Franchise Non-Compete Agreements: Mostly Unenforceable as Written

Every month, I see a dozen different franchise non-compete agreements. The vast majority of them are absurd, over-broad and should be deemed unenforceable. For all of my fellow non-compete defense lawyers, here you go:

The Relevant Legal Framework & How We Got Here

For the past several decades, courts in most jurisdictions have handed out injunctions like candy in franchise non-compete cases. Many courts incorrectly treat non-compete matters as pure breach of contract cases rather than antitrust cases. Their analysis is fixated on one fact: You signed the contract. From there, courts routinely give lip service to the applicable legitimate business interest test and preliminary injunction factors. Plaintiffs who makes generic allegations about confidential information or customer goodwill often get a free pass and a rubber stamped injunction.

Respectfully, I submit that this is simply wrong. Both legally and morally. Let me explain: Decades ago, non-compete agreements were widely regarded with suspicion and limited to only a handful of high-ranking employees within a given company. That began changing in the 1980’s and picked up steam over the next couple decades. The era from 1990 through circa 2010 was the Golden Age of non-compete enforcement in America. Big firm corporate lawyers built entire practices dedicated to non-compete enforcement. Judges in certain jurisdictions engaged in judicial activism and eroded many logical defenses to non-compete claims. Instead of applying the actual law (i.e. antitrust), many judges simply assumed that they were in a pure contract realm and proceeded to talk about the sanctity of contracts.

Nobody should be a judge in America who has not studied the basics of American antitrust law. And in this context, those principles operate as follows: There are two lenses in a non-compete case. The first lens is the restraint of trade lens. In viewing the case through that lens, we ask ourselves the following: Is the restraint of trade reasonably necessary to protect a legitimate business interest? Many amateurs consider reasonableness only as relates to temporal or geographic scope. Again, that is completely wrong. The question of reasonableness goes far beyond temporal or geographic scope. In evaluating the reasonableness of a given restraint, courts are supposed to ask what the restraint (i.e. the non-compete) is protecting. From a policy standpoint, the only legitimate purpose for using a non-compete agreement is to prevent unfair competition by prohibiting the defendant from unfairly taking advantage of, e.g., truly valuable, confidential, proprietary information; certain special customer relationships; goodwill; or – in limited instances – an extraordinary investment in an employee’s education or training.

Logically, it should be incumbent upon the plaintiff to prove the existence of that legitimate business interest and the imminent threat of unfair competition before the case moves from the first lens (antitrust) to the second lens (contract) and becomes a breach of contract case. If there is no legitimate business interest, then the contract is unenforceable as written. Depending on the jurisdiction, the non-compete will either be struck completely or blue-penciled (modified). But from an antitrust and policy standpoint, all over-broad non-compete agreements should be struck in their entirety. There should be no blue-penciling. Because blue-penciling gives companies an incentive to use over-broad, abusive non-compete agreements knowing that (1) most people subject to those non-compete agreements will not risk challenging them and (2) if there is a challenge, the non-compete will simply be modified rather than struck. Blue penciling creates perverse incentives.

Against this backdrop, it is legally improper that so many courts enforce non-compete agreements that are clearly unenforceable and illegal restraints of trade. But that’s what happens. Because all of the resources (i.e. big law firms, big corporate interests, big money) are on the pro-non-compete side. Even when a defendant has the resources to retain serious counsel, they are fighting against the status quo of the past 30+ years. I have seen numerous instances where courts enforced non-compete agreements for a big company based on the fact that the company had successfully enforced those agreements in the past. But that’s not how the law is supposed to work. Just because ABC Co. successfully enforced a non-compete agreement in 1996 should have no bearing on the question of enforceability today. But it does. And that brings us to the specific issue of franchise non-compete agreements.

Franchise Non-Compete Agreements: The Emperor Has No Clothes

Before we get into the classic legitimate business interest test, let’s take a step back and consider the basic dynamics of franchise relationships. In order to establish a franchise of anything, franchisees have to pay start-up costs. Take McDonald’s for example. If you want to start a McDonald’s franchise, you will pay McDonald’s corporate a $45,000 franchise fee and start-up costs for construction and equipment. Those start-up costs average between $1 million and $2.2 million depending on various factors such as location, size, décor and landscaping. Then you pay McDonald’s 4% of your annual gross sales. Then you pay McDonald’s rent, because McDonald’s owns the physical property. That rent is paid as a percentage of sales. From reports I’ve read, that figure is between 8.5 and 15% of gross sales, depending on location. So over the lifetime of a 10-year franchise agreement, you are paying McDonalds several million dollars.

Does this bear any resemblance whatsoever to the classic employment law non-compete case, where the company claims that the employee built special customer relationships while employed and paid by the company? No. Does this look anything like the sale of a business non-compete context, where the company could claim they bought the business and all the goodwill, thereby entitling them to enter the market unimpeded by competition from the seller? No, because in this context, McDonald’s is the company. In fact, it is almost the opposite situation: The franchisee is paying the company – McDonald’s – millions of dollars over the course of the relationship. They effectively bought the franchise. But courts are relatively deferential to franchise non-compete agreements, treating them with a level of scrutiny somewhere between employment and sale of a business non-compete agreements. Evaluating franchise non-compete agreements through either the employment or sale of a business framework (and treating the franchisor as equivalent to the employer or purchaser of the business) is logically incoherent. That framework simply does not fit. But courts just assume that it does.

The correct approach to franchise non-compete agreements is as follows: The franchisee pays lots of money – often millions of dollars – to buy that space in the market. When the franchise relationship is over, the franchisee should be able to do whatever they want short of continuing to hold themselves out as, e.g., a McDonald’s or affiliated (and that’s already covered by trademark law). So what if contract ends and the franchisee starts a BurgerFi across the street. Where’s the threat of unfair competition? I’ll tell you: It simply doesn’t exist. It’s a figment of imagination. It’s been conjured out of thin air. The emperor has no clothes. The law is simply set up this way because the big franchisors are massive, multi-billion dollar corporate interests. Rather than pretending like the law is logically and morally sound, it would be far more honest for everyone to admit the obvious: Big companies that sell franchises and their big corporate lawyers occupy a central role in the power structure. The law is not fair, the law is logically unsound and none of this makes any sense. But that’s just the way it is. That’s a problem, but at least such a statement would be honest. I consider it highly unlikely that courts in pro-non-compete jurisdictions will embrace my underlying logic. So, instead, let’s stick with the traditional legitimate business interest test. Because most franchise non-compete agreements also fail that test, too.

Franchise Non-Compete Agreements & Legitimate Business Interests

Here is a great example from my case files. Joe owns five McDonald’s locations in a high traffic area. Joe decides not to renew his franchise agreement. He figures he can go start some other food business, probably fast casual. But according to his franchise non-compete agreement, Joe is prohibited from working in, owning or operating ANY quick service food establishment for three years from the date of termination. Let’s get this straight: Joe ran 5 McDonald’s locations. And now, for the next two years, he’s not allowed to operate a Wendy’s, a Chipotle, a Smoothie King, a Subway, a Dunkin Donuts. Let’s run this through the legitimate business interest framework.

Let’s take another burger joint. Say Joe goes across the street and starts a BurgerFi franchise. McDonald’s will scream and howl: Joe signed a contract! And now, he’s across the street running a BurgerFi. It’s a burger place, just like McDonald’s! This is so unfair! Oh the humanity! But how does this implicate any legitimate business interest and threaten unfair competition? It doesn’t.

  • Confidential Information: Confidential information only constitutes a legitimate business interest when that information is valuable, truly confidential, and unique to the holder, and the defendant (Joe) could use that information to gain an unfair advantage. Let’s assume that Joe had access to certain confidential information about methods, process, strategy, finances, etc.
    • It is highly likely that numerous other quick service restaurant chains have the same type of general/strategic market data.
    • It’s highly likely that numerous other quick service restaurant chains have the same type of information about methods, processes, etc.
    • If McDonald’s has specific financial data related to, g., its sales in various markets, that information might be valuable to someone running a McDonald’s in the same exact location, but it’s probably not very useful for somebody running a BurgerFi up the street. BurgerFi might be a burger joint, but its an entirely different product and market. Different market level. Different product offerings. Different supply chain. Different target demographic. Information about running a McDonald’s – confidential or otherwise – is irrelevant to someone running a BurgerFi. And it’s even more irrelevant for somebody running a different type of quick service food establishment (e.g. Subway, Smoothie King, mom & pop pizza joint).
  • Customer Relationships & Goodwill: This one makes absolutely no sense at all in the present context. Joe is starting a BurgerFi. McDonald’s cannot plausibly contend that Joe could somehow convert walk-in, retail McDonald’s customers to BurgerFi customers. Even if McDonald’s somehow could magically make such a showing, they cannot demonstrate that it involves unfair competition or any legitimate business interest. This is all about market realities. Unfortunately, most corporate-side non-compete lawyers and many judges do not address market realities. They talk about the contract (because the contract argument is much simpler). But the real answer lies in market realities.
    • In this context, the market dictates that there are no protectable customer relationships. Customers who want McDonald’s will still get McDonald’s. Customers who want BurgerFi will get BurgerFi. The fact that Joe switches chains isn’t depriving McDonald’s of any substantial, special, protectable customer relationships. It is not unfairly harming McDonald’s customer goodwill. These are walk-in fast food customers. There are no contracts. These aren’t high-dollar transactions. The relationships are hardly exclusive. Customers are not making these purchasing decisions based on goodwill. Customers consume lots of food and beverages across multiple. It’s a free for all. The market dynamics do not suggest exclusive or near-exclusive, long-term relationships with customers that other competitors could not get access to.
    • Anybody can start a burger joint, pizza place, Subway, Smoothie King, etc. They can put up a sign and compete for that business. The only legitimate threat to McDonald’s customer relationships and goodwill: Joe stays in the same location, converts his place to Joe’s Burgers and uses similar logos, color scheme, marketing materials, etc. If that’s the case, then we’re in Lanham Act territory re a violation of trade dress. There’s a separate remedy for that. But to stop Joe from opening a BurgerFi down the street? Because of customer relationships and goodwill? The market realities do not support such a restriction.
  • Training: This is one of the most absurd claimed legitimate business interests. True story: I was in an injunction hearing one time when this old time Miami lawyer argued that the Company had a legitimate business in training because it taught the defendant how to pronounce the names of certain pharmaceutical drugs. Injunction granted! It was like being in the Twilight Zone. The point being: Any claimed interest in training is bogus unless the training is truly extraordinary and goes beyond what somebody could get elsewhere in the industry. Lots of franchisors either think they have unique training, or, just pretend like they do solely for non-compete purposes. Most of the time, there is nothing unique or extraordinary about any company’s training. I have seen this play out in litigation dozens of times. Most corporate training programs are built on other well-established, commercially available training programs. And that’s obviously not protectable as a legitimate business interest (if the law is correctly applied).
    • Sidebar: As previously noted, the argument about training makes zero sense in the franchise non-compete agreement context. Franchisees pay the Company a ton of money for everything (including training). They should have a right to use that training! And unlike confidential information, it’s training. It’s absorbed. It can’t be unlearned. It can’t be misappropriated.

The upshot of all this: The only legitimate restriction here would be a post-term restriction that prohibited Joe from operating a burger joint at the exact same location. But since McDonald’s likely owns the property, that’s impossible. If Joe goes anywhere else – even literally across the street – and opens a Burger King, I don’t care. That would not threaten McDonald’s confidential information, any customer relationships or any interest in “extraordinary” training. Even if Joe opens another burger joint, there is no legitimate business interest and no true threat of unfair competition. But it doesn’t stop there. McDonald’s considers 7-11, Dunkin Donuts, KFC, Pizza Hut, Subway and Starbucks (among others) to be competitive businesses. It should be abundantly clear by now: McDonald’s is not concerned about preventing unfair competition. McDonald’s is using franchise non-compete agreements to (1) prevent ordinary competition and (2) prevent franchisees from leaving the company by limiting their post-term business options. That’s what’s really happening here.

McDonald’s is just one example out of hundreds, if not thousands. The vast majority of large franchises use incredibly broad franchise non-compete agreements that are unenforceable as written and not necessary to protect any legitimate business interest. So what do you do?

  1. Check the choice of law. That alone could be dispositive. California has no exception for franchise non-compete agreements. In states like New York or Illinois, you’ve probably got a fighting chance. In Florida? You’re in for tough sledding until you get to the right appellate court, or, the United States Court of Appeals for the Eleventh Circuit.
  2. Declaratory Judgment. I wouldn’t sink $1 million+ into a new venture until I’d cleared any applicable franchise non-compete agreements off the table. This is fertile territory for a declaratory judgment action.

Jonathan Pollard with cigar

Jonathan Pollard is a competition lawyer based in Fort Lauderdale, Florida. He litigates and arbitrates complex non-compete, trade secret, trademark and unfair competition disputes. Pollard has appeared on or in the New York Times, Wall Street Journal, Bloomberg, FundFire, Digital Guardian, Law360, Litigation Commentary & Review, Inc. Magazine, PBS News Hour and more. He is the principal of Pollard PLLC. His office can be reached at 954-332-2380.