Covenants Not to Compete in Franchise Agreements

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 What Is A Business Franchise?

In a business franchise, one party allows another to use their company’s marketing techniques, materials, and logos in order to start another branch of the company. The most common example of this would be fast-food chains and retail department stores. The head company is called the franchisor, while the party starting the new branch is called the franchisee. The franchisee purchases rights to use the material and business processes from the franchisor.

Business franchise opportunities are considered to be a straight-forward way in which to start business, because the business owner simply must follow the guidelines provided by the franchisor. However, various franchise disputes can still arise, such as:

  • Trademark or copyright violations, such as using the franchise logo for personal use;
  • Unauthorized disclosure of trade secrets;
  • Failure to follow company policies;
  • False advertising or unfair business marketing practices; and
  • Breach of business contracts, which will be further discussed below.

Most franchise disputes involve the franchisee failing to adhere to the guidelines and intentions of the franchising company. However, some cases may involve other types of violations, such as when the franchisee is suing the franchisor because they refuse to provide them with promised payments or benefits.

What Is A Franchise Agreement?

A franchise agreement is the contract which establishes the relationship, rights, and obligations of the franchisor and franchisee. Generally speaking, the franchise agreement provides the following information:

  • The franchise fee;
  • Restrictions placed on the business management structure of the franchisee;
  • The cost of inventory;
  • The income that the franchisor requires, as well as their payment schedule;
  • Length of the agreement; and
  • A termination clause, such as how some franchisors require that if your franchise does not make a specified income, the franchise will be terminated.

A franchise agreement may also be associated with a distribution agreement. A distribution agreement is a contract between suppliers and distributors of a product, also referred to as distributor agreements. They may involve other parties as well, such as manufacturers. A distribution agreement allows a distributor the rights to sell and market a supplier’s products.

Distribution agreements between suppliers and distributors vary greatly based on the needs and goals of each specific distributor and supplier partnership. Generally speaking, such agreements focus on the supply and distribution of a specific product.

In many cases, distribution agreements may also be classified as exclusive dealing contracts. What this means is that the supplier and the distributor agree to work only with one another, and as such will not work with any other parties. Depending on the specific business goals of the parties involved, this could be the more desirable outcome compared to others.

What Is A Covenant Not To Compete?

When signing a covenant not to compete, an employee agrees that if they leave the employer, they will not go to work for the employer’s direct competitors during a specified amount of time. The employee will sometimes receive compensation in exchange for signing the agreement. Covenants not to compete are more commonly known as “non-compete clauses.”

Historically, covenants not to compete have been used in two situations:

  • Employment Contracts: Employers often have employees sign agreements stating that after leaving the company, the employee will not go to work for the company’s direct competitors for a specified amount of time. This is done in order to protect trade secrets and business strategies; or
  • Sale of Business Contracts: When purchasing a pre-existing business, the buyer will often have the seller agree not to form another business that would be in competition with the buyer.

Businesses that most commonly utilize covenants not to compete include those that are associated with:

  • Highly confidential materials;
  • Client demographic and information databases that an employee can access;
  • Businesses with a direct competitor;
  • Trade secrets; and/or
  • Trademarks and copyrights.

Some of the most common restrictions included in a Covenant not to Compete agreement would be:

  • Time: After the employee leaves their former employer, the employee must refrain from working for the competitor, at least for a certain period of time;
  • Type of Business: The employee may be prohibited from working in certain industries and businesses that are related to that of the employer; and
  • Location: The employee may not be allowed to work for a competitor within a specified geographic location, generally a certain mileage from the employer. An example of this would be how the employee may not be allowed to work for any competitor within a ten mile radius.

While the secrets of an employer are generally considered to be valuable, the legal system also places value on a person’s freedom to pursue other means of employment. In order to be legally enforceable, courts generally require that a covenant not to compete is reasonable.

A covenant not to compete will be considered unreasonable when:

  • It lasts for too long;
  • The geographic area that it applies to is too large;
  • The types of business that it covers are too far-reaching; and/or
  • The employer does not have a legitimate business interest in enforcing the covenant not to compete.

Is A Covenant Not To Compete Enforceable In A Franchise Agreement?

The enforceability of a non-competition covenant in a franchise agreement largely depends on whether the court views a franchise contract as a sale of business, or an employment relationship. Most courts determine that it is closer to a sale of a business, because no side has a significantly stronger bargaining position, and therefore they will allow more significant restrictions associated with covenants not to compete.

In other cases, the courts will only determine if the agreement is reasonable based on its terms and the interests of the parties, as was previously mentioned. Additionally, some states have statutes that impact the enforceability of agreements not to compete.

In terms of potential legal penalties, distributor agreements are subject to contract laws. As such, a violation of a distributor agreement is generally addressed under breach of contract laws. Legal remedies may refer to monetary award damages, such as:

  • Compensatory;
  • Nominal; and
  • Liquidated damages.

Equitable remedies are issued by a court when a legal remedy will not sufficiently remedy the damage that was done. An example of this would be remedies such as specific performance, reformation, or rescission.

Other examples of damages could include:

  • Expectation;
  • Reliance;
  • Consequential;
  • Punitive damages;
  • Contract rescission, which is the cancellation of the contract; and/or
  • Contract reformation, which is the re-writing of a portion of the contract in order to reflect the parties’ specific needs.

Which type of remedy that will be prescribed by the court will largely depend on the type of violation involved. An example of this would be how monetary damages are only available for specific types of contract breaches, while rescission may only be prescribed for other types of breaches.

Do I Need A Lawyer For Help With Covenants Not To Compete In Franchise Agreements?

The rules which govern covenants not to compete can be especially complex and difficult to understand. It is imperative when writing a covenant to ensure that it is something that a court will enforce.

An experienced business attorney can help you determine your legal rights and options under your state’s specific laws, and can help with drafting an agreement or reviewing an existing contract. Additionally, your business lawyer will also be able to represent you in court, as needed, if legal action becomes necessary in order to resolve the issue.

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