Non-Competition Covenants

Most franchise agreements contain “non-compete” provisions which prohibit the franchisee from operating a business that competes with the franchised business. Most frequently, the franchise agreement defines what constitutes a “competitive business” and then provides that the franchisee cannot own, operate, or assist in operating a competitive business during the term of the franchise agreement, and for some period of time after the agreement expires or is terminated.

The standard justification given for such provisions is that the franchisor provides the franchisee with valuable specialized “secret” or “proprietary” information and know-how, and that it would be unfair to allow the franchisee to use the franchisor’s proprietary information to compete with the franchisor or the franchise system. In many franchise systems there is little or no secret or proprietary information (with the exception of recipes in some restaurant franchises), and the value of the franchise is mainly due to the trademarks and the public recognition which comes with them. Since even without a non-compete provision a franchisee loses the right to use the trademarks and any actual trade secrets when the franchise agreement ends, the standard justification arguably devalues the contributions, intelligence and experience of the franchisees, and overvalues the non-trademark aspects of the franchise system.

The intended (and actual) effect of non-compete provisions is to limit the franchisee’s options. During the term of the agreement they limit the other businesses a franchisee can own or invest in. This can keep a successful franchisee from expanding in its area of competence except by purchasing additional franchises. More significantly, they limit the franchisee’s ability to plan for the future, after the franchise’s term ends. Such provisions can mean that the franchisee’s business and customer relationships, experience, location, equipment and inventory are worth little or nothing at the end of the franchise relationship. Almost all franchise agreements have a limited term. Renewal is not guaranteed, and if available generally requires the franchisee to satisfy the franchisor’s conditions which may include signing a franchise agreement that is significantly different from the previous version. There may also be other good reasons for a franchisee not wishing to renew. Since the relationship is probably not going to last forever, it is prudent to plan for life after the franchise, and non-compete provisions make this more difficult.

Enforceability: California

The obvious question therefore, is whether the non-compete provisions are enforceable? The answer depends on a number of factors, but the single most important factor is where you live. Some states have a law which prohibits enforcement of contracts which act as restraints of trade, but California takes its law exceptionally seriously.

California Business and Professions Code Section 16600 states:

Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.

The California courts have consistently held that this law means what it says – that non-compete provisions are not enforceable. The only exceptions are where the provision is in a contract for the sale of a business or the sale or dissolution of a partnership or limited liability company. These exceptions recognize that it would be unfair for a business owner to sell the goodwill associated with a business and then essentially take it back by opening a similar business nearby. Franchise agreements have been held not to involve the transfer of goodwill, so non-compete provisions in franchise agreements do not fall within an exception to Section 16600’s rule.

Separate laws prohibit use of trademarks or trade secrets without the owner’s permission. So even in California, when the franchise agreement expires the franchisee cannot just continue operating the franchised business. But, in California an ex-franchisee who removes the trademarks, stops using any genuine trade secrets, and changes the look of the business enough so it cannot be confused with the franchise, generally cannot be forced out of business due to a non-compete provision in the franchise agreement.

Enforceability: Other States

A little less than half of the other states have a restraint of trade law, some of them identical to Section 16600. In most of the remaining states there are common law decisions applying to non-compete covenants in various types of contracts. In either case, in the majority of states covenants against competition are generally enforceable, at least to some extent. Most states’ courts will analyze the reasonableness of the restrictions on the franchisee in light of the protectable interest of the franchisor. What interests are protectable, and what restrictions are reasonable vary from state to state. In addition, some states’ courts will re-write an unreasonable restriction to make it reasonable, while others will merely invalidate it.

Enforceability: During and After the Term

A final distinction is between non-compete covenants which apply during the term of the franchise agreement (“in-term”) and covenants which apply after the franchise term is over (“post-term”). The arguments supporting enforcement of in-term covenants appear somewhat more compelling than those regarding post-term covenants: It could be considered particularly egregious for a franchisee to go into competition with the franchise system while it is part of the system.

Under California’s strict non-enforcement statute it can be argued that there is no legally meaningful difference between in-term and post-term covenants, and that neither is enforceable. A relatively recent Federal Court decision, however, weakens that argument. In 2009 the 9th Circuit Court of Appeal held that under California law an in-term covenant against competition could be enforced to prohibit a licensee from competing in the same counties as the licensed business. This decision conflicts with the California Supreme Court’s statements about Section 16600, and relies on cases which can be distinguished. Nonetheless, 9th Circuit decisions are binding on federal courts in California, so there is the possibility that California franchisees could face significantly different results on this issue depending on whether the matter is heard in federal or state court.