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

Lack of Proximate Cause Fatal to Damages Claim in Breach of No-Hire Clause (Overland Solutions v. Christensen)

No-hire clauses, or those which prohibit ex-employees from enticing away former co-workers, are generally viewed as a less problematic restraint of trade in most states. In Louisiana, they do not even fall under the state'e non-compete statute.

The appropriateness of damages for breach of a no-hire clause, however, is a more vexing problem for employers. In Overland Solutions v. Christensen, the court found that the general manager of a premium audit services company violated a no-hire clause which prohibited him from enticing away co-workers for a year following his termination of employment. The defendant offered jobs to eight Overland employees and hired five of them within a year after he resigned from Overland.

At trial on the issue of damages, Christensen acted pro se and defeated the damage claims against him entirely. The problem for Overland was its presentation of the evidence: it simply could not show that the costs it claimed as damage components were incurred as a result of Christensen's solicitation of former employees.

Most notably, Overland claimed as damages the costs of training and replacing the solicited employees. However, it included in its damage calculation an array of fixed costs it would have incurred regardless of whether the solicitation ever occurred. On the issue of training pay, Overland's presentation of evidence was unconvincing because the costs it incurred in expending training pay was less than the salaries that would have been paid to the five employees who left as a result of Christensen's wrongful solicitation.

As a result, the court simply held the evidence was too speculative to support any kind of lost profits damage award. In cases involving breach of no-hire covenants, injunctions against further solicitation of employees seems to be the most widely available remedy. On this score, courts likely won't apply the injunctive relief to require a defendant from terminating someone who was wrongfully solicited and started work before the order of injunction is entered. So for that category of employees, a damage award would seem to be the most practical remedy.

But proving it is a different matter. Practitioners always must consider the exacting standards required by courts to satisfy an award of lost profits. The presence of multiple intervening causes and speculative evidence often reduce, or eliminate, lost profits awards in competition cases. For this reason, reasonable liquidated damages clauses should be considered to provide a remedy for breach of a no-hire clause.

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Court: United States District Court for the Middle District of Louisiana
Opinion Date: 8/21/09
Cite: Overland Solutions, Inc. v. Christensen, 2009 U.S. Dist. LEXIS 74601 (M.D. La. Aug. 21, 2009)
Favors: Employee
Law: Louisiana

New York Court Takes Narrow View of Computer Fraud Statute in Misappropriation Claim (Jet One Group v. Halcyon Jet Holdings)

Readers know from my previous postings on the Computer Fraud and Abuse Act that one of the most widely litigated areas under that statute concerns misuse of digitally-stored information by an ex-employee. To summarize (again), plaintiffs have been using the CFAA's terms to assert that pre-termination misappropriation of computer-based data constitutes unauthorized access of a protected computer.

Another court - this time in New York - has rejected this broad view, most prominently adopted in the Seventh Circuit by Judge Posner. District Judge Seybert has held that the CFAA should be interpreted more narrowly because the plain language of the statute speaks of unauthorized (or impermissible) "access" to a computer, not misuse or misappropriation of information. This narrow reading is a repudiation of what has become, in many jurisdictions, a federalization of trade secrets law. The narrow view basically acknowledges that even information which was wrongfully misappropriated may not have been done so pursuant to unauthorized access of a computer under the CFAA. Footnotes 7 and 8 give a summary of citations addressing both sides of this issue.

Sooner or later, the Supreme Court will have to reconcile the disparate views on this subject. As the court noted, conflicts exist even within the same circuit.

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Court: United States District Court for the Eastern District of New York
Opinion Date: 8/14/09
Cite: Jet One Group, Inc. v. Halcyon Get Holdings, Inc., 2009 U.S. Dist. LEXIS 72579 (E.D.N.Y. Aug. 14, 2009)
Favors: Employee
Law: Federal

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

North Carolina Court Upholds Equitable Tolling Provision (Philips Electronics v. Hope)

The concept of equitable tolling is simple: for any period of time in which an employee is found to be in violation of his non-compete agreement, that is added on to the length of the restriction. In other words, an employee cannot run out the clock during litigation and escape an order of injunctive relief. Tolling provisions, though, are rarely the subject of judicial interpretation. In most states, they appear to be valid. Often times, courts just simply default to the language of the contract.

The recent case of Philips Electronics v. Hope addressed a contractual tolling provision and held that it extended the non-compete period for 11 months. The case involved a dispute in the MP3 accessory equipment business between Philips and its former Vice-President of Sales, Jason Hope. Hope was employed by Digital Lifestyle Outfitters, prior to the time it was acquired by Philips. During the course of Hope's employment with DLO, he executed a letter agreement guaranteeing him $180,000 in exchange for a non-compete covenant. The restriction applied during his employment term with DLO and for 2 years thereafter.

Not long after that, Philips purchased all of the stock of DLO and accepted Hope's resignation as Vice-President of Sales in May of 2007. He remained on the DLO payroll, but as an at-will employee. The court found that the two-year non-compete term began to run as of the date of his May 2007 resignation from DLO, which was compelled by the terms of the business sale, and not the time he resigned as an at-will DLO employee some 18 months later. The impact of this finding potentially eliminated Philips' ability to obtain an injunction.

The court, however, found that Hope was in violation of the non-compete agreement from April 2008 (before his second resignation) through May 2009 when Hope voluntarily ceased competitive activity. During this time (and while still employed by DLO), Hope appropriated a company business plan for competitive purposes, met with potential investors to start up a competing firm, and prepared a power-point presentation using market data that DLO regarded as confidential. Following his resignation, Hope began working with Riot Outfitters in violation of his non-compete and developed relationships with some of DLO's top accounts, ones he himself was responsible for managing while at DLO.

The court interpreted Hope's non-compete agreement and specifically the tolling provision to extend the term an additional 11 months. The tolling provision stated that "the periods of protection...shall not be reduced by any period of time during which [Hope is] not in compliance therewith." The court found this language, awkward though it may be, was enough to extend the term of the non-compete by the amount of time it found Hope to be in violation of his covenant.

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Court: United States District Court for the Middle District of North Carolina
Opinion Date: 6/30/09
Cite: Philips Electronics North America Corp. v. Hope, 631 F. Supp. 2d 705 (M.D.N.C. 2009)
Favors: Employer
Law: North Carolina

Enforceability of Restrictive Covenants Too Fact Specific To Resolve at Pleadings Stage (Henderson v. U.S. Bank)

When employees affirmatively challenge a non-compete agreement through a declaratory judgment action, their primary interest is resolving the case with speed. Many times, a new employer will be waiting in the wings, perhaps backing the employee's suit financially, to determine whether a non-compete will be judicially invalidated.

But obtaining a quick ruling is far from easy, even in the most employee-friendly states.

An example of this can be found in a case from Wisconsin's Eastern District, which involved an effort by Miles Henderson to have his non-solicitation/non-disclosure agreement with U.S. Bank invalidated. Henderson was a manager of investment portfolios for U.S. Bank clients and left to start a competing firm. He sued U.S. Bank, contending his restrictive covenants were void under Wisconsin law.

Because of Wisconsin's strict blue-pencil rule, any invalid part of a non-compete can doom otherwise enforceable provisions. This, no doubt, fueled Henderson's interest in seeking immediate relief. He moved right away for judgment on the pleadings, contending the entire agreement was unenforceable without consideration for any facts or circumstances unique to his case.

The court, however, denied the motion. In particular, the court found that the non-disclosure clause, which protected U.S. Bank's confidential information, was not invalid as a matter of law despite the fact it had no time limit. Under Wisconsin law, a non-disclosure clause is treated as a restrictive covenant, which subjects it in most cases to the requirement that it have a reasonable time limit. In most other states, non-disclosure clauses do not need to have temporal or geographic restrictions. The court recognized that some Wisconsin decisions seemed to depart from the general rule and uphold non-disclosure covenants that have no time limit. At least during the initial pleadings stage, the court could not find the agreement was invalid as a matter of law.

The court also rejected Henderson's argument that the customer non-solicitation covenant was invalid as a matter of law. The covenant was fairly narrow, basically limiting Henderson's ability to work with clients or prospects he developed while at U.S. Bank or about whom he had confidential information. In other words, the non-solicitation restriction was not a blanket prohibition on working with any U.S. Bank customer - a provision which could extend to many thousands of potential clients Henderson did not even cultivate. The court noted that the non-solicitation was drafted reasonably, and the lack of a geographic term did not render it unenforceable.

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Court: United States District Court for the Eastern District of Wisconsin
Opinion Date: 5/11/09
Cite: Henderson v. U.S. Bank, N.A., 615 F. Supp. 2d 804 (E.D. Wis. 2009)
Favors: Employer
Law: Wisconsin

Third Circuit Clarifies Standard for Misappropriation of Confidential Information (Thomas & Betts v. Richards Manufacturing)

After many years of practicing in this area, it is surprising to me we don't have more court decisions like this.

Most employment agreements contain some sort of contractual commitment on the part of an employee not to disclose confidential information belonging to an employer. The contractual clauses are sort of "trade secret-lite" obligations. Where the focus of a trade secrets dispute is the type of information at issue, a claim involving breach of a confidentiality clause generally depends on what an employee has and what he has done with it. The nature of what was taken or retained is far less important than the fact it was retained at all.

In Thomas & Betts Corp. v. Richards Mfg. Co., the Third Circuit reversed a summary judgment order in favor of the defendants on a breach of confidentiality claim. The nature of the alleged misappropriated confidential information - customer data and technical product drawings - is fairly typical in an employment dispute. The individual defendant, Glenn Luzzi, admittedly retained documents after he parted ways with T&B.

On appeal, T&B dropped its claim that this information rose to the level of a trade secret. That admission is significant; it eliminates various damages theories, and in many states, the opportunity for punitive damages and fee-shifting.

But certain information which is not protected under the laws of trade secrets may still be confidential, and it is here where the District Court applied the wrong test. The Third Circuit remanded and ordered the court to consider the following factors when determining whether Luzzi breached his obligation of confidentiality:

(1) whether the information was generally available to the public;
(2) whether the defendant would have been aware of the information if not for his employment with T&B;
(3) whether the information gave the defendant a competitive advantage; and
(4) whether the defendant knew T&B had an interest in protecting the information to preserve its own competitive advantage.

The court did note that these factors were not elements of the underlying cause of action. New Jersey is not unlike many states, even though it has not adopted the Uniform Trade Secrets Act. Common law breach of confidentiality claims exist in most jurisdictions, and the Thomas & Betts decision no doubt will be influential in how courts assess these causes of action.

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Court: United States Court of Appeals for the Third Circuit
Opinion Date: 7/30/09
Cite: Thomas & Betts Corp. v. Richards Mfg. Co., 2009 U.S. App. LEXIS 16837 (3d Cir. July 30, 2009)
Favors: Employer
Law: New Jersey

IBM Rebuffed In Another Attempt to Enjoin David Johnson (IBM v. Johnson)

I previously wrote about the bizarre litigation between IBM and David Johnson, a highly paid executive who left to accept a new position at Dell. Judge Stephen Robinson rejected IBM's attempt to enforce a non-compete, because quite simply Johnson never agreed to the non-compete terms while employed at IBM.

Judge Robinson's admonition in his June 26 decision that IBM faced a "daunting, if not insurmountable, task" in prevailing apparently did not deter IBM and its law firm one bit. IBM filed an appeal along with a request that the Second Circuit issue an injunction. Though the appeal will be expedited, the motion for an injunction pending appeal was denied.

IBM then filed another request for injunctive relief in the district court, seeking essentially the same relief on the same set of facts known to it prior to the June 22 preliminary injunction hearing. The only difference: the legal theory on which IBM proceeded. Rather than basing its claim on Johnson's violation of a non-compete agreement, IBM posited that Johnson should be enjoined under a confidentiality agreement signed with IBM. It sought to enjoin him from working in any role at Dell that would require him to advise Dell on mergers and acquisitions, or to participate in strategic decisions concerning certain of Dell's products or services.

The court, to put it mildly, was unimpressed with IBM's serial motions for injunctive relief. As the court stated: "This Court shall not allow IBM to litigate this matter through piecemeal, seriatim motions requesting the same relief, especially when the information that is the basis for the successive motion was in IBM's possession at the time of the filing of its first motion for preliminary injunction. This method of proceeding - which would require another bout of expedited discovery and likely would require another extensive evidentiary hearing - is vexatious and does a great disservice to the interests of Mr. Johnson and of the Court in the orderly conduct of this litigation."

In essence, the court applied a motion for reconsideration standard to IBM's request. IBM clearly should have included this legal theory within the presentation of its first motion, and because no after-acquired evidence formed the basis for the injunctive relief sought, IBM had little grounds to proceed on a new legal theory closely related to one already rejected by the Court.

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Court: United States District Court for the Southern District of New York
Opinion Date: 7/30/09
Cite: IBM v. Johnson, 2009 U.S. Dist. LEXIS 66851 (S.D.N.Y. July 30, 2009)
Favors: Employee
Law: New York

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

Employee's Declaratory Judgment Claim on Non-Compete Not Ripe for Decision (McKenna v. PSS World Medical)

It is difficult enough these days for employees to go job-hunting, even in their areas of expertise. But that task becomes more complicated if the employee has a non-compete hanging over his head.

For some employees, pursuing a declaratory judgment action regarding the enforceability of a non-compete is an investment worth making. Though expensive, this type of action, if successful, can help an employee escape the shackles of a non-compete and lead to a prosperous job opportunity. New employers may even be willing to subsidize a lawsuit, particularly if it is successful.

However, there is no guarantee an employee's declaratory judgment claim will ever get heard, particularly if the venue is federal court. And this is exactly what happened to Mark McKenna, a medical equipment salesman, who challenged his non-compete only to have a federal court dismiss it on the grounds there was no ripe dispute.

McKenna's claim resembled one I see frequently. An employee has an agreement which is arguably overbroad in its restrictions, and he has identified potential job opportunities which may be available to him but for his non-compete. McKenna filed suit and alleged that not only was he aware of certain opportunities in the medical supply business, but also that "prospective employers [were] unwilling to hire him as a result of the existence" of his non-compete.

McKenna did not allege that he had an offer or conditional offer from a specific new employer. It was this omission that proved fatal. McKenna's former employer removed the action to federal court and argued that the controversy was not ripe for review under the Declaratory Judgment Act.

That statute permits (but does not require) a court to declare the rights of the parties in the case of an "actual controversy." Under the Third Circuit's interpretation of the Act, this requires a court to focus on three factors when determining whether to issue a declaratory judgment:

(1) the adversity of interest;
(2) the conclusivity that the declaratory judgment would have on the legal relationship between the plaintiff and defendant; and
(3) the practical help of the judgment.

The court held that the "adversity of interest" factor did not favor the exercise of jurisdiction, primarily because McKenna never alleged a specific opportunity being foreclosed by his ex-employer's threatened enforcement of the non-compete. If an employee can locate a job opportunity, secure a commitment of some kind regarding his hiring, and demonstrate an effort by the ex-employer to enforce the covenant, the "adversity of interest" factor likely will favor jurisdiction.

The second factor, "conclusivity", also indicated the court would be issuing an advisory opinion. For starters, the court had no set of facts regarding the employment opportunity. Most likely, the court thought it could not apply a "reasonableness" standard to the covenant without any idea of what job McKenna was seeking. The other unspoken factor was that the covenant at issue was a client non-solicitation clause, a restriction that is inherently fact-specific and less broad than an outright prohibition on work in an industry.

Finally, the court held that the "utility" factor was no help to McKenna. The court's reasoning here was curious - it basically said that it could not consider the impact of a ruling on a third party such as McKenna's prospective employers. Arguably, this makes no sense since a person's ability to become employed is totally dependent on the willingness of someone to hire him or her. The court would have been better off ruling that the client-specific nature of the restraints would require the court to consider very specific facts about McKenna's new employment before determining whether the covenant was valid.

Declaratory judgments may indeed be helpful for employees. When the restraint that is subject to challenge is an activity covenant - a non-solicitation or a non-disclosure clause, for instance - the task of declaring a party's rights becomes complicated. Those covenants are always fact-specific, as solicitation of one client may be permissible but another may be improper even under a well-drafted covenant. For general non-compete clauses, the court may have a basis to rule on an agreement without hearing detailed evidence about a specific job opportunity. The law concerning those restrictions is such that a determination on the face of the document may be proper.

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Court: United States District Court for the Western District of Pennsylvania
Opinion Date: 7/9/09
Cite: McKenna v. PSS World Medical, Inc., 2009 U.S. Dist. LEXIS 58292 (W.D. Pa. July 9, 2009)
Favors: Employer
Law: Federal