Wednesday, November 23, 2011

Non-Compete Clauses in Franchise Agreements

Generally, non-competition clauses are governed by one of two standards: the strict scrutiny test applied most commonly to employment agreements, and the reasonableness test applied in the context of a sale of business.

The tests are different in degree, not kind. Both tests require a showing of reasonableness, but in the employment context, the employer must articulate a legitimate interest worthy of protection. Courts often scrutinize the asserted interest carefully and find that the covenant does not support something the law protects. In the sale of business context, the courts employ are more straightforward time, territory and scope analysis, and generally presume a protectable interest exists - usually goodwill.

In many states, the tests are colloquially known as the employment test and the sale of business test. But many covenants do not fall neatly within these two buckets. A common example is the covenant incidental to a franchise agreement.

I have had many clients come to me with these issues, and there is not a ton of case law assessing whether a franchisor/franchisee non-compete should be judged according to the strict scrutiny standard or the more traditional reasonableness standard. Courts in Pennsylvania, Kansas, and Washington have looked at franchise agreements as akin to employment agreements and applied strict scrutiny to the reasonableness analysis. Courts in New Jersey, Wisconsin, Virginia, and Montana have taken the opposite approach. There appears to be no majority rule.

What are the main differences between a franchisee and employee which might lead one to conclude that the sale of business standard should apply? Here are four:

(1) The franchisee usually has a close association with the franchised system's goodwill;
(2) Tradesmarks and trade secrets are more likely to be closely aligned with, and entrusted to, the franchisee;
(3) Franchisees lose their capital investment upon termination, where an employee's job simply ends;
(4) Competition by ex-franchisees impacts the economic interests of other franchisees.

Additionally, some courts have concluded that failing to enforce covenants in franchise agreements undermines the franchise systems entirely, where that is not at all the case in the employment arena.

There also are, however, some differences between franchisees and sellers of a business. Here are two big ones:

(1) The franchisor retains a significant amount of control over a franchisee;
(2) Franchisees typically are not compensated for the value of the business upon termination.

In my mind, this is a close call. From my review of cases, it seems as though franchise covenants are drafted better than those found in employment agreements and have more reasonable time and territory restrictions. I don't know why this is, but I think there is less adhesion up front. Potential franchisees always have more choices than potential employees.

I also disagree with the idea that covenants automatically should be characterized as employment or sale of business. I think courts should recast them as either arms-length transactions or contracts of adhesion. For instance, executive employees may be in a far superior bargaining position to change or narrow up their non-competes than even a seller of a business or a franchisee.

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