Covenants Not to Compete, Non-Compete Agreements, Restrictive Covenants, and Restraints of Trade in Franchise and Employment Relationships
The common law historically has looked askew on restraints of trade. Although federal and state statues predominately govern restraints of trade in the antitrust realm, the common law of restrictive covenants both complements and sometimes gives meaning to federal and state anticompetition or antitrust statutes.
Covenants not to compete are the largest type of restraint of trade subject to common law scrutiny. Covenants not to compete are also known as noncompete agreements, noncompetition agreements, or anticompetitive agreements (hereinafter “CNCs”). Typically, CNC enforcement actions arise in the context of disputes based upon the following types of agreements, including: (1) employment agreements; (2) sale of a business agreements; (3) partnership agreements; and (4) franchise agreements. The most general articulation of the principles regarding legal enforcement of CNCs is found in the Restatement (Second) of the Law of Contracts, specifically Sections 186, 187 and 188, each of which is set forth below.
Regarding franchise agreements specifically, almost every franchise or dealership relationship nowadays has a CNC that applies both during and after the term of the franchise or dealership agreement. CNCs prohibit franchisees (as well as many people and entities associated with the primary franchisees) from competing with their franchisors. Courts today regularly enforce most CNCs, especially in a franchise context. In so doing, courts apply a reasonableness test that focuses almost myopically on the term and geographic scope of the CNC.
Experience and Expertise of Goldstein Law Firm in Litigating for or Counseling Clients on Noncompete Agreements
Jeff Goldstein and the Goldstein Law Firm have a long track record of winning lawsuits against franchisors and manufacturers attempting to enforce noncompete agreements against franchisees and dealers. Regarding these successes, the Firm has always relied heavily on its ability to identify and highlight for courts and arbitrators the lack of legitimate business interests proffered by the franchisor allegedly supporting the CNC in dispute. Further, in some cases, the Goldstein Law Firm has succeeded on behalf of its clients by showing that the franchisor should be barred from enforcing a noncompete agreement because of prior wrongdoing by the franchisor during the term of the franchise or dealership relationship, before the franchisor’s attempt to enforce the CNC.
Historically, beginning in the early 1400s, courts were hostile to the use and enforcement of CNCs, viewing them as inconsistent with free market forces. A few hundred years later, in the early 1700s, courts started to recognize the procompetitive benefits associated with CNCs; and, consistent with this new view, courts readily ruled that such clauses were lawful so long as they were reasonable. The reasonableness analysis today is best evidenced by three sections of the Restatement (Second) of Contracts, set forth below.
§ 186 Promise in Restraint of Trade
(1) A promise is unenforceable on grounds of public policy if it is unreasonably in restraint of trade.
(2) A promise is in restraint of trade if its performance would limit competition in any business or restrict the promisor in the exercise of a gainful occupation.
§ 187 Non-Ancillary Restraints on Competition
A promise to refrain from competition that imposes a restraint that is not ancillary to an otherwise valid transaction or relationship is unreasonably in restraint of trade.
§ 188 Ancillary Restraints on Competition
(1) A promise to refrain from competition that imposes a restraint that is ancillary to an otherwise valid transaction or relationship is unreasonably in restraint of trade if
(a) the restraint is greater than is needed to protect the promisee’s legitimate interest, or
(b) the promisee’s need is outweighed by the hardship to the promisor and the likely injury to the public.
(2) Promises imposing restraints that are ancillary to a valid transaction or relationship include the following:
(a) a promise by the seller of a business not to compete with the buyer in such a way as to injure the value of the business sold;
(b) a promise by an employee or other agent not to compete with his employer or other principal;
(c) a promise by a partner not to compete with the partnership.
The Restatement (Second) of the Law of Contracts is the best-known and most cited legal treatise regarding contracts law in the United States. It is consulted by judges, arbitrators, scholars and practicing lawyers, and is highly influential with courts although not necessarily binding on them.
As noted above, CNCs are used in four general contexts, including: (1) employment agreements, (2) franchise agreements; (3) partnership agreements; and (4) business sales agreements. Although a common thread of ‘reasonableness’ connects courts’ tests of the legality of CNCs in all four settings, many states view CNCs in employment agreements more harshly than CNCs in franchise agreements. These courts generally view CNCs in franchise agreements to be legally equivalent to those in business sales agreements. In so doing, such courts embrace the rationale that employees need more protection from CNCs than business sellers and franchisees.
Putting aside federal antitrust laws, noncompete agreements are evaluated under state, not federal, law. Although some states have passed statutes regarding the reasonableness of CNCs, others rely upon the more fluid common law definition of reasonableness. In many cases this complex competitive analysis pivots merely off the following: (1) the number of years of the CNC; and (2) the geographic area covered by the CNC.
State laws also differ on whether a court has the power to ‘blue pencil’ or rewrite an overbroad noncompete agreement so that it does not transcend the boundaries of the reasonableness test. Such an ability is detrimental to the interests of franchisees and dealers, to the extent that it allows franchisors and manufacturers to get two bites at the apple on enforcing initially unlawful CNCs.
Like in other agreements, CNCs in franchise agreements can operate to restrict business conduct either during or after the term of the franchise agreement. Post-term covenants not to compete have been triggered regardless of the cause of the end of the franchise agreement, including termination and expiration. Moreover, courts generally give in-term noncompete agreements less scrutiny, and they arguably do not need to be crafted as narrowly as a post-term CNC.
Rationales in favor of the use of noncompete agreements depend for the most part on the type of CNC at issue. For instance, in a business sale context, the buyer is purchasing the goodwill of the business which could arguably be ‘stolen back’ by the seller after the sale if the seller were permitted to compete with the new owner, the buyer, after the sale. And, in an employment context, the employer arguably would not have an optimal incentive to invest in training of his employees and developing costly trade secrets if his employees were able to quit and promptly begin to use this valuable information to compete with the former employer.
The justifications for CNCs in franchise agreements as set forth in relevant case law including those from other business contexts, as well as several others manufactured by franchisors that are unique to franchising. These include, for instance, the protection of the franchisor’s right and need to refranchise the former franchisee’s territory after the termination of the franchise relationship.
As with other areas in franchising, there are very few, if any, empirical studies regarding the economic effects of CNCs in franchise agreements. However, many resources have been expended by the government, scholars and academics on evaluating the impact of CNCs in the employment context. And because the Goldstein Law Firm believes that franchise CNCs are equivalent to employment CNCs, we view the results of these recent CNC employment studies to be directly applicable to CNCs in the franchise setting.
For instance, in 2016, the Office of Economic Policy of the U.S. Department of the Treasury, published “Non-compete Contracts: Economic Effects and Policy Implications.” This study found that although CNCs could provide many social benefits, such as the promotion of innovation and the provision of training, they could also impose significant costs on workers, through lower wages and less productive job path formulation. Most important, the study concluded that there is reason to believe that many specific instances of non-compete agreements are less likely to produce previously conjectured social benefits. In this regard, the study states:
- Non-competes are often used by employers in non-transparent ways:
- Many workers do not realize when they accept a job that they have signed a noncompete, or they do not understand its implications.
- Many workers are asked to sign a non-compete only after accepting a job offer. One lower-bound estimate is that 37 percent of workers are in this position.
- Many firms ask workers to sign non-competes that are entirely or partly unenforceable in certain jurisdictions, suggesting that firms may be relying on a lack of worker knowledge. For instance, California workers are bound by noncompetes at a rate slightly higher than the national average (19 percent), despite the fact that, with limited exceptions, non-competes are not enforced in that state.
- Only 24 percent of workers report that they possess trade secrets. Moreover, less than half of workers who have non-competes also report possessing trade secrets, suggesting that trade secrets cannot explain the majority of non-compete activity.
- Non-competes are common among workers who report lower rates of trade secret possession: 15 percent of workers without a four-year college degree are subject to noncompetes, and 14 percent of workers earning less than $40,000 have non-competes. This is true even though workers without four-year degrees are half as likely to possess trade secrets as those with four-year degrees, and workers earning less than $40,000 possess trade secrets at less than half the rate of their higher-earning counterparts.
- Available evidence suggests that workers with a low initial desire to switch jobs are not more likely to match with employers who require non-competes.
- In some cases, non-competes prevent workers from finding new employment even after being fired without cause; in such cases, it is difficult to believe that non-competes yield social benefits.
As noted above, a few states have what might be viewed as a statutory ban or prohibition on the enforcement of noncompete agreements, at least in a post-term context. For instance, the relevant statute in California states:
§ 16600. Unauthorized contracts
Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.
Cal. Bus. & Prof. Code 16600
Although the majority of CNC franchise cases rule in favor of enforcing the relevant CNC against the franchisee, there are a minority of decisions that void or set aside the putative CNC. The case below, 3 Natives Franchising, LLC, is an example of a decision in which the court has refused to enforce a CNC based on both insufficient legitimate business interests in the franchisor’s franchise “system,” as well as prior (or pre-termination) wrongdoing of the franchisor. 3 Natives Franchising, LLC v. 3 Natives Stuart, LLC, No. 19-14093-CIV-MAYNARD, 2019 U.S. Dist. LEXIS 136631 (S.D. Fla. Aug. 13, 2019).
As the 3 Natives Franchising, LLC court explained:
The Plaintiff [franchisor] complains that the Defendants’ [franchisees’] operation of the City Beets business [post-termination business] still violates the contract’s non-compete covenant. The Plaintiff complains that the “City Beets” business also infringes on some of its propriety and intellectual property. City Beets operates out of the same physical space, and it uses the same furniture and juice-pressing equipment that the Defendants used for their “3 Natives” cafe. It offers a substantially similar menu, and some of the food that it serves comes from its approved vendors including from one vendor with whom the Plaintiff has an exclusive relationship. The Plaintiff complains that City Beets is based on its proprietary “System” (including training and know-how).
The Defendants also complain that the Defendants used its trademarks and franchise name to market City Beets on the internet. The Defendants deny any wrongful infringement. At page 16 of DE 14-1, Mr. McLaughlin attests that it closed down all of 3 Natives Stuart LLC’s social media accounts within the 30-day post-termination period that the Franchise Agreement permits. Within that permitted time frame, the Defendants posted to some social media accounts a notice that was limited to announcing their “3 Natives” Stuart cafe as now “permanently closed” and to inviting the public to check out City Beets which “has the same great staff, amazing acai bowls, smoothies, and juices.” Mr. McLauglin furthers that the Plaintiff locked the Defendants out of 3 Natives Stuart LLC’s email accounts. As for any results that search engines might give for the now closed 3 Natives Stuart LLC, the Defendants deny having any control over that.
Generally speaking, Florida law enforces a restrictive covenant, such as a non-compete agreement, only if it is reasonable and protects legitimate business interests. The restrictive covenants at issue here in this case, the Defendants argue, fail that test. This is because the Plaintiff identifies no specific intellectual property or other proprietary asset in need of protection. Instead the Plaintiff’s claims of such are all conclusory. Moreover the Defendants deny receiving any proprietary information from the Plaintiff. What the Plaintiff is trying to accomplish here is simply to put the Defendants out of business, the Defendants retort, but Florida law does not enforce restrictive covenants for the purpose of constraining ordinary marketplace competition.
The case of Pirtek USA, LLC v. Wilcox, 2006 U.S. Dist. LEXIS 41569, 2006 WL 1722346 (M.D.Fla. 2006) is directly on point and supports the Defendants’ argument. Pirtek found insufficient legitimate business interests in the plaintiff’s franchise “system” to justify enjoining the defendant-franchisee’s compliance with the franchise agreement’s [*18] non-compete covenant. See also, IDMWORKS, LLC v. Pophaly, 192 F.Supp.3d 1335 (S.D.Fla. 2016) (declining to enjoin the defendant-employee’s compliance with the restrictive covenants of the employment contract after finding insufficient business interests in need of protection) and AutoNation, Inc. v. O’Brien, 347 F.Supp.2d 1299, 1304 (S.D.Fla. 2004) (stating the general rule that “information that is commonly known in the industry and not unique to the allegedly injured party is not confidential and is not entitled to [preliminary injunction] protection.”). See also, Passalacqua v. Naviant, Inc., 844 So.2d 792 (Fla. 4th DCA 2003) and Advantage Digital Sys., Inc. v. Digital Imaging Servs., Inc., 870 So.2d 111 (Fla. 2nd DCA 2004) (likewise declining to enjoin on a preliminary basis the defendants’ compliance with restrictive covenants because the plaintiffs failed to demonstrate sufficient business interests to justify such protection under Florida law).
In any event the Plaintiff waived its right to enforce the non-compete and related restrictive covenants. The creation of the competing “3 Natives” franchise in Palm City not only directly violated the Franchise Agreement, the Defendants complain, but it ran contrary to the need to avoid competition between “3 Natives” franchisees, a need that Mr. Bambino, himself, had conceded. Because the Plaintiff allowed the competing Palm City franchisee to open, it may not now enforce the non-compete covenant against them, [*19] the Defendants reason. In addition to opening the competing Palm City cafe, the Defendants complain of various other ways in which the Plaintiff breached the Franchise Agreement first. If the Plaintiff indeed had breached the Franchise Agreement first, then that raises the question of how its initial breach of the contract affects its ability to compel the Defendants’ compliance.
This Court notes the above countervailing points because to secure its requested preliminary injunction, the Plaintiff not only must demonstrate the likelihood of success on the prima facie elements of its claims for relief, but it also must demonstrate a substantial likelihood of prevailing over the Defendants’ defenses to them. See Lucky Cousins Trucking, Inc. v. QC Energy Resources Texas, LLC, 223 F.Supp.3d 1221 (M.D.Fla. 2016). The Lucky Cousins decision, in which the court declined to enjoin the defendant’s compliance with the restrictive covenants of the parties’ contract, supports the Defendants’ position here. The plaintiff had yet to overcome at the preliminary injunction stage the defendant’s defense that it was the plaintiff who had breached the contract first, who had hindered the defendant’s ability to perform under the contract, and who was seeking the contract’s enforcement with unclean [*20] hands. (Also, the Lucky Cousins court found insufficient business interests to justify enforcement of the restrictive covenants, similar to the finding that this Court reaches above.)
Based in part on the recent empirical studies of CNCs in the employment context, as well as the Goldstein Law Firm’s analysis of the economic principles underlying CNCs in general and in the franchise context in particular, we believe that there are many proposals that would minimize the costs or harms associated with franchise and employment CNCs, including the following:
- Augment increased transparency in the offering of CNCs to franchisees and employees;
- Encourage franchisors and employers to use more narrowly tailored CNCs in their agreements;
- Limit the enforceability of CNCs to times earlier in the franchise or employment relationship, such that the enforceability of a CNC will be drained by the end of the employment or franchise relationship;
- Allow employees and franchisees the possibility of buying themselves out of their noncompete agreements at the time of termination or expiration of their employment of franchise relationships; and
- Prohibit by statute the use of ‘blue penciling’ that allows courts to give a second life to an unlawful noncompete provision by trimming the unreasonable and overbroad aspects of the CNC so that it thereafter it is viewed to fall within the acceptable reasonable range of CNCs.
If you are considering not renewing, terminating, or otherwise ending your relationship with your franchisor or manufacturer, you must consider the impact of this decision on your ability to operate and earn a living after the conclusion of that relationship. To a lesser extent, you should also be concerned about what business activities you are permitted to engage in while you are under contract with the franchisor or manufacturer.
To protect yourself, you must be able to answer the following questions before you terminate, fail to renew, or otherwise end your relationship:
- Does my franchise, distribution or dealership agreement have an in-term noncompete provision?
- Does my franchise, distribution or dealership agreement have a post-term noncompete provision?
- Does relevant state law permit a court to ‘blue pencil’ my noncompete clause?
- Does the duration clause of my CNC span too many years?
- Does the geographical scope clause of my CNC cover too much territory?
- Does the training I received from the franchisor, distributor or manufacturer comprise a trade secret?
- Am I permitted to keep my franchise business phone number, email address, website, and décor?
- Am I required to assign my lease to my franchisor or manufacturer after the relationship ends?
- Does my state have any statutes that prohibit the enforcement of CNCs?
- Does my CNC prohibit my wife and other family members from engaging in certain specified business activities?
- Do my future plans involve interacting with customers I previously serviced as a franchisee or dealer?
- Are my employees also subject to the CNC?
- Can the franchisor prohibit me under my CNC from operating an independent business in addition to my working for or with other competing franchisors or businesses?