Protecting the Franchise Against Unfair Competition
by Cheryl Mullin and Christianne Edlund
Because the franchise relationship is built on a foundation of sharing trade secrets, confidential information and customer goodwill, the standard franchise agreement will contain covenants not to compete that prohibit a franchisee’s involvement in a competitive business during the franchise term and for a number of years following termination or expiration of the franchise term.
During the franchise term, the geographic limit on the restriction is very broad, and typically includes any jurisdiction in which the franchisor or its franchisees conduct business. A geographically broad restriction is reasonable in this context because a franchisee has continuing access to a franchisor’s trade secrets, confidential information and beneficial supplier relationships throughout the franchise term. A franchisee should not be able to divert these benefits to another business that pays no royalties to the franchisor, or to use those assets to unfairly compete with other franchisees or company-owned businesses.
For a limited time after the franchise relationship ends, most franchise agreements prohibit a franchisee from operating a competing business at the former franchised location or within a certain distance from other franchised- or company-owned locations. Preventing the former franchisee from continuing to operate a business at the former franchised location gives the franchisor some time to refranchise, and to protect its goodwill in the former franchisee’s trade area while the new franchisee gets established. Preventing the former franchisee from operating a business near other franchisees protects other franchisees from unfair competition.
Enforcement of a franchise agreement noncompete provision is governed by the Texas Covenants Not to Compete Act, which provides for enforcement if the covenant is “ancillary to or part of an otherwise enforceable agreement at the time the agreement is made to the extent that it contains limitations as to time, geographical area, and scope of activity to be restrained that are reasonable and do not impose a greater restraint than is necessary to protect the goodwill or other business interest of the promisee.” In the franchise context, examples of legitimate protectable interests include business goodwill, trade secrets and other confidential or proprietary information.
The Act further provides that if the covenant is ancillary to a personal services agreement (in other words, an employment contract), the promisee has the burden of proving that it meets the applicable enforcement criteria. If the agreement has a different primary purpose (such as sale of a business), it is the promisor’s burden to show that the covenant fails to meet those criteria. Although the Texas Supreme Court has not directly addressed this issue in the context of franchising, other Texas courts have held that a franchise agreement is not a personal services contract and, therefore, it is the franchisee’s burden to prove that a covenant is unenforceable.
When seeking to enforce a covenant not to compete in a franchise agreement, it is generally the franchisor’s burden to prove the elements necessary for an injunction, including that irreparable injury will result if injunctive relief does not issue. Although a typical franchise agreement will state that violation of the covenant not to compete will result in irreparable harm, contractual stipulations are insufficient, by themselves, to support a finding of irreparable harm. Because injunctive relief is an extraordinary remedy, courts have held that contractual stipulations are merely one factor to be examined in making the irreparable harm determination.
Finally, it is important to determine who is subject to the obligation. Noncompete provisions bind the “franchisee” and often purport to bind the franchisee’s “owners” (which, to create a binding agreement, requires the owner’s signature on a written obligation). Sometimes, they will purport to extend to related parties, such as a franchisee’s family members, who are not parties to the franchise agreement. Although such a provision may not create an enforceable obligation against the nonsignatory, the fact that the nonsignatory is involved in a competing business may provide independent grounds for termination of the franchise agreement. Moreover, if a nonsignatory conspires, acts in concert or aids and abets the franchisee’s breach of a covenant not to compete, a court is likely to enjoin the tortious conduct.
Covenants not to compete are necessary to protect the franchise system from unfair competition, and will be enforced to the extent necessary to protect the franchisor’s legitimate business interests as determined on a case by case basis.
Cheryl Mullin is Founding Shareholder at Mullin Law, PC and can be reached at Cheryl.Mullin@mullinlawpc.com. Christianne Edlund is Managing Attorney at Mullin Law, PC and can be reached at Christianne.Edlund@mullinlawpc.com.