Franchisors: Competition Is Great So Long As You Don't Compete With Me

Almost every franchise agreement includes a post-term covenant not-to-compete whereby the franchisor has the right to thwart a franchisee’s right to operate or own a competitive business after the expiration or termination of the franchise agreement.

The enforcement of “covenants not-to-compete” or “post-term restrictive covenants” evokes strong reactions from franchisors and franchisees alike. Not surprisingly, franchisors are in favor of them, and franchisees are not.  While franchisors argue that such covenants are crucial to permit them to protect their interests in good will, trademarks, trade secrets and other confidential information, franchisees make the case that these restrictions are oppressive and destroy their ability to earn a living in their post-franchise world.

Restrictive covenants come in many shapes, forms and flavors; however, they do have one common link: they are almost always upheld and enforced by courts. Courts evaluate restrictive covenants under a very forgiving, malleable and many times outcome-determinative standard of reasonableness. Absent the case where a restrictive covenant bars a former franchisee from selling “anywhere around the world for eternity,” the overwhelming majority of restrictive covenants drafted by franchisors pass legal muster.

One issue that constantly arises in my practice is whether a franchisee can escape the claws of a post-term covenant if he were “to put the business in my wife’s or son’s name.” While in “the old days” the tactic had some legs, it no longer does. Today, it is clear that persons and entities who did not sign a franchise agreement can be held to the strictures of the agreement’s post-term covenant not-to-compete. Although courts’ rulings on this issue are not analytically pure, the bottom line is the same. 

For instance, in H&R Block v. Letha Nell Sheets, the court was confronted with a terminated tax franchisee’s daughter who had formed a new company and sold tax return services out of the same location that had been used by her mother, the former franchisee. The daughter prepared taxes for former customers of her mother, hired the former employees of her mother, used the same computers, furniture and telephone number as did her mother, and solicited directly by mail all of the former customers of her mother. In order to reach the daughter’s operations, the court used a successor liability theory even though the mother and daughter argued that no assets of the former franchisee had been sold or transferred to the daughter or her new business.

In Servicemaster v. Commercial Services a franchisee filed for bankruptcy and the assets of his franchise company became part of the bankruptcy estate. The franchisee’s son sought to purchase the assets formerly owned by the father’s franchise company from the estate using them in competition with ServiceMaster. Thereafter the bankruptcy court approved of the sale. The son’s wife then formed a new corporation in which she was the sole owner and officer and her husband then transferred all of the assets he had purchased from his father’s bankruptcy estate. No money changed hands and no price was established. The new business used the old one’s telephone and facsimile numbers. The new company did not offer any services that were not also offered by the franchise business before it, and it solicited former customers. The court stated that if it did not so extend the sweep of the covenant, the terminated franchisee could evade the ordered relief by acting through his straw men.

In ATC Healthcare Services v. Southwestern Staffing Services  a temporary health care staffing services franchisor sued the president of one of its staffing franchises by alleging that he personally breached the franchise agreement’s post-term covenant. After termination of the franchise, the president began operating a competitive business and took the former franchisee’s telephone number and customers. The court rejected the president’s argument against personal liability; it made no difference to the court that the president had not signed the franchise agreement in his personal capacity. The court also placed liability for violation of the restrictive covenant on the successor corporation as the “alter-ego” of the terminated franchisee, since the new company operated in the same business, shared the same resources, and had the same corporate principal as the terminated franchisee.

The best advice a franchisee attorney can give his client on this issue is to move to California and open a franchise out there. In California, all post-term covenants are void as a matter of law.