Implementing and Enforcing Covenants Against Competition in The Franchise Context: Part 2

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Click here to read Part 1 from our July 2016 issue.

IV.       What is a Reasonable Covenant in the Franchise Context?

Even where there is a protectable interest, a covenant against competition must be narrowly tailored to protect that interest to be enforceable.  In other words, it must be reasonable in time, geographic reach, and scope of proscribed activities. As noted above, the reasonableness of a covenant against competition is an incredibly fact-intensive inquiry that depends on numerous factors, including the nature of the industry, which state’s law governs the covenant, the economy, the effectiveness of the lawyers representing the parties, or even the mood of the judge.

There are some general rules that can be drawn from prior precedents within each state, however, which can provide helpful guideposts for a franchisor seeking to include a covenant against competition in its franchise agreement. Again, the industry, the number of franchisees, the nature of the protectable interest, and the like can play a determinative role in this inquiry.

For example, an international fast food franchise with outlets in most major geographic areas may have a difficult time enforcing a covenant that prohibits former franchisees from operating a competing restaurant within 100 miles of any of its restaurants, even within a single state (which, in some places, could be virtually impossible), whereas a covenant that prohibits competition within 5-10 miles of any outlet(s) that the franchisee itself operated or had an ownership interest in is more likely to be enforceable.

Distinctions can also be drawn between “in-term” and “post-term” covenants against competition.  Indeed, most states permit covenants that restrict what a franchisee can do during the term of the franchise agreement to be more restrictive than covenants that restrict what a franchisee can do after the franchise relationship ends. This is because franchisors have a greater interest in demanding loyalty from a franchisee that is representing its brand in the marketplace, and because the franchisee, during the term of the franchise agreement, has an ability to earn a living, whereas after the agreement is terminated the franchisee may have limited marketable skills or opportunities other than to open a competing business.

Because of the fact-intensive nature of the inquiry, and varying state laws, a covenant may be deemed reasonable in one state or context, and unreasonable in another. As discussed immediately below, some states will reform overbroad covenants to make them enforceable (e.g., reducing a two year covenant to one year), whereas others will strike the entire covenant if it is overbroad.  Regardless of the state, there are ways to draft covenants against competition to be enforceable nationwide, or regionally, such that a franchisor can avoid implementing separate covenants for each state, which can be very costly and burdensome.  Experienced counsel can assist with this as well.

V.        State- and Industry-Specific Nuances and Particularities

There are numerous state- and industry-specific nuances and particularities about which franchisors should consult with experienced counsel before implementing covenants against competition. For instance, some states, such as California, do not permit covenants against competition under any circumstances, as they view such covenants as unreasonable restraints on trade. Other types of covenants, such as confidentiality agreements, are permissible, however. Similarly, in the automotive industry, for example, most states have laws and regulations on the books that prohibit a manufacturer from restricting dealers from selling on behalf of other brands, which is why you will often see automobile dealers selling multiple brands, sometimes right next door to each other.  Most states and industries, however, allow covenants against competition that are reasonable and protect a legitimate business interest.

Moreover, certain states will enforce covenants against competition only where there is evidence of trade secret misappropriation—goodwill or other business interests are insufficient. Other states will even enforce covenants against non-signatories thereto, such as family members of the franchisee, newly formed corporations, and the like. This becomes important with family-owned franchises and/or where the franchisee sets up special purpose entities for each of its franchises, such that different companies technically own each franchise even though they are all controlled by the same individual(s).

Another important state-specific nuance has to do with whether courts will strike portions or all of an overly-broad covenant (sometimes called “blue penciling” or “red penciling”), or “reform” the covenant to make it enforceable. 30 states are “reformation” states, meaning that courts are empowered to reform overbroad covenants to make them reasonable; 17 states are “blue pencil” states, meaning that any overbroad restrictions will be stricken (although the remainder of the covenant itself may be enforceable if what is left after the overbroad restrictions are stricken is reasonable); and three states are “red pencil” states, meaning that if any portion of a covenant is overbroad the entire covenant will be stricken.  Moreover, 22 states have specific franchise relationship laws, and nine have non-compete statutes specifically relating to or that have been applied in the franchise context.

Again, as noted above, experienced counsel can help franchisors draft covenants against competition that will be enforceable in the largest number of states and broadest array of circumstances so as to avoid the necessity of implementing multiple covenants, which can become unwieldy when it comes time to implement and/or enforce them.   Experienced counsel can also provide advice about how to add a new non-compete provision to a mature franchise system with existing franchisees who are not currently subject to such restrictions, a process that is more complicated than it may initially appear.

VI.       Conclusion

Covenants against competition can be an invaluable tool for franchisors seeking to protect themselves against misappropriation and misuse of trade secrets and confidential information, and to protect the company’s goodwill.  However, they should be narrowly tailored to satisfy those goals and not overreach. As noted above, nobody can provide absolute assurances about the enforceability of covenants against competition because there are so many factors to be considered, which is why it is imperative that franchisors hire counsel experienced with implementing and enforcing such covenants, who are familiar with the state- and industry- specific nuances and particularities—which is certainly not every attorney, even those who are highly skilled and experienced in other facets of the law.  A covenant against competition is only useful to the extent it is enforceable, and when drafted and implemented properly and with due care, they can be a very worthwhile protective measure for a limited upfront investment.

Mr. Erik 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. John Skelton is a partner in Seyfarth’s Boston office and co-chair of the firm’s Distribution & Franchise Litigation and Counseling practice group.  Ms. Anne Dunne is an associate in Seyfarth’s Boston office.