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Franchise POST: A Franchise Chain's Non-compete Agreement Comes Under Congressional Scrutiny

Updates on Franchise Law

January 6, 2015

Tremors were felt throughout the franchise community when a recent article in The Huffington Post reported that the Jimmy Johns sandwich franchise is under Congressional scrutiny for its franchisees’ practice of requiring lower level employees to sign non-competition agreements. The agreements prohibit the employees from working for another restaurant that receives more than 10% of its business from the sale of sandwiches for two years after they leave Jimmy Johns. Although it is unclear whether the franchisor requires or endorses this practice, it seems to be pervasive within the franchise system. Two United States Representatives, describing the agreements as “anti-competitive and intimidating to workers,” have asked the Federal Trade Commission (FTC) to investigate the practice. 

The scrutiny on Jimmy Johns should cause franchisors and franchisees to think twice about the use of non-competition agreements for lower level employees, lest they attract similar calls for investigation by Congress or the FTC. And setting aside the issue of Congressional scrutiny, requiring or even strongly suggesting that franchisees obtain non-competition agreements from their employees may have unintended consequences for the franchisor, the franchisee, and franchising in general.

The Covenant Against Competition as Part of the Franchise Relationship

Most franchisors require their franchisees to agree to a post-termination non-competition agreement as part of the grant of their franchise rights. The purpose of this covenant is to protect the franchisor and the franchise system from franchisees that leave the system and use what they learned to open a competing business. The former franchisee, freed from royalty obligations, then could compete unfairly with other franchisees and with the franchise system as a whole. In one case, a court reasoned that to permit a franchisee to violate its non-compete agreement could cause the “entire franchise system [to] unravel.”

For similar reasons, franchisees may require their store or unit managers to agree to post-employment non-competition agreements as a condition of their employment. The rationale for these covenants is the same: the franchisee does not want its manager, with whom it has shared confidential information about operations and customer lists, to use that information in a competing business. The enforcement of non-competition agreements against store or unit managers is subject to the same scrutiny that applies to non-competition agreements between a franchisor and its franchisees – or perhaps to slightly greater scrutiny given that the franchisee is an independent business and the manager is an employee whose ability to earn a living may be affected by enforcement of the covenant.

Why Are Some Covenants Against Competition Not Enforceable?

Although covenants against competition have been enforced in the franchise context and in certain employment contexts, they are not a favored contract provision. Long considered a restraint of trade and anti-competitive, they are enforceable only if they protect a legitimate business interest. Examples of legitimate business interests include the aggregate components of a franchisor’s operating system and the customer lists acquired by the franchisee through its affiliation with the franchise.

Imposing that type of restraint on a non-managerial employee is problematic at best.  Lower level employees – like the sandwich makers covered by the Jimmy John’s covenant –typically have no access to trade secrets or confidential information; their sandwich making is performed in the open, for everyone to see. And they usually pose no threat of poaching the franchisee’s customers. Thus, franchisees may have difficulty establishing a legitimate business interest in preventing a non-managerial employee from working at a competing store.  The real effect of such a covenant is to prevent the employee from taking a similar job at a higher wage.  Courts take a dim view of contracts that prevent an individual from earning a living. 

Unintended Consequences for Franchisors, Franchisees

Mandating or even encouraging non-competition covenants against lower-level employees may have unintended consequences for franchisors and franchisees alike. First, by requiring or urging franchisees to enforce such covenants, a franchisor may risk being found to have exercised enough control over the franchisees’ employment decisions to be deemed a joint employer with the franchisee. As explained in the August 5, 2014 issue of the Franchise Post, a franchisor acting as a joint employer exposes itself to a host of risks, including liability for unfair labor practices and workers compensation claims.  These are the same risks from which a franchisor seeks to protect itself through the language in its franchise agreement proclaiming that a franchisee is an independent contractor and not an agent or employee of the franchisor. 

Second, enforcement of non-competition covenants requires time, effort, and financial resources. Franchisees obligated to enforce such covenants against violators would have to file a lawsuit or an arbitration demand. Even if the covenant is found to be enforceable, the costs of enforcement may outweigh the benefits. If a franchisee is unable or unwilling to enforce a non-competition covenant against its lower level employee, this sets a precedent of non-enforcement, which emboldens other employees to breach and makes enforcement against future breaches more difficult.

This same dilemma exists for the franchisor as well.  If the franchisor has mandated non-competition covenants for lower-level employees, and its franchisees fail to enforce those covenants, the franchisee's failure constitutes a breach of the franchise agreement. If the franchisor fails to default breaching franchisees, this emboldens other franchisees to ignore the requirement and makes future enforcement of the franchise agreement more difficult.

Best Practices

Franchisors must keep covenants against competition in perspective. There is a discernable business interest in requiring franchisees to comply with post-termination non-competition agreements, and this interest may extend to a franchisee’s managers. But the protectable business interest begins to evaporate further down the employment ladder. 

Requiring, or even encouraging, non-competition agreements for lower-level employees is problematic as a legal matter and as a practical matter. Quite simply, the benefits of enforcement – even if enforcement is possible – are almost certainly outweighed by the costs involved.

A better practice for franchisors is to focus on the risks of unfair competition where those risks are greatest -- with key higher-level employees, or with business partners who have access to the franchise system’s confidential and proprietary information and trade secrets.  Franchisors may want to provide a model non-competition agreement to franchisees, reserved for use with such parties. Even then, provision of a model agreement should come with a strong caution that the franchisee should discuss the agreement with a legal advisor who understands non-competition law in the state where the franchisee’s business is located.