Court Prohibits Tax Franchisee from Operating by Enforcing Post-Term Restrictive Covenant
By: Jeffrey M. Goldstein
A federal judge in Washington recently issued a preliminary injunction enjoining a former Liberty Tax franchisee from operating as an independent tax preparer for two years following the termination of the franchise agreements. JTH Tax LLC v. McHugh, No. C20-329RSM, 2020 U.S. Dist. LEXIS 61139 (W.D. Wash. Apr. 7, 2020) As discussed below, the court agreed with the franchisor’s argument that McHugh knowingly and intentionally breached her Franchise Agreements with Plaintiffs by operating KVC, a competing tax preparation business, after Plaintiffs terminated her franchise.
In 2015, Defendant Lorraine McHugh entered into Franchise Agreements with Liberty Tax and she was given a territory of areas near and including Federal Way, Washington, in which to operate her franchise. The Franchise Agreements included a non-compete clause, which stated that: “[f]or a period of two (2) years following the . . . termination . . . of the Franchised Business . . . you agree not to directly or indirectly, for a fee or charge, prepare or electronically file income tax returns . . . within the Territory or within twenty-five miles of the boundaries of the Territory.” The Franchise Agreements also included non-solicit and non-disclosure clauses. Further, in the Franchise Agreements, McHugh agreed that Liberty Tax is “entitled to a temporary restraining order, preliminary and permanent injunction for any breach of duties under any of the non-monetary obligations of paragraph 9 [post-term obligations] above or of this Paragraph 10 [non-compete/non-solicitation agreements] and that such an order or injunctions shall issue without the posting of any bond by Liberty.”
In arguing their case, Plaintiffs relied on their verified Complaint and declarations submitted with their Motion for Preliminary Injunction. According to Liberty Tax, McHugh effectively abandoned her franchises in the Spring of 2019, after which Liberty Tax sent her a franchise termination letter for the franchises. The letter discussed evidence that McHugh abandoned her franchises and pointed out that she owed Plaintiffs thousands of dollars. The Court observed that after the terminations, Liberty Tax found out that McHugh’s business, KVC, and KVC Tax Services, a new independent tax preparation business, were operating out of an office ten miles from Federal Way (the “Kent location”). In this regard, the court noted that “Plaintiffs state that “[c]ustomer reviews regarding KVC demonstrate that McHugh and KVC are operating a competing tax business and soliciting Plaintiffs’ former franchises’ customers.” In addition, the court stated that “Plaintiffs cite to three reviews indicating that Defendant McHugh has retained customers who are returning for the same tax services this year” and that “Plaintiffs argue that McHugh’s LinkedIn page still notes that she is “director of operations” at Liberty.”
The court began its analysis by noting that granting a preliminary injunction is “an extraordinary remedy that may only be awarded upon a clear showing that the plaintiff is entitled to such relief,” and that it may be obtained only where a party can show that (1) it is likely to succeed on the merits, (2) it is likely to suffer irreparable harm in the absence of preliminary relief, (3) the balance of equities tips in its favor, and (4) an injunction is in the public interest.
Interestingly, the court next noted in particular that “evidence of loss of control over business reputation and damage to goodwill [can] constitute irreparable harm,” so long as there is concrete evidence in the record of those things, and that a party seeking injunctive relief may not rely on “unsupported and conclusory statements regarding harm [the plaintiff] might suffer” in the future. Essentially, the court set out the traditional legal boundaries to irreparable harm by cautioning that “irreparable harm will not be presumed where a plaintiff presents no proof beyond speculation that its reputation or goodwill in the market will be damaged, because the Court has no way of evaluating this intangible harm.”
Next, the court turned to the likelihood of success prong when, after reviewing the record, found that Plaintiffs made a sufficient showing of a likelihood to succeed on the merits to warrant a preliminary injunction. In this regard, the court found that Defendants likely breached or may intend to breach valid and enforceable noncompetition, nonsolicitation, and nondisclosure agreements by operating a competing tax business within 25 miles and soliciting former customers. In support of this finding, the court also held that the non-competition provisions were appropriately limited in time and geography and had been upheld in Virginia courts.
Regarding the third prong, based on its earlier ruling that Plaintiffs had made the required showing of irreparable harm based on their argument that Defendants’ actions risk a loss of customer goodwill and damage to the franchisee system, the Court agreed with Plaintiffs that, “based on this record, the balance of equities tips in favor of Plaintiffs and that a preliminary injunction was in the public interest as it could prevent customer confusion.”
The burden of proof in obtaining a preliminary injunction is upon the party seeking the preliminary injunction, in this case, the franchisor. A preliminary injunction request must be supported by a factual showing of irreparable harm and the need for an injunction immediately, before a full trial can be held. In most cases, the presentation of evidence is through the submission of affidavits, declarations, and documents, not oral testimony. Further easing the procedural burden on the party seeking an injunction, the moving party may be allowed to submit evidence that is less formal and complete than would normally be required under the federal rules of evidence. In some cases, this means inadmissible evidence is permissible to support a preliminary injunction request. The judge, in turn, is granted wide discretion in considering the weight and relevancy of the evidence produced in a preliminary injunction proceeding. Despite such evidentiary leniency, the petitioner seeking a preliminary injunction is nevertheless required to make a “clear showing”, usually on four independent issues, that it is entitled to the extraordinary relief.
In this case, although not discussed in detail by the court, the evidence presented by the franchisor in its affidavits and verified complaint seemed relatively weak in form, reliability, and volume. Although the franchisee’s opposing memo was short on legal theory, it was long on powerful evidentiary criticisms of Liberty’s affidavit evidence. For instance, a Liberty affiant named Ms. Johnson stated that “throughout this tax season, multiple people have come into the Franchise Location looking for McHugh [the franchisee] and asking if she could do their taxes.” The Franchisee responded by pointing out the following defects:
- Ms. Johnson does not identify who these persons may have been.
- Ms. Johnson does not and apparently cannot specify how many of these declarants there may have been.
- She cites no facts indicating that such persons would have come in response to any contact, communication, or invitation from Ms. McHugh.
- Ms. Johnson presents no facts to indicate that such persons would have appeared at Liberty’s location per any motivation other than their memory of Ms. McHugh working there.
Given that the franchisor appeared to have had ample time and resources to uncover the actual underlying facts, a good argument can be made that Liberty’s overall anemic evidentiary showing should have been rejected as insufficient to support the preliminary injunction.
The current legal climate strongly favors franchisors in preliminary injunction post-term restrictive covenant cases. Those in support of this position reflexively justify their view by pointing to the abstract free-market argument that franchisees enter into franchise agreements with the full knowledge that they contain a post-term covenant. This argument, however, misses the analytical overbreadth of the point: the efficiency justification for a post-term restrictive covenant is to protect the franchisor’s investment in unique and specific business information and training. To the extent that a post-term restrictive covenant sweeps far beyond a hypothetical level of remuneration that might arguably be due from the franchisee to the franchisor in exchange for the franchisor’s sharing of such information and training, it impedes—not promotes—competition and efficiency. Another way of examining a similar analytical mistake in the pro-enforcement rationale can be seen by parsing the apparently uniform concept of goodwill. While most courts and those seeking enforcement of post-term covenants view goodwill as a uniform immutable concept tethered only to goodwill owned only by franchisors, a more precise definition encompasses two sub-categories of goodwill—that attributed to the efforts of the franchisors, and that attached to the efforts of the franchisees.
In the case of post-term restrictive covenants, as with other contentious contractual clauses regarding market conduct, the mere incantation of abstract free market principles to bolster post-term covenants, especially when untethered to an analysis of how the asserted free-market principles interact with the dynamics of the particular covenants, frequently leads to a diminution in overall societal efficiency – the very goal and benefit of the free market system. Here, efficiency considerations, in addition to equitable concerns, suggest that closer theoretical and empirical analysis of post-term restrictive covenants as currently used by franchisors and employers would be beneficial to all stakeholders, as well as the judiciary.