The Franchise

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.