Franchise Agreements: The Case for Limited Non-Compete Clauses

By Alexandros Kazimirov

In early 2023, the Federal Trade Commission proposed a rule under the notice-and-comment process arguing that non-compete clauses constitute an unfair method of competition and therefore violate Section 5 of the Federal Trade Commission Act. The Commission’s intent is to absolve the labor force from binding clauses that impose restrictions on its movement in the market, which in turn harms competition in the country. In the Commission’s enclosed fact sheet, the widespread use of non-competes is highlighted through grossly disproportionate instances, such as the case of a security guard being prevented from getting a job with a new employer by virtue of a two-year non-compete with his previous employer. The Commission’s view is that such over- broad use of non-competes at all levels of employment, cannot be justified to protect trade secrets in light of the fact that some states like California do not enforce such clauses anymore. In the rule proposal, the FTC recognizes that some cases may require deeper inquiry and asks feedback on whether franchisees should be covered by the rule.

Taking as an example a fictional restaurant chain called Big Kahuna Burger (BKB). BKB is in the business of selecting locations, building restaurants, then selling the restaurants and franchising the buyers to allow them to become individually owned and operated BKB restaurants. Let’s assume that all individual BKB restaurants are owned and operated by franchisees. The potential franchisee enters into a standardized franchise agreement which governs many aspects of the franchise operations. BKB franchisees do not receive an exclusive territory, and prospective franchisees are told that franchisees may face competition from other BKB restaurants as well as, of course, from restaurants of other chains. The franchise agreement includes a non-compete clause, which states that: “No employee may seek employment at a different BKB franchise within six months after their termination of employment with their initial BKB franchise.”

It would be an uphill battle to make the case that such a noncompete clause is per se illegal. The reason is because:

(i) it is fairly narrow in scope, i.e. it applies only to BKB franchises and for a limited time,

(ii) does not prescribe price-fixing on its face and

(iii) may retain a pro-competitive effect vis-a-vis other chain restaurants.

The bench is more comfortable in declaring something per se unlawful when the restraint is clearly restrictive on its face. When it is less obvious, the bench may exercise its discretion and review a restraint under the rule of reason theory. It is therefore worth considering whether limited non-competes between franchises can be considered as an unreasonable restraint of trade under a rule of reason analysis.

Would it survive a rule of reason analysis?

In this analysis, the judge would identify two forces: an intrinsic anti-competitive force and an extrinsic pro-competitive force. The intrinsic force concerns the restraint viewed between one franchise and another. In this intrinsic market of employment, the employees are indeed restricted and the clause functions as a brazenly anti-competitive feature because it limits the post-employment options of a franchise employee. The extrinsic force concerns the restraint as viewed between the franchise and the competing restaurants. In this extrinsic market, the employees are not restricted and taken holistically this feature functions more as a pro-competitive feature, because it enhances labor security between franchises and the employees retain an “out” to competing chains.

Next, the analysis would turn to facts and circumstances, i.e. how many opportunities of an “out” the employees of a particular franchise actually have. For example, the judge can select a designated area around a BKB franchise and ask how many competing chains have presence versus BKB franchises. By having an approximate understanding of the market, a judge can determine how broad or narrow the restrictive character of the clause is. For example, if there are more BKB franchises within a designated area than other restaurants, then the intrinsic force of the clause is stronger and therefore it may be interpreted as an unreasonable restraint on competition. Alternatively, if there are more competing chain restaurants than BKB franchises, then the extrinsic force of the clause is stronger and therefore it may be interpreted as a reasonable restraint on competition.

Perhaps weighing the limitations of non-compete covenants and then rewriting them to an acceptable standard is a task that should not burden the courts, some may argue. Traditionally, courts in Delaware and New York (where until recently state law has tolerated non-competes, although state legislatures have indicated to adopt a more hostile stance), have required that restrictions be reasonable in duration, geographic scope and in kind of the business restrained.

However, in Kodiak v. Adams the Court of Chancery admonished parties seeking to have the bench “blue pencil” restrictive covenants to a reasonable and enforceable scope, echoing the growing hesitancy not only to enforce but also to correct non-competes.

Conclusion

Whether the FTC decides to carve out an exception for post-termination non-competes in franchise agreements or moves to include them in its ban, remains unknown so far. Between the hesitation of courts to review non-competes and the lack of flexibility for franchises that a total ban may entail, the former may be the lesser evil.