Indentured Servitude in the 21st Century: Employee and Franchisee Noncompete Covenants
By: Jeffrey M. Goldstein
Founding Partner – Goldstein Law Firm, PLLC
In a recent decision regarding the right of a former franchisee to operate and work after the conclusion of its franchise agreement, the North Carolina Superior Court (the “Court”) held unenforceable a post-term covenant not to compete (“CNC”). Window Gang Ventures, Corp. v. Salinas, 2019 NCBC LEXIS 24, 2019 NCBC 23, 2019 U.S.P.Q.2D (BNA) 115878, 2019 WL 1471073. However, in so ruling, the Court also found that the Franchisor nevertheless had a legal interest protected by trade secret misappropriation and unfair trade practices laws.
The franchisor in Window Gang Ventures, Window Gang Ventures, Corp. (“Window Gang” or “Franchisor” or “Plaintiff”) had franchise locations in 20 states, and “engaged in the business of operating or franchising ‘Window Gang’ locations for residential, commercial, industrial and high-rise cleaning services including window cleaning, blind cleaning, gutter cleaning, window tinting, chimney sweeping, dryer vent cleaning, roof washing, oil remediation, no slips floor, and low and high pressure spray applications.” The Defendant Gabriel Salinas (“Salinas”) was the President of Defendant The Gang Group, Inc. (“Gang Group”), and Defendant Window Ninjas, LLC (“Window Ninjas”). Defendants Red Window, LLC (“Red Window”), Orange Window, LLC (“Orange Window”), and Blue Window, LLC (“Blue Window”) (together, the “Affiliated Defendants”) are limited liability companies organized by Salinas to operate Window Gang franchises in South Carolina, Tennessee, and Virginia, respectively.
The factual background of the case, some of which is set forth below, was included in the Complaint; for purposes of ruling on the Defendants’ motion to dismiss at an early stage of the legal proceedings, these allegations were accepted by the Court as true. On or about July 22, 1997, Salinas entered into a franchise agreement with Window Gang under which he was granted the exclusive right to operate a Window Gang franchise in “Wilmington, NC, (New Hanover County); Brunswick County; Pender County; and Duplin County” for 10 years (the “1997 Franchise Agreement”). The 1997 Franchise Agreement also granted Salinas a limited right to use Window Gang’s trade secrets. On or about June 10, 2007, Salinas, “individually and on behalf of Gang Group,” entered into a renewal franchise agreement (the “2007 Franchise Agreement”), extending the franchise relationship through 2017. The 2007 Franchise Agreement specifically defined Salinas and Gang Group’s operating territory as the “Wilmington, NC, area.” Window Gang alleged that “from 1997 through December 15, 2017, Salinas and Gang Group operated the Wilmington Territory (New Hanover, Brunswick, Duplin, and Pender Counties) Window Gang franchise,” and occasionally serviced customers outside the Wilmington Territory. During the latter portion of this period, the Affiliated Defendants operated Window Gang franchises in other states under oral agreements with Window Gang containing the same terms set forth in Salinas’s franchise agreements.
In early 2017, Window Gang with the Defendants began negotiating a new franchise relationship that would cover 2017 to 2027. Salinas confirmed to Window Gang that the agreements were under review and that “his signature was forthcoming.” Even though the 2007 Franchise Agreement expired on June 10, 2017, Salinas, Gang Group, and the Affiliated Defendants continued to pay monthly royalty fees to Window Gang under an “oral license” until September 2017. Similarly, Salinas and Gang Group continued to operate in the Wilmington Territory as a Window Gang franchise until December 15, 2017.
The dispute began during these 2017 negotiations when, according to the Franchisor, Salinas “began operating a competing window cleaning, blind cleaning, gutter cleaning and high pressure spray application service business, called Window Ninjas, in the Wilmington territory and in other” territories in which he had previously conducted business as a Window Gang franchisee. Window Gang alleged that in launching and operating Window Ninjas, “Salinas utilized the proprietary Window Gang system, customer lists, phone numbers, and Window Gang’s trade secrets” to compete with Window Gang in violation of the 2007 Franchise Agreement. The Franchisor also claimed that Salinas intentionally diverted customers and revenue from Window Gang to Window Ninjas using e-mail, social media, and direct marketing. Specifically, Window Gang alleged that Defendants utilized Window Gang’s customer lists and other trade secrets to falsely represent to existing and potential customers that Window Gang had gone out of business, was no longer servicing the customers’ areas, or had changed its name to Window Ninjas. Defendants also allegedly continued to use and advertise telephone numbers licensed and used by Window Gang in their efforts to advance Window Ninjas’ business.
Initially, Window Gang sought and obtained a temporary restraining order (the “TRO”) from the North Carolina Superior Court. The TRO restricted Defendants from using Window Gang’s “marks, likeness, good will, customer lists, Trade Secrets and proprietary systems and processes as defined in the Complaint and from soliciting or interfering with Window Gang, its customers, or contracts.” The TRO further ordered Defendants to immediately stop using certain phone numbers belonging to Window Gang. On February 13, 2018, Window Gang filed a motion for preliminary injunction, reiterating its arguments in support of its TRO Motion and further contending that while Salinas was operating as a Window Gang franchisee, he used an e-mail account (the “Google Account”) to store materials belonging to Window Gang, including customer information.
The Court held an initial hearing on Window Gang’s preliminary injunction motion on February 16, 2018, and issued a Preliminary Injunction on February 21, 2018, requiring Defendants to return all Window Gang Protected Information, and prohibiting Defendants from using and accessing the Google Account. Thereafter, Window Gang alleged that on February 19, 2018—three days after the preliminary injunction hearing but before the Court’s ruling—Brandee Pohlson (“Pohlson”), Gang Group’s Office Manager and Window Ninjas’ Vice President of Operations, accessed the Google Account, and “moved well over a thousand files related to the operation of Window Gang franchises into the trash.” Pohlson now admits that she deleted files from the Google Account on February 19 and 27, 2018, and that she was specifically “deleting all files off the Google Account that contained the name or mark for Window Gang.” Window Gang also contended that Defendants continued to use Window Gang’s phone numbers after entry of the Preliminary Injunction.
- Breach of Contract: Breach of the Non-Compete Provision
The Court began its analysis by examining Window Gang’s allegation that Salinas, Gang Group, and the Affiliated Defendants (“Defendants” or “Franchisees”) breached the 2007 Franchise Agreement by: “engaging in direct competition with Window Gang, disparaging Window Gang, diverting customers away from Window Gang to . . . Window Ninjas, transferring Window Gang telephone numbers into the name of Window Ninjas, failing to keep Window Gang’s trade secrets, failing to return information and documents belonging to Window Gang, and failing to pay required royalty payments in addition to other breaches of the written and oral agreements.”
The Franchisees moved to dismiss Window Gang’s breach of contract claim as it related to the non-compete provision, arguing that the provision was unenforceable as a matter of law because it was overbroad as to the territory identified in the CNC. The Court began its analysis of the CNC by noting that although “covenants not to compete are ‘disfavored’ under North Carolina law,” they are nevertheless enforceable under certain circumstances, including where the CNC is: “(i) in writing, (ii) made as part of the employment contract, (iii) supported by valuable consideration, (iv) reasonable as to time and territory, and (v) designed to protect the employer’s legitimate business interest.” Further, the Court noted that in attempting to prove these matters, Window Gang, “as the party seeking to enforce the covenant, has the burden to prove the covenant’s restrictions are reasonable.” Ultimately, the Court pointed out that “the reasonableness of a non-competition agreement is a matter of law for the court.”
As an initial matter, the Court explained that “the only written non-competition provision at issue is in the 2007 Franchise Agreement, a document Window Gang alleges Salinas signed both in his individual capacity and on behalf of Gang Group.” Based on this, the Court explained, Window Gang appropriately “conceded that it is only pursuing its non-competition claim against Salinas, and those acting in concert with him, arising from the 2007 Franchise Agreement.” As a result, Window Gang’s breach of contract claim against the Affiliated Defendants was dismissed.
With regard to Window Gang’s breach of contract claim against Salinas and Gang Group, the non-competition provision in the 200 Franchise Agreement (the “Non-Compete”) provided that, for a period of two years after the termination or expiration of that agreement, Salinas and Gang Group will not: “have any interest as an owner (except of publicly traded securities that are traded on a stock exchange or on the over-the-counter market), partner, director, officer, employee, consultant, representative or agent, or in any other capacity, in any other business conducting residential or commercial cleaning services including window cleaning, blind cleaning, gutter cleaning and high pressure spray applications or any business which is the same, similar to or competitive with Window Gang and the WINDOW GANG Franchise System within a radius of 50 miles of their Operating Territory.”
The Court next tackled what is an almost omnipresent issue in franchise CNC litigation: whether to characterize the disputed franchise CNC as either an “employment CNC” or a “business sale CNC”. In this regard, the Court stated that “when evaluating the enforceability of covenants not to compete, North Carolina courts “have determined that non-competes in franchise agreements present hybrid situations in which courts should combine the elements used to evaluate non-competes for the sale of a business and those used to analyze non-competes in employment contracts.” In support, the Court then quoted a prior Court of Appeals decision stating: the ultimate issue which we must decide in resolving such disputes among franchisors and franchisees is the extent to which the non-competition provision contained in the franchise agreement is no more restrictive than is necessary to protect the legitimate interests of the franchisor, with the relevant factors to be considered in the making of this determination to include the reasonableness of the duration of the restriction, the reasonableness of the geographic scope of the restriction, and the extent to which the restriction is otherwise necessary to protect the legitimate interests of the franchisor.
In turn, the Court addressed the legal relationship between the duration and territory restraints: “In evaluating reasonableness, the time and territory restrictions must be read in tandem . . . while either the time or the territory restriction, standing alone, may be reasonable, the combined effect of the two may be unreasonable.” The Court indicated that “courts applying North Carolina law have regularly held that a two-year post-employment or post-sale non-competition restriction similar to that here is reasonable.” Regarding the geographic aspect of the restraint, the Court stated that “in determining the reasonableness of the geographic scope of a non-compete agreement in the employment context, courts assess, among other things: “(1) the area, or scope, of the restriction, (2) the area assigned to the employee, (3) the area in which the employee actually worked or was subject to work, (4) the area in which the employer operated, (5) the nature of the business involved, and (6) the nature of the employee’s duty and his knowledge of the employer’s business operation.” The Court provided a rule of thumb regarding the reasonableness of a geographic area in a CNC: “ordinarily, a covenant’s geographic scope will be found reasonable if it encompasses the area served by the business that the covenant protects.”
To support their contention that the CNC was unenforceable as to the territory, Defendants relied on the Court of Appeals’ statement in a prior CNC case, that “to prove that a geographic restriction in a non-compete provision is reasonable, an employer must first show where its customers are located and that the geographic scope of the covenant is necessary to maintain those customer relationships.” The Court rejected the Franchisees’ argument that Window Gang’s claim necessarily should be rejected because Window Gang has failed to allege that it has existing customers located within New Hanover, Brunswick, Pender, and Duplin Counties, or that Window Gang has any customers within a 50-mile radius beyond the borders of those counties. As the Court explained, “although in bare-bones fashion, Window Gang has alleged that it serviced customers in New Hanover, Pender, and Brunswick Counties within the ‘Wilmington, NC, area,’ as well as customers in Bladen and Onslow Counties within a 50-mile radius of the ‘Wilmington, NC, area.’”
After ruling on the Plaintiff’s allegations regarding the reasonableness of the duration and territory restrictions, the Court considered “the extent to which the restriction is otherwise necessary to protect the legitimate interests of the franchisor.” Here, the Court ruled that the Franchisor’s argument failed as a matter of law. The Court began its analysis of this factor by pointing out that “in the employment context, our courts have recognized that an employer has a legitimate interest in protecting customer relationships and goodwill against misappropriation by departing employees.” But, according to the Court, the restriction “must be no wider in scope than is necessary to protect the business of the employer.” And, the Court further instructed that, on this basis, “our courts routinely hold that non-competition covenants are overbroad, and therefore unenforceable,” when they “prohibit the employee from engaging in future work that is distinct from the duties actually performed by the employee.”
In applying these precepts in the franchise context, the Court relied upon an earlier Court of Appeals decision stating that “although the specific job description of the person sought to be restrained has been deemed less relevant when courts analyze a restriction placed on a business owner, we believe that the extent to which a particular contractual provision unreasonably impairs a former franchisee’s ability to work in a related field or particular industry is relevant to the reasonableness of a non-competition restriction arising from the termination of a franchise agreement.” In turn, the Court explained, it is necessary to rely upon traditional contracts law to interpret the meaning of the CNC: “If the plain language of a contract is clear, the intention of the parties is inferred from the words of the contract, so that if the language is clear and only one reasonable interpretation exists, the courts must enforce the contract as written.” However, as the Court stated, “when the language in a contract is ambiguous, we view the practical result of the restriction by ‘construing the restriction strictly against its draftsman.’”
The CNC in the case precluded Salinas and Gang Group from working in any capacity for the following: “any other business conducting residential or commercial cleaning services including window cleaning, blind cleaning, gutter cleaning and high pressure spray applications or any business which is the same, similar to or competitive with Window Gang and the WINDOW GANG Franchise System within a radius of 50 miles of the Operating Territory.” The Court quickly observed that “by the non-compete’s own terms, the prohibition extends to businesses that are “the same” or “similar to” Window Gang and its system, not simply to those that are “competitive” with Window Gang. This critical point doomed the validity of the CNC. According to the Court “this feature alone makes the non-compete overbroad and unenforceable.” In support of its conclusion on this issue the Court referenced a prior case in which it had held unenforceable a CNC restricting the franchisee from having any involvement in any business “operating in competition with an outdoor lighting business” or any business “similar” to the franchisee as it went “well beyond the prohibition of activities that would put the franchisee in competition with the franchisor”.
The Court noted that the CNC was also overbroad and unenforceable because Salinas and Gang Group are “restricted from working for those prohibited businesses in any capacity whatsoever—not simply in roles which would cause competitive harm to Window Gang or only in divisions of those businesses which compete with Window Gang.” In reaching this conclusion, the Court relied in part on a prior franchise case that held that a non-compete preventing a franchisee from working for a competitor in an area which did not compete with franchisor’s business impermissibly “prevented franchisee from engaging in activities that had no tendency to adversely affect franchisor’s legitimate business interests.”
Apparently recognizing that its claim suffered from this defect in scope and language, Window Gang sought to have the Court salvage its claim by taking a “blue pencil” to the CNC to render it reasonable, acceptable and enforceable. According to the Court, “blue-penciling is the process by which “a court of equity will take notice of the divisions the parties themselves have made in a covenant not to compete, and enforce the restrictions in the territorial divisions deemed reasonable and refuse to enforce them in the divisions deemed unreasonable.’” Although the Court agreed that use of the blue pencil process existed, it also pointed out the extreme application limits inherent in the doctrine under North Carolina law: “As a general rule, the courts will not rewrite a contract if it is too broad but will simply not enforce it.” Specifically, the Court identified the limits of its discretion in this regard: “A court at most may choose not to enforce a distinctly separable part of a covenant in order to render the provision reasonable. It may not otherwise revise or rewrite the covenant.” In sum, as the Court stated: “the Court may not resurrect, in whole cloth, a covenant not to compete by erasing and replacing offending, but key, portions of a contract.”
With regard to the potential use of blue penciling, at oral argument, Window Gang suggested that the Court could make the clause reasonable by striking the following language entirely – “will not have any interest as an owner (except of publicly traded securities that are traded on a stock exchange or on the over-the-counter market), partner, director, officer, employee, consultant, representative or agent, or in any other capacity, in any other business conducting residential or commercial cleaning services including window cleaning, blind cleaning, gutter cleaning and high pressure spray applications or any business which is the same, similar to or competitive with Window Gang and the WINDOW GANG Franchise System within a radius of 50 miles of Your Operating Territory.” The Court, however, rejected Window Gang’s suggestion, stating: “While less restrictive, Window Gang’s proposed blue penciling does nothing to remedy the Non-compete’s overly broad language precluding Salinas and Gang Group from working for a business which is the “same or similar to,” but not “competitive” with, Window Gang.” Accordingly, the Court concluded that “Window Gang’s breach of contract claim against Salinas, Gang Group, and the Affiliated Defendants for breach of the Non-compete fails as a matter of law and should be dismissed.”
- Misappropriation of Trade Secrets
The Court thereafter addressed Window Gang’s allegation of trade secret misappropriation against all Defendants under the North Carolina Trade Secrets Protection Act (“NCTSPA”). Under the NCTSPA, an “owner of a trade secret shall have remedy by civil action for misappropriation of his trade secret.” Under this statute, “Misappropriation” is the “acquisition, disclosure, or use of a trade secret of another without express or implied authority or consent, unless such trade secret was arrived at by independent development, reverse engineering, or was obtained from another person with a right to disclose the trade secret.” And a “trade secret” under the NCTSPA consists of “business or technical information” that “derives independent actual or potential commercial value from not being generally known or readily ascertainable through independent development or reverse engineering by persons who can obtain economic value from its disclosure or use; and … is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.” The burden of proof under the NCTSPA provides as follows: “Misappropriation of a trade secret is prima facie established by the introduction of substantial evidence that the person against whom relief is sought both: (1) Knows or should have known of the trade secret; and (2) Has had a specific opportunity to acquire it for disclosure or use or has acquired, disclosed, or used it without the express or implied consent or authority of the owner.”
In its Complaint, Window Gang alleged that it had developed trade secrets “through over thirty years of market and customer development, research, effort, and significant financial investment.” Window Gang specifically identified its trade secrets as including “its pricing and estimation methods; its step-by-step service manual; its employee manual; its operations manual and guidelines and recommendations for operating a successful franchise; compiled customer information, including the identity of potential customers and specifications provided by customers to Window Gang; and information regarding its proprietary equipment and chemical cleaning solutions.” Earlier in the case, Window Gang alleged a far broader definition of its trade secrets including its entire franchise system defined as its “distinctive system for the operation, marketing, promoting, advertising and management of a cleaning services business including distinguishing characteristics using proprietary knowledge, procedures, specifications for equipment, systems forms, printed material, applications, specifications, standards and techniques.” The latter, broader definition was abandoned in favor of the narrower definition at the Oral Argument in the case.
The Franchisees first attacked the trade secret claims by arguing that Window Gang had failed to technically plead the claim with sufficient particularity; the Court agreed only in part with this argument. As the Court stated: “Our Supreme Court recently noted that “to plead misappropriation of trade secrets, a plaintiff must identify a trade secret with sufficient particularity so as to enable a defendant to delineate that which he is accused of misappropriating and a court to determine whether misappropriation has or is threatened to occur.” In sum, the Court found that “Window Gang has failed to satisfy its pleading burden as to some of its alleged trade secrets but satisfactorily, albeit minimally, pleaded its misappropriation claim as to others under Rule 12(b)(6).” To reach this conclusion, the Court evaluated each of Window Gang’s specific trade secret allegations.
Regarding the substantive parameters of the trade secrets claim, the Court initially addressed the relationship between various types of customer information and a trade secret. The Court stated that, under relevant law, information regarding a customer list could be viewed as a trade secret given that “compiled customer information, including the identity of potential customers and specifications provided by customers to Window Gang” is the sort of non-public information that has been identified in prior cases as a trade secret. The Court also relied upon prior case law recognizing that “confidential customer information” such as customer contact information and “customer buying preferences and history,” as well as “customer lists including names, contact persons, addresses and phone numbers and the ordering habits, history, and needs of . . . customers” could constitute trade secrets.
The Franchisees argued that the customer information claimed by the Franchisor did not comprise trade secrets because the information was “readily ascertainable from public sources as a matter of law.” In making this argument the Defendants relied upon prior cases finding that the customer lists in those cases would have been easily obtainable from public sources, such as the yellow pages.
The Court relied upon the public-private access distinction in ruling on the other types of alleged trade secret information in the case. With regard to Window Gang’s “pricing and estimation methods,” the Court identified prior cases that found that “pricing information, customer proposals, historical costs, and sales data” constitute trade secrets. Similarly, the Court found that Window Gang’s claims regarding its step-by-step service manual, employee manual, and operations manual, guidelines, and recommendations for operating a successful franchise fell within the confines of existing law defining a trade secret. As the Court quoted from another court, “Business plans, marketing strategies, and customer information represent the type of information that, when accumulated over time, can be extremely valuable to competitors and can qualify as trade secrets.”
In contrast, the Court found that some of the alleged trade secrets were not susceptible of such characterization. The Court stated that it could not conclude that Window Gang’s purported trade secret consisting of “information regarding its proprietary equipment and chemical cleaning solutions,” is identified with sufficient particularity to satisfy Window Gang’s pleading obligation; in particular, the description of the Franchisor in its Complaint was “vague, imprecise, and nonspecific.” The Court analogized the Plaintiff’s allegations to another case in which the “original ideas and concepts for dance productions” were found deficient because, “While certain ‘chemical formulations’ may constitute a trade secret, Window Gang’s identification here is so general that it leaves Defendants entirely in the dark as to what information about what proprietary equipment and what chemical cleaning solutions they are alleged to have misappropriated.”
The Court examined whether Window Gang’s Complaint had sufficiently alleged that it had taken reasonable steps to keep its trade secrets a secret. Before evaluating the specific allegations, the Court pointed out that the reasonableness of a plaintiff’s efforts to maintain secrecy are “necessarily fact dependent” and that a trial court must “closely examine the circumstances surrounding the trade secret.” Initially the Court examined the confidentiality provision in the Franchise Agreement, which stated that “the franchisee and anyone who works in connection with the franchise shall keep confidential the contents of “the Operations Manual, specifications, techniques, training materials, operation procedures, tape and films, computer software, client lists and other data.” The Court also noted that the Franchise Agreement required “the franchisee to require anyone operating in a ‘managerial or supervisory position’ to sign a confidentiality agreement.”
These two provisions were enough for the Court to rule for the Franchisor on the pleading issue: “While these measures to protect the secrecy of Window Gang’s alleged trade secrets are not extensive, the Court concludes they are sufficient to survive Defendants’ Motion under the circumstances of the franchise relationship at issue here.” The Court here relied on earlier relevant cases that had held confidentiality agreements under certain circumstances are one method recognized as sufficient to protect confidential information.
Last, the Defendants attacked the trade secret claim by arguing that Window Gang had not identified how Defendants misappropriated its alleged trade secrets; the Court rejected this argument pointing out that, “Window Gang alleges, however, that Defendants failed to return the trade secret information provided to them under the 2007 Franchise Agreement, including the operations and step-by-step service manuals, after the expiration of the 2007 Franchise Agreement, and also that Defendants have disclosed and used Window Gang’s customer and pricing information in the conduct of the Window Ninjas business.” The Plaintiff’s allegations, therefore, according to the Court met the definition of misappropriation, which is the “acquisition, disclosure, or use of the trade secret of another without express or implied authority or consent”.
Accordingly, the Court concluded that the Franchisees’ motion would be granted as to Window Gang’s misappropriation claim against all Defendants concerning Window Gang’s “information regarding its proprietary equipment and chemical cleaning solutions” in particular; but with regard to all of the other trade secret claims, “the Motion should be denied.”
Franchisor lawyers and advocates have done an incredibly effective job of convincing courts that when evaluating the enforceability of franchise CNCs they must equate ‘CNCs in franchise cases’ with ‘CNCs in business sales cases,’ and not with employment cases (“CNC Franchise False Equivalency”). These efforts to create such an equivalency are motivated by the general rule that employer CNCs are evaluated more leniently than CNCs in a business sale context. This manufactured equivalency, however, is deceiving and, like the original artificial distinction between CNC’s in business sales and employment contracts, is systematically untenable. In addition, modern CNC analysis in franchise cases suffers from other myriad methodological defects (“CNC Methodological Defects”) and false empirical assumptions (“CNC Mistaken Empirical Assumptions”).
The best way to understand these methodological defects and false empirical assumptions is to recognize, consider and evaluate the prolific potential interests implicated by CNCs; although the following discussion will use employment terminology, it is in general for this purpose equally applicable to the franchise setting. The implicated interests of CNCs include: (1) maximization of the mobility of workers; (2) maximization of the market power of employers vis-à-vis employees; (3) maximization of the market power of employees vis-à-vis employers; (4) maximization of employer investments in training; (5) maximization of employer investments in trade secrets; (6) maximization of productive spillover of knowledge; (7) maximization of the freedom of parties to contract; (8) maximization of market rivalry; (9) maximization of allocative efficiency; and (10) maximization of an employee’s right to obtain a return on his investment in human capital (altogether the “Implicated Interests of CNCs”).
There exist two significant problems associated with appraising the Implicated Interests of CNCs. First, there is no accepted evaluative structure in place for giving priority to one interest over any other. Second, there is no uniform understanding of the definitions of the primary terms comprising the substance of the individual interests (together the “CNC Competing Policy Questions”.)
The CNC Competing Policy Questions, in turn, may be answered by assessing the following doctrines, policies and principles: (1) the decision framework used by courts that ruled on CNCs in the early 1700s; (2) the theory of monopsonistic markets and their derivative impact upon final product markets; (3) the dynamics of the neoclassical economic labor market; (4) the economic theory of human capital investment as modified by Becker; (5) the economic theory of investment in intellectual property; (6) the economics of the legal ownership rights to goodwill; (7) the ancillary restraints doctrine and its component parts including shifting burdens of proof; (8) the available legal alternatives to CNCs for interested parties; (9) the economic costs and benefits of CNNs; and (10) the non-economic costs and benefits of CNNs (altogether the “Underlying CNN Principles”).
In courtrooms throughout the country, the existing legal analysis of CNNs has devolved into fifty distinct, although related, state laws; although these laws have may similarities with each other, they are frequently in conflict with each other. The opposing view, that state CNC laws are robust and may be easily dichotomized into one of two general positions, including one group where CNCs in the employment context are unlawful per se, and a second group in which CNCs in the non-employment settings are lawful if they are ‘reasonable’ – is misleading, unhelpful and antithetical to rebuilding CNC law on a more stable, substantial and uniform foundation.
The existing general common law ‘reasonableness test’ for evaluating CNCs, with its genesis in the ancillary restraints doctrine, and if limited to its skeletal framework, is a useful foundation on which to build a new, more productive CNC jurisprudence. However, the existing analytical structure standing on this foundation should be selectively, but liberally, dismantled and rebuilt so that it reflects both the Underlying CNN Principles and the CNC Competing Policy Questions. Conceptually, the current application of our CNC enforcement law is inefficient and counterproductive; it is incapable of efficiently resolving the conflicts between the prolific Underlying CNN Principles. While some of the analytical tools in the existing framework can be sharpened and repurposed, some others are no longer up to the task. For instance, it cannot be the case – as it is many times under modern restraints analysis – that employers are entitled to ‘possess’ and ‘own’ all the human capital and goodwill acquired by employees during their work relationship with their former employer. Similarly, it cannot be accurate that every aspect of knowledge obtained by a worker will, if used by the employee at a competing firm, cause cognizable and irreparable competitive harm to the former employer. More precise diagnostic enquiries must be adopted by courts to allow various policy goals to be efficiently achieved, especially the overarching goal of allocative efficiency. Indeed, allocative efficiency is the result of a blending of varying amounts of the potential solutions based on a relative marginal analysis, such that none of them alone is maximized in isolation.
In this regard, it is important to understand the essential dynamic components of the neoclassical model of the labor market. Labor in this model is abstractly equivalent to every other supply input to the production process; employers compete against every other employer to attract and retain workers, just as they do for other inputs for their products and services. Neither employers nor employees have buying or selling market power in the labor component market, and the employer lacks market power in the upstream or final product market.
In this market, firms have an economic incentive to invest in productivity-enhancing types of employee training; and, in a competitive market, employees will accept a lower wage in exchange for such training. Essentially, employees, by accepting a lower wage, implicitly borrow such educational costs from their employers instead of from a lending institution. And, in those cases where the wage does not reflect this lending and training differential, employers will try to ensure that they can recoup their expenditures in training and education. By using CNCs which prevent employees from switching jobs, employers ensure themselves a payback of their direct investments in human capital. Without some type of mechanism to guarantee repayment (since involuntary servitude is prohibited), the theory goes, employers will underinvest in intangible intellectual property and training.
Although the above is accurate, it is true only so far as it goes. In this regard, employees and franchisees should be arguing in response that CNCs, for instance, are not always the least restrictive alternative for achieving optimal investment in intellectual property and human capital. The current legal framework for evaluating CNCs fails to take account of less restrictive alternatives to the use and enforcement of CNCs, such as trade secret misappropriation laws, non-disclosure agreements, and non-solicitation laws. More important, the current analysis does not account for various forms and types of education, training, and research that would have been provided under normal market forces regardless of the employer’s ability to protect it; there is little rationale for enforcing CNCs protecting these types of information. Last, the modern legal analysis fails to deal adequately, if at all, with the incentives for the generation and ownership of goodwill, in particular; without a more wide-ranging and extensive evaluation, it is impossible to distinguish between employee and employer-generated goodwill. In this regard, courts have improperly and frequently embraced the conclusion that all goodwill is homogenous and belongs to the employer or franchisor.
Recent empirical studies regarding CNCs show that they tend to stultify creativity, impede dynamic efficiency and distort innovation by impeding the free flow of workers and ideas. Studies have shown that lower velocity of workers among employers has a downward pressure on wages. Moreover, some recent studies suggest the presence of monopsony power by employers in many markets. These experiential conclusions appear to cut against some of the theoretical assumptions of the neoclassical labor market that support enforcement of CNCs.
In the franchise context specifically, the prevailing court analysis for CNCs is unpretentious, unsophisticated and inexact. Indeed, many times the crux of the analysis is merely an inquiry as to whether to equate an abstract franchise CNC with an abstract employment CNC or an abstract ‘sale of a business’ CNC. This “looks like a duck, must be a duck” mode of evaluation is devoid of any economic theory or logic; it fails to answer or address adequately even one of the prolific Underlying CNN Principles or CNC Competing Policy Questions. Even assuming the “looks like” inquiry has some minimal relevancy, there is almost no justification for finding that a franchise relationship is ‘more like’ the ‘sale of business’ than an ‘employment relationship’. In this regard, the proper theoretical analysis can be found in Ronald Coase’s “The Nature of the Firm” from 1937. In this article, Coase, inter alia, explains why firms will vertically integrate forward – in the franchise context the theoretical choice of a manufacturer considering how to distribute its product is to either grow internally (by using employees) or transact in the market, outside the firm, with others downstream in the market (by using franchisees). Decision making regarding training and investments in human capital, for instance, is very similar in both the franchise and employment contexts. The awkward, artificial and contrived analyses that are used to arrive at a false equivalency between a franchise CNN and a business-sale CNN rely solely upon the surficial fact that the CNN in each realm is in part justified by its enforcer on an efficiency justification; nothing more and nothing less. Under this defective equivalency rationale, one could argue that the decision and reasoning in upholding a Sherman Act Section 1 conspiracy claim in the auto manufacturing industry would be binding on every other court in evaluating a Sherman Act Section 1 conspiracy claim in an unrelated case and industry.
In franchise CNN cases, after courts have completed the ‘looks like a duck’ analysis, they then spend an impractical amount of time on whether two other CNN terms – the durational term and territorial scope – are within the confines of prior case rulings on CNNs. This wholly out-of-context evaluation abstracts from the most important aspects of the ancillary restraints doctrine. Whether a court has enforced a CNN in a manufacturing industry for a low-skill job for a two-year period in an entire state is unrelated to whether it is proper to enforce a CNN in a high-tech industry for an upper level executive for two years in an entire state.
This dart-throwing exercise, which masquerades itself as an ancillary restraints analysis, is hopelessly disconnected from the underlying economic realities of CNCs. Analytically, this disjointed inquiry also is inherently defective, inter alia, because it dispenses with the need to determine the legitimacy of the professed interests protected by the franchisor’s CNC – the sine qua non of allocative efficiency. In addition, this “2+2=2” analysis is defective in that it provides no place for determining the half-life of the alleged secret and valuable information – notably, the duration of the CNC remains constant whether the employee or franchisee leaves the relationship after one year or eight years.
Ultimately the modern legal approach to CNC analysis should be relaxed to allow it to specifically take account of all the interests implicated by CNCs – ironically, although such expansion would allow the explicit consideration of all interests for employers, employees, franchisors, franchisees and society, it would also likely lead to less enforcement of CNCs by courts. At the same time, it would create a jurisprudence that would weed-out those CNCs that are over-broad, unreasonably restrictive, and anticompetitive. In this regard, it would also disincentivize employers and franchisors from misusing CNCs primarily to artificially inflate their bargaining power vis-à-vis employees and franchisees; such opportunistic behavior harms not only franchisees and employees, but consumers and other workers as well.