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The Role of Restrictive Covenants in Franchising

On Behalf of | Jan 5, 2017 | Blog, Franchise Law |

Franchise agreements typically include in-term non-compete covenants, which restrict competition during the term of the franchise agreement, and often include a post-term covenant that restricts competition following the termination or expiration of the agreement. These provisions routinely ban competition within a certain radius of the franchised location and sometimes within the territory of other franchisees or company-owned stores, as well. Because restrictive covenants restrain trade and freedom of enterprise, courts typically subject them to strict or close scrutiny. For example, most jurisdictions require that post-term covenants be reasonable in temporal and geographic reach, line-of-business or other scope (such as the type of activities restricted or particular market segment or customers that are off limits), and necessary to protect a franchisor’s legitimate business interest. Depending on the jurisdiction, covenants not to compete may be subject to state contract law, franchise statutes and more generally-applicable statutes that cover franchising as well as other enterprises.

Most courts scrutinize non-competition covenants using a four-part test. The covenant must be 1) ancillary to the main purpose of an otherwise lawful contract; 2) necessary to protect the enjoyment of legitimate benefits of the contract; 3) reasonable and not impose an undue hardship on the franchisee; and 4) not injurious the public or against public policy. Such inquiries are very fact-specific and depend on the particular franchise at issue.[1] If a covenant not to compete has an unreasonable term, many courts rewrite the contract and correct the offending term (so-called, “blue pencil” states). On the other hand, some courts will declare the entire covenant invalid if any part of it is unreasonable or against public policy.

Well-drafted restrictive covenants can be a very useful tool for franchisors seeking to protect their business interests from former or current franchisees who generally have liberal access to the franchisor’s proprietary information. This information often includes employee training manuals, operational manuals, advertising and marketing information, and useful policies and procedures that lead to the effective operation of the business. To many franchisors, this type of information can be invaluable assets that allow for the quick set up and easy operation of new franchised locations. Protecting this proprietary information is understandably seen as necessary to ensuring the preservation of the franchisor’s trademarks, trade secrets, goodwill, and brand identity.

Given the important role that restrictive covenants can play in the protection and preservation of a franchisor’s brand identity, it is prudent that franchisors maintain awareness of current trends in the law regarding restrictive covenants as applied to franchises. Franchisors should be wary of sloppily drafted provisions that are not sufficiently limited and precise in scope to avoid any unnecessary pitfalls when seeking enforcement. In drafting or modifying restrictive covenants, franchisors should make all attempts to narrow the restrictions to only those reasonably necessary to protect the franchisor’s legitimate business interests and not draft such clauses with the attempt to penalize current or former franchisees for attempting to expand their own business interests where such expansion does not place an unfair burden on the franchisor or the franchise system. So long as these clauses are reasonable in length of time, geographic scope, and the areas of competition disallowed, the franchisor is more likely to have success gaining an injunction or other legal remedy to prevent damage to its brand.

The attorneys at Zarco, Einhorn, Salkowski are experienced in drafting and analyzing the provisions of franchise agreements and other contracts, such as restrictive covenants in franchising. If you are seeking to draft or revise an agreement or are involved in a franchise contract dispute, please contact the attorneys of Zarco, Einhorn, Salkowski for a consultation.

[1] For example, the fourth factor sometimes turns on the effect the restriction has on the public’s ability to access the specific goods and services offered by the franchise. See e.g., Interstate Automatic Transmission v. W.H. McAlpine Co., 1981 WL 2193 (N.D. Ohio 1981).

Michael Braunstein
Law Clerk