Tag: covenants not to compete

Signal 88 Security case illustrates the Challenge of Obtaining A Preliminary Injunction to Enforce a Franchise Non-Compete

August 4th, 2017

A covenant not to compete is typically included in a franchise agreement to ensure that customer goodwill, once developed in the name of franchise, is not destroyed by former franchisees. The ultimate weapon for a franchisor to enforce a covenant not to compete is obtaining a preliminary injunction against the former franchisee. However, many courts place a heavy burden on the franchisor to prove that a preliminary injunction is proper.  The recent case of Colorado Security Consultants, LLC v. Signal 88 Franchise Group,  decided in March 2017 by the U.S. District Court for the District of Nebraska, illustrates how difficult that burden can be to meet under unfavorable facts.

Colorado Security Consultants, LLC (CSC), had a three year franchise agreement with franchisor, Signal 88 Franchise Group, Inc., to provide on-site security guard services within a territory in Colorado Springs. CSC also had a right of first refusal over additional franchises to be added within a radius of Colorado Springs. At the end of the initial term, the franchisor and franchisee continued the franchise agreement on a month-to-month basis, subject to 30-day notice of termination.  Signal 88 informed CSC that another person, Rebecca Resendes, wished to enter into a franchise agreement for a territory in the right of first refusal area where CSC had developed contracts with some customers.  Resendes and CSC negotiated for several months over her either purchasing CSC’s franchise or compensating CSC for customers it had developed in her contemplated territory.  When no agreement was reached Resendes signed a direct franchise agreement with Signal 88.  After additional negotiations between CSC and Resendes failed, Signal 88 told CSC that it had to stop serving customers in Resendes’ territory and then terminated CSC’s franchise entirely.  CSC began providing security services under the name “Guardhail”, and then Signal 88 sued CSC for violation of the 2 year post termination non-compete and sought an injunction to stop it from providing any security services.

To obtain an injunction Signal 88 had to demonstrate the following: (a) without an injunction it would suffer irreparable harm greater than the harm the franchisee would suffer from its issuance; (b) it had more than 50% likelihood of demonstrating violation of an enforceable non-compete by CSC, and (c) the injunction would serve the public interest.

Signal 88 alleged that CSC was causing it irreparable harm because it “contacted Signal 88’s customers, undercut Signal 88 on price, and caused a number of customers to cancel contracts with Signal 88.” CSC responded that it did not use “any of the names or trademarks of Signal 88” nor did they use any confidential materials.  All customer contracts in the Signal 88 system are entered into in the name of the franchisor, which also does billing and collection. So if Guardhail sought to continue to serve the customers that CSC recruited for Signal 88 (as seems likely) then CSC would have had to utilize the customer contact information and likely would have made offers that were more attractive than the pricing offered under the franchise.

Nevertheless, in declining to issue a preliminary injunction, the Court determined that Signal 88 failed to show that the “harm is certain and great and of such imminence that there is a clear and present need for equitable relief,” because Signal 88 failed to show that in the harm of CSC’s actions “threatened the very existence” of Signal 88’s business. Accordingly, even if there is a loss of customers and revenue for Signal 88, money damages would still suffice without the “extraordinary” measure of a preliminary injunction.

Signal 88 also argued that failing to enforce the non-compete would cause “irreparable harm to its franchise system”, presumably by encouraging other franchisees to not renew and to flout the non-compete. The court said that Signal 88 had no evidence to back up that general supposition.  Since a preliminary injunction would effectively put CSC out of business and would moot the parties’ claims before addressing the merits of the case, including CSC’s breach of contract counterclaim, the court found that the balance of hardships heavily favored CSC.

Despite the case being heard in Signal 88’s hometown of Omaha and the franchise agreement stating that Nebraska law governed, the Court held that Colorado had a greater material interest in the franchise agreement and therefore its laws regarding non-competes applied. Under Colorado law non-compete provisions are disfavored except to protect trade secrets or if issued when selling one’s business. The Court found that the evidence presented did not demonstrate CSC’s use of Signal 88’s trade secrets with any specificity.  Moreover, CSC argued that, as Signal 88’s selling and servicing agent when dealing with the customers, its principals were Signal 88’s employees – an allegation that, if proven, would cause the non-compete being held to very strict scrutiny under applicable law.  Since that determination is fact-specific the Court would not make such a decision at the preliminary injunction stage.

It is likely that these factors heavily influenced the Court’s denial of the preliminary injunction: (a) CSC recruited and developed the Signal 88 security customers in Colorado Springs, probably through the sales efforts of its owners more than franchisor-provided marketing; (b) accordingly CSC was not provided a customer list and did not inherit a list of long-standing Signal 88 customers, so the Colorado Springs customer list was not trade secret provided by Signal 88; and (c) Signal 88 terminated its relationship with CSC, apparently without cause, and allowed new franchisee Resendes to service all of CSC’s contracts without requiring her to pay for the goodwill that CSC had developed in them.

As this case shows, absent favorable facts it is very difficult for a franchisor to obtain a preliminary injunction enforcing a non-compete. Accordingly, certain franchisors may be well-served by adding a provision requiring a former franchisee that violates a post-expiration covenant not to compete to pay 2 years’ worth of continuing franchise fees.  Such a liquidated damages provision is more easily enforced and represents a fair compromise between franchisor’s interest in retaining customer goodwill and franchisees’ interests in making sure that the franchisor’s brand and business system continue to provide value.

Recent Franchise Non-Compete Cases Show Unpredictability of Enforcement

December 20th, 2013

Summary: Recent cases involving attempted enforcement of covenants not to compete by franchisors show the unpredictability of the results in such cases. However, careful reading of the factual circumstances of the cases also supports the adage that “bad facts make bad law.” So it behooves franchisors to check whether they have a sympathetic case on the facts when trying to enforce their non-competes.

In July 2013, in the case of Golden Crust Patties, Inc. v. Bullock, Case No. 13-CV-2241, the U.S. District Court for the Eastern District of New York “threw the book” at a recently terminated Golden Krust Caribbean Bakery & Grill Restaurant franchisee. The franchise was terminated because the franchisee was “not only selling the competitor’s products (i.e., frozen Caribbean-style patties), but were selling those products using Golden Krust packaging.” Thus, the franchisee was engaging in a classic form of trademark piracy, likely to cause harm to the brand. Despite receiving an immediate termination notice, the franchisee only stopped using the trademarks after Golden Krust filed suit. Even then, rather than adopting a new name it put up a sign reading, “Come in. We are Open. Nothing has Changed Only Our Name”; and another sign that read: “Open. Same Great Food, Same Great Service. Thanks for Your Support!!! Come Again.”

Under those circumstances, the court enjoined the former franchisee and her son, who had managed the restaurant, from continued operation of a Caribbean-style restaurant. In its order the court, acting under New York law, enjoined such operations at the former franchised location and within 4 miles of it (rather than 10 miles, as written in the contract), or within 2.5 miles of any other Golden Krust restaurant (rather than 5 miles, as written in the contract). While giving them a bit of a break on the geographic extent of the non-compete, the court overall had no sympathy for the franchisee’s arguments of harm to their livelihood, including the possibility that their landlord would not allow them to operate a different type of restaurant at the leased premises; rather, the court found that to be a harm of the former franchisee’s own making.

In September of this year, in the case of Steak ‘N Shake Enterprises, Inc. v. Globex Company, LLC, the U.S. District Court for the District of Colorado found that the franchisor had good cause to terminate and force its Denver franchisee to cease use of the trademarks, but did not find cause to enjoin the former franchisee from violating the covenant not to compete. The cause for termination was that the franchisee refused to comply with the franchisor’s demand that it offer a “$4 value menu” and instead insisted on charging higher prices. The court held that Steak ‘N Shake had good cause to terminate the franchise and enjoined continued use of the Steak ‘N Shake trademarks, trade dress and menu item names.

However, the court did not order the former franchisee to refrain from operating a similar restaurant, finding that, because the next closest Steak ‘N Shake restaurant was in Colorado Springs (about 100 miles away) and the franchisor had no prospects to open up any Denver area locations in the near future, it could not prove irreparable harm if the former franchisee continued to operate. This decision does not preclude the franchisor from seeking damages due to violation of the covenant not to compete later in this case. While not expressly stated in the opinion, it is quite possible that the court may have been swayed by the fact that Steak ‘N Shake was requiring that an enormous number of meals be offered for $3.99, which likely would mean little or no profit to the franchisee on those sales. In other words, Steak ‘N Shake had a right to insist that restaurants using its name follow its pricing demands, but if it chose to terminate on those grounds it would have to suffer repercussions.

Finally, on August 6, 2013, in the case of Outdoor Lighting Perspectives Franchising, Inc. v. Patrick Harders, the North Carolina Court of Appeals affirmed a state trial court ruling denying enforcement of a post-expiration covenant not to compete by a North Carolina based franchisor against its former franchisee in northern Virginia. In so doing, the court wrote, “During the time in which Mr. Harders operated as an OLP franchisee, entities holding OLP franchises encountered numerous problems with OLP suppliers. Since [Outdoor Living Brands] purchased [the franchisor] in 2008, numerous franchises have closed and the OLP business model has been devalued. Among other things, [the franchisor] failed to provide its franchisees with adequate support, feedback, and product innovation. Although the information provided to Mr. Harders and OLP-NVA by [the franchisor] was alleged to be proprietary, much of it was publicly available and common knowledge in the industry. Similarly, the training that Mr. Harders had received from [the franchisor] was readily available without charge in many national home improvement stores.

Once the court laid out the facts in this manner, it was obvious that it would rule against the franchisor. It did so in a fairly creative manner, seizing on the fact that the non-compete prohibited the non-renewing franchisee from engaging in a “competitive business” within any “Affiliate’s territory.” At the time of the franchise agreement, the franchisor was only involved in Outdoor Lighting Perspectives, but during the term the franchisor was purchased by OUtdoor Living Brands, which also owned the Mosquito Squad® and Achadeck® franchise systems. While the likely purpose of restricting competition with “affiliates” was to protect Outdoor Lighting Perspective businesses owned by the Franchisor’s corporate siblings, and the franchisor was not seeking to enjoin the former franchisee from competing with later-acquired affiliates in unrelated fields, the literal language of the non-compete supported an argument that it was overbroad in its geographic scope.

The court also found that the definition of a prohibited “Competitive Business” under this non-compete was overly broad. It prohibited involvement in “any business operating in competition with an outdoor lighting business” or “any business similar to the Business.” The provision’s scope could prohibit the former franchisee from operating an indoor lighting business or “obtaining employment at a major home improvement store that sold outdoor lighting supplies, equipment tor services as a small part of its business even if he had no direct involvement” in that part of the operation. The appeals court affirmed the trial court’s decision to read the provision literally and therefore refuse to enforce it in any manner, rather than entering a more limited injunction prohibiting the former franchisee from operating or managing an outdoor lighting business.

Conclusion

These court rulings demonstrate the “bad facts make bad law” truism. The Golden Krust franchisor had a sympathetic case and a franchisee acting badly; in the Steak ‘N Shake case, the parties clearly needed to go their separate ways, but the franchisor’s inflexibility persuaded the court to allow the franchisee to operate independently, at least pending a full trial; and the Outdoor Lighting franchisor, despite litigating in its “home court,” apparently had such an unimpressive franchise system that the court was unwilling to fashion an equitable remedy when confronting an overly broad non-compete. These cases should make franchisors think carefully about the situations in which they seek to enjoin competition by their former franchisees.

Franchise Selection from Both Sides of the Table — part 2

August 6th, 2010

Part 2 of this series focuses on how a prospective franchisee should investigate a specific Franchise Opportunity, after narrowing focus through self-evaluation:

After examining your capabilities and ambitions, the next step is to perform your due diligence and fully investigate the franchise opportunity you are considering. In addition to researching the opportunity directly, this also involves investigating competitive opportunities to make sure that the one you choose is the best fit for you. You should carefully read the franchisor’s Franchise Disclosure Document (“FDD”), and you should prepare questions and talk with the franchisor’s representatives regarding any issues or concerns you may have.

You also should contact existing franchisees to find out how their business is doing and what they feel the benefits are of being involved with the franchisor’s system and brand name. Franchisors are often willing to “assist” with this process, by referring prospects to their most successful franchisees. What may go overlooked, however, is the opportunity to gain information from former franchisees. The third table in Item 20 of the FDD provides valuable information concerning former franchisees. Franchisors are required in this table to list the numbers of terminations, non-renewals and reacquisitions during each of the three prior calendar years, as well as the number of franchisees who “Ceased Operations – Other Reasons”—which often means that the franchisee was simply forced to close their doors because they were unable to turn a profit. In addition, franchisors are required to provide contact information for all current franchisees and former franchisees who left the system during the past year. Both current and former franchisees can provide first-hand insight into numerous qualitative aspects of a franchisor’s system.

If the franchise system has been in existence for at least five years, also consider researching the availability of existing franchises through the Internet. It is a bad sign if many franchises are for sale and at low prices. It is a good sign if relatively few are for sale and at high prices. If you find no information through the Internet on this topic, then you should ask franchisees in locations near you about purchasing their business; and, if they express interest, pursue the topic to see their level of interest in “getting out” and their reasons for wanting to do so.

Other, often overlooked, aspects of a franchise system that can ultimately have a significant effect on franchisees’ profitability include supply and purchase arrangements established by the franchisor. A powerful purchasing cooperative can significantly improve a system’s franchisees’ bottom line. Among the required disclosures in the FDD, franchisors are required to state in Item 8 whether they receive rebates or commissions based on franchisees’ purchases of goods and services from suppliers. In a successful franchise system, the bulk of the franchisor’s revenue should come from franchisee royalties, and not from franchisees’ mandatory purchases from outside vendors. Moreover, quality franchisors do not force their franchisees to pay a premium over the fair market price for ingredients and other products central to the operation of the business.

Finally, is equally, if not more important to your potential for long-term success, to look beyond the FDD and the franchise system’s historical performance, and evaluate the current and future market for the franchisor’s goods or services. Just because you have a strong interest in a particular field or product and fall in love with a franchisor’s system and business methods does not mean that the general public will do the same. In addition, while joining a regional, national or international franchise system typically will have immediate name-recognition benefits, this may not be the case with a newer or smaller franchisor. If the franchisor’s name has little or no value, and the franchisor’s system is not unique or distinctive from the competition, then you should consider whether their franchise is worth the investment.

Recent Case Demonstrates the Importance of Protecting Intangible Property Rights

June 15th, 2010

A recent decision by the Maryland Court of Special Appeals illustrates the fundamental importance of seeking affirmative legal protection for your intellectual property rights. While Brass Metal Products, Inc. v. E-J Enterprises, Inc., 984 A.2d 361, 189 Md. App. 310 (Md. App. 2009) involves an inventor’s loss of rights as a result of his failure to obtain a patent for his invention, the principles applied by the Court are equally applicable to other forms of intangible property.

In Brass Metal Products, Brass Metal, a distributor of aluminum construction railing products, entered into a wholesale supply agreement with E-J Enterprises (“E-J”), under which E-J would purchase unique aluminum railings from extrusion mills for resale to Brass Metal on an as-needed basis. The railings were designed by Brass Metal’s owner, James Burger, but Burger never obtained patents on his designs. Several years later Brass Metal authorized E-J to sell its excess inventory of railings extruded from Burger’s designs.

Eventually, E-J began selling railings it had purchased for Brass Metal to Parthenon, a new company owned by Brass Metal’s top salesman. When E-J refused Brass Metal’s request to stop these sales, Brass Metal filed suit against Parthenon and E-J. However, since neither Brass Metal nor its owner had obtained patents for the designs, Brass Metal was limited to basing its claim concerning use of designs on the tort theory of conversion rather than a statutory patent infringement. Brass Metal settled with Parthenon before trial, but lost its case against E-J and then appealed.

Conversion is essentially theft (“any distinct act of ownership or dominion exerted by one person over the personal property of another in denial of its right or inconsistent with it”). Darcars Motors of Silver Spring, Inc. v. Borzym, 379 Md. 249, 261 (2004). Fundamental to any claim for conversion is that the claimant must have a property interest in the thing that it claims was converted. This requirement imposes unique hurdles to protect intangible property rights. To succeed on a claim for conversion of intangible property, the Maryland courts have held that the owner’s rights must be “merged or incorporated into a transferable document.” Allied Inv. Corp. v. Jasen, 354 Md. 547 (1999). Burger and Brass Metal failed to meet this requirement in this case, at least as to E-J.

Brass Metal also asserted that custom and usage in the industry demonstrated that E-J understood that Brass Metal’s rights in the railings’ design were protected. The court denied this claim, citing Brass Metal’s failure to meet the “clear and convincing evidence” standard for establishing the custom and usage of the aluminum extrusion industry.

Absent the prerequisites for a claim for conversion of intangible property, since Brass Metal failed to obtain a patent for Burger’s design, it did not have the right to prohibit E-J from selling to Parthenon (or anyone else) aluminum railings extruded from Burger’s designs or extremely similar ones provided by to E-J by Parthenon. As a result, the trial court ruled in favor of E-J Enterprises on all claims.

The Maryland courts have held that, subject to the limitation discussed above, claims for conversion may succeed for forms of intangible property other than patents, such as partnership interests and copyrights, although conversion claims for copyrightable materials may be subject to preemption by the federal Copyright Act. See U.S. ex rel. Berge v. Bd. of Trustees of the Univ. of Alamaba, 104 F.3d 1453 (4th Cir. 1997).   Before entering into any transaction involving any type of creative work, including technical designs or specifications, business people should be sure to take all steps necessary to fully protect their intangible rights and write contracts properly safeguarding these rights.

Welcome to the Fair! The dangers of oral contracts

June 9th, 2010

During the summer two parties agree to a transfer of a mobile festival concessions business for a total sales price of $150,000. The assets of the business to be transferred include a truck, a trailer, kitchen equipment, signs and lighting apparatus. The purchasers (a mother and daughter) pay $10,000 cash up front, with the balance due once the purchaser secures bank financing. The purchasers take possession of the assets and operate the business for several months, paying the sellers (a husband and his wife) a modest consulting fee to assist with the business transition. Insurance and title to the assets remains in the sellers’ name, pending payment of the $140,000 balance owed. The purchasers buy replacement equipment, pay the business’s taxes and pay the business’s employees.

By the end of the festival season, the profits do not meet the purchasers’ expectations. The purchasers’ loan has been approved, but the funds have not been transferred. The purchasers attempt to return the truck and equipment to the sellers’ storage facility and avoid the parties’ oral agreement. Who wins and why?

This law school-worthy fact pattern presented itself in a 2008 case from Illinois, Jannusch v. Naffziger, 883 N.E.2d 711 (Ill. App. 2008), and the entertaining scenario provides a well-suited platform for analyzing contract issues relevant to commercial transactions and business acquisitions of all shapes and sizes.

The purchasers argued that the parties had never entered into a valid agreement for the sale of the concessions business named “Fesitival Foods”. Specifically, the purchasers asserted that the parties’ discussions did not address numerous essential terms that were necessary for a binding agreement, including allocation of the purchase price among equipment and goodwill, whether there would be a covenant not to compete binding the sellers, how lien releases would be obtained, and what would occur if the financing never came through. The court disagreed, finding that the parties had agreed to all the necessary “essential terms” which were the purchase price and the items to be transferred. Thus, the purchasers’ argument that the parties course of conduct was merely preliminary to a potential future purchase agreement was found unpersuasive:

“The conduct in this case is clear. Parties discussing the sale of goods do not transfer those goods and allow them to be retained for a substantial period before reaching agreement. [The purchasers] replaced equipment, reported income, paid taxes, and paid [the sellers] for [their] time and expenses, all of which is inconsistent with the idea that [the purchasers were] only ‘pursuing buying the business.’ An agreement to make an agreement is not an agreement, but there was clearly more than that here.”

Contracts for the sale of goods are governed by Article 2 of the Uniform Commercial Code (“UCC”). However, whether a business acquisition constitutes a “sale of goods” is not always cut and dry. Where a transaction, such as a typical business acquisition, involves sales of both goods and services, courts apply the “predominant purpose” test to determine whether Article 2 applies. In Jannusch, the court held that the fact that, “significant tangible assets were involved” was sufficient to place the parties’ transaction within the scope of Article 2.

As noted by the purchasers, the general rule under Article 2 is that contracts for the sale of goods over $500 must be in writing to be enforceable. However, even oral contracts in excess of $500 will be enforced if one side has either acknowledged the agreement in court or partially performed its obligations under the agreement. Thus, in Jannusch, even though the parties’ contract was oral, it still was governed by Article 2 because both sides had partially performed. Specifically, the sellers had delivered the equipment, the purchasers had made the $10,000 down payment and, most importantly, the purchasers had applied for and obtained a bank loan to pay the $140,000 balance of the purchase price. In addition, one of the purchasers acknowledged in her testimony that the purchasers had agreed to pay $150,000 for the business, she just couldn’t recall exactly when.

As a result, despite the lack of formality and the limited terms upon which the parties had actually agreed, the trial court found—and the appellate court affirmed—that the parties had entered into a valid, binding and enforceable contract for the sale of the business. The defendants’ attempt to “get out of the deal” because of disappointing profits during two months of operations failed, and the defendants were liable for a $140,000 judgment.

Court decisions like Jannusch are important for businesspeople because they demonstrate that a party’s subjective understanding of a transaction—or even a communication not intended to form a transaction—can be irrelevant to the legal results that arise. While the purchasers’ claims in this case may have been an after-the-fact attempt to avoid the effects of their knowing conduct, the implications extend to cases of legitimate misunderstanding and lack of intent to form a contract. Parties considering any substantial sale or purchase need to be careful to take steps to ensure that their oral or informal (e.g., email) interactions with potential buyers or sellers are limited so that they do not reach a binding agreement without intending to. Carefully drafted documentation is the best way to avoid disputes based upon conflicting intents and understandings.

Non-Competition Covenants May Apply to Individual Franchise Owners, Even if They Never Agree to be Bound

October 27th, 2009

In a recent case out of the Federal District for the Eastern District of Virginia, it was held that a franchise agreement’s non-competition covenant could be applied to an owner of a corporate franchisee who had not signed the franchise agreement or a personal guarantee of the franchisee’s obligations. The facts of the case make the outcome unsurprising, and highlight a rule of federal law that can serve as an important tool for franchisors facing similar situations.

 The case involved a short-lived Little Caesar’s pizza restaurant in Portsmouth, Virginia. Apparently in ongoing discussions with Little Caesar’s, an individual prospective franchisee, Ms. Ross, worked with her partner, Mr. Krever, to acquire a lease and begin building out the leased space to suit a Little Caesar’s franchise. Ms. Ross approached Little Caesar’s about Mr. Krever also becoming a party to the anticipated franchise agreement, but Little Caesar’s refused.

 Despite this refusal, Ms. Ross and Mr. Krever jointly formed Little Caesar’s VA, Inc., and Ms. Ross entered into a franchise agreement with Little Caesar’s on the corporation’s behalf. While the agreement contained provisions requiring all owners to be approved and to sign a personal guarantee, Little Caesar’s was never made aware of Mr. Krever’s ownership interest.

 The franchisee’s restaurant quickly failed and Mr. Krever took over operations, rebranding the restaurant as “Family Pizza Plus”, but continuing to use Little Caesar’s advertising and ingredients. Little Caesar’s sent a notice of default and termination to Ms. Ross, and sent multiple cease and desist notices to Mr. Krever, the unauthorized partner.

 Following Mr. Krever’s refusal to cease operations of Family Pizza Plus, Little Caesar’s sued the franchisee-entity and both owners in federal court. Among other things, the complaint sought injunctive relief to enforce the franchise agreement’s non-competition provisions against both Ms. Ross and Mr. Krever.

 The court awarded Little Caesar’s the relief sought. Despite never signing the franchise agreement or a personal guaranty, Mr. Krever was found to be subject to the franchise agreement’s non-competition provisions. The court cited two reasons for this result. First, Rule 65(d) of the Federal Rules of Civil Procedure grants federal courts the authority to issue injunctions against parties and their “officers, agents, servants, employees, and attorneys.” Second, the court held that the unauthorized partner should not be permitted to benefit from his own fraud and deception. According to the court, had Mr. Krever’s involvement been made known to Little Caesar’s, he would have been required to agree the franchise agreement’s non-competition provisions. The equities clearly favored Little Caesar’s in this case, and accordingly the court issued an order enjoining Mr. Krever from operating the Family Pizza Plus business at the former Little Caesar’s franchise location.

By: Jeffrey S. Fabian