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Licensing, Technology Transfers,
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Although it is frequently the case that the purpose of a post termination covenant not to compete in a franchise agreement is to terrorize franchisees into staying with the system under threat of losing their investment, it is also frequently the case that there are legitimate reasons for enforcement.
The usual first line of attack is the protection of proprietary, confidential information which is not readily available to people not affiliated with your or another similar franchise system. Even if what the franchisee was taught at the beginning of the franchise term has become obsolete, a franchisor that refreshes the system and stays ahead of the curve still retains meaningfully proprietary and valuable information which has been shared with the franchisees, so that there is a basis to claim a threat of unfair competition if a franchisee were allowed to depart and not observe the covenant. This is certainly not intended to be a law review article treatment of the issues involved in these disputes, but rather a guide for attorneys who may not encounter these disputes often and who may have tried few or none of these cases. I shall describe the issues and some of the categories of evidence that will help show whether enforcement is warranted. How to develop that evidence, and how to present it in an admissible format and a compelling argument, are not covered here. That comes mainly with experience.
This discussion assumes that the temporal scope of your covenant, as written, is not a problem. If the covenant itself was ineptly drafted in the first instance, you are hopefully smart enough not to bet the farm on it. Length of proscriptive period and geographical scope are assumed to be reasonable in this discussion.
The dissatisfied departing franchisee always claims that the franchisor's proprietary information is essentially valueless. It is not easy to prove the value of intangibles. Sometimes it must be proven indirectly.
A franchisee who leaves the system, but continues, even for a short time, to trade on his former affiliation with the franchisor's identity is tacitly admitting that there is substantial value in the identity and in the system. Otherwise, he would take absolutely no risk and would never be found, even for a day, with his old sign still up; with his people still answering the telephone using the franchise system's identity and not immediately setting the record straight when a customer or investigator inquires whether this is a shop associated with the franchise system; with any paperwork anywhere still bearing the franchisor's name or logotype or style. The look and feel of a franchise identity also comprise an integral part of that proprietary value. Changing the name, but keeping the style doesn't quite negate the argument that the departed franchisee is still trying to rip off aspects of the former franchise system and identity.
Evidence of value inheres in a franchisee's having purchased more franchises after the first store, especially if any of those purchases occurred after there was awareness of some of the problems being complained of. Every system has problems and complaints. None is perfect. That the departing franchisee harbors very negative opinions of the value of the relationship in a meaningful competitive sense is usually seen as disingenuous in light of multi-unit ownership. If there is also any retention of any aspect of the old identity, bad mouthing its value is frequently viewed by judge and jury as a recent fabrication, not a truly held genuine belief. Where the multiple unit ownership has accounted for an essentially enclosed geographic area of some proportion, that franchisee will have enjoyed a totality of the marketing value of the franchisor's identity throughout the term of the franchise relationship. The loss of a substantial area is sometimes viewed as a greater injury to the franchisor in this context than would be the case of the loss of a single store.
If there are business statistics showing that units bearing this franchisor's identity have performed better in sales than non-affiliated competitors, that is more direct evidence of value of the proprietary elements of the franchisor's system. The test should be sales volume, not profitability, because the measurement being made is consumer perception of value expressed in patronage. And, in small businesses, the level of profitability is frequently an election by the franchisee to accommodate his own tax or financial planning.
Where there has not been a history of encroachment or of the franchisor competing with its own franchisees through alternative, non-franchised channels of trade (including the Internet), the departing franchisee will have received the benefit of the covenant's impact in the sense that it has kept others from defecting and moving into his geographic area with the same system. He now seeks to inflict upon his former fellow franchisees that from which he was previously immune by virtue of his franchise agreements. Where there has been an encroachment history, this argument is of less value as a basis for covenant enforcement.
Where there has been no history of encroachment or franchisor competition through alternative channel distribution, if the departing franchisee seeking to avoid the covenant not to compete has enjoyed signal success and is one of the strongest and most successful in the system, there is a valid reason to consider that especially effective support and training has been provided, and that his subsequent ability to compete directly would have a more damaging effect than would be in the case of some mediocre performer. Where a super star wishes to defect and challenge the covenant not to compete, it is also frequently the case that the other top-of-the-heap franchisees are watching the progress of the case, waiting to do the same thing if this guy gets away with it. It is not the same issue with a less than stellar performer. The mediocrity is less able to be a believable system destroyer than the lead dog. Again, this is significant when there has been no encroachment issue. Importantly, have there been meetings among the lead franchisees leading up to the time of this franchisee's defection, and what was discussed at these meetings? Did they contribute anything to a war chest to defray legal expenses in this case? Are they showing up to testify for this franchisee? Is there evidence of any other acts in support of this effort on the part of the other leading franchisees?
If the post term covenants of the franchise agreement have alternative remedial avenues calculated to protect the value of the franchisee's business, in addition to preventing his post term competition, the reasonableness of the entire post term covenant construct goes very far in showing that punishment is not the primary goal of the franchisor. By way of illustration, if the departing franchisee has the opportunity to sell his business as a franchise rather than take off out of the system and try to defeat enforcement of the covenant not to compete, that is very helpful as a rule of reason issue. Having the ability to sell the business and choosing not to do so shows that there was a willingness to defy rather than to reach a middle ground in resolving the end of the relationship. To be sure, there would still be a covenant ancillary to the sale of the business, but there would have been substantial value to the departing franchisee through that option, had it been exercised. The same may be said for a provision granting the franchisor the right to purchase or resell the stores, with the departing franchisee getting the proceeds of that transaction minus a reasonable brokerage fee. If the dispute were in mediation, one would expect a reasonably competent mediator to be recommending an approach similar to that. In fairness to the franchisor, it is to be hoped that any undertakings by the franchisor on behalf of the franchisee will accelerate by their own terms upon termination of the franchise or upon its expiration without being renewed.
There is a material question of essential unfairness to the franchisor where the departing franchisee seeking to avoid the covenant not to compete has had a history of being granted indulgences during the franchise relationship that the franchisor was not obligated to provide.
Has this franchisee a history of being in violation of the agreement and being allowed repeatedly to recover without being terminated? Has this franchisor shown compassion when compassion was needed? It is of extreme value later on for a franchisor with an inclination to forgive and recover a relationship to require as a condition of such indulgences that there be a formal acknowledgment by the franchisee upon each such event that the indulgence is not required; that the franchise agreement was and remains in full force and effect; that the franchisee values the franchise relationship and wishes fully and in every respect to ratify the agreement and waive any claims, real or otherwise, he might believe he had at the moment. Where this approach has been followed, it is nigh impossible for a departing franchisee to insinuate that the franchisor is a company that would over reach given the chance to do so.
Aside from instances that could have been treated as breaches and were not insisted upon, any other special affirmative treatment which the franchisor was not obliged to extend should be similarly memorialized, so that there is a real opportunity to present to a court or jury a tangible record of beneficent concern for this franchisee's welfare throughout the relationship. Has the franchisor ever extended any financing which the franchisee would have had to seek through normal bank facilities to obtain? Has the franchisor been willing to go on the business premises lease, even if the franchisor did obtain some degree of premises disposition control by doing so? Was any assistance provided that was not required to have been provided by the terms of the franchise contract itself? The memorializing of these instances represents a valuable body of 'equity' evidence.
Finally, there is the catchall of looking for bad acts on the part of the franchisee that could be relevant to any issue at all in this dispute. Since enforcement of a covenant not to compete is an issue of equity, franchisee bad acts come into play. Did the franchisee engage in dirty tricks, so to speak, relating in any way to the events at hand? Did he solicit the landlord to refuse consent to a leasehold transfer? Did he decline a reasonable offer to purchase the business? If there are resources available to handle this, it is often worthwhile to have independent investigators pretext visit the franchisee as potential buyers to preserve evidence on what the franchisee is telling a potential buyer that would be inconsistent with a good faith willingness to sell at a reasonable price. Did he surreptitiously transfer ownership to a family member or friend without valid consideration - even if he took a note, is the maker of the note financially capable of paying it and are the terms other than arm's length? Did he go register the franchisor's name as a service mark of his own at the state level so that the franchisor might have difficulty using it - or did he incorporate using the franchisor's name just to block the franchisor from doing so in that state or county? Any fooling around with devious attempts to frustrate the franchisor's ability to re-establish itself in his market is highly relevant here. Did his son or other relative suddenly open up the same kind of business? Is there a bankruptcy filing where assets of the business are suddenly gone and unaccounted for, as in a fraudulent transfer? Have new bank accounts been set up in other names that indicate something not quite right? Did he recently order printing using names suggestion a relationship inconsistent with his duties under the covenant? Has inventory been transferred outside the normal course of business, and, if so, under what arrangements? Are there any recent site leases in which he is involved under any name or incorporation? All these are leads that should be explored through discovery and through independent investigation. Now is a good time to exercise those audit rights in your franchise agreement. In fact, it is good practice to do the audit before the agreement's expiration date under almost any circumstance, even if the franchisee is renewing the agreement. What kind of audit you do depends upon what you want to find out.
It is important in these disputes to pick your fight. Betting the farm on the enforceability of your covenant not to compete on the wrong fact situation creates precedent that your covenant is weak. If the departing franchisee is a mediocrity who cannot be portrayed as a serious competitive threat, consider the option of allowing him to make a monetary settlement rather than seek enforcement. It is not always the case that if one gets away all the rest will follow. A careful examination of the relationship history with this franchisee may reveal some information about yourself that would surface in this kind of dispute that you would just as soon not see in the record where others might have access to it. In your mind, change sides and try to think of what the franchisee's counsel might do in discovery and what hot issues they may raise that could hurt the company. Frequently, these are hot button situations where insufficient effort is devoted to vetting your own situation for relevant negatives. Don't fire your lawyer for asking embarrassing questions in private. That counsel is doing you a favor. Executive ego can be a very dangerous factor in covenant not to compete cases, a factor that the opposition may be able to exploit. In fact, if your lawyer does not vette for negatives, you need another lawyer. Your own counsel should be putting you through a grueling cross examination on files in your own company that contain information that could be helpful to the other side. It is far more preferable to hear this in private than while you are on the witness stand getting the knife from opposing counsel on the record and in front of the judge or jury. You must ride the right horse into this kind of battle.
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