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.

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If covenants not to compete following expiration/termination of

a franchise agreement are unenforceable in California, how can any franchisor that chooses to franchise in California claim - without being intestinally estopped - that failure to enforce the covenant elsewhere would constitute irreparable injury.

If it aint irreparable injury in California, it aint irreparable injury anywhere else.

What am I missing?

I think some judges realize california is another planet...

EMC Corp. v. Donatelli, Suffolk Superior Court, Civil Action 09-1727-BLS2, "Where Massachusetts has an interest in the employment relationship of Massachusetts employers and employees that is significant, this Court should not deny an otherwise meritorious motion for injunctive relief simply because another state may not enforce the injunction should the Massachusetts employee move to that state. Equitable considerations come into play here. It is one thing for a person who has lived and worked in California to wish to continue to live and work in California, only with a different employer. It is quite another for a Massachusetts resident who has agreed to a non-competition covenant, enforceable in Massachusetts, to choose for his new residence and place of employment the one state where the likelihood of his defeating his non-competition covenant may be the greatest..." "Defendant's claim is further diminished when the Court examines the reasonable expectations of the parties at the time of the non-competition was executed. A Massachusetts employer who obtains a non-competition covenant from an employee who at the time lives and works in California is on notice that, should the employee later resign and seek employment with a competitor, the California court will likely strike the covenant. Where the employee lives and works in Massachusetts, however, there is much less reason for the employer, at the time the employee executes the covenant, to expect that it will be unenforceable. Similarly, the Massachusetts employee, unlike his California counterpart, upon signing the covenant has reason to expect that it will be enforced..." "[Defendant] may move to modify this order upon a showing... that the services which he would provide to Hewlett Packard do not overlap with products or services being developed, produced, marketed or sold by EMC."

This has nothing to do with franchising covenants and their

stated dependence upon there being irreparable harm resulting from non compliance, and the absence of an adequate damages remedy. The Mass employer in your situation is not said to be operating also in California.

Some states - like Texas - have changed their covenant not to compete law to specifically permit the award of damages in covenant enforcement cases. Since such damages in a franchising case would be nigh impossible to prove, the courts are awarding "feel good" money in amounts determined by which party is seen to be most at "fault". Accordingly, there is no way in hell to predict outcomes vis a vis amount of damages.

In at least one Texas case the court adopted a rationale that the covenant ought to be enforced because if this guy gets away with it everyone would leave the franchise system. The judge failed to recognize that what he was saying is that the franchise has no perceived value to any franchisee. Franchisors now use that argument in every covenant case.

Hey - this sure beats honest work, doesn't it.

EMC has like 30 offices in California...

...wrong! The point this judge makes is valid...'what is the reasonable expectation at the time the contract was formed' is an issue the courts need to consider.