The Reading List (2017, No. 14): Showing Irreparable Harm Requires Actual Facts

Non-Compete and Trade Secrets News for the week ended April 7, 2017

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Franchise Non-Competes and Irreparable Harm

Disputes over franchise non-competes arise less frequently than employment-based covenants, but they tend to produce some interesting results. Often, they are combined with claims for trademark infringement if franchisees continue to promote their business using the same signage, slogans, or other source indicators that were part of the original franchise relationship. But other times, the franchisee simply ends the relationship and starts a completely separate business in the same territory.

A district court in Nebraska confronted precisely this type of fact-setting in Colorado Security Consultants, LLC v. Signal 88 Franchise Group and denied a preliminary injunction motion brought to enforce a 3-year non-compete. The interesting aspect of the decision, which is available here, concerns the discussion about "irreparable injury," a required element that a plaintiff must prove to establish injunction relief. The court was critical of the plaintiff's conclusory evidence about customer contact. And, at least according to the facts available in this opinion, it appeared the way in which the franchisor elected to end the relationship may have been a contributing factor in the court's denial of its injunction motion. The lesson here is intuitive. If you're asking for injunctive relief, then you need to demonstrate actual, concrete evidence that illustrates how continued competition threatens imminent injury. Abstract statements or mere suggestions of future harm won't cut it.

Bad Faith in Trade Secrets Actions

The bad-faith fee-shifting clause under the Uniform Trade Secrets Act allows for a "prevailing party" to recover fees. By definition, it does not apply to counsel. A successful showing of bad faith by a defendant entitles him to fees only from the plaintiff itself.

Last year, a California Court of Appeal decision in a case called Cypress Semiconductor found that a plaintiff's voluntary dismissal without prejudice did not prevent a defendant from claiming it had been a "prevailing party" for purposes of claiming fees under the bad-faith provision. This past week, the Illinois Appellate Court in an unpublished and non-precedential order disagreed with Cypress Semiconductor. It found that the term "prevailing party" could not include a voluntary dismissal without prejudice. The case is Matrix Basement Systems, Inc. v. Drake.

In the interest of full disclosure, I joined the representation of Tom Drake on appeal after the circuit court had denied his fee petition. Obtaining reversal of an order denying a motion for sanctions is quite difficult under an "abuse of discretion" standard of review, but I felt that Mr. Drake more than deserved a vigorous appeal. The appellate court's order, while not giving us the desired outcome, certainly helped establish that Mr. Drake was the victim of a completely meritless suit that never should have been filed in the first place. The circuit court found that Matrix Basement Systems had indeed lodged allegations against him that were false, but that this alone wasn't enough to warrant sanctions.

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On his Michigan Employment Law Advisor, Jason Shinn has a more in-depth discussion with practical tips on Estes Forwarding Worldwide v. Cueller, the "Google Drive" access case I discussed two weeks back. The tips he offers are geared towards employers who need to secure web-based storage accounts from improper employee use.

Michael Elkon at Fisher & Phillips has an excellent compliance-oriented post dealing with the hiring of employees from competitors. This lengthy post covers a number of specific questions and procedures employers should be asking and investigating when hiring new employees from competitors.

Korn Ferry, the executive search leader which pursued the high-profile Computer Fraud and Abuse Act case against David Nosal, finds itself on the other end of a competition dispute. Spencer Stuart, a K/F competitor, filed suit in Chicago. This case appears to be more of a garden-variety non-compete dispute, but it involves the defection of a group practice leader - Francois Truc - who earned over $4 million a year from Spencer Stuart.

Munger Tolles & Olson released a 2016 Defend Trade Secrets Act Roundup summarizing DTSA filings and major issues that courts have decided under the law as we approach the one-year anniversary of its enactment.

Finally, Seyfarth Shaw this week flagged a pending bill in Missouri that would invalidate restrictive covenants in the employment setting. House Bill 479 would bring Missouri more in line with the California approach to restrictive covenants, which permits them in connection with the sale of a business. We see legislation creep up like this time and again in the States, but it usually is meant to spark debate that leads to incremental reform. Seyfarth's post on the Missouri bill is available here.

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.

In-Term Non-Compete Clause In Franchise Agreement Held Void (Atlanta Bread Co. v. Lupton-Smith)

There are two rules you can generally count on in most states:

(1) Non-compete clauses in franchise agreements generally will be subject to lower scrutiny than those in employment contracts; and

(2) In-term covenants are far less problematic than post-term restraints.

However, these rules do not apply when Georgia law is at issue.

In Atlanta Bread Co. v. Lupton-Smith, the Supreme Court of Georgia held that a covenant not to compete contained within a franchise agreement which barred a franchisee from acquiring any interest in another bakery/deli business while the agreement was still in effect failed to pass muster under the strict scrutiny standard applicable to employment non-compete agreements.

Effectively, the Court held there is no distinction in the test to be applied to covenants in franchise arrangements and employment contracts. Most courts would disagree - reasoning that no franchisor would enter into such a relationship unless its business goodwill were protected for a period of time following expiration of the agreement.

The aspect of the case that is even more unique is the lack of any distinction under Georgia law between in-term and post-term covenants. Clauses which bar someone from competing during the term of a franchise (or employment) contract are usually far less problematic, and are somewhat derivative of general agency or fiduciary duty law. In fact, some courts do not even consider them restraints at all.

In Georgia, there is no functional difference. To be fair, the Supreme Court was somewhat hamstrung in this case as past precedent set forth a fairly clear, well-established rule that in-term covenants followed the strict scrutiny standard applicable to post-term restraints.

As readers may know, Georgia statutory law has changed to allow for more equitable application of non-compete agreements, particularly the blue-pencil doctrine. Still, because Georgia's constitution bars the legislature from authorizing a restraint of trade, that new law may not be effective until some act is taken to amend the state constitution.

UPDATE X1: The Atlanta Journal-Constitution comments on the Atlanta Bread case here.

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Court: Supreme Court of Georgia
Opinion Date: 6/29/09
Cite: Atlanta Bread Co. Int'l, Inc. v. Lupton-Smith, 285 Ga. 587 (2009)
Favors: N/A
Law: Georgia

Franchisor Loses Preliminary Injunction on Non-Compete Claim Due to Unclear Agreement (Victory Lane Quick Oil Change v. Hoss)

Assume you own a franchise, and that you're bound by fairly restrictive terms and conditions contained in the governing agreement. One of those terms prevents you from opening a competing franchise location within 10 miles of any other franchised spot for 3 years after your agreement ends.

Now assume that prior to the time your franchise agreement expires, the franchisor opens up a competing location close by. What do you?

Well, if you're the owner of a Victory Lane Quick Oil Change in Howell, Michigan, you change your company name and operate a competing business at the same location in direct competition with the newly-opened franchise store in town. Is this permissible?

Maybe.

Not suprisingly, the franchisor - Victory Lane - threatened and eventually pursued injunctive relief against the defendants, who changed the signage on the franchise location to "Checkered Flag" - which not coincidentally was the name of Victory Lane's widely distributed newsletter.

The defendants argued that Victory Lane had no protectable interest in enforcing the post-termination non-compete clause given that it opened another location in the same area. On legal grounds, the defendants have the edge.

But the rub in this case was the ambiguous franchise right granted to the defendants under the master franchise agreement. Specifically, the agreement stated that "Victory Lane grants to you the exclusive right to own and operate a [Victory Lane franchise] at the following location: Howell." The defendants claim this gave them the exclusive right in the entire city of Howell, while the franchisor simply claimed an exclusive right existed at the location.

Granting someone an exclusive right to operate a business at a single location is redundant and unnecessary. Logically, one would expect any reasonable franchisee to expect some customary geographic exclusivity beyond the exact spot he or she runs the business. Furthermore, any ambiguity probably would be resolved against the franchisor. Because of the ambiguous nature of the exclusivity provision, the court declined to enforce the non-compete term at the preliminary injunction stage.

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Court: United States District Court for the Eastern District of Michigan
Opinion Date: 3/20/09
Cite: Victory Lane Quick Oil Change, Inc. v. Hoss, 2009 U.S. Dist. LEXIS 72145 (E.D. Mich. Mar. 20, 2009)
Favors: N/A
Law: Michigan

Bad Ass Injunction Shuts Down Coffee House (Bad Ass Coffee Co. v. JH Nterprises)

Non-compete agreements within the context of a franchise relationship pose a unique problem. On the one hand, the covenants are still a restraint of trade and therefore must be analyzed under the rule of reason. On the other, the nature of the protectable interest at stake is far more malleable than rules associated with employment non-compete agreements. It is, in fact, almost identical to the protectable interest associated with a sale-of-business non-compete. But unlike sellers of a business, franchisees often have little bargaining power.

The recent case of Bad Ass Coffee Co. of Hawaii, Inc. v. JH Nterprises, LLC demonstrates why the traditional employee non-compete test does not, or should not, apply to covenants in franchise agreements, and why - effectively - courts seem to apply a sale-of-business analysis instead.

The franchisor, Bad Ass Coffee Company, is a purveyor of gourmet coffee through various franchise locations in the United States. Each franchisee enters into an agreement with a personal and corporate restrictive covenant, preventing it from opening a similar business within a certain geographic area of the assigned franchise store. In this case, the restricted territory was construed under the governing agreement as the City of Jacksonville, Florida.

When the franchisee's agreement with Bad Ass Coffee expired in February, the franchisor gave it the opportunity to renew the contract without paying an additional fee. However, almost immediately after the franchise term expired, the franchisee converted the store to "Java Cove", selling the same products from the same suppliers. The drinks were even sold under the same names.

Bad Ass Coffee filed suit seeking injunctive relief and prevailed with relative ease. The court applied the four-part test in Utah to assess the validity of the restrictive covenant. It did not distinguish the case from a traditional employment case, but this oversight had no impact on the outcome. The only issue concerning the validity of the covenant was the nature of the interest Bad Ass Coffee sought to protect by way of the non-compete. And it was clear the court effectively looked at the same factors that would be discussed in a sale-of-business case.

The court described the goodwill of the franchisor that was at risk from being impaired through the franchisee's conduct. Specifically, the court found that "Defendants' actions in opening Java Cove are likely to send negative messages about [Bad Ass Coffee] to the market and to other ... franchisees....Defendants' overnight switch to Java Cove may signal to potential customers that the Defendants lost faith in the [Bad Ass Coffee] brand. To other franchisees, Defendants' conduct might set an example that they can leave the ... franchise and immediately start competing if they are unhappy with [Bad Ass Coffee]." These factors are nearly identical to what courts would deem important when analyzing a sale-of-business covenant.

Courts, though, often are not clear about which test to apply. In Utah, there are so few non-compete cases in the reported decisions, the court in Bad Ass Coffee may not have had much to work with. But it still should have distinguished the type of interest at issue from those raised in employment cases.

In fact, courts ought to begin with a rebuttable presumption that the covenant protects a franchisor's goodwill and demand a franchisee introduce evidence to the contrary. The focus of such covenants should be on the element of reasonableness. In this case, the court found a citywide limitation was reasonable, and that the covenant was not intended to prevent the defendants from opening, for instance, a gas station which also happened to sell coffee as an incidental product.

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Court: United States District Court for the District of Utah
Opinion Date: 7/2/09
Cite: Bad Ass Coffee Co. of Hawaii, Inc. v. JH Nterprises, LLC, 636 F. Supp. 2d 1237 (D. Utah 2009)
Favors: N/A
Law: Utah