How Non-Compete Clauses Are Dividing the Franchising Industry

The Federal Trade Commission recently proposed the Non-Compete Clause Rule (16 C.F.R. Parts 910), which would ban employers from imposing non-compete clauses on employees. In relation to franchises, non-compete clauses protect franchisors by preventing franchisees from working for a competing franchise and stopping franchisees from sharing knowledge and trade secrets with competitors. Sometimes thought to be an exploitative practice that negatively affects wages, hinders innovation, and prevents entrepreneurs from starting new businesses, the FTC believes the ban would bring significant advantages to the business world.

The FTC is seeking comment on the Non-Compete Clause Rule, and when it comes to franchises, people have a lot to say. Below, we’ll discuss the opposing opinions of the North American Securities Administrators Association, Inc. (NASAA) and the International Franchise Association (IFA) as well as outline the pros and cons of the FTC’s proposed rule.

Competing Beliefs About Non-Compete Clauses in Franchise Agreements

There’s no question that non-compete agreements are dividing the franchising industry. Many associations, like the NASAA, have come out against non-competes, stating they limit franchisees’ ability to find jobs and inhibit entrepreneurship. Alternatively, the IFA favors it, believing they are essential and protect franchisors’ interests.

NASAA

NASAA, organized in 1919, is the oldest international organization devoted to protecting investors. Their membership includes securities administrators in 50 states, as well as the District of Columbia, the U.S. Virgin Islands, Puerto Rico, Canada, and Mexico. With duties like developing model statutes, rules and guidelines for states, cooperative enforcement projects, information-sharing, and training and education of state securities regulators, NASAA members also administer and enforce state franchise registration and disclosure laws.

When commenting on non-compete clauses following the termination of the franchise agreement (“post-term” clauses), the NASAA had a few main points to address:

FTC’s Prosed Rule Should Include Post-Term Non-Compete Clauses

Non-compete clauses could hinder the formation of new businesses and reduce franchisee earnings. While most franchisees may not qualify as employees, the post-term non-compete clauses have adverse effects similar to non-compete provisions in the employment context.

FTC’s Prosed Rule Should be Banned Upon Franchisee Leaving the Franchise System

Strict non-compete clauses can make a buyer vulnerable if the seller establishes a competing business nearby. The seller’s actions can negatively impact the value of the business. Therefore, buyers often seek a non-compete agreement to protect their investment.

Franchise Agreements involve a long-term relationship between unequal parties. The franchise controls the intellectual property and operations of the business. At the same time, the franchisee invests money into the business and risks losing if the franchise does not succeed. If the franchisor chooses to end the relationship, the franchisee must seek a new livelihood. Restricting the franchisee from establishing a new business that could compete with a former franchisor is unreasonable.

NASAA believes that post-term non-compete clauses should be banned as they’re an unfair method of competition. By doing so, competition in the labor market will increase, jobs will be created, and we’ll see increased innovation and new business formations.

FTC’s Proposed Rule Should Apply Uniformly—No Exemptions Or Different Standards.

Franchisees are, at times, in a dependent relationship with franchisors. Franchisors and franchisees can compete within the franchise system, but competition is restricted when the franchisee leaves the franchise system. This demonstrates the power imbalance between franchisors and franchisees and is clearly an unfair method of competition.

IFA

The IFA is pro non-compete clauses. The General Counsel for the IFA went so far as to say that “Non-compete clauses protect the integrity of franchising and individual franchisees from unfair competition from existing and former franchisees. Such a ban would be extremely damaging to the franchise business model, encourage breaches of contract, and hurt small business owners that depend on the viability of the franchise system to protect their equity in their franchised businesses.”

How IFA Justifies the Non-compete Clause

Believing that non-compete clauses serve an important function by protecting franchisees’ equity, franchisors’ confidential and proprietary information, and the integrity of franchise businesses, IFA believes promoting competition is a good thing and is in support of the non-compete clause, stating that a ban of such would relegate franchisees to become mere employees of their franchisors.

The IFA Has Support in Opposition

The IFA is joined by 280 organizations in their opposition to the proposal stating that non-competes serve vital business and employee interests. The opposition group includes a wide range of organizations, ranging from advertisers and bakers to bankers, truckers, and electrical contractors, among many others.

Pros of Non-Compete Clauses in Franchise Agreements

Non-compete clauses in franchise agreements provide many benefits and offer protection in several different ways:

1. Protect the franchise business model. Non-compete clauses prevent franchisees from directly competing with franchisors during their franchise relationship and for a specified time after their relationship ends.

2. Protect Brand Integrity. Since non-compete clauses prevent franchisees from establishing competing businesses in the same region, this protects the brand image and the franchisor’s reputation.

3. Protect return on investment. Since franchisees often make a substantial investment upfront, non-compete clauses help protect the investment by limiting competition from the franchisor as well as other franchisees.

Cons of Non-Compete Clauses in Franchise Agreements

Non-compete clauses in franchise agreements come with significant drawbacks.

1. Restricts the franchisee’s ability to pursue further business opportunities. This limits career flexibility, options, and entrepreneurship.

2. Restricts franchisees from operating similar businesses in a certain geographic area. This can be hard for franchisees, especially if they live in a small town with limited options.

3. Franchisee Financial Loss. When a franchise relationship ends, a non-compete clause can stop them from using their existing knowledge and expertise to pursue further employment options in the same industry. Obviously, this comes with significant financial loss.

Within the year, the FTC will determine whether its proposed non-compete ban encompasses franchising. Stay tuned!

Work with an Experienced Franchise Lawyer

The franchise relationship is unique, and the FTC’s proposed rule may significantly affect franchise businesses. Consult with an experienced franchise lawyer to learn more. We’re here to help. Contact us to schedule a consultation.