In a recent blog, we cautioned readers that an overprotective non-compete can result in no protection at all. In that case, Unlimited Opportunity, Inc. v. Waadah, a franchisor could not enforce a non-compete clause despite its franchisee’s clear violation. 861 N.W.2d 437 (Neb. 2015).
A recent case, JH Inc. v. Cline, paints a rosier picture for franchisors. No. 14-6931 (D.N.J. Oct. 29, 2015). Here too, the allegations stated a blatant violation of a non-compete. But while Waadah was a drafting cautionary tale, Cline shows why certain provisions should be on the drafting checklist. In this blog, we’ll explain how certain franchise agreement provisions paved the way for a preliminary injunction prohibiting a former franchisee from competing.
Jackson Hewitt, Inc. (“JH”) is a tax preparation business franchisor. David Cline was a JH franchisee, operating four locations in California and Arizona. Their franchise agreements contained a non-compete and post-termination obligations:
- Duration: 2 years after termination
- Scope: Within the territory (defined by zip code) + 10 miles outside the territory.
- Post-Termination Obligations
- Pay all amounts owed to JH;
- Return all trade secret, confidential and proprietary materials to JH;
- Delete all confidential and client materials; and
- Transfer telephone numbers to JH.
The franchise agreements also required Cline to acknowledge that the unauthorized use or disclosure of trade secrets, confidential and proprietary information would cause “irreparable injury” to JH.
JH terminated Cline’s franchise for failure to fulfill his financial obligations. JH alleged that Cline continued to operate tax return preparation businesses in the same locations and with the same telephone numbers and employees as when he was a JH franchisee. Importantly, JH also alleged that Cline was using its client files. JH claimed that Cline even posted fliers advertising his new tax preparation business that were directly targeted at JH’s customers in its Walmart location:
“ATTENTION WAL-MART CLIENTS the Jackson Hewitt Tax Service in the Walmart is NOT the same Jackson Hewitt that did your taxes last year.”
JH filed suit seeking a preliminary injunction compelling Cline to observe his obligations under the franchise agreement. To succeed JH had to establish:
- That JH was likely to eventually succeed on the merits if the case went to trial;
- That JH would suffer “irreparable harm” if the court did not grant the injunction;
- That the harm to Cline with the injunction would not exceed the harm to JH without the injunction; and
- That the public interest favors granting the injunction.
Prong 1 was easily established: JH alleged a blatant breach of the non-compete and Cline offered no evidence in his defense. Prong 4 was also easily satisfied.
With respect to prong 2, the court stated there is a likelihood of irreparable harm when one party possess another party’s confidential information and is “poised to use or disclose” such information. Cline’s failure to return client files and his potential use or inevitable disclosure of the information in the client files established irreparable harm. The court also noted that Cline had acknowledged as much in the franchise agreement.
With respect to prong 3, the court found that the 2-year/10 mile non-compete was reasonable. It did not restrict Cline from engaging in his livelihood outside the restricted area. By comparison, the hardship JH faced would be significant if the court permitted Cline to retain and potentially use JH’s client information.
Notably, the court’s analysis did not turn solely on the non-compete. Instead, the court was most interested in Cline’s possession and potential use of JH’s client information. Had JH relied only Cline’s competition, it may not have so easily established “irreparable harm.”
Drafting Takeaway 1: Cline’s post-termination obligations under the franchise agreement specifically included returning all trade secret, confidential and proprietary materials. This provision protected JH’s IP by paving the way for a breach of contract claim. But more importantly for injunction purposes, it helped establish “irreparable harm” and tipped the balance of hardships in favor of JH – perhaps more than if JH simply alleged a violation of the non-compete. Franchise agreements should have robust post-termination obligations, especially regarding the return and/or destruction of confidential information. They not only protect a franchisor’s IP, but may help enforce non-competes.
Drafting Takeaway 2: JH’s franchise agreement specifically required Cline to acknowledge that unauthorized use and disclosure of trade secrets would cause “irreparable injury” to JH. Under another set of facts, this provision alone may not mean much. But here the court specifically noted it. Including an “irreparable injury” acknowledgment in a franchise agreement may help eventually establish a successful preliminary injunction.
Waadah and Cline represent two sides of the non-compete coin. Although their facts both involve egregious violations of non-compete clauses, the results were very different. The devil is in the drafting. Waadah demonstrates the importance of understanding how state law will interact with contract provisions, especially non-competes. Cline shows that attention to other provisions in a franchise agreement can strengthen a claim to enforce a non-compete. The bottom line, of course, is the bottom line: An upfront investment in attentive drafting can save a lot of hard earned franchise fees and royalties in the long run.