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Franchise Law Update Commentary on Business and Legal Issues of Franchising

Are Noncompetition Agreements Actually Useful?

Posted in Business Updates

Should former franchisees be able to compete with the franchisor? The franchise agreement says “No.” Most franchise agreements contain a clause that prohibits a former franchisee from engaging in the same or similar business as the one franchised. These clauses come to the fore when a franchise agreement is terminated or expires.

In most states, such clauses will be enforced if the prohibited activity is appropriately limited and the limitation is reasonable in duration and geographic area. For example in the fictional Gustoso Pizza system, that clause would not prohibit the franchisee form engaging in any service business anywhere in the world in perpetuity. Besides the fact that no sane person would sign such a clause, it could not be enforced anyway. However, that clause might prohibit the franchisee from engaging in any business that features pizza for two years and within ten miles of any Gustoso Pizza outlet.

PizzaOven pizza-6However, even the latter example may be unenforceable in some jurisdictions. California may be the most well-known example. The California statutory law says that “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Leaving aside employment issues, in the franchise world, the public purpose is to promote competition. Does this mean that in California Gustoso can train a franchisee how to make a Gustoso pizza, give him the recipes and teach him operations but when the contract is over, the franchisee can open his own pizza place and compete with other Gustoso franchisees?

If that were the case, any franchisor might seriously consider not selling to a California resident. However, the Gustoso franchise agreement probably also contains a confidentiality clause that prohibits the franchisee from using trade secrets outside his Gustoso business. Generally speaking, the recipe would be a trade secret and can be protected. The customer list may also be a trade secret developed in the business that can be protected. The operations manual is certainly the franchisor’s property and must be returned when the franchise contract is over. Of course, the trademark is protected anyway by other laws. Obviously, proof becomes more difficult here. It should be far easier to prove the former franchisee is operating a pizza business down the street from another Gustoso franchisee than proving he is using Gustoso recipes, operational methods and their customer list.

However, one might conclude that if the goal is fostering entrepreneurship and competition, starting with the premise that post-termination non-competition clauses are presumptively void could result in a better balance between fostering competition and protecting intellectual property. An interesting macro view of this issue can be found in a recent Wall Street Journal article.