Covenants Not To Compete: Another Franchise Quandary
Imagine that you have operated a successful franchise business for the past several years. Your franchise agreement's term expires in the near future and you are contemplating whether renewing the agreement would be a wise business decision. In the past couple of years it has become all too apparent that you are receiving little, if any, benefit or assistance from your franchisor. Yet, you continue to pay the franchisor thousands of dollars each year in royalties and other fees. You therefore decide that it would make better "business sense" to operate independently after expiration of your franchise term. After all, you are very familiar with the business and have worked extremely hard in developing and establishing a solid client base to enable you to continue running a profitable and prosperous operation.
After your franchise term expires, you continue contacting and providing services for new and former clients ? albeit under a different business name. Shortly thereafter you receive a "cease and desist" letter from your former franchisor notifying you that you are in breach of your post-term covenant not to compete and could face court proceedings, including injunctive relief, if you do not immediately turn over all of your client and business records and stop operating from your current location. Effectively, you have been put on notice that you are no longer permitted to operate your business or, in most instances, carryon your livelihood.
This scenario, while overly simplistic in many respects, confronts many franchisees and often times results in dire consequences for their businesses. In law school, my professors taught me that "covenants not to compete" were "unfair restraints on trade" and courts across the country were loath to enforce them. Like many aspects of law school, this perspective lacked the practicalities of real life and failed to account for the complexities involved in analyzing commercial contracts. In the context of franchisor/franchisee relationships, covenants not to compete are routinely enforced to the detriment of the franchisee. While it is true that most courts do not favor restraints on trade, as these contract clauses are sometimes called, many courts have held that so long as the covenant not to compete is reasonable as to the geographical scope, the duration and the activities regulated, it is valid.
What Is A Covenant Not To Compete?
Simply put, a covenant not to compete is an agreement that prohibits an individual from operating or working for a business that is the same as or substantially similar to a business with which the individual was previously affiliated. This agreement is sometimes referred to as a post-term covenant not to compete and is common in employment agreements. In the context of franchises, covenants not to compete are designed, from the franchisor's standpoint, to protect franchisors from unfair competition from departing franchisees. For example, if a departing franchisee utilizes a franchisor's "proprietary" information to operate its own independent business, a court may find that it would be unfair and damaging to the franchisor and its existing franchisees to permit the departing franchisee to continue competing against them in the same market area.
Covenants not to compete can also be in effect during the term of a franchise agreement. These agreements are typically referred to as in-term covenants not to compete. In Keating v. Baskin Robbins, the Eastern District of North Carolina held that the franchisor had properly terminated a franchise agreement because the franchisee operated another ice cream store (in addition to operating the franchise store) within the covenant's restricted geographic area during the term of the franchise agreement. The court stated that so long as the covenant was geographically limited and reasonable, it was valid.
Enforcement Of Covenants Not To Compete
As mentioned above, so long as a covenant not to compete is reasonable as to the geographical scope, the duration and the activities regulated, there is a high probability it will be found valid and enforceable. Nevertheless, states employ differing standards to determine whether a restrictive covenant in a franchise agreement is reasonable. For instance, some states apply the same strict standard that is typically used in determining the reasonableness of an employment agreement's restrictive covenants. Other states apply a more lenient standard akin to the sale of a business. Still other states apply a blending of the elements of both relationships. In contrast, certain post-term franchise covenants not to compete in California are invalid as a matter of statute.
Franchise Covenants Not To Compete In Virginia
In Virginia, it is unsettled whether the stricter standard typically associated with employment contracts would govern, or whether the lessened standard related to the sale of a business would apply. The recent circuit court decision in Brenco Enterprises, Inc. v. Takeout Taxi Franchising Systems, Inc., sheds some light on how Virginia courts might analyze the issues involved in a breach of restrictive covenant case.
In Brenco, various franchisees of Takeout Taxi, a restaurant food delivery service, filed suit against Takeout Taxi alleging various causes of actions, including material breaches of contract. In addition, the franchisees sought a declaration that the post-term covenants not to compete contained in their franchise agreements were unenforceable. The restrictive covenants at issue prohibited the franchisees from directly or indirectly operating, advising or assisting in any business which was the same as or substantially similar to their franchised businesses, within a ten-mile radius of their "designated territories" or any other franchise locations in existence at the date of expiration or termination of their franchise agreements.
In overruling the franchisees' challenges to the covenants not to compete, the court found that the one-year, ten-mile restriction, as well as the activities restricted by the covenant (i.e., restaurant food delivery), were reasonable and enforceable.
In enforcing the covenants not to compete, the court utilized the lessened standard typically reserved for sales of businesses, rather than the heightened standard typically associated with enforcement of an employment covenant not to compete. While the court distinguished both scenarios in the franchise context, the court reasoned, among other things, that unlike an employment relationship, safeguards on competition of former franchisees is necessary to protect the economic interests of existing and future franchisees. Such protections, the court noted, are generally not as important to former co-workers of an ex-employee.
Despite the court's finding of reasonableness, the franchisees also attempted to attack the covenants arguing that the covenant was greater than necessary to protect Takeout Taxi's business interests in light of, among other factors, Takeout Taxi's decision to cease selling franchises. Nevertheless, the court found that despite Takeout Taxi's decision to stop selling franchises, it still had a "legitimate protectable business interest" and that the franchisees would be bound by the bargain of their agreement.
Needless to say, franchisees trying to escape the confines of a previously agreed to covenant not to compete under Virginia law may find themselves at the mercy of a court, as the franchisees did in the Brenco case. Not all situations are alike, however, and a franchisee looking to exit a franchise system and continue his or her livelihood in the face of a covenant not to compete should consider all viable options and attempt to resolve the matter before it goes to court.
What Can You Do?
In almost every franchise case where a franchisor is seeking to prohibit a departed franchisee from competing with the franchise system through enforcement of a post-term covenant not to compete, it is the burden of the franchisor to prove, among other things, that it will be "irreparably harmed" by the continuation of the departed franchisee's business. While most franchisors in covenant not to compete cases tend to reflexively repeat that they are being "irreparably harmed" by any actions taken by the franchisee after expiration or termination of the franchise agreement, the reality may be that there is very little impact, if any, on the franchisor or other franchisees.
Going back to our hypothetical above, in the event you are forced to defend against a franchisor's claim or suit for injunctive relief, you as the franchisee should consider, among many other factors, the relative number of competing businesses in your market area or the area defined by your covenant. If there are hundreds of competitors outside of your franchise vying for clients in your market area, the franchisor would have a harder time arguing that it would be irreparably harmed by one franchisee leaving the system. On the flip-side, you would arguably suffer more harm if the covenant was enforced against you and your livelihood was destroyed.
You should investigate the history of the franchise and whether similarly situated franchisees were forced out of business by hard-line enforcement tactics by the franchisor. If the franchisor in the past rarely sought enforcement of covenants not to compete against other franchisees, or accepted cash settlements in exchange for a release of the franchisee's obligations, such factors could go a long way in attacking the necessity of the covenant's protection for the franchisor's business interests. Remember, covenants not to compete are arguably intended to be a means to protect the franchisor from unfair competition ? not a tool to extort gargantuan sums of money out of hard-working businessmen and women.
Make Informed Decisions
Signing a franchise agreement that contains a covenant not to compete can potentially harm your business and restrict your ability to carryon your livelihood after your franchise relationship has ended. If you are an individual that has signed a franchise agreement with restrictive covenants, or are considering signing one, you should always review the contract language with an experienced franchise attorney and analyze it in terms of the statutory and controlling case law in the state where your franchise is located, as well as in the state designated in the franchise agreement for choice of law purposes. This will enable you to make the most informed business decision in order to continue maximizing your business interests.
Bradley J. Hansen is an attorney in the Northern Virginia law firm of Hughes & Associates. Mr. Hansen's practice focuses on franchise, construction and complex civil litigation.
Brad is admitted to the Bars of the Commonwealth of Virginia and D.C. Prior to joining Hughes & Associates, Brad practiced with a national litigation boutique law firm located in Washington, D.C. where his primary focus was on complex commercial litigation and franchise law. Brad has represented franchisees in state and federal courts throughout the country with regard to issues of encroachment, specific performance, fraud, monetary defaults, quality assurance defaults, wrongful terminations, franchise transfers and compliance with state and federal franchise laws.
Brad can be reached at firstname.lastname@example.org or by calling him at 703-671-8200.
This article is not intended to provide legal advice, but to raise issues bearing on legal matters.
Franchising in The Middle East There Will Bring Significant Opportunity for US Based Franchisors
As stability emerges in the Middle East there will be significant opportunity for the Franchising Community. Arab Franchising appears to be of interest for those seeking economic growth in much of that region of the World. They are more excited about economic expansion than we are in the US. They seem to understand the benefits of many small businesses employing millions of people and rightfully so. Check out this article:
Make Your Business More Profitable
More sales and more profit. Isn't that what you want from your business? It's not hard to achieve if you follow these 4 simple tips.
Cost Effective Franchise Regulations, Come again
The Franchise Group at the Federal Trade Commission in all their ego and glory has proclaimed that franchise disclosure laws are "Cost Effective." I hate to break it to the FTC, but your comments and court are completely naked. The folks at the FTC are wearing no clothes. In a recent franchise report put out by the commission they actually had the tenacity to say that these rules and regulations in the franchise law are cost effective.
Administration Of Your Small Business
You've been meaning to tend to the administration part of your business, that is, the growing list of things to do that relates to your small business. You've shoved all other appointments aside and starts getting down to working on the nitty gritty details, you're ready to go all out and tick everything on the list off! But where in the world is the list?
Franchisee; Vacation Managing
Do you own a franchised business? Over 400,000 franchised businesses currently operate in the United States, which is a true testament of free enterprise. There are many advantages of franchised businesses, which anyone who owns a small business has thought about. One thing they probably have not considered; whether they are franchisee or not is that in a franchise system; your local franchise runs as store exactly like yours. They are aware of every single aspect of your business. So it makes sense that if you want to go on vacation you should have the closest franchisee watch your store for you and you can return that favor for them later.
Using Technology to Manage Customer Loyalty
Don't let your customer satisfaction research initiative collect dust on a shelf. Integrate technology with research to optimize the use of customer information.
SBAs 8(a) Program Can Help Some Companies Compete
Q: A friend told me that as a woman of Native American descent I might be eligible for a special SBA program that will help me start a small business. He said I could compete for government contracts through this program. Can you tell me what SBA program he's referring to?-- Clara P.
Share Ad Expenses to Boost Profits
The challenges of the small business owner are well documented. They must battle for market share against larger competitors, run all aspects of their business, and even pay higher rates for advertising and other marketing related expenses. Small businesses generally do not qualify for volume discounts when it comes to buying advertising space or marketing materials, and thus they end up paying higher rates for the same ad space or marketing materials purchased by their corporate counterparts.
Making a Donation to Bring MORE Business
How a donation is different from a sponsorship and what is the advantage to you?
Are You Running Your Business or Is Your Business Running You?
Being a small or home-based business owner can be loads of fun and very rewarding.
10 Filler Activities for the Summer Business Slowdown
Summer is a time for the outdoors, for that well-deserved vacation, and with everyone out and about, it's also a time that you may notice a slowdown in demand for your products and services. So what can you do during this summer slowdown? Well, it's a great time to do the work that otherwise never gets done during the busy business year.
FTC Adding to the Franchise Rule
Last summer the FTC put forth a report and then asked for comments on modifications of the franchise rule. There has been no real significant changes since the 1970's, but lots of opinions and case law along the way. All these complications of rules and the rules proposed today by the Federal Trade Commission do not help franchisors remain efficient or franchisees sell more pizza, hamburgers or donuts.
Hard Money Lenders -- No Money Down The Easy Way
Would it help you as a real estate investor to be able to"Close For Cash in Days," even if you're tapped outfinancially?
Small Business Savvy: Reaching Key Big Business Decision Makers
As a solo entrepreneur or small business owner, one of our key challenges can be reaching key decision makers in larger companies. Getting to the right person who can seal the deal can be a frustrating experience, especially if you don't have a game plan. Here are three ways to connect with the right people.
Grants vs. Contracts
Commonly folks have asked me what the technical difference is between a contract and a grant. The difference is not about the dollar value or who the buying entity is nor the kind of work being done. Instead it is about the legal concept of default. In my eyes, the corner stone of whether something should be called a grant or a contract lies in whether one is legally bound to produce results as one is in a contractual relationship or whether you are simply granted funds to do something. Did you get that nuance? Perhaps that is oversimplifying it.
Arranging Your Fundraiser
When deciding to host a fundraiser for your company or organization there are many fundraising ideas available to you for choosing. The most popular fundraising ideas range from chocolate, magazines and candles to candy and much more!
What Your Small Business Can Learn From The Doctor
Most doctors never distinguish the difference between customers and patients. That's why they have waiting rooms instead of reception areas.
Small Business Planning -- Three Myths
Are you -- like 70 percent of small business owners -- working without a plan?
Image of Your Franchise Automotive Outlet is So Important
Image of your franchise automotive outlet is so important. Some say image is everything, well then if you buy a franchise you should be constantly thinking of image and cleanliness. If you read Ray Kroc's book "Grinding it Out" (McDonalds Visionary) or Tom Monahan's (Founder of Dominos Pizza) book "Franchising for Dummies" or Howard Shultz's book; "Pour Your Heart Into it" (Story of Starbucks) you will see they all built brand on image. Even for those of you who are the extroverted sales type, plenty of examples such as "Customer's For Life" by Carl Sewel and "Exceeding Customer Expectations" by Jack Taylor (founder of Enterprise Rent-A-Car). But as I travel the country and have literally been to every city in the country over 10,000 population in the US;
Top Ten Resolves for Building Your Business in 2005
1. Resolve to build a consistent network system.
|© Athifea Distribution LLC - 2013|