Effect of Non-compete and Confidentiality provisions in the franchise agreement

Author: LegalEase Solutions

Introduction

PostNet International Franchise Corporation (“PostNet”) is the franchisor of the franchise program described in the Franchise Disclosure Document. PostNet offered franchises for retail stores which offer business and consumer services and products through a marketing program (“System”). The business typically sell black and white/color photocopying, digital photocopy and scanning, computer and Internet services, printing and finishing services etc. The business involved trademarks, logos and related intellectual properties under the tradename “PostNet.” PostNet enter into a franchise agreement with operators to give the right to establish and operate a PostNet Center in an exclusive ‘Territory’ with certain specific conditions.

The memo analysis the non-competency and confidentiality clause to provide guidance to the franchisee (“Store Owner”)  who wishes to sell off the franchise but  retain the assets of the business and open a new printing business.

Relevant Clauses related to the Agreement

Franchise Agreement – Covenants (§§ 15, 15.3 and 15.4): 

As per the covenant, without the written consent of ProNet, during the term of the Agreement or for an uninterrupted, continuous one year period after the termination or expiry of the Agreement, the franchise shall not own, maintain, advise, operate, engage in, be employed by, make loans to, have any interest in or relationship or association with, a business which offers the same or similar products or services as those offered by the Center or the System at the Approved Location or within 10 miles of the Approved Location, or any other location at which a PostNet Center is open or under construction at the time of signing the Franchise Agreement. There is an exception to this prohibition if the Store Owner is less than a 5% owner of certain companies registered with the Securities and Exchange Commission.

This clause does not appear to be a problem if Store Owner is planning to operate the business at least 10 miles away from the current business and away from any existing PostNet locations (either open or under construction).

Franchise Agreement – Transfer of Interest (§ 12.2):

This clause restricts the Store Owner, without the prior written consent of PostNet, to sell, assign, transfer, convey, give away, pledge, mortgage, or otherwise encumber (1) any interest in the rights under the agreement; (2) any change of control over the Store Owner; (3) all or substantially all of the assets of the ProNet Center. As per the agreement “Transfer” by definition includes transfer of Store Owner’s rights under the Agreement, transfers that change Store Owner’s ownership, and transfers of ProNet Center assets.

A Store Owner who wants to stay in compliance with the Franchise Agreement is prohibited from taking the actions in § 12.2 without the written consent of the franchisor.  Moreover § 12.2.1 states that PostNet shall not unreasonably withhold its consent under Section 12.2 provided all the conditions under Section 12.2.1 are met.which include:

  • Store Owner meets all monetary obligations to PostNet
  • Transferee attends an in person evaluation at PostNet’s headquarters
  • PostNet and transferor execute a mutual release
  • Store Owner not in default under the Franchise Agreement
  • Transferee upgrades the premises to meet the then-current standards and specifications
  • Transferee attends training sessions
  • Store Owner reimburses Post for all reasonable legal, accounting, management, training and incidental expense (minimum amount of $5,000).

 

Franchise Agreement – Default and Termination (§ 13.2):

The Store Owner shall be in default if, without the written consent of ProNet, the Store Owner or its partner or shareholder purports to transfer any rights or interest of the Store Owner, or the assets of the ProNet Center.

Development Agreement – Non-competition covenants during the term of the Agreement (§ 5.2):

The section prohibits association with any business which offers the same or similar products or services as those offered by PostNet Center or diverting business from a PostNet Center, without their approval.

However, this clause will be applicable only during the term of the Franchise Agreement.

Development Agreement – Non-competition covenants after the Agreement is terminated (§ 5.3):

Has a one-year prohibition to associate with a business which offers the same or similar products or services as those offered by PostNet Center and related activities which is located in or within 10 miles of the Development Area.

This clause applies only when the same business is offered within 10 miles of the Development Area.

Franchisee Agreement – Store Owner’s obligations upon termination or expiration (14):

Store Owner should immediately:

  1. cease to operate ProNet Center, and shall not thereafter, directly or indirectly, represent to the public or hold itself out as a present or former Store Owner of PostNet.
  2. Permanently cease to use any confidential methods, procedures, and techniques associated with the System in any manner.
  3. all telephone, facsimile numbers, social media websites and Internet addresses used in the operation of the ProNet Center which are assets of PostNet.

Personal guarantee and covenants (Attachment C to Franchise Agreement):

Guarantors, who are officers, directors, employees of Store Owner, or owners of a legal or equitable interest in Store Owner, while the Franchise Agreement is in effect, shall not attempt or divert any business or customer of Store Owner’s PostNet Center to any competitor. Under the risk factors before buying the franchise, it is specifically stated that spouses must sign a guaranty which make such spouse jointly and severally liable for the obligation under the agreement placing personal assets at risk.

Governing law:

Colorado law is seen applicable under all of the agreements which is subject to state law. The parties seems to agree for mediation and arbitration as per the Agreement before resorting to judicial intervention.

RESEARCH FINDINGS

Colorado law on enforceability of non-compete clause:

            “At the common law, a covenant not to compete could not exist as an independent agreement, even if proper consideration were given for that covenant.” Keller Corp. v. Kelley, 187 P.3d 1133, 1137 (Colo. App. 2008). “Rather, it was enforceable only to the extent that it served an interest of the promisee worthy of protection; it had to be ancillary to a transaction or relationship creating such an interest.” Id. The provisions of Colo. Rev. Stat. Ann. § 8-2-113(2) have “limited the use of a covenant not to compete to the extent that such a covenant would restrict ‘the right of any person to receive compensation for performance of skilled or unskilled labor for any employer.’” Id. (quoting § 8-2-113(2)). “Such a right to perform labor cannot be restricted, except in certain specified instances.” Id. “Among these exceptions are situations where the covenant not to compete is contained within a ‘contract for the purchase and sale of a business or the assets of a business,’ § 8–2–113(2)(a), or in a contract ‘for the protection of trade secrets.’” Id. (quoting § 8–2–113(2)(b)). “This statute reflects a public policy that generally does not favor covenants not to compete.” Id. at 1138 (citing DBA Enters., Inc. v. Findlay, 923 P.2d 298 (Colo. App. 1996)). “And, therefore, even if the covenant is contained within one of the authorized contracts, nevertheless, it still must be reasonable as to its territorial reach and its duration.” Id. (citing Nat’l Graphics Co. v. Dilley, 681 P.2d 546 (Colo. App. 1984)).

In Keller Corp. v. Kelley, the Colorado Court of Appeals considered a similar case with regard to non-compete clause in a franchise agreement. Per the Court, “[t]n the case of the sale of a franchise, the buyer would seem clearly to have a protectable interest in not having the franchisor compete with it in its exclusive franchise territory during the period that the franchise is in existence.” Id. 187 P.3d at 1138. “At the same time, however, once the franchised term ends, the franchisor may well possess an interest worthy of protection in not having the former franchisee use the knowledge, training, and experience gained from the franchisor to compete against it.” Id. According to Court, “[i]n both cases, the covenant not to compete protects the goodwill of the business.” Id.

It has been recognized that “the primary characteristic of a franchise is the license given to the franchisee to trade upon and exploit the franchisor’s goodwill.” Id. at 1139. To state it broadly, “the franchise constitutes an elaborate agreement whereby the franchisee undertakes to conduct business or to sell a product or service in accordance with methods and procedures prescribed by the franchisor, while the franchisor undertakes to assist the franchisee through advertising, promotion, and other advisory services.” Id. (citing Piercing Pagoda, Inc. v. Hoffner, 465 Pa. 500, 351 A.2d 207, 211 (1976)). “Thus, the foremost business interest that a covenant not to compete in a franchise agreement seeks to protect is the basic product that the franchisor has to sell, namely the goodwill created by the franchisor and its business methods.” Id. “Similar to the repeated patronage that is inherent in the goodwill purchased by a buyer in a contract for the sale of a business, a franchisee seeks to exploit the name and service marks of the franchisor.” Id. (citing McCart v. H & R Block, Inc., 470 N.E.2d 756, 763 (Ind.Ct. App. 1984)). “Such service marks are a form of business assets that may be legitimately protected.” Id. “Thus, similar to a covenant not to compete in a sale of a business context, a covenant not to compete in a franchise agreement seeks to enable the buyer of a franchise to enjoy the goodwill for which he or she has bargained.” Id.

However, “a franchise agreement may also be viewed as a conveyance of the franchisor’s goodwill only for the period the franchise is in existence.” Id. at 1139. “Thus, when the franchise terminates, the goodwill is, ‘metaphysically, reconveyed to the franchisor.’” Id. “A covenant not to compete against the franchisor therefore seeks to protect that goodwill.” Id.

In Kelly, the franchise agreement between Franchisor and Kelley was entered into as part of the same transaction in which Kelley acquired a going business from the previous franchisees. The Court in Kelly concluded that, at least under these circumstances, the agreement between Franchisor and Kelley constituted an agreement for the purchase and sale of a business under the statute. Therefore the Court held that, given appropriate circumstances as in Kelly, a covenant not to compete running in favor of a franchisor is an enforceable covenant under that statute.

Texas Law on enforceability of Non-compete clause:

Covenants restraining trade and competition:

According to the Supreme Court of Texas, “[c]ovenants that place limits on former employees’ professional mobility or restrict their solicitation of the former employers’ customers and employees are restraints on trade and are governed by the Act [V.T.C.A., Bus. & C. § 15.50].”  Marsh USA Inc. v. Cook, 354 S.W.3d 764, 768 (Tex. 2011) (citing DeSantis v. Wackenhut Corp., 793 S.W.2d 670, 681–82 (Tex. 1990)). It has been held that “nonsolicitation covenant is also a restraint on trade and competition and must meet the criteria of section 15.50 of the Texas Business and Commerce Code to be enforceable.” Id. However, “[a]greements not to disclose trade secrets and confidential information are not expressly governed by the Act.” Id. (citing CRC–Evans Pipeline Int’l, Inc. v. Myers, 927 S.W.2d 259, 265 (Tex.App.-Houston [1st Dist.] 1996, no writ).

Freedom to contract:

“The Texas Constitution protects the freedom to contract.” Marsh USA Inc., 354 S.W.3d at 768 (citing Tex. Const. art. I, § 16). “Entering a noncompete is a matter of consent; it is a voluntary act for both parties.” Id. “However, the Legislature may impose reasonable restrictions on the freedom to contract consistent with public policy.” Id. (citing Fairfield Ins. Co. v. Stephens Martin Paving, LP, 246 S.W.3d 653, 664–65 (Tex. 2008)). “It has done so with the Texas Free Enterprise and Antitrust Act of 1983, Tex. Bus. & Com.Code ch. 15, which includes the Act, Tex. Bus. & Com.Code §§ 15.50–.52.” Id. “The purpose of Chapter 15 is ‘to maintain and promote economic competition in trade and commerce’ occurring in Texas.” Id. at 769 (citing Tex. Bus. & Com.Code § 15.04).

“Unreasonable limitations on employees’ abilities to change employers or solicit clients or former co-employees, i.e., compete against their former employers, could hinder legitimate competition between businesses and the mobility of skilled employees.” Marsh USA Inc., 354 S.W.3d at 769 (citing Tex. Bus. & Com.Code § 15.04). The court has held that “a contract between two insurance companies to limit compensation and not hire their competitors’ companies was unenforceable as it was intended to “crush and destroy competition.’” Id. (quoting Potomac Fire Ins. Co. v. State, 18 S.W.2d 929, 934 (Tex. Civ. App.-Austin 1929, writ ref’d).

Valid covenants not to compete:

“On the other hand, valid noncompetes constitute reasonable restraints on commerce agreed to by the parties and may increase efficiency in industry by encouraging employers to entrust confidential information and important client relationships to key employees.” Marsh USA Inc., 354 S.W.3d at 769 (citing Hill v. Mobile Auto Trim, Inc., 725 S.W.2d 168, 176–77 (Tex. 1987) (Gonzalez, J., dissenting) (citing Restatement (Second) of Contracts § 188 cmt. c (1981)), superseded by statute, Tex. Bus. & Com.Code § 15.50(a)). The employers’ “high cost of developing human capital, including extensive training, revelation of confidential information and exposure to key customers” was been was given due importance while noting that “valid covenants not to compete ensure that the costs incurred to develop human capital are protected against competitors who, having not made such expenditures, might appropriate the employer’s investment.” Id. (citing Greg T. Lembrick, Garden Leave: A Possible Solution to the Uncertain Enforceability of Restrictive Employment Covenants, 102 Colum. L.Rev.. 2291, 2296 (2002)). Pertinently, quoting section 15.05(a) of the Business and Commerce Code, the Supreme Court of Texas has held that “‘[e]very contract, combination, or conspiracy in restraint of trade or commerce is unlawful.” Marsh USA Inc., 354 S.W.3d at 770.

Nonetheless, “[t]he Legislature also recognized that, even though it may restrain trade to a limited degree, a valid covenant not to compete facilitates economic competition and is not a naked restraint on trade.” Marsh USA Inc., 354 S.W.3d at 771 (citing Tex. Bus. & Com.Code § 15.04). “A noncompetition agreement is enforceable if it is reasonable in time, scope and geography and, as a threshold matter, ‘if it is ancillary to or part of an otherwise enforceable agreement at the time the agreement is made.’” Id. (quoting Tex. Bus. & Com.Code § 15.50(a)).

The courts administer a two-step enquiry in determining the threshold issue of enforceability of the covenant not to compete under the Act.

Enforceability of non-compete covenants:

Common law generally prohibits all restrains on trade. United States v. Addyston Pipe & Steel Co., 85 F. 271, 279-80 (6th Cir. 1898) aff’d as modified, 175 U.S. 211, 20 S. Ct. 96, 44 L. Ed. 136 (1899)). At one time, the Texas jurisprudence held that covenants not to compete are unenforceable because they were in restraint of trade and contrary to public policy. Chenault v. Otis Eng’g Corp., 423 S.W.2d 377, 381–82 (Tex. Civ. App.-Corpus Christi 1967, writ ref’d n.r.e.)). Subsequently, a rule was “well-established in Texas that reasonable noncompete clauses in contracts . . . are not considered to be contrary to public policy as constituting an invalid restraint of trade.” Marsh USA Inc., 354 S.W.3d at 771 (citing DeSantis v. Wackenhut Corp., 793 S.W.2d 670, 681 (Tex. 1990)).

The common law requirement recognized by courts of appeals in Texas and other states is that “a covenant not to compete must be ‘ancillary’ to another contract, transaction or relationship.” Id. Analyzing various courts, the Texas Supreme Court in Marsh USA Inc. held that “for noncompete agreements to be valid and enforceable, the common law required that they be ‘part of and subsidiary to an otherwise valid transaction or relationship which gives rise to an interest worthy of protection.’” Id. at 772 (citing DeSantis, 793 S.W.2d at 682). Additionally, “[t]he ‘otherwise enforceable agreement’ requirement is satisfied when the covenant is ‘part of an agreement that contained mutual non-illusory promises.’” Id. at 773 (quoting Alex Sheshunoff Mgmt. Servs., L.P. v. Johnson, 209 S.W.3d 644, 648–49 (Tex. 2006)). The Court considered whether the Act requires that consideration for covenants not to compete must “give rise” to the employer’s interest in restraining the employee from competing. According to Marsh Court, “the Legislature required a nexus—that the noncompete be ‘ancillary to’ or ‘part of’ the otherwise enforceable agreement between the parties.” Id. at 775 (citing Tex. Bus. & Com.Code § 15.50(a)). Therefore, the Court held that “[t]here is nothing in the statute indicating that ‘ancillary’ or ‘part’ should mean anything other than their common definitions.” Marsh USA Inc., 354 S.W.3d at 775. According to the Court, “‘ancillary means ‘supplementary’ and part means ‘one of several … units of which something is composed.’” Id. (quoting Sheshunoff, 209 S.W.3d at 665 (Wainwright, J., concurring) (quoting Webster’s Ninth New Collegiate Dictionary 84, 857 (9th ed.1990)). Therefore, “[r]equiring that a covenant not to compete be ancillary to an otherwise enforceable agreement or relationship ensures that noncompete agreements that are naked restraints of trade will not be enforceable under the Act.” Id. at 775-76 (citing Restatement (Second) of Contracts § 187 cmt. b (1981). Pre the court, “[t]he common law requirement that there be a nexus between the otherwise valid transaction and the interest worthy of protection bolsters the ancillary requirement.” Id. The core inquiry of the statute is “whether the covenant ‘contains limitations as to time, geographical area, and scope of activity to be restrained that are reasonable and do not impose a greater restraint than is necessary to protect the goodwill or other business interest of the promisee.’” Id. (citing Sheshunoff, 209 S.W.3d at 655).

In Butts Retail, Inc. v. Diversifoods, Inc., 840 S.W.2d 770 (Tex. App. 1992), writ denied (Apr. 21, 1993), the franchisor brought action against franchisee, alleging breach of franchisee agreement permitting franchisee to operate retail fruit and nut store. The court held that the covenant not to compete governing operation of retail fruit and nut store, prohibiting franchisee from operating competing store within same shopping mall, was reasonable and enforceable. However, according to the court, the covenant is ancillary to valid transaction or relationship and the restraint created by agreement not to compete was to protect promisee’s legitimate interest. However, a non-compete covenant governing operation of similar store, prohibiting franchisee from operating another business within “metropolitan area,” was unreasonable and unenforceable, where contract did not define “metropolitan area.”

Additionally, Tex. Bus. & Com. Code Ann. § 15.51 provides the procedures and remedies in actions to enforce covenants not to compete whereby the Court can modify the restrains imposed by those covenants. Franlink, Inc. v. GJMS Unlimited, Inc., 401 S.W.3d 705 (Tex. App. 2013), review denied (Dec. 13, 2013).

CONCLUSION

 

            A valid covenant not to compete is considered to facilitate economic competition and not a naked restraint on trade. The enquiry would be whether the covenant contains limitations as to time, geographical area, and scope of activity to be restrained that are reasonable and do not impose a greater restraint than is necessary to protect the goodwill or other business interest of the promisee. Under Colorado law, in the case of the sale of a franchise, the franchisee have a protectable interest in not having the franchisor compete with it in its exclusive territory during the period that the franchise is in existence. However, after the expiry of the franchised term, the franchisor possesses an interest worthy of protection in not having the former franchisee use the knowledge, training, and experience gained from the franchisor to compete against it. The court has held that in both cases, the covenant not to compete protects the goodwill of the business. To be enforceable, the non-compete clause under Texas law should be ancillary to an otherwise enforceable agreement or relationship. This is to ensure that the noncompete agreement that are naked restraints of trade will not be enforceable under the Act.

In the instant case, the non-compete may be enforceable to the extent that it prohibits the store owner or franchisee from operating competing store in a reasonable manner which will not impose a greater restrain than is necessary to protect the goodwill or other business interest of ProNet.