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.

In The News:


Business Insider

Survey finds UK small business confidence on the wane
ABC News
A lobby group for small businesses in Britain is warning that rising prices and a stuttering domestic economy are driving confidence down and prompting an increase in the number of entrepreneurs considering selling their firms. In a quarterly survey of ...
UK small business confidence 'plummets' to its lowest level since the Brexit voteBusiness Insider
Small business optimism at lowest level since Brexit voteThe Times
Small companies' confidence plunges, says FSBFinancial Times

all 6 news articles »

Health benefit offers from small businesses keep vanishing
Fox Business
Cost was the main reason cited by 44 percent of those small businesses that don't offer benefits, Kaiser's study found. Seventeen percent said they were too small to offer coverage. Other employers said they didn't offer the benefit mainly because ...

and more »

Washington Examiner

Almost half of Export-Import Bank's small-business plans go totally unused
Washington Examiner
The Export-Import Bank, a federal agency blasted by conservatives and some liberals as corporate welfare, has bolstered the case for its existence in recent years by ramping up support for small businesses. But most of that "small-business support" is ...


Business Insider

iZettle gets €30m to invest in artificial intelligence for small ...
Business Insider
Swedish payment terminal company iZettle has won €30 million (£26.6 million) in funding from the European Investment Bank (EIB) to explore artificial ...
The EIB just invested €30 million in iZettle to provide Europe's small ...Business Insider Nordic

all 10 news articles »

Small Business Trends

Florida SBDC Offering Assistance to Small Businesses Impacted by Hurricane Irma
Small Business Trends
Small businesses remain closed or are struggling to re-open. And small business owners are faced with no electricity, limited cell service, damaged or destroyed properties, and limited resources to do anything about it. According to Dun&Bradstreet, 2 ...


Small Business Trends

iOS 11 Brings AR to iPhone, Is Your Small Business Ready?
Small Business Trends
Every iPhone 5s or later, or iPad Air or later is going to be able to run iOS 11 and the new Augmented Reality (AR) feature. If you are a small business, shouldn't you be making the most of these features? The availability of AR on iOS means instant ...

and more »

Small Business Trends

Are You Keeping Up with Employee Recordkeeping Requirements? You Might be Surprised
Small Business Trends
Paperwork and recordkeeping burdens can fall harder on small businesses because smaller entities have less staff to manage HR functions, or may not have dedicated HR resources at all. But the good news is that technology can help you stay on top of ...


Florida Times-Union

Small Business Administration opens Jacksonville disaster ...
Florida Times-Union
The U.S. Small Business Administration has established a disaster assistance center in Jacksonville to help victims of Hurricane Irma secure loans to help pay ...
SCORE: Small business owners can get help in recovery from HarveyCorpus Christi Caller-Times

all 4 news articles »

Eagle 99.3 FM WSCH

Lawrenceburg Main Street Launches Small Business Boot Camp
Eagle 99.3 FM WSCH
(Lawrenceburg, Ind.) – Are you ready to take the first steps toward turning your daydream of starting a small business into a reality? Do you live in or near Lawrenceburg? If both of these pertain to you, consider applying for the Small Business Boot Camp.


Small business diversity summit Tuesday in Tuscaloosa
WBRC FOX6 News - WBRC.com
A lot of times, with small businesses, you're so busy running your business, you don't have the time to network and connect. And that's the opportunity we like to provide. We know that if you're stepping away from your small business, it's got to be ...

Google News

Beating the Small Business Cash Flow Blues

Small business owners can relieve a lot of their own... Read More

Build Your Small Business by Building Relationships

-- The One Pager Shortcut Series --People do business with... Read More

9 Things You Must Do To Maximize Your Chances Of Obtaining A Small Business Loan

To get approval for your small business loan application, you... Read More

Starting a Small Business: Balancing Risk and Reward

In a perfect world, starting a small business would be... Read More

Creating a Power Plan

Part of the power plan is making sure you have... Read More

Selling Your Business, Entrepreneurs Role

$elling $elling $ellingWhat makes a great sales person? Well, the... Read More

How Mastering 5 Essential Money Making Ideas Can Lead Your Business to Longterm Cashflow

Essentially there are 5 tremendously powerful methods to make money... Read More

Starting is the Hardest Part

You can't imagine how many people ask me how I... Read More

What Happened to the Money and Freedom?

Ask anyone trapped in a cubical about their entrepreneurial dream... Read More

Bogus Investor and Consumer Complaints and Consumer Misrepresentation

Like most regulatory bodies in the United States, the Federal... Read More

Setting Prices - Pricing Your Consulting Services

THE PSYCHOLOGY OF PRICINGIn case you hadn't noticed, people can... Read More

Self-Employment: Managing Your Money: Tips for Living with a Fluctuating Cash Flow (Part One)

The way you manage your money is one of the... Read More

Boat Cleaning Business Case Study: Entrepreneurship 101

How do marine type businesses start? Have you ever thought... Read More

Pressure Washer Companies and Steam Cleaner Maintenance

If you run a pressure washing business it is a... Read More

Nevada Incorporation: The Advantages of Incorporating in Nevada

Incorporation in Nevada has become an attractive option for savvy... Read More

Your Small Business Suggestion Box

A suggestion box is a really good idea for your... Read More

Top 10 Lessons for Small Business Success - As learned From My Twin 3 Year Olds

Small business success is very similar to learning to walk,... Read More

Getting City Contracts; Local Government Contracting

All cities have a purchasing office and/or a procurement officer.... Read More

Due Dilegence 101 Or What You Do Not Know Can Kill You! - Part 1

Introduction: This article is written as a general discussion on... Read More

Small Business Survival

In today's economic climate, the first priority for the small... Read More

The Role of the Business Model and Strategy for Business

People will always stress that having a well researched business... Read More

Knowledge is Power

Why does research and education play an important part of... Read More

Don?t Quit Before You Get to the City!

We were more than excited. Our women's doubles tennis team... Read More

A Portable Trade Show Exhibit Makes for an Easier Show

You can make your trade show experience much easier by... Read More

What Is YOUR Value Proposition?

Every company has a value proposition. That is a statement... Read More