American Bar Association 32nd Annual Forum on Franchising RECENT TRENDS IN LITIGATING NON-COMPETE AGREEMENTS, Michael J. Boxerman Marcus Boxerman & Chatman, LLP Chicago, Illinois William K Whitner Paul Hastings Janofsky & Walker LLP Atlanta, Georgia October 14 - 16, 2009 The Westin Harbour Castle Toronto, Canada © 2009 American Bar AssociationVI TABLE OF CONTENTS INTRODUCTION STATE STATUTES GOVERNING FRANCHISE NON-COMPETE AGREEMENTS a INTERESTS ADDRESSED BY NON-COMPETE AGREEMENTS. A. Franchisor Perspective. 1. Protection of Confidential Information and Trade Secrets 2. Protection of Business Method and Specialized Training 3. Protection of Goodwill 4. Ensuring Franchisee Commitment to the System B. Franchisee Perspective ‘THE EVOLVING ANALYSIS OF WHAT LIMITATIONS ARE REASONABLE. A. Standards for Enforceability... eseneee 4. Broader Restrictions Generally Are Allowed In-Term 2, Georgia Rule — No Distinction Between In-Term and Post-Term Reasonableness Analysis. B. _In-Term Non-Compete Agreements. 1, Scope of Restricted Activity... 2. Geographic Restrictions... C. Post Term Non-Compete Agreements... 1. Evaluated Under an Employment Standard, Under Sale of Business Standard or Under a Generic Reasonableness Standard 2. Scope of Restricted Activity 3. Time Restrictions... 4, Geographic Restrictione..... D. Court Modification, Biue Penciling and Severance . ARGUMENTS AGAINST ENFORCING NON-COMPETE AGREEMENTS A. Non-Competes Constitute Restraints of Trade B. Non-Compete Agreements Prevent Former Franchisees From Enjoying Goodwill Acquired During the Franchise Term C. Adequate Protections Are Available Without Non-Compete Agreements PROCEDURAL AND SUBSTANTIVE LITIGATION STRATEGIES FOR ENFORCEMENT. ‘A. Franchisor Considerations for Enforcement. 1. Where to Litigate, 2. Relief Sought: 3. Monetary Damages. 23 23 23 25 229TABLE OF CONTENTS (continued) Page 4. Liquidated Damages : eaueeeee eee) B. Franchisee Defense Considerations... ee 80, 1. Consider Beating Franchisor to the Courthouse... eat 2. Non-Compete Is Overly Broad in Time or Scope 1 3, Franchisor Lacks Protectable Business Interest. 34 4, Claimed Irreparable Harm "Speculative"/Lack of Actual Interference .ennnnsnnennnrnseen 7 32 5. Franchisor's Conduct Precludes Enforcement ad 6. _Use of the Marks, Confidential Information or Trade Secrets Discontinued 34 Vil. BEST PRACTICES FOR DRAFTING ENFORCEABLE NON-COMPETE AGREEMENTS. 35 A. Acknowledge Protectable Interests and Harms 35 B. Tailor Restrictions as Narrowly as Possible to Protect Interest 36 1. Activity Restrictions... 36 2, Geographic Restrictions. 37 3, Time Restrictions... ese 7 4, People Restrictions: 38 C. Use Savings Clauses 38 Vill, ENFORCING NON-COMPETE AGREEMENTS AGAINST NON-SIGNATORIES........39 IX. TIPS FOR ACCOMPLISHING POST-TERMINATION PROTECTION WHERE ENFORCEABILITY OF NON-COMPETE AGREEMENT IS NOT LIKELY. at A. Alternative Contractual Covenants ..... at 4, Confidentiality/Non-Disclosure Agreements... : at 2. Subleases, Lease Assignments and Lease Option Agreements ........47 3. Assignment or Cancellation of Telephone Numbers and Listings........42 4, Purchase of Equipent....scsnunsnnnmuemnnananninernae 42 B. Intellectual Property Laws 42 1. Unfair Competition and Deceptive Practices Laws. 43 2. Trade Secrets Act z oe 43 ©. Common Law Tort Claims : 43 4. Conversion 44 2. Tortious Interference... 44 D. Inevitable Disclosure Doctrine... 44 X. CONCLUSION. 46American Bar Association 32nd Annual Forum on Franchising RECENT TRENDS IN LITIGATING NON-COMPETE AGREEMENTS, Michael J. Boxerman Marcus Boxerman & Chatman, LLP Chicago, Illinois William K Whitner Paul Hastings Janofsky & Walker LLP Atlanta, Georgia October 14 ~ 16, 2009 ‘The Westin Harbour Castle Toronto, Canada © 2009 American Bar AssociationRECENT TRENDS IN LITIGATING NON-COMPETE AGREEMENTS 1. INTRODUCTION Nearly every franchise agreement contains a provision which restricts the ability of franchisees to engage in in-term and post-term activities deemed competitive with, or injurious to, the franchise system. Whether termed a non-compete agreement, a covenant not to compete or a restrictive covenant, through these provisions franchisors seek to protect their franchise systems from unfair competition and their confidential and proprietary information from misappropriation. The enforceability of non-compete agreements is governed by state law, and the decision of whether or not to issue injunctive relief requires the court to engage in a fact-specific inquiry. Because some states have legislation limiting or prohibiting the enforcement of non- compete agreements, some states view non-compete agreements less favorably than others and some states enable courts to sever or modify unreasonable non-compete restrictions, judicial decisions governing the enforceability of non-competes vary from state-to-state, and ‘even within each state. This paper sets forth the general law governing the enforceability of non-compete agreements and discusses recent developments and their implications for procedural and substantive litigation strategies relating to the enforcement of non-compete agreements. This paper also discusses alternative strategies to obtain enforcement of a non-compete in jurisdictions that are hostile to enforcement. This paper also offers tigation strategies to prevent enforcement and outlines best practices for drafting enforceable non-compete agreements. STATE STATUTES GOVERNING FRANCHISE NON-COMPETE AGREEMENTS: The enforceability of franchise non-compete agreements still is guided primarily by the state law controlling the agreements.’ The status of state statutes addressing, directly or indirectly, non-compete agreements has not changed in the last five years.* Several maintain franchise statutes that directly address the enforcement of non-compete agreements: ilinois,* Indiana,’ Iowa,’ Louisiana,” Michigan,’ and Minnesota.’ While the requirements of these * For a comprehensive analysis of state laws applicable to tranchise non-compete agreements, see COVENANTS [AGAINST COMPETITION IN FRANCHISE AGREEMENTS (Peter J. Klarfeld ed, 2d ed. 2003). 2 The Georgia General Assembly recently passed a bill that reverses Georgia's long-held legal bias against ‘enforcement of non-compete agreements, making it far easier to enforce such restrictions, particularly in-term. The Governor has signed the legislation, but the law will become effective only ifthe voters of Georgia ratify a related slate consttutional amendment in the November 2010 general election | 8 The ilinois Franchise Disclosure Act of 1987, 815 ILCS 705/20 (2006), addresses non-compete agreements in relation to franchise renewal “The Indiana Deceptive Franchise Practices Act, Ind. Code 23-2-2.7-1 et seq. (2008), appiles both temporal and ‘geographic restictions to franchising non-compete agreements. Under the act, it is unlawful for any franchising non- ‘compete agreement to exceed a period longer than three years after termination ofthe franchise relationship, or an ‘area greater than the exclusive area granted by the franchise agreement, or in the absence of such a provision, an ‘area of reasonable siz. * Iowa has two franchise statutes, one that applies to agreements entered into after 1992 (S.A. §§ 523H.1 ef 5eq.), and one that governs agreements entered into after July 1, 2000 (1S.A. § 537A.10) (2008). LS.A. §§ 6234.1 et (continued...)statutes vary, the underlying public policy concem is the same, to ensure that franchise non- compete agreements are not overly restrictive with respect to duration, scope of prohibited activity, and geographic territory.” ‘A number of states that do not have franchise specific statutes specifically addressing non-compete agreements do have statutes generally governing non-compete agreements that may apply to franchise agreements: e.g., Alabama,"? California," Colorado,”” Florida,'® (continued) 909. addresses covenants agains! competition in several diferent aspects of the franchise relationship. First, in the Context of transferring a franchise, a franchisor cannot enforce any covenant ofthe transferred franchise against the transferor ‘that prohibits the transferor feom engaging in any lawul occupation or enterprise.” S.A. § 523H.6 subd 40._ This restriction, however, does net prohibit a franchisor from enforcing covenants not to exploit the franchisor’s, trade secrets or infellectual property. {d. Second, the Act limits the grounds for which a franchisor may refuse to renew a franchise. if franchisors reason for nonrenewal Is that its withdrawing from the franchise's geographic. market, the franchisor must agree not to enforce any non-compete agreement against the franchisee. 1.8.4 § 623.118. Lastly, § §23H.11 coniains a general prohibition against post-termination covenants, with two exceptions: (1) ifthe former franchisee's new business relies on a substantially similar marketing program; or (2) unless the franchisor offers to purchase the assets ofthe franchise for fair market value no later than ten business days before expiration of the franchise. S.A. § 623H,11. lowa’s second franchise statute, 1.S.A. § 5378.10 contains identical language as ISA. § 523H 8 regarding nonrenewal of a franchise agreement, however, both the general prohibition ‘against enforcing post-termination covenants and the regulation ofthe transfer of franchises is absent. © Louisiana Reviged Statute 23:021 et seg. (2008) provides that during the term of the franchise relationship, franchisees shall refrain from competing with the franchisor or other frenchisees, and that non-compete agreements may not exceed to years following the termination of the franchise agreement "The Michigan Franchising Investment Law (MIL), Mich. Comp. Laws Ann. § 445.1501 ef seg. (2009), does not ‘address directly non-compete agreements. However, section 27(d) of MFIL, which prohibits the termination of a ‘ranchise agreement without fair compensation, only apples if (a) the term of the franchise is less than five years, and (©) the franchisee is prohibited from continuing to conduct substantially the same business in the same area subsequent to the expiration ofthe franchise, or the franchisee does not receive at least six months’ advance notice of the franchisors intent not to renew the franchise agreement, ® Under the Minnesota Franchise Act, Minn. Stat. Ann. §§ 80C.01-30 (2008), a franchisor's public offering statement must set forth the conditions of any covenant not to compete, Additionally, # is unfair under the act to enforce “any unreasonable covenant net to compete after the franchise ceases to exist.” See Minn. R, 2860.4400 ()) (2008), ° For instance. the Indiana Deceptive Franchise Practices Act prescribes a temporal limitation of three years to any post-lerm franchise non-compete agreements, and a geographic restriction of ether the area granted by the franchise ‘agreement, or an area of reasonable size. Ind. Code 23-2-2.7-1 ef seq. (2008), % Ala, Code § 8-1-1 (2009) deals generally with restraint of trade, and has been applied in the franchise context ‘See, e4g,, Curves Intern, Ine. v. Mosbarger, 625 F. Supp. 26 1310, 1313 (M.D. Ala, 2007), Gafnea v. Pasquale Food Co, 454 So. 2d 1365 (Ala, 1984) * California Business and Professions sections 16600 et seg. (2008) invalidates all non-compete agreements, except those exempted by the statute, Cal Bus. & Prof. Code §§ 18600 ef seq. Section 16500 appiies fo “any sort of contract’ including franchise agreements, Scott v. Sneliing & Snelling, 732 F. Supp. 1034, 1040-41 (N.D. Cal. 1990); ‘see also LaFortune v. Ebi, 26 Cal. App. 3d 72 (1972); Great Harvest Franchising v. Mickinley, Bus, Franchise Guide (CCH) 111,260 (C.D. Cal. 1997). * Colorado Revised Statute § 8-2-113 (2008) prohibits all covenants that void future employment, except those limited to the sale of a business, the protection of trade secrets, the recovery of traning expenses, or the restraint of ccortain Key personnel. Colo, Rev, Stat, § 8-2-113 (2008). Under this statute, the sale of an existing franchise falls tunder the sale of a business exemtion, Keller Corp. v. Kelley, 187 P.3d 1133 (Colo. Ct. App. 2008); DBA Enters v. Findlay, 823 P.2d 298 (Colo. Ct. App. 1998), The sale of an intial franchise, however, does not fal under the sale of ‘a business exemption, Instead, covenants against competition entered into during the ination of a franchise are valid under the protection of trade secrets exception. Gold Messenger, Inc. v. MoGuay, 937 P.2d 907 (Colo. Ct. App. 1987),Hawaii,"* Michigan,"® Montana,"? New York,” South Dakota," and Texas.’ Besides (continued) Florida has three sets of laws governing the enforceability of covenants not to compete: (1) the older version of Florida Statute § 542.33, which governs contracts entered into before June 28, 1890; (2) The new version of § 542,33, which applies to contracts entered into after June 28, 1990 but before July 1, 1996; and (3) Section 542.335, which controls agreements entered into on or after July 1, 1996. Under Section 842.936, a party seeking enforcement of a non-compete must show’ (1) the existence of one or more legitimate business interests justifying the restrictive covenant; and (2) that the contractually specified restraint is reasonably necessary {0 protect the legitimate business interest or interests justifying the restriction. FLA. Star. § 542.335(1)(b) and (). “Kf the [plant] can establish its prima facie case, the burden shifts to the [defendan!] to show that the restriction is overbroad, overlong, of otherwise not reasonably necessary to protect tho established interests of the {plaintif}” Autonation, Ine, v, O'Brien, 347 F, Supp. 2d 1209, 1904 (S.D. Fla. 2004). Section 642.335(1)(b) ofthe Florida Statute provides that "legitimate business Interests" include: trade secrets, valuable confidential business information, substantial relationships with specific prospective or existing customers, customer goodwill, and extraordinary of specialized training, FLA, Star. § §42,335(1)(B) (2009). Pirtok USA, LLC v. Whitehead, Bus, Franchise Guide (CCH) {] 13,539 (S.. Ala, 2006); Pitek USA, LLC v. Wilcox, Bus, Franchise Guide (CCH) §| 13,986 (M.D. Fla. 2006), “Hawai anti-trust statute, Haw. Rev. Stal. Ann, § 480-4 (2008), provides a general exemption for certain forms of non-compete agreements, Although franchise non-compete agreements are not among the restricive covenants specifically declared lawviul by § 480-4(c), the supreme court of Hawail held that the restraints specified in 480-4(c) {are not the only allowable types, and that restrictive covenanis that are reasonable and not per se unlawtul are enforceable in Hawail, Technicolor, nc. v. Traeger, 951 P.2d 163 (Hawall 1976). 4 Michigan's Franchise Investment Law {MFIL), Mich, Comp. Laws. Ann. (NICLA) § 445.1601 et seq., does not The court held that in-term restrictions in franchise agreements are subject fo the samo strict scrutiny analysis as_post-term restrictions and that provisions without a territorial limitation are per se unenforceable.” The Georgia supreme court granted certiorari to determine whether “the reasonableness standard applicable to post-termination restrictive covenants also applies to in-term restrictive ‘covenants.""” By unanimous opinion, the supreme court answered that question in the affirmative. The court never discussed the policy reasons suggested for employing different standards of reasonableness to evaluate in-term and post-term covenants, simply stating: All such restraints on trade in a franchise agreement, regardless as to when they are in effect, must be reasonable as to time, scope and territorial limitation. [cites omitted] Accordingly, there is no distinction to be made as to the level of scrutiny applied to a non-competition clause in a franchise or distributorship agreement based on its status as being active during the term of the agreement, and this Court declines to adopt a lesser standard of scrutiny.” The court followed Georgia's traditional refusal to modify or “blue pencil" overbroad restrictive covenants to render them enforceable, and held that the franchisor's in-term covenant was unreasonable, and thus unenforceable, because it lacked any territorial limitation.” ‘The supreme cours ruling may render invalid the in-term restrictive covenants of many franchisors with business operations in Georgia. International Franchise Association (“IFA"), represented by the co-author of this paper, William K Whitner, filed an amicus brief in support of Atlanta Bread Company's position, that a different test of reasonableness should apply in-term verses postlerm. In connection with filing the brief, IFA reviewed the in-term restrictive ‘covenants of 42 restaurant and food-related franchises with significant operations in Georgia and determined that 32 of them did not contain any territorial imitation, which would render them unenforceable under Georgia law. The others likely contain provisions that are overly broad under Georgia's strict scrutiny analysis. This ruling affects not only franchisors based in Georgia (whose franchise agreements likely contain Georgia choice of law provisions), but also franchisors based outside of Georgia that have Georgia franchisees. Generally speaking, a Georgia court will not honor a choice of 75 Atlanta Bread Co,, 683 S.E 24 743, % Id, The non-compete agreement at issue stated, “During the term of this agreement, neither Franchisee nor any Principal Shareholder, for so long as Principal Shareholder ous an Interest in Franchisee, may, without prior writen ‘consent of Franchisor, directly or indirectly engage in, or acquire any financial or beneficial interest in (including any interest in corporations, partnerships, rusts, unincorporated associations or joint ventures), adviso, help, guarantee, loans to, any bakerideli business whose method of operation is similar to that employed by store units within the System.* 7” Bus, Franchise Guide (CCH) ¥ 13,991 (Oct 6, 2008). Atlanta Bread Company Int! v. Lupton-Smith, No. $09G1815, 2008 WL 1834215, at “3 (Ga. June 28, 2008) a, 12