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Covenants Not To Compete: Another Franchise Quandary

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 brad@hughesnassociates.com 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.

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Covenants Not To Compete: Another Franchise Quandary

Small Business