Franchise 101: Taking the Red Pill on Non-Compete Covenants; and They Were Just Kidding

Franchisor 101: Taking the Red Pill on Non-Compete Covenants

Franchisors and Franchisees in California have long conducted themselves based on precedent that voids post-termination covenants against competition in a franchise agreement in California. Recently, a franchisor’s ability to enforce such covenants in California may have changed dramatically.

The California Supreme Court faced the question of what standard determines whether California Business and Professions Code Section 16600 voids a contract that restrains a business from engaging with another business. The plaintiff, Ixchel Pharma, Inc. (“Ixchel”) had an agreement with a third party, Forward Pharma (“Forward”), for the creation of a new drug. Forward terminated the agreement with Ixchel and entered into a new, exclusive agreement with defendant Biogen, Inc. (“Biogen”). In the new agreement, Forward agreed to avoid new partnerships with companies dealing in similar biotech products. Ixchel sued Biogen in California federal court alleging the Forward/Biogen agreement was an unenforceable non-compete agreement under Section 16600. Ixchel claimed it restrained Forward and Ixchel from engaging in future business.

Section 16600 states: “Except as provided in this chapter, every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” Prior case law held that such restraints are automatically unlawful, unless an exception applies.

Prior holdings upheld reasonable restrictions in commercial contract cases and, therefore, departed from a strict reading of the statute. The court held that in analyzing whether a covenant between businesses is valid or void, the proper inquiry is “whether an agreement harms competition more than it helps by considering the facts peculiar to the business in which the restraint is applied, the nature of the restraint and its effects, and the history of the restraint and the reasons for its adoption.” Thus, restrictive covenants between businesses should be reviewed under a “rule of reason” which considers various interests and asks if the challenged conduct promotes or suppresses competition.

The court used exclusive dealing provisions in franchise agreements as an example of potentially enforceable restrictions. It acknowledged such provisions are often part of a franchise agreement or distributorship contract. In exchange for the right to sell the franchisor’s products, franchisees often agree to buy from a particular supplier or operate in a particular geographic area and franchisees are often prohibited from selling a third party’s products. Recognizing possible procompetitive effects of such provisions, the court would not “call such arrangements into question simply because they restrain trade in some way.”

The door is open for argument that a franchise agreement’s covenants against competition, whether in-term or post-term restrictions, are enforceable, if shown to be limited and supported by procompetitive commercial interests. Franchisors should expect franchisees with prior experience in the type of franchised business to negotiate the nature and scope of such covenants before entering into a franchise agreement. Franchisors who once shied from enforcing such covenants against California franchisees, should stay abreast of future case developments on this subject.

Franchisee 101: They Were Just Kidding

A federal district court in Baltimore granted summary judgment against a former franchisee who claimed negligent misrepresentation against the franchisor and its officers. The court found there was no genuine issue of material fact whether the franchisee reasonably relied on the officers’ statements in the construction, marketing, and operation of franchisee’s childcare facility.

The franchisor of Kiddie Academy Educational Child Care (“Kiddie Academy”) centers sued a former Texas franchisee, alleging the franchisee defaulted on their financial obligations and refused to return proprietary materials. In a counterclaim, the franchisee alleged Kiddie Academy induced them to enter into a franchise, misrepresented that the curriculum was superior to competitors, that Kiddie Academy would guide the franchisee through construction, provided inaccurate site analysis that led the franchisee to select a poor location, provided false pro formas, and failed to disclose licensing requirements. One by one, the trial court found the franchisee did not rely on any alleged statement.

Kiddie Academy made promotional representations that franchise owner-operators did not need training or experience because “all training” was provided; that its curriculum “was as good or better than its best competitor;” and that Kiddie Academy had a platform that would guide franchisees to success. These statements were mere puffery according to the court because they did not convey concrete verifiable facts. The court found the franchisee was not justified in claiming to have relied on them.

The franchisee’s reliance on other statements was also unjustified. The franchisee was involved in generating draft pro formas and placed blind faith in them, but should have been on notice that projections based on frequent changes in first year student enrollments were optimistic, not conservative. Accusations that Kiddie Academy underestimated investment cost and did not disclose licensing requirements, did not support the element that the defendant state a partial truth that triggered justifiable reliance. There was no evidence of incomplete information or that the franchisor prohibited the franchisee from understanding the full cost of construction.

When a franchise venture goes bad, lawsuits on the basis of “sales talk” can be challenging to sustain. Proving reliance is fact-intensive. It requires specific inquiry into the education and background of the franchisee and circumstances of the interaction for any warning signs of deception. In this case, the franchisee made statements in affidavits that were contradicted by other evidence. Franchise counsel can be a franchisee’s best resource when a business turns south as a direct result of untrue statements or material omissions in the sales process.