Franchise Non-Compete Agreements: Mostly Unenforceable as Written
The Relevant Legal Framework and How We Got Here
Over the past several decades, courts in many jurisdictions have routinely issued injunctions in franchise non-compete cases, incorrectly treating these matters as pure breach of contract cases rather than antitrust cases. The analysis often centers on one fact: that the franchisee signed a contract. From there, franchisors will often make generic allegations about confidential information or customer goodwill, causing courts to overlook the applicable "legitimate business interest" test, leading to a rubber-stamped injunction in the process.
This is wrong and has led to the erosion of many logical (and legal) defenses to non-compete claims. Franchise non-compete agreements should instead be analyzed under two lenses. The first being the restraint of trade lens which requires us to ask: Is the restraint of trade reasonably necessary to protect a legitimate business interest? In evaluating reasonableness, courts should ask what the restraint (i.e. the franchise non-compete in this example) is protecting. However, many mistakenly consider “reasonableness” only as it relates to temporal or geographic scope. From a policy standpoint, the only legitimate purpose for enforcing a non-compete agreement is to prevent unfair competition by prohibiting the defendant from unfairly taking advantage of truly valuable, confidential, proprietary information (i.e. certain special customer relationships; goodwill) or – under limited instances – an extraordinary investment in an employee’s education or training.
Logically, it should be incumbent upon the party seeking to enforce the non-compete agreement to prove the existence of that legitimate business interest and the imminent threat of unfair competition before the case is analyzed under the breach of contract lens. If no legitimate business interest exists, then the contract should be deemed unenforceable. Depending on the jurisdiction, however, the non-compete will either be struck completely or blue-penciled (tailored). Unfortunately, blue-penciling incentivizes companies to use over-broad, abusive non-compete agreements knowing that (1) most people subject to those non-compete agreements will not challenge them and (2) if there is a challenge, the non-compete will simply be tailored rather than struck.
Franchise Non-Compete Agreements: Background
Before we address the legitimate business interest test, it’s important to consider that, in order to establish a franchise, franchisees have to pay significant start-up costs. Let’s use McDonald’s as an example. If you’re starting a McDonald’s franchise, you’ll pay McDonald’s corporate a franchise fee plus start-up costs for construction and equipment. Those start-up costs can be as high as $2 million depending on factors such as location, size, and decor. A franchisee will also pay McDonald’s 4% of its annual gross sales, as well as rent (because McDonald’s owns the physical property) which is paid as an additional percentage of gross sales. For McDonald’s that figure ranges between 8.5% and 15%.
Does the situation described above look anything like the classic employment non-compete case where the company claims that the employee built special customer relationships while employed by the company? No. Does it resemble the non-compete you’d see associated with the sale of a business where the purchaser could claim they bought the business and all the goodwill associated with it, thereby entitling it to enter the market without competition from the seller? No. In fact, it’s nearly the exact opposite scenario: The franchisee is paying the company millions of dollars over the course of their business relationship to occupy a certain space in the market. Treating the franchisor similar to an employer or the purchaser of a business is logically incoherent. When the franchise relationship is over, the franchisee should be able to do whatever it wants short of continuing to hold itself out as – using the example above – a McDonald’s. Nonetheless, courts remain relatively deferential to franchise non-compete agreements.
Franchise Non-Compete Agreements: Legitimate Business Interests
Here’s a great example: Bob is a franchisee of five McDonald’s locations in a high traffic area but decides not to renew his franchise agreement. According to his franchise non-compete agreement, Bob is prohibited from working in, owning, or operating any quick service food establishment for three years from the date the franchise agreement ends. Under this set of facts, Bob wouldn’t be allowed to own or operate a Wendy’s, Chipotle, or any other quick service food establishment for the next three years! Let’s run this through the legitimate business interest framework.
Say Bob goes across the street and starts a Five Guys franchise. McDonald’s will argue: “Bob signed a contract, now he’s across the street running a Five Guys?! It’s a burger place, just like McDonald’s! This is unfair competition!” But how does this implicate any legitimate business interest and threaten unfair competition? The answer: It doesn’t.
Confidential Information. Confidential information only qualifies as a legitimate business interest when that information is valuable, truly confidential, unique to the holder, and the defendant (Bob) could use that information to gain an unfair advantage. Let’s assume that Bob had access to certain confidential information about methods, processes, strategy, etc. It’s highly likely that numerous other quick service restaurant chains have the same general strategic market data information about methods, processes, strategy, etc. If, for example, McDonald’s has specific financial data related to its sales in various markets, that information might be valuable to someone running a McDonald’s in the same exact location, but it’s probably not very useful for somebody running a Five Guys down the street. While Five Guys also sells burgers, it’s an entirely different product and market. Information about running a McDonald’s – confidential or otherwise – is irrelevant to someone running a Five Guys, and even less relevant for somebody running a different type of quick service food establishment such as a Wendy’s or a Chipotle.
Customer Relationships & Goodwill. McDonald’s can’t plausibly contend that Bob could somehow convert walk-in, retail McDonald’s customers to Five Guys customers. Even if McDonald’s somehow made such a showing, they can’t demonstrate that it involves unfair competition or any legitimate business interest. Bob’s switch to Five Guys isn’t depriving McDonald’s of any substantial, special, protectable customer relationships. Customers who want McDonald’s will get McDonald’s while customers who want Five Guys will get Five Guys. It’s not unfairly harming McDonald’s customer goodwill. These are walk-in fast food customers. There are no contracts. Customers aren’t making these purchasing decisions based on goodwill. Market dynamics don’t suggest exclusive or near-exclusive, long-term relationships with customers that other competitors couldn’t otherwise get access to. The only legitimate threat to McDonald’s customer relationships and goodwill would be if Bob stayed in the same location, changed the name of the restaurant to Bob’s Burgers, and used a similar logo, color scheme, etc. If that were the case, then there’s a potential violation of trade dress under the Lanham Act for which there’s a separate remedy.
Training. Most of the time, there’s nothing unique or extraordinary about any company’s training. Most corporate training programs are built on other well-established, commercially available training programs Unless the training is truly extraordinary and goes beyond what somebody could get elsewhere in the industry, any claimed interest in training is likely not protectable as a legitimate business interest (if the law is correctly applied).
The only legitimate restriction under the example above would be a post-term restriction prohibiting Bob from operating a burger restaurant at the exact same location. But since McDonald’s likely owns the property, that’s impossible. If Bob goes anywhere else – even across the street – and opens a competing burger franchise, it shouldn’t matter. That wouldn’t threaten McDonald’s confidential information, customer relationships, or any interest in “extraordinary” training. There’s no legitimate business interest or true threat of unfair competition. It’d be one thing if it ended there, however, McDonald’s considers 7-11, Dunkin’ Donuts, KFC, Pizza Hut, Subway, and Starbucks (among others) to be competitive businesses. McDonald’s isn’t concerned about preventing unfair competition. Rather, it’s just one of several franchisors who use franchise non-compete agreements to (1) prevent ordinary competition and (2) prevent franchisees from leaving by limiting their post-term business options. The vast majority of large franchises use incredibly broad franchise non-compete agreements that are unenforceable as written and not necessary to protect any legitimate business interest. So, what do you do?
Check the choice of law. That alone could be dispositive. California has no exception for franchise non-compete agreements. In Florida? You’re in for an uphill battle until you get to the right appellate court or, the United States Court of Appeals for the Eleventh Circuit.
Declaratory Judgment. Don't sink a ton of money into a new venture until you clear any applicable franchise non-compete agreements off the table. This is fertile territory for a declaratory judgment action.
Rick Duarte is the owner of The Duarte Firm, P.A., where he focuses his practice on business law. He received his law degree from the Emory University School of Law and has been named a “Rising Star” in Business Litigation by Florida Super Lawyers for 2016 – 2019. Rick also serves as general counsel to emerging and medium-sized businesses, guiding clients through corporate governance, risk management issues, and strategic decisions where business and law intersect.