On December 28, 2018, the D.C. Circuit Court of Appeals issued an opinion in the Browning-Ferris case. In this much anticipated decision, the Court of Appeals concluded that the National Labor Relations Board’s decision to enumerate a new joint employer test was a valid exercise of its authority. The Court of Appeals held, however, the NLRB failed to properly apply the newly created test. Consequently, while the Court of Appeals didn’t completely abrogate the NLRB’s ruling, the opinion frankly raises many questions respecting the future of the Browning-Ferris standard.

In the Browning-Ferris decision, the NLRB generally outlined a new joint employer test where two entities would be considered to be a joint employer if a common law employment relationship exists and if the joint employer possesses “sufficient control” over the “essential terms and conditions” of employment to permit “meaningful bargaining”. This test eliminated the long-standing precedent requiring an employer to have direct and immediate control over the subject employee. For a more detailed analysis of the original decision, and its various twists and turns, please see our previous blogs posts here, here and here.

The controversy surrounding what the Dickens the initial decision in Browning-Ferris means has festered since that time, with the concern from employers being particularly vocal. Specifically, employers have argued that the NLRB failed to establish what the “essential terms and conditions” of employment are, calling the language impermissibly vague and impractical. It didn’t help matters that the NLRB’s response to such concerns had been, essentially, “we’ll know an employment relationship when we see one.”

The Court of Appeals, in reviewing prior jurisprudence, concluded that the right-to-control standard is an established aspect of common-law interpretations of agency and that the analysis is not limited to the direct and immediate control an employer exerts over the employee. In analyzing this new standard versus long-held common-law agency decisions, the Court of Appeals found that cases of common-law agency focused not only on actual control over the employee but the “right to control” the employee as well. Thus, according to the Court of Appeals, the NLRB properly considered not only direct control but also control which is reserved and unexercised.

However, in remanding the case to the NLRB, the Court of Appeals held that the NLRB failed to reserve its application of the indirect control factor to those “essential terms and conditions” of employment. The Court of Appeals stated that the NLRB failed to differentiate between those aspects of indirect control relevant to status as an employer, and those aspects which are simply the by-product of common-law third-party contractual relationships.

The Court of Appeals further guided the NLRB in future actions by stating that, if it again finds Browning-Ferris to be a joint employer, it could “not neglect to (a) apply the second half of its announced test; (b) explain which terms and conditions are ‘essential’ to permit ‘meaningful collective bargaining’; and (c) clarify what ‘meaningful collective bargaining’ entails and how it works in this setting.” In the view of these commentators, the Court of Appeals’ guidance highlights the concerns raised by employer groups and provides hope that the NLRB will dedicate itself to further fleshing out the standards so as to provide meaningful guidance.

Unfortunately, one important question that the Court of Appeals failed to answer is whether indirect control, in and of itself, can establish joint employer liability. Given this continuing ambiguity, the franchise community will continue to be left with many questions as to whether franchisors will be considered the joint employer of their franchisees’ employees.

But this is not the only open question.

Perhaps the more important question is what will the NLRB do now? As is noted in our blog post here, the NLRB is currently in the midst of a rulemaking process to further develop and define the joint employer standard. The deadline for comments on this proposed rulemaking has been extended multiple times, suggesting both a large number of comments and disparate views. It is unclear whether the NLRB will rule on the remanded Browning-Ferris case prior to implementation of a new rule or wait for the completion of the rulemaking process. Either way, grab your popcorn, candy and pop, and settle in for more excitement and fireworks, NLRB-style.

Out-of-state franchisors beware of opening a franchise in New Mexico due to the recent decision in A&W Restaurants, Inc. v. Taxation and Revenue Department of the State of New Mexico and the potential for tax liability. The Taxation and Revenue Department of the State of New Mexico (“Dept.”) assessed over $29,000 in unpaid taxes against A&W Restaurants, Inc. (“A&W”) arising from its collection of royalty fees from several New Mexico franchisees.

In 2007, the New Mexico legislature amended the definition of “gross receipts” subject to the state gross receipts tax to include any money or value received from the grant of a franchise employed in New Mexico. Additionally, it removed from the definition of “gross receipts” any money or value received in connection with a trademark license agreement. Based on these definitions, A&W filed a protest seeking abatement of the gross receipts tax. During the course of the tax proceeding, A&W argued that the royalty fees were paid in connection with the trademark license provisions of the franchise agreements, omitting it from inclusion in the gross receipts tax. The hearing officer disagreed and upheld the Dept.’s assessment. A&W appealed the hearing officer’s decision.

The Court of Appeals in this case completed a thorough review of the amendments made by the New Mexico legislature and noted that the intent behind such revisions was to include royalty fees received in connection with franchise agreements subject to the gross receipts tax. Further, the New Mexico legislature wanted to exclude trademark license agreements but not franchise agreements that contain a trademark licensing provision. The Court noted, and A&W admitted, that a franchise agreement would not be entirely complete without a trademark license. With that, the Court upheld the hearing officer’s decision and held that A&W cannot separate out the trademark licensing provisions of the franchise agreement in order to avoid the gross receipts tax.

This decision serves as a reminder to ensure that your franchise agreement adequately protects you in this situation. It is important to keep your eye on similar legislative efforts in the future to appropriately plan for a franchisor’s potential tax liability.

In a closely watched 5 to 4 decision authored by retiring Justice Kennedy in South Dakota v. Wayfair, 585 U.S. ___ (2018), the U.S. Supreme Court reversed decades of Supreme Court precedent, giving state and local governments the right to collect sales taxes from out of state retailers on online sales made into the local jurisdiction.

The case involves Wayfair, a furniture and home company which sold products over the Internet into the state of South Dakota.  The law in question required the payment of a 4.5% sales tax by out-of-state retailers that make at least 200 sales or sales totaling at least $100,000 in South Dakota.

Prior to the Wayfair case, the standard, from two Supreme Court cases named Bellas Hess and Quill, was that a company had to have a physical presence in the state in order to be required to pay local tax.  A “physical presence” was something like a retail outlet, employees or property in the jurisdiction.

The Supreme Court stated, overruling decades of precedent, that the physical presence rule is unsound and incorrect. The Court noted that the rule has become removed from economic reality as technology has advanced.  The Court stated that the physical presence rule creates market distortions and puts local businesses and others at a competitive disadvantage given the new online marketplace.

The court concluded that, if a retailer establishes a substantial nexus with a state, that state can tax the sales in that state.  In this case, they concluded that the South Dakota law’s requirements of number of sales or total value satisfies the substantial nexus requirement.

This case has attracted much attention. Nonetheless, it is not surprising. Readers of this blog might recall that several years ago, the Supreme Court refused to hear an appeal of an Iowa law that required the collection of income taxes from franchisors on royalties for the use a franchisor’s intangible intellectual property by its franchisees within the physical confines of the state of Iowa.  The US Supreme Court let stand a ruling that such use presents “a sufficient connection to Iowa to justify the imposition of income taxes.” To us, this sounds an awful lot like the new “substantial nexus” test for the imposition of sales taxes.

Given that so many states rely on sales tax revenue for huge portions of their budgets and state governments have a strong aversion to new income taxes, this green light from the Supreme Court means that other states are likely to take a hard look at their laws and consider the enactment of laws calling for the collection of online sales taxes like the one in South Dakota. At the same time, for the franchise world, the related issue of whether the presence of franchisees in a state constitutes a substantial nexus for taxes on royalties will be closely watched by the franchise industry.

This information does not constitute legal or tax advice.  You should, of course, consult an attorney or tax adviser regarding any taxation issues you might have, as each situation is unique.

In Lomeli v. Jackson Hewitt, Inc., the United States District Court in the Central District of California held that the plaintiff, Luis Lomeli (“Lomeli”), had submitted enough evidence to hold the franchisor (“Jackson Hewitt”) vicariously liable for potential class actions due to a franchisee’s preparation and submission of fraudulent tax returns. The most concerning part of this decision is that the Court held that Jackson Hewitt could be directly liable for the fraud claims. This decision is another lesson in the necessity of leaving a certain level of discretion to a franchisor’s franchisees.

Under the direct liability claim, the Court examined Jackson Hewitt’s level of involvement in the submission of a franchisee’s tax returns. Specifically, the Court noted that the franchisee was required to use Jackson Hewitt’s proprietary software to submit the fraudulent tax returns and that Jackson Hewitt controlled the software. Further, despite the fact that Jackson Hewitt had approved the submission of a tax return for Lomeli mere days before, Jackson Hewitt approved a second submission for Lomeli with a markedly different tax return. As such, Jackson Hewitt had and controlled the information that gave rise to the fraudulent filing of the tax returns. To make matters worse, Jackson Hewitt had recently run an advertising campaign touting its 100% accuracy guarantee and superiority to “mom and pop” tax preparers. The Court held that these affirmative statements to the public had the explicit purpose of engendering their trust. Further, Jackson Hewitt could not run these advertisements to convince consumers to use them and then immediately turn around and dismiss any reliance on them. As such, Lomeli could proceed with its fraud claim directly against Jackson Hewitt.

As a secondary claim if the direct liability claim fails, the Court examined the level of control Jackson Hewitt exerted over certain areas of the operation of the franchise to determine vicarious liability. In holding that Jackson Hewitt could be vicariously liable for Lomeli’s fraud claim, the Court highlighted Jackson Hewitt’s ability to hire, direct, supervise, discipline or discharge the franchisee’s employees, the required use of Jackson Hewitt’s Code of Conduct for employee relations and required attendance by franchisee’s employees at training sessions aimed at preventing the specific harm claimed by Lomeli. The Court noted that Jackson Hewitt’s control of the instrumentality that caused the harm, the hiring of tax preparers, directly contributes to its vicarious liability.

Unfortunately for Jackson Hewitt (and franchisors everywhere), Jackson Hewitt could be 100% liable for the filing of the inaccurate and fraudulent tax returns.

 

The fight against joint employment of franchisors and franchisees took a small hit when the Western District of Pennsylvania (“Court”) chose to allow a franchisee’s employee’s suit to proceed. In Harris v. Midas, et. al., the plaintiff, Hannah Harris (“Harris”), convinced the Court that she had proffered enough evidence to allege a plausible basis to hold the franchisor (“Midas”) as a joint employer and vicariously liable for the franchisee’s conduct with respect to Harris’ sexual harassment claims against her franchisee employer.

In the instant case, the Court looked at three factors commonly employed to evaluate joint employer liability. First, the Court examined Midas’ authority to hire and fire employees, promulgate work rules and assignments and set conditions of employment. While the Court noted that Midas did not have the authority to hire or fire employees, the Court held that Midas could establish work policies. Specifically, the Court pointed to the provisions of the Franchise Agreement that require franchisees to comply with all lawful and reasonable policies imposed by Midas. Those policies specifically include those policies governing the training of personnel. Further, Harris noted that Midas provided guidance to its franchisees on the creation of its employee handbook and the inclusion of a sexual harassment policy, further exerting its control to influence these workplace policies.

Second, the Court held that while Midas did not exert control over the day-to-day supervision of employees, under the Franchise Agreement, Midas had the authority to do so. Notably, the Court cited Midas’ ability to require employees to attend additional training programs. Further, Midas trained the franchisee who, in turn, trained its employees on the Midas system. Lastly, the Court noted Midas’ ability to visit and inspect the franchisee’s location as further evidence of Midas’ potential influence over the day-to-day supervision of the franchisee’s employees. The Court’s reliance on these provisions is worrisome because many franchisors use similar language to protect the uniformity of the brand.

The last factor, Midas’ control over employee records, the Court again made a stretch to connect the dots. The Midas Franchise Agreement stated that Midas has the right to audit and examine the franchisee’s books and records, which, the Court held, could be interpreted to include personnel files if read as broadly as possible.

Furthermore, Harris argued that Midas was vicariously liable for the franchisee’s conduct because the franchisee was essentially acting as Midas’ agent. The Court agreed holding that the terms of the Franchise Agreement are so generally phrased as to provide Midas broad discretionary power to impose nearly any restriction or control it deems appropriate.

While the case at hand is at the initial phase and will likely be subject to further scrutiny, it demonstrates another avenue that courts are using to impose joint employer liability. Here, the Court is relying upon the broad and sweeping provisions of the Franchise Agreement that Midas is using to protect its brand and franchise system. The fine line franchisors must continue to tread between exerting just enough control to ensure proper maintenance of the franchise system but not enough to cause joint employer liability continues.

 

Below is a Guest blog post authored by our own Michael Viscount:

A concern for franchisees is the impact on license agreements for intellectual property when the licensor files bankruptcy and seeks to shed itself of burdensome obligations under license agreements. The impact on the licensee is different depending on the type of IP licensed. And, to further complicate matters, with regard to impact on trademarks the results can be different depending upon where the licensor files for bankruptcy.

Registered trademark symbol on a red backgroundRejection of Executory Contracts – An Overview

The scenario arises because Section 365 of the U.S. Bankruptcy Code allows the debtor party to reject certain contracts that are burdensome.

License agreements can be rejected, and this includes licenses for trademarks and other intellectual property. Under Section 365, when a license is rejected, the debtor party is excused from all obligations.

In 1985, in a case involving intellectual property licensed by Lubrizol Enterprises, the 4th Circuit Court of Appeals in Virginia allowed the rejection of the license agreement and ruled that the rejection by the licensor terminated the licensee’s right to use the intellectual property.

As can be imagined, this caused a stir in the business community, particularly in sectors like the franchise business.

In reaction, Congress amended Section 365 by adding subsection (n) to give licensees of certain types of intellectual property protection – under 365(n) the licensee of IP can either treat the license as terminated or continue to use the IP for the balance of the term of the contract provided all royalties are paid without the right of set off, and without the ability of the licensee to receiver any support from the licensor.

Impact on Trademark Licenses

When Congress amended Section 365 by adding 365(n), it also defined what it meant by the term intellectual property. The definition found at Bankruptcy Code Section 101(35A) does not include a reference to trademarks. The result is that cases are all over the board on whether trademark licenses have the protection from rejection codified in Section 365(n).

Some bankruptcy courts in the 4th Circuit and elsewhere hold that since the definition of IP does not include trademarks, the 4th Circuit’s analysis in Lubrizol dictates that the rejection of a trademark license terminates the rights of the licensee to use the trademark, i.e., no 365(n) protection. Courts in other jurisdictions hold that to treat trademark licenses differently cannot be supported, and these courts find equitable reasons to allow licensees to continue to use trademarks after license rejection.

The equitable approach was discussed in the 3rd Circuit’s 2010 ruling in Exide Techs. The 3rd Circuit did not decide the issue in Exide. But in a concurring opinion, Judge Ambro wrote that bankruptcy courts can fashion equitable protections for rejected trademark licensees. That judge is a former business bankruptcy lawyer whose opinions on bankruptcy are often cited favorably, and his concurrence in Exide was applied by at least one judge in New Jersey to support the equitable protections approach.

In 2012, the 7th Circuit weighed in in a case involving the bankruptcy of Sunbeam Products, when it held that the rights of the trademark licensee “do not vaporize” by rejection. The 7th Circuit rejected the analysis of the 4th Circuit in Lubrisol setting up a clear circuit split.

In 2016, a case from New Hampshire, involving licenses for all sorts of IP granted by Tempnology, LLC, started in the Bankruptcy Court, went to a 3-judge Appellate Panel and then to the full 1st Circuit. By the time the Tempnology case got to the full circuit court of appeals, two judges had ruled against the trademark licensee (Bankruptcy and BAP dissent) and two others had ruled in favor. The Bankruptcy Appellate Panel majority of two judges relied heavily on the 7th Circuit’s analysis in Sunbeam in finding that trademark licensees have the same protections as licensees of other IP.

In a split decision, the full 1st Circuit held that:

  1. Licensees of trademarks do not have protection under 365(n).
  2. It is not appropriate to craft equitable remedies to protect trademark licensees – rejecting the Judge Ambro approach
  3. The analysis of the 7th Circuit in Sunbeam was rejected
  4. The analysis of the 4th Circuit in Lubrizol was followed.
  5. The rights of the trademark licensee were rejected.

Conclusion

If you are a franchisee or other license holder and your franchisor/licensor files bankruptcy, until the Supreme Court resolves the split between the Circuit Courts, the outcome and impact on future rights to use trademarks may very well depend on the state in which you find yourself litigating the issues.


Michael J. Viscount Jr. is a partner in Fox’s Financial Restructuring & Bankruptcy Department, based in its Atlantic City and Philadelphia offices. He can be reached at 609.572.2227 or mviscount@foxrothschild.com.

In December, we wrote that the NLRB had issued a decision overturning Browning-Ferris’ joint employer test and returning to the previous standard for determining joint employment.  That decision in Hy-Brand Industrial Contractors was seen as a return to sanity by employers and pro-business groups.

Unfortunately, the NLRB announced today that it had vacated the Hy-Brand decision due to the fact that one of its members who heard the case had a conflict.  Member William Emmanuel’s law firm had participated in the Browning-Ferris case.  Since Hy-Brand directly addressed the Browning-Ferris standard, the NLRB Inspector said that Emmanuel should not have participated in the Hy-Brand case.

The Browning-Ferriss case set forth a standard for joint employment that noted that businesses could be joint employers simply because they reserved the right to control the actions of the other entity’s employees, even if they never actually exercised that authority.  That, of course, created great consternation in the franchise setting as franchisor agreements may typically have a broad right to address franchisees’ employee issues that may never actually be exercised.  Franchisors, conscious of protecting their brand’s image, usually inserted such clauses to insure that a franchisee’s employees would not denigrate the brand.

It is not clear at this point when Hy-Brand will be reheard or if the issue will come before the Board in another case.  In the meantime, employers are stuck with Browning-Ferriss.  To the extent that employers revised franchise agreements after the Hy-Brand decision was issued, they should have those agreements reviewed by legal counsel.

Yesterday afternoon, the NLRB issued a decision in Hy-Brand Industrial Contractors that caused a collective sigh among employers.  The decision rolls back the joint employer standard to what it was before Browning-Ferris Industries, 362 NLRB No 186.

The Browning-Ferris decision was greeted with alarm by most employers, especially franchisers and franchisees, as it made it easier for employees to claim that two entities were joint employers.

Specifically, Browning-Ferris held that two entities could be joint employers even where they never exercised joint control over essential terms and conditions of employment.  It was enough that there was an agreement between the parties where they reserved the right to exercise joint control.

The Hy-Brand decision explicitly overrules Browning-Ferris.  Interestingly, the decision discusses in some detail the negative impact Browning-Ferris had on franchisers.

Now the test for determining whether an employer has exercised joint control goes back to what it was before Browning-Ferris was decided in 2015.  Two entities will be found to be joint employers where:

  • joint control is exercised;
  • the control has a “direct and immediate” impact on employment terms; and
  • where such control is not merely “limited and routine.”

Franchisers should still be careful when setting up controls over payroll processes or scheduling of employees of franchisees or when they have reserved the right to address discipline with the franchisee’s employees.  The mere fact that an employer reserves the right to weigh in on disciplinary issues will no longer mean that they could be a joint employer.  However, if that right to weigh in on discipline is frequently exercised, then there might be a finding of joint employment.  In other words, wade carefully.

A recent decision in the United States District Court of Arizona (“Court”) could have far-reaching consequences to many franchisors based on the broad-sweeping principles the Court used in its reasoning. In Zounds Hearing Franchising, LLC et. al. v. Bower et. al., the Court answered the question of whether the Ohio Business Opportunity Purchasers Protection Act (BOPPA) trumps a choice of law and venue provision that provides for the application of law other than the State of Ohio.

Here, four franchisees filed suit against Zounds Hearing Franchising, LLC and Zounds Hearing, Inc. (collectively, “Zounds”) in the state court of Ohio for failure to comply with the five-day cancellation requirement under the BOPPA. Further, the aggrieved franchisees claim that Zounds made false, misleading and/or inconsistent representations than that contained in its FDD in connection with the sale of its franchises in violation of the BOPPA. Each Franchise Agreement provides that Arizona law governs the interpretation and enforcement of the Franchise Agreement and all disputes are subject to pre-suit mediation (at Zounds’ option) and venue in Arizona. As such, Zounds moved to remove the suits to Ohio federal court, which then transferred the suits to the instant Court.

In analyzing whether BOPPA should trump the provisions of the Franchise Agreement, the Court relied on the rules of the Restatement of Conflict of Laws. Specifically, the law of the state with the “most significant relationship” to the parties shall govern the agreement or, if the parties chose the law of another state, that state’s law shall govern. However, if the choice of law is contrary to a fundamental policy of the state with the most significant relationship, that state will presume to have the materially greater interest in its state law governing the agreement. In holding that Ohio has the most significant relationship to the parties, the Court noted that all of the franchises and franchisees were located in Ohio and it has a strong interest in protecting its residents, particularly where the underlying statute is designed to protect franchisees that are in an inferior bargaining position. Further, Arizona lacks a statute that protects purchasers of franchises, while BOPPA is directly on point to address the franchisees’ purported harm. Essentially, the franchisees would be left with little recourse against Zounds if Arizona law applied.

Further, the Court held that it is difficult to imagine that a statute that makes certain conduct a crime as being anything but the fundamental policy of the state. Additionally, the Ohio legislature amended the BOPPA in 2012 to explicitly state that any venue or choice of law provision that deprives an Ohio resident of protection thereunder is contrary to public policy, void and unenforceable further evidencing its intent. Lastly, the Court went so far as to say that even if a statute does not explicitly outline that it is fundamental policy of that state, a court still could deem it so by its very nature. Further, the lack of a non-waivability term does not doom the statute under this analysis. These principles may open the door to seemingly endless arguments about what constitutes the fundamental policy of a state.

As such, even though the parties agreed to the Arizona choice of law and venue provisions, the application of Arizona law would be contrary to the public policy of Ohio because Arizona does not have a statute that protects the rights of franchisee purchasers as does Ohio. Further, Ohio has a materially greater interest in the enforcement of its law because the franchisees are Ohio residents and the franchises are located therein.

In the alternative, Zounds filed a motion to compel mediation pursuant to the requirement for pre-suit mediation in Arizona in the Franchise Agreement. Here, the Court determined that the pre-suit mediation requirement violated the franchisees’ rights to Ohio venue because the mediation is “intimately bound up” with the franchisees’ right to sue under the BOPPA. Lastly, the Court determined that the mediations for all four franchisees could be joint despite the Franchise Agreement requiring that all proceedings arising out of the Franchise Agreement be decided on an individual basis. Here, the Court held that because pre-suit mediation was a “proceeding” (as argued by Zounds’ counsel), then the BOPPA prohibitions apply to the mediation requirement and the BOPPA specifically prohibits class action waivers. As such, the requirement to conduct pre-suit mediation was void in violation of the BOPPA. However, the parties conceded to conduct mediation during the course of the suit. As such, the Court required that the parties conduct joint pre-suit mediation. To take it a step further, the Court awarded the franchisees their attorneys’ fees because Zounds burdened the franchisees with a multiplicity of actions in a distant forum. Further, the Court cited the unequal provision in the Franchise Agreement that stated Zounds could recover attorneys’ fees upon a successful claim against a franchisee but did not afford franchisees with a reciprocal right. The Court noted that it would be a presumptive abuse of discretion not to award attorneys’ fees against an unsuccessful party who “used its superior bargaining position to impose such a term”.

Overall, this result could have substantial effects to any franchisor that currently has franchises in Ohio or has Arizona law as its choice of law. This decision suggests courts have wide latitude to determine whether another state has a substantial interest in the transaction and whether that state’s law should govern the agreement. Further, it is important to take note of the consequences this has on a franchisor’s ability to enforce non-binding mediation as a preliminary form of dispute resolution (and on an individual basis) and to collect attorneys’ fees (without a corresponding right afforded to the franchisee). Lastly, it would be prudent for all franchisors to review their franchise agreements in light of this decision.

A federal court in Colorado recently upheld a franchisor’s non-competition provision despite that state’s strong public policy against non-competes. The franchisor prevailed due to its thoughtful contract drafting and ability to effectively communicate the unique nature of franchising to the court.

In-home care franchisor Homewatch International, Inc. and its franchisee, Prominent Home Care, Inc., signed a franchise agreement that terminated on June 30, 2016. The next day, Prominent’s sole shareholder and officer (the “Defendant”), started a competing company. Homewatch sued the Defendant for breach of contract, seeking to enforce the non-competition provisions in their agreements.

The Defendant made two arguments in her defense (i) the franchise agreement’s non-competition provision did not bind her because she signed the franchise agreement only in her executive capacity on behalf of Prominent; and (ii) the non-competition provision was unenforceable under Colorado law.

Argument 1:  Parties Bound
The franchise agreement stated that, after the term of the franchise agreement, Prominent and its officers and shareholders could not own or operate a competing business within a twenty-five mile radius of a Homewatch location. Only Prominent (not the Defendant) signed the franchise agreement. However, the franchisor had also required the Defendant to sign a personal guaranty. The guaranty stated that the Defendant would be bound by the non-competition covenant in the franchise agreement.

The court ruled in the franchisor’s favor. It held that the guaranty unambiguously stated that the Defendant—in her individual capacity—would be bound by the franchise agreement’s non-competition provisions.

Argument 2:  Colorado Policy
Colorado law generally disfavors non-competition provisions. One exception to this rule is for a contract for the purchase and sale of a business. This exception promotes the purchase and sale of businesses by protecting the good will of the business being sold (i.e., a purchaser may be less likely to buy a business if it cannot obtain an enforceable non-compete from the prior owner).

Prior to Homewatch, the courts had not definitively decided whether the sale of a franchise qualified for this exception under Colorado law. The Defendant argued that the exception did not apply because the sale of a franchise is not a sale of a business—instead it is the sale of a license to the franchisor’s methods and intellectual property for a certain term.

The court rejected this argument, holding that the exception applied and the non-compete was enforceable. The court concluded that the “good will” rationale was just as important in the franchise context, noting that a significant portion of the value of a franchise system is its good will. (It should be noted, however, that Homewatch is a federal court opinion. A Colorado state court could come to a different conclusion; however, the state court would likely consider the Homewatch rationale in its decision.)

The Takeaways
Franchisors should take note of the Homewatch decision and ensure that their franchisees’ owners and key employees, especially those with access to confidential materials and training, sign non-competes in their individual capacities. This is often addressed in the personal guaranty, as it was in Homewatch. Franchise systems in states that frown upon non-competition provisions should be aware of the Homewatch rationale in the event they need to enforce their non-competes. Franchisors should also make sure to use experienced franchise counsel. In Homewatch, counsel was able to communicate the unique franchise model to the court and to persuasively argue why the court should apply a law that was probably not drafted with franchising in mind. The result was a win for the franchisor and also franchising, which relies on non-competes to mitigate risks inherent in the franchise model.