, owning a single franchise is many times a franchisee’s sole source of income.  On the other hand, as noted above, franchisors necessarily provide franchisees with access to confidential information, and, to some degree, put the fate of their brand in the hands of their franchisees. Indeed, many franchisees, particularly those with multiple franchises, are often highly sophisticated operations.

Because most litigation surrounding covenants against competition is won or lost an the preliminary injunction stage, where the judge must make an equitable (i.e., fairness) determination as to whether an employee should be ordered to stop working for a competitor or a franchisee to stop operating a competing business for a certain amount of time, there are numerous factors that go into whether an injunction will be granted—including the economy, which state’s law governs the agreement, the proclivities of the particular judge assigned to the case, and the effectiveness of the lawyers.  As discussed above, however, the most critical factors are whether the covenant actually protects a legitimate business interest and whether it is reasonable in scope.  Because the inquiry is so fact-intensive and circumstance-driven, however, it is difficult to predict the outcome of any future disputes. As such, it is important when drafting and implementing covenants against competition to work with experienced counsel to reduce the risks, and increase the likelihood of enforcement, under any set of circumstances.  It is also important to keep abreast of legal developments and update covenants when appropriate.

III.       What is a Legitimate Business Interest in the Franchise Context?

A.        Trade Secrets and Confidential Information

Like covenants against competition in other contexts, protecting a franchisor’s confidential information and trade secrets is a legitimate business interest. Examples of confidential information and trade secrets in the franchise context will vary among industries, and perhaps even between companies, and may include profit margins, strategic growth and/or marketing plans, terms of exclusive vendor relationships, cost of goods sold, and even recipes. Regardless of what form the information takes, or whether it is marked “confidential” or a franchisor considers it to be confidential, in order to be protectable under the law the franchisor must treat it as confidential or a trade secret. Experienced counsel should be retained to make sure all necessary precautions are being taken, such as limited need-to-know access, password protections, individualized log-in credentials, signed confidentiality agreements, and the like. For larger and more sophisticated companies, a formal trade secret audit may be appropriate.

B.        Goodwill

Protecting goodwill is also a legitimate business interest. Goodwill is an amorphous term, however, that can be difficult to define. Indeed, the term can mean different things in different contexts. In the employment context, for instance, more often than not it refers to customer relationships. In other words, where a salesperson is assigned certain customers, or is provided with leads or resources to obtain leads or to build a book of business, and is the primary contact person for those customers, the employer may be able to enforce restrictive covenants (including not only non-competes, but also customer non-solicitation and confidentiality provisions) in the event the salesperson leaves to join a competitor and/or attempts to poach the customers. This can be true with in the franchise context as well. Indeed, where the franchise is an insurance brokerage or a tax preparer, for instance, the franchisee may use the franchisor’s name, reputation, national marketing campaigns, and resources to build a substantial book of business, only to terminate the franchise relationship, set up a competing company (or join a competitor), and solicit all of the clients obtained as a result of being associated with the franchisor.  In such circumstances, customer relationships may constitute a protectable business interest.

With many franchises, however, the customer is not another company or an individual with which there is an established or ongoing relationship, but rather it is the general public (e.g., a patron at a convenience store or fast food restaurant, or someone looking for a new car).  Or the franchisee may be able to convince a court that its customer relationships are a result of its own personal skills and attributes, not the franchisor’s—in other words, that the goodwill “belongs” to the franchisee. In these circumstances, a franchisor’s goodwill may not include customer relationships, so the franchisor will have to rely on something else as a protectable interest.  Other types of goodwill in the franchise context can include the franchisor’s reputation, brand loyalty, investment in the franchise, and even the integrity of the franchise network. Again, these will depend largely on the industry and which state’s law governs the franchise agreement, and experienced counsel should be retained to analyze whether your company can claim any protectable goodwill.

LOOK OUT FOR PART 2 IN OUR AUGUST ISSUE

Mr. Weibust is a partner in Seyfarth Shaw LLP’s Boston office, and a member of the firm’s Trade Secrets, Computer Fraud & Non-Competes and Distribution & Franchise Litigation and Counseling practice groups.  Mr. Skelton is a partner in Seyfarth’s Boston office and co-chair of the firm’s Distribution & Franchise Litigation and Counseling practice group.  Ms. Dunne is an associate in Seyfarth’s Boston office.