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Non-Competition and Non-Solicitation Clauses in Franchise Agreements

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April 4, 2017

I) Non-Competition and Non-Solicitation Clauses: What Are They?

Franchisors often include within their franchise agreements provisions that seek to restrict the ability of the franchisee and the franchisee’s principals to (i) compete with the franchisor and (ii) solicit the franchisor’s employees to compete. Provisions that seek to do the former are known as “non-competition clauses” or “non-competition covenants”; provisions that seek to do the latter are known as “non-solicitation clauses” or “non-solicitation covenants”. 

II) Why do Non-Competition and Non-Solicitation Clauses Matter to Franchisors and Franchisees?

When a franchise agreement is terminated prematurely, it is not unusual for any subsequent legal dispute to concern itself with the enforceability of these types of covenants. Accordingly, it is important for both the franchisor and the franchisee to develop an early understanding of how the other side’s interests are affected by the presence of such clauses within the franchise agreement.

From the franchisor’s perspective, the inclusion of non-competition and non-solicitation clauses within the franchise agreement is essential; such clauses help protect the franchisor from competition by a franchisee who will have, over the course of the franchise relationship, learned many of the franchisor’s trade secrets and acquired highly confidential information of the franchisor. Accordingly, a franchisor would typically want these clauses to grant it as much protection as possible.

From the franchisee’s perspective, the inclusion of such clauses within the franchise agreement can have the effect of greatly restricting the franchisee’s and its principals’ ability to earn a livelihood following termination of the franchise agreement. Accordingly, a franchisee would typically want these clauses to restrict its and its principals’ conduct as narrowly as possible.

III) What Happens When a Non-Competition or Non-Solicitation Clause is Disputed?

This tension between the interests of the franchisor and those of the franchisee can become readily apparent when the franchise agreement is terminated prematurely. For instance, it may become apparent to the franchisor that the now former franchisee intends to compete with the franchisor by, for instance, de-branding and continuing to offer the same goods or services under the franchisee’s own name. In that circumstance, the franchisor may ask the arbitrator or the court to enforce the non-competition or non-solicitation clause and order the former franchisee and its principals not to do so. Conversely, a franchisee may ask the arbitrator or court to declare that the non-competition and non-solicitation clauses are unenforceable, so as to give the franchisee permission to earn a likelihood in the field of its choice.

In considering whether to enforce a non-competition or non-solicitation clause within a franchise agreement, the arbitrator or court will generally first assess whether the clause is ambiguous. If it is ambiguous, the clause will be unenforceable; if it is unambiguous, the court will then evaluate whether it is reasonable.

The evaluation of reasonableness will generally involve an assessment of whether the clause at issue is limited by (i) temporal and (ii) spatial (or territorial) restrictions, and if it is so limited, whether those restrictions are sufficiently narrow, in the sense that they protect no more than the legitimate interest of the party seeking to rely on that clause.

Outside of the franchise context, the arbitrators’ and courts’ approach to enforcement of these types of clauses varies depending on whether the restrictive covenant in dispute is contained within a commercial contract (usually a contract for the sale of a business), or within an employment contract. Although the test is essentially the same, courts will scrutinize more carefully the reasonableness of a non-competition or non-solicitation cause in an employment contract, than they would the same clauses in a contract for the sale of a business. One rationale for the different approaches is the court’s concern with remedying the perceived imbalance in bargaining power between employer and employee.

Within the franchise context, the Court of Appeal of Ontario in a recent decision observed that it is unsettled whether a non-competition clause in a franchise agreement should be viewed and treated as it is in a contract of employment because of an imbalance in bargaining power, or as it is in the sale of a business. The Court held that it did not need to decide what level of scrutiny to apply to the non-competition contained in the franchise agreement at issue in that case because:

the focus of the inquiry is not the reasonableness of the extent of the temporal or territorial restrictions. Instead, it is whether there is a legitimate interest of the franchisor in this case that is entitled to the protection of the covenant. The requirement of a legitimate protectable interest is common to both levels of scrutiny.1

IV) Conclusion

All of these requirements (ambiguity, reasonableness, and legitimate interest) provide opportunities to attack non-competition and non-solicitation clauses in franchise agreements. In some circumstances, the arbitrator or court will have no choice but to strike out the clause altogether; in other circumstances, the arbitrator or court may have jurisdiction to interpret the clause in a way that makes the scope of its prohibited conduct more reasonable.

Accordingly, franchisors must take great care both in drafting such clauses and seeking to enforce them; a properly drafted clause can give the franchisor comfort that an arbitrator or court will enforce it against an improperly competing franchisee. The franchisor’s ability to rely on such a clause will depend on the franchisor’s ability to demonstrate that it has a legitimate interest to protect in the territory covered by the clause; for instance, if the franchisor can be shown to have had no intention to develop the territory, the court will be reluctant to prevent the franchisee from competing in that territory.

Similarly, franchisees must exercise caution in deciding whether to engage in competitive conduct that could run afoul of a clause that may well end up being enforceable.

Both franchisors and franchisees stand to limit their respective exposure to the risks and costs of litigation by seeking early legal advice about the enforceability of any non-competition or non-solicitation clauses in their franchise agreements.