N.C. Appeals Court Adopts New Standard for Determining if a Franchise Agreement’s Non-Competition Clause is Enforceable

By Jerry Meek (August 9, 2013)

Is a non-competition provision in a franchise agreement similar to a non-compete between employer and employee or to one between the seller and buyer of a business?  According to the North Carolina Court of Appeals, it is both.  The “hybrid” nature of such provisions when used in a franchise agreement requires that a new standard be applied to determine if they are enforceable.

In Outdoor Lighting Perspectives Franchising, Inc. v. Harders, COA12-1204 (August 6, 2013), the franchisor sought to enforce a provision in the franchise agreement which purported to bar a former franchisee from involvement in any business “operating in competition with an outdoor lighting business” or “any business similar to” the former franchisee’s business, for a period of two years.

As the Court of Appeals noted, non-competition agreements in employment contracts are “more closely scrutinized” than those contained in a contract for the sale of a business.  The Court rejected the franchisor’s argument non-competition provisions should be analyzed under the more lenient standard applied to the sale of a business.  Instead, franchise agreements involve a “hybrid situation which does not fit neatly within either” category.  A franchisee often possesses a skill set “that makes him capable of earning a livelihood in a variety of different businesses,” thus rendering him less dependent than the typical employee on a specific type of work.  On the other hand, unlike the situation that typically arises from the sale of an established business, the franchisor is likely to benefit from the goodwill created by the franchisee and can sell some of that goodwill to a new franchisee.

Adopting a new standard, the Court held that a non-competition provision in a franchise agreement will be enforceable only if it is “no more restrictive than is necessary to protect the legitimate interests of the franchisor,” considering “the reasonableness of the duration of the restriction, the reasonableness of the geographic scope of the restriction, and the extent to which the restriction is otherwise necessary to protect the legitimate interests of the franchisor.”  Armed with this new standard, the Court of Appeals concluded that the non-competition provision before the Court failed to meet two prongs of this test and was therefore unenforceable.

First, the provision purported to bar the franchisee from engaging in the outdoor lighting business within the territory assigned to any of the franchisor’s “affiliates.”  But, the franchisor had two affiliates engaged in lines of business totally unrelated to outdoor lighting.  Thus, the geographic scope of the restriction was unreasonable.

Second, and more relevant to the typical franchise agreement, the Court held that the non-competition provision was not necessary to protect the franchisor’s legitimate interests.  The provision before the Court purported to restrict the former franchisee from being involved in any business “operating in competition with an outdoor lighting business” or any business “similar” to the franchisee’s former business.  If enforced, this would prohibit the former franchisee from owning a franchise that sold and maintained indoor lighting or from working at a major home improvement store that sold outdoor lighting supplies, equipment, and services, even if the former franchisee were not involved in those operations.  The non-competition agreement, the Court concluded, “would prevent [the former franchisee] from engaging in activities that have no tendency to adversely affect [the franchisor’s] legitimate business interests.”  The provision is therefore unenforceable.

The Court’s ruling reinforces the need for franchisors to give careful, measured consideration to the scope of such provisions when drafting franchise agreements.