May 7, 2015 - Franchise Articles by |

Post-Term Restrictive Covenants Not-To-Compete In Franchise Agreements

The existence of a post-term restrictive covenant (also known as a franchise noncompete clause,a franchise covenant not to compete or franchise covenant not-to-compete) in franchise agreements or distribution agreements that prohibits franchisees and dealers from working or operating competitive independent businesses at the conclusion of their franchise terms is common-place. Very simply, these provisions bar franchisees from operating or owning competitive businesses in their post-franchisee lives. Although franchise lawyers and franchisees object vociferously to the validity of such post-term restrictive covenants, courts nevertheless readily approve of and enforce them; however, from time to time a good franchisee lawyer is able to convince a court to invalidate such a restriction. Franchisors contend that they are necessary to protect the goodwill associated with former franchisees’ businesses, franchisees argue that they are the ones who created the good will in the first place, and that they need a way to earn a living. Sometimes the antipathy of some courts towards franchisees in general is so strong that it leads to the odd situation where a court will strike down the covenant not-to-compete, but finds that the franchisee's post-termination competition is unlawful for other reasons. 

Restrictive covenants are triggered not only by terminations, but expirations as well. They apply regardless whether the franchisee has been at fault at any time during the franchise term. The test applied by courts in evaluating whether a covenant-not-to-compete is valid, is whether the prohibition is “reasonable” in time and substantive scope. Courts grant franchisors such great a latitude in crafting these clauses, that absent a clause prohibiting competition “anywhere in the United States for 20 years” the clause will be held to be reasonable.

The purpose of this short article is not to explore the nooks and crannies of this legal reasonableness standard. I have written about that issue in other articles. The question today is a more narrow one: assuming the reasonableness of any particular restrictive covenant, will the franchisor also be able to bind non-signatories to the franchise agreement. For instance, where a husband is the only signor on a franchise agreement, do franchisors have the legal right to enjoin the franchisee’s wife or other family member from operating a similar competitive independent business after the termination or expiration of the agreement.

A cursory perusal of the relevant cases reveals an interesting, but jurisprudentially disturbing, fact – courts utilize very different legal theories to justify stretching the boundaries of non-compete clauses to reach those who do not sign franchise agreements. Set forth below are a few cases that illustrate how courts have applied these theories and principles.

In McCart v. H&R Block, the court held that a non-signatory to an H&R Block franchise agreement, the husband of the franchisee, could be enjoined from competing with Block after the termination. The court ruled that a stranger to a covenant may be enjoined from aiding and assisting the covenanter in violating his covenant. After the franchise agreement had terminated, the defendants attempted to establish an income tax preparation business relying upon the supplies, slogans, customer listing, telephone listings, and mail in which H & R Block had a proprietary interest. The court found that although a party usually cannot be bound by the terms of a contract he did not sign, the rule does not apply where the non-signatory’s activities constitute a conspiracy for its breach. Further, the court found that the defendant could be held under an alter-ego theory.

In essence, the court found that the defendant’s conduct of the business was a “veiled subterfuge” designed to avoid the franchisee’s obligation under the franchise agreement. The court, relying in part upon the husband and wife’s having treated the franchise and new business as their joint operation for tax purposes, found that the husband and wife had always held themselves out to the public that way. The court concluded that: “Robert knowingly participated and aided June in the violation of her contract with Block. Their cooperative conduct amounted to mere subterfuge designed to avoid June's obligation under the contract.”

In Merry Maids v. Merry Maids Franchise, a franchisor of a cleaning service business sued the former franchisee, and his wife, alleging that both of them were bound by the franchise covenant not-to-compete (post-term-restrictive covenant), even though the wife had not signed the franchise agreement. After the expiration of the franchise agreement, the husband gave his wife $10,000 to start her new cleaning service and transferred the assets of the old business to her. Moreover, the wife hired the former employees of the franchise to work for the new business and solicited the former customers of the franchise. The court banned the wife from operating the business after the franchise agreement was terminated.

In Pirtek v. Zaetz, the court appears to have used a very simple “assistance” test to examine a father and son’s post-term alliance in establishing an industrial and hydraulic hose business. In concluding that the father had assisted his son in establishing the new business, the court relied upon the facts that the son’s business was at the same address as the father’s, the mobile hose business of the son was almost identical to that of sold his father, and the son’s having told his father’s customers that he was continuing his father’s business just under a different name. In the face of the son’s substantial monthly payments to his father, the court concluded that it was “not believable” that these payments could merely be payments for the leasing of equipment. Accordingly, the court enjoined the son from operating his business.

In Medicine Shoppe v. Pill Dr. the franchise agreement between the franchisor and Cape Fear required Cape Fear to operate the pharmacy as a Medicine Shoppe Pharmacy. Neither the successor company, Pill Dr., nor its principal, Swartout, signed the franchise agreement. The court appeared initially to define the issue as whether Pill Dr. or Swartout was the alter ego of or successor in interest to Cape Fear. Although Pill Dr. did not automatically begin servicing Cape Fear's customers, it began operations in the same location, with the same phone number, employees, and pharmacist-manager, and invited Cape Fear's customers to transfer their prescriptions using a form indicating that only its name had changed.

Since liability will flow to a successor if there has been a sale of substantially all of the predecessor’s assets, the court traced the assets that had been transferred from Cape Fear to Pill Dr. Cape Fear's inventory of drugs and stored the drugs, office equipment, and other fixtures were boxed up by Swartout and kept in the pharmacy's store room. However, the patients’ files, store location and store furnishings were transferred to Pill Dr. This was dispositive because the court found that the primary assets of a pharmacy are its inventory, its customer and patient files, and its location. The court did not hesitate to prohibit the new entity, Pill Dr., from operating.

If for some reason you foresee a termination or expiration of your franchise agreement on the horizon, you should promptly obtain an opinion from an experienced franchise attorney to determine whether the post-term covenant would be held to be valid, who it would arguably cover, and what activities in particular it would prohibit. Waiting until after the agreement expires or is terminated to get answers to these questions could spell the difference between your being able to earn a living or instead having to hit the unemployment lines.

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