NASAA Guidance for Franchise Non-Competes

Last May, the Federal Trade Commission looked to ban non-compete agreements in most employment contracts aside from franchise agreements. Although scheduled to become effective in September, a federal court vacated the ruling in August indicating the FTC did not have the authority to implement it.

Since this ruling, the FTC filed a notice of appeal with the Fifth Circuit Court of Appeals.

Non-Compete Restrictions serve some important goals, but also significantly impact franchisees.  Specifically, many franchisees believe the clauses are inherently unfair, create a restraint on leaving a franchise, limit competition in the marketplace, and prevent franchisees from earning a livelihood. Franchisors on the other hand believe post-term non-competes are needed to protect the franchise system, other franchisees that join or remain in the franchise system, and franchisors’ trade secrets.

With these rulings, reversals and policy debate over post-term non-competes, the Franchise and Business Opportunities Project Group – a committee within the North American Securities Administrators Association – issued guidance on post-term non-competes in the franchise business model. In drafting their guidance, they explored the following:

The Nature of Franchise Relationships

• The relationship between franchisors and franchisee differs from that of a buyer and a seller of a business.
• A franchisee acquires the right to initiate and operate a business for a specific time consistent with a system already established by the franchisor.
• Franchising allows the franchisor to expand or build value using the franchisee’s investment instead of, or in addition to, its capital.

Expectations of Franchisors and Franchisees

• Franchisors expect to expand their franchise systems to increase brand value, market recognition, and profitability.
• Franchisees consider themselves the owners of the businesses and seek to make decisions that affect operations and profitability to build future value.

Challenges at the End of Franchise Relationships

• Franchisor and franchisee expectations may differ and may not come to light until the end of the relationship.
• While franchisors can exercise post-termination rights, franchisees may want to capitalize on their investment and experience gained during the franchise relationship.

To Level the Playing Field, NASAA Urges Reasonable Non-Competes in Franchising

”Reasonable” post-term non-competes mean franchisors should indicate legitimate interests, especially those pertaining to scope, duration, and geography. For example:

1. Scope:  Non-competes should focus on similar industries or competition to the franchisors and not be overly expansive.
2. Duration: Post-Term Restrictive covenants should not be longer than reasonably necessary to protect the franchisor’s legitimate business interests.  The actual period of time can vary across markets and industries but should be tailored not to exceed “reasonably necessary” time frames.
3. The geographic area in which the non-compete applies may be a specific distance around a physical location or areas around other franchise-branded locations.  NASAA specified that any geographic restrictions should be drafted as narrowly as possible to protect the legitimate interests of the franchisor yet allow the franchisee to benefit from its investment and experience by operating a different business post-termination.

In addition to non-restrictive covenants, Franchisors may also require franchisees to return all branding, trademark, and trade dress assets (including signage, website URLs, etc.) on termination or expiration of their agreement.

Besides being reasonable, post-term non-competes should be drafted as narrowly as possible to protect franchisors’ legal interests yet enable franchisees to utilize investments and experience in a new business.

Franchisors should seek the assistance of qualified franchise counsel to evaluate their non-competes to assess whether their agreements should be modified in view of NASAA’s new guidance. 

Tal Grinblat is a California Bar Certified Specialist in Franchise and Distribution Law.