Post-Term Franchise Noncompete Provision Succumbs to Franchisee’s Legal Attack
By:
Jeffrey M. Goldstein
Goldstein Law Firm
(202) 293-3947
Jani–King of Omaha v. Anthony Waadah, 290 Neb. 629, Supreme Court of Nebraska. April 10, 2015
The infamous and ruinous post-term franchise noncompete clause reared its ugly head again, this time in the Nebraska Supreme Court. Although many post-term restrictive covenants (also known as franchise covenants not-to-compete or franchise noncompete clauses) in distribution and franchise agreements are upheld as valid and reasonable, some of them nevertheless remain vulnerable to successful legal challenge. In a recent case, the Supreme Court of Nebraska held that the noncompete clause in a professional cleaning and maintenance services franchise agreement was unenforceable against a former franchisee. As discussed more fully below, in the Nebraska case, the one-year noncompete covenant contained within the larger two-year noncompete clause in the franchise agreement was not severable from the different, two-year noncompete covenant, and thus the entire noncompete clause was ruled invalid.
In this Nebraska case, in 2008, appellant, Unlimited Opportunity, Inc., doing business as Jani–King of Omaha (“Jani–King” or the “Franchisor”), granted appellee, Anthony Waadah (“Waadah” or the “Franchisee”), a Jani-King franchise in Omaha, Nebraska. After the franchise agreement was ultimately broken, Waadah diverted a number of Jani–King’s Omaha customers to his new independent business. Jani–King thereafter sued Waadah for breach of the noncompete clause in the franchise agreement. The trial court held that the noncompete clause encompassed a sub-provision that was an unreasonable restraint on competition and refused to sever the offending subpart from the larger noncompete clause, resulting in the invalidation of the entire post-term covenant not to compete. On appeal, the Nebraska Supreme Court reaffirmed its general prior longstanding legal position against the severability of noncompete clauses.
The split-up between the Nebraska Jani-King Franchisee and Franchisor began in 2010, when Jani–King began receiving reports from its customers that Waadah was attempting to divert franchise customers to his own independent janitorial business. In this regard, the record shows that in January 2010, a dairy company terminated its relationship with the Jani–King Franchisee and thereafter immediately began receiving janitorial services from Waadah. Jani–King immediately thereafter terminated Waadah, claiming that this constituted a breach of the Jani–King franchise agreement. For 18 months following the franchise termination, Waadah operated Legbo Services of Omaha (Legbo), which provided janitorial services to several of Jani–King’s client accounts. Legbo also secured janitorial contracts from new clients in the Omaha area.
Interestingly, for purposes of the litigation, the parties also stipulated to the following legal conclusions, including: (1) that the noncompetition covenant in the franchise agreement protected “the reputation and goodwill associated with the franchise’s trademarks,” (2) that the noncompetition covenant in the franchise agreement protected Jani–King’s “overall investment in its franchise system,” (3) that the noncompetition covenant in the franchise agreement protected the “proprietary information and knowledge [Jani–King] disclosed to franchisees” through the course of the franchise relationship, (4) that the “intended purpose” of the non-competition agreement was the “protection of the integrity of the overall franchise system [and] protection of current franchisees in the Jani–King system,” and (5) that had the franchise agreement been followed, the new contracts obtained by the Franchisee after the termination would have belonged to Jani–King.
The portion of the noncompete covenant that gave rise to the noteworthy litigation stated, inter alia: “Franchisee … agrees that, during the term of this Agreement and for a continuous uninterrupted period of (2) years thereafter … commencing upon expiration or termination of this Agreement, … Franchisee … shall not … (d) Own, maintain, operate, engage in or have any interest in any business (hereinafter referred to as “Competing Business”) which is the same as or similar to the business franchised under the terms of this Agreement, which Competing Business operates, solicits business, or is intended to operate or solicit business: (i) within the Territory of this Agreement; and (ii) for a period of one (1) year commencing upon expiration or termination of this Agreement (regardless of the cause for termination), in any other territory in which a Jani–King franchise operates.”
The Court viewed this clause to incorporate two distinct and different noncompete restrictions prohibiting a franchisee from operating: (1) for 2 years the same or a similar business within the territory of the agreement; and (2) for a period of 1 year a competing business in any other territory in which a Jani–King franchise operates. The post-term time periods began to run under the franchise agreement upon expiration or termination of the agreement.
After a bench trial, the district court issued a ruling in favor of Waadah. In so finding, the lower court relied on a prior Nebraska case, H & R Block Tax Servs. to rule that it was unreasonable to restrict competition outside of the area in which Waadah actually conducted business. The trial court reasoned that “Since the 1–year restraint restricted commencement of a competing business “in any other territory in which a Jani–King franchise operates,” and since Jani–King operated in countries throughout the world, this restraint was deemed unreasonable in geographic scope.” After making this finding, the trial court concluded that it did not need to address the remaining parts of the noncompete clause, because “‘it is not the function of the courts to reform a covenant not to compete in order to make it enforceable.’” Jani–King appealed and petitioned the court for the unusual relief of bypassing the Nebraska Court of Appeals, which the Supreme Court granted.
On appeal, the Supreme Court initially explained that the case presented two different issues, including: “first, whether the 1–year noncompetition covenant was severable from the 2–year covenant, and if not, second, whether the entirety of the non-competition agreement is valid and enforceable.” With regard to the severability issue, the Court stated that “This court has long held that it is not the function of the courts to reform a covenant not to compete in order to make it enforceable.” In this regard, the Court explained that “We have declined to apply the “‘blue pencil’ rule,’ which allows for the reformation of covenants to make them enforceable, stating that ‘we must either enforce [a covenant] as written or not enforce it at all.’” The Court further observed that “We have found that ‘reformation is tantamount to the construction of a private agreement and that the construction of private agreements is not within the power of the courts.’”
The Court then explored the underlying reasoning supporting its rule against reforming a noncompete provision: “Though this position against the severability of noncompete covenants is the minority one, it is backed by important public policy considerations. Severability of noncompete covenants is against public policy because it creates uncertainty in employees’ contractual relationships with franchisors, increases the potential for confusion by parties to a contract, and encourages litigation of noncompete clauses in contracts.”
The Court then examined the continuing validity of its former decision in H & R Block Tax Servs., which the lower court relied upon in striking the post-term covenant in this case, summarizing the H & R Block Tax Servs. case as follows:
[A] noncompete clause restrained franchisees from competing in the business of preparing tax returns within 45 miles of the franchise territory for 1 year following termination of the franchise contract. One of the defendants had done tax planning for the franchisor in Ogallala, Nebraska, and later moved to North Platte, Nebraska, where she began an independent tax return preparation business. Some of her former clients from the franchisor’s similar business wished to retain her services after she moved. The former clients pursued and enlisted her services in North Platte. In that case, we found that separate paragraphs of a covenant not to compete were not severable, so that if any portion of the covenant was invalid and unenforceable, the remainder of it was unenforceable as well.
Because the lower court found that the 1–year provision restricting competition wherever ‘any Jani–King franchise operated’ was unenforceable, it did not consider Jani–King’s other claim regarding the validity of the 2–year covenant.
Jani-King on appeal argued, in part, that the Supreme Court should reexamine Nebraska law barring severability of integrated clauses restraining trade. Jani-King further requested that the Supreme Court, based on this reexamination, permit courts to reform or modify the scope or duration of covenants against competition, particularly within the context of franchise agreements. In this regard, Jani–King also made the interesting argument that Nebraska’s Franchise Practices Act should trump any common law analysis regarding the prohibition on severability and the blue pencil rule.
The Supreme Court, however, with little apparent hesitation, declined “Jani-King’s invitation to reconsider [its] rejection of the blue pencil rule, based on “’public policy considerations.’” The Court also disagreed that Nebraska’s Franchise Practices Act was contrary to case law, citing the legislative history: “The Legislature … declares that distribution and sales through franchise arrangements in the state vitally affect the general economy of the state, the public interest and public welfare. It is therefore necessary in the public interest to define the relationship and responsibilities of franchisors and franchisees in connection with franchise arrangements.” Very simply, according to the Court, “While the Act defines the relationship and responsibilities between franchisors and franchisees, it does not reference non-compete covenants in franchise agreements.”
Next, the Court debunked the argument that the Nebraska Franchise Act was contrary to, and therefore trumped, common law, referring notably to H & R Block Tax Servs. and CAE Vanguard, Inc.:
Essentially, the Act attempts to stabilize relationships between franchisors and franchisees by providing guidelines on what is and what is not acceptable in the context of a franchise agreement. For example, the sections of this Act state that it is a violation for a franchisor to terminate a franchise without good cause, to restrict the sale of securities or stock to employees or other personnel of the franchise, to impose unreasonable standards of performance upon a franchisee, or to prohibit the right of free association among franchisees for any lawful purpose. However, the Act does not discuss noncompete covenants in a franchise agreement. We decline to conclude that the Act dictates public policy for the severability of franchise agreements.
After concluding that the 1–year covenant not to compete was not severable from the 2–year covenant, and that the two covenants had to be considered together such that the entire clause must be declared invalid if one portion of it is invalid, the Court turned to the issue of whether the noncompete agreement was unenforceable. To decide this question, the Court stated that it was necessary to determine the nature of the transaction by categorizing the covenant as either an employment contract or a contract for the sale of goodwill. In examining this question, the Court stated: “Regardless of the context, a partial restraint of trade such as a covenant not to compete must meet three general requirements to be valid”, including: (1) the restriction must be reasonable in the sense that it is not injurious to the public; (2) the restriction must be reasonable in the sense that it is no greater than reasonably necessary to protect the employer in some legitimate business interest; and (3) the restriction must be reasonable in the sense that it is not unduly harsh and oppressive to the party against whom it is asserted.
Returning to the issue it had initially identified but strayed from, the Court commented that “Nebraska courts are generally more willing to uphold promises to refrain from competition made in the context of the sale of goodwill as a business asset than those made in connection with contracts of employment, reasoning that in the sale of a business, ‘[i]t is almost intolerable that a person should be permitted to obtain money from another upon solemn agreement not to compete for a reasonable period within a restricted area, and then use the funds thus obtained to do the very thing the contract prohibits.’ Confirming the Court’s general willingness to embrace reasonable restrictive covenants of any nature, the Court again repeated “Whether such a covenant not to compete is reasonable with respect to its duration and scope is dependent upon the facts of each particular case.”
The Court next examined H & R Block Tax Servs., a case in which the Supreme Court previously found that a franchise agreement was analogous to the sale of a business for purposes of determining enforceability of the post term covenant, and that the restrictive covenant in that case was enforceable. The Court then reaffirmed that the H & R Block Tax Servs. decision had been decided correctly, and proceeded to apply the standard from that case to the Jani-King case.
Accordingly, the Court applied the 3-part analytical framework it had identified for testing post term provisions, beginning with consideration of the reasonableness of the restriction on competition, noting that since there was no allegation that the restriction was injurious to the public, it would focus its analysis instead on the other questions “whether the covenant was reasonable in both space and time such that the restraint imposed will be no greater than necessary to achieve its legitimate purpose.” In concluding that the restrictive clause in Jani-King did not pass the test, the Court explained that “In order for something to be reasonable in both space and time, it must usually have a territorial restriction.” The Court provided the example of an offending covenant as follows: “a covenant restricting a prospective rent-a-car franchisee from operating in competition anywhere in the western hemisphere for a period of 2 years has been held unreasonable as being a restraint of trade. Similarly held unreasonable was the covenant of a franchisee of a tax preparation firm, which covenant did not expressly have any territorial restriction placed upon it.”
The Court pointed out that it had upheld the restriction in the H & R Block Tax Servs. case, which restrained its franchisees from competing in the business of preparing tax returns within 45 miles of the franchise territory for 1 year following termination of the franchise contract, because the clause was “reasonable in time and geographic scope because it only prohibited competition for one tax season.” The Court quickly pointed out that it viewed Jani–King’s 1–year covenant as “quite different” from the noncompete clause in H & R Block Tax Servs. As the Court explained, “Jani–King’s 1–year restraint prohibited the franchisee from operating a ‘Competing Business’ ‘in any other territory in which a Jani–King franchise operates.’” This difference was significant, and apparently dispositive, to the Court “Since Jani–King operates on a multi-state and international basis, on continents as far away as Australia,” and, accordingly, the restriction barring competing in ‘any … territory in which a Jani–King franchise operates’ is similar to having no territorial restriction at all.”
Based on the above, the Court in Jani-King wiped out the franchise noncompete clause concluding both that the clause was unreasonable in geographic scope, and that the 1–year restraint was not severable from the 2–year restraint also included in the covenant, which made the entire noncompete agreement unenforceable.
Jeffrey M. Goldstein
Goldstein Law Firm
(202) 293-3947
