Hotel franchisors often use non-competition agreements, a form of “restrictive covenants,” to restrict hotel franchisee owners and their affiliates from varying levels of involvement with competing hotel brands. Some franchise agreements permit a limited involvement with a competing brand. For example, some allow a hotel franchisee to become a franchisee of other competing brands, as long as the hotel franchisee owner and its affiliates do not have a majority interest in, or are not controlling minds of, competing brands.
Franchisee owners also seek protection through non-compete covenants. Many hotel franchise and management agreements restrict franchisors and brand operators from operating other hotel properties within a certain territory of the franchisee’s hotel. Some of the legal principles underlying non-compete covenants against hotel franchisors or brand operators as opposed to those against franchisee owners are similar, although those against franchisors or brand operators involve additional factors, and a different legal perspective that will be discussed in a future column.
Fund sponsors of real estate investment trusts also commonly enter into non-compete covenants with REITs in the hospitality industry. Those commercial arrangements are not subject to the restrictions of franchise law principles that are discussed in this article.
In a common scenario, a franchisee owner makes an actual or purported sale of a hotel property to a competitor brand, or to an entity that controls a competitor brand. Assuming the hotel franchisor opts not to exercise a right of first refusal (where such right exists), the hotel franchisor might be technically entitled to seek an injunctive relief in court or before an arbitration body to restrain a franchisee owner from continuing to breach a non-competition covenant. Often, irreparable harm is difficult to prove and other legal impediments exist, and a hotel franchisor might prefer to treat the hotel franchise agreement at an end and seek damages.
Sophisticated hotel franchisors tend to recognize the uncertainty involved in trying to enforce a post-termination non-compete covenant, and instead impose a penalty of liquidated damages in lieu of the restrictive covenant. While such a liquidated penalty clause is not a restrictive covenant in and of itself, its underlying premise is based on a non-competition covenant.
Under the laws of many jurisdictions in the United States and Canada, determining whether such non-competition covenants are enforceable tends to involve a legal analysis that is multi-faceted and pragmatic.
The starting point in the legal analysis is the nature of a franchise relationship. Even between sophisticated parties in a hotel franchise agreement, the relationship is not equivalent to a pure commercial arrangement where, for example, a party wants to restrain a seller of a business from competing with a buyer, or prevent a shareholder from competing with a company.
In pure commercial arrangements, courts tend to more readily enforce restrictive covenants. In the U.S. and Canada, courts tend to, more or less, lean away from the general public policy against restraints of trade, in favor of giving effect to parties’ greater freedom of contract.
Exceptions exist. On one end of the spectrum, some states in the U.S. have laws that limit the enforceability of non-competition covenants. On the other end, where an enforceable restrictive covenant is breached, some states create a presumption of irreparable harm. Such a presumption supports an injunction application by an aggrieved party. In Canada, the Supreme Court in a recent case created a presumption that a restrictive covenant in the commercial context is lawful, unless it is shown on a balance of probabilities that its scope is unreasonable.
Reasonableness of the non-competition covenant, particularly in a franchise relationship, is key.
Unlike in a pure commercial contract, courts might construe a franchise agreement as a “contract of adhesion” if it is drafted entirely by the franchisor and presented to the franchisee in a non-negotiable final form, or where there is a perceived imbalance of power.
This is despite the fact that franchisors and franchisees are independent contractors, parties to a business arrangement. In the hotel industry, both the hotel franchisor and the franchisee owner group often tend to be sophisticated parties. Even in small hotel systems, where franchisors might be considerably more sophisticated than franchisees, both sides are generally deemed sophisticated for legal purposes.
Key to the analysis is the desire of courts to be satisfied that a non-competition covenant is reasonable in protecting the legitimate interests of the beneficiary in the non-competition covenant, in an effort to balance the public policy against restraints of trade and the desire to promote freedom of contract in commerce.
Legal jurisdictions across the U.S. and Canada have different thresholds for what is a reasonable non-competition clause in any particular franchise dispute. The “reasonableness” test does not always result in predictability. The following outlines some of the factors courts tend to take into account in the analysis.
Non-compete analysis
First, the wording of the non-compete covenant will go a long way to determine whether it will be enforceable.
To maximize the chances of a court or arbitration panel enforcing a non-competition covenant, it is generally desirable that the wording of the covenant be unambiguous about the following key legal components:
(i) the geographic territory of the restrictions;
(ii) the period of time during which they are effective; and
(iii) the extent of the prohibited activities.
An ambiguous clause, i.e., one that lends itself to more than one plausible interpretation based on a plain reading of any of these three components, will not help the interests of the party seeking to enforce the clause.
Franchise agreement framework
Courts will look to other relevant provisions in the franchise agreement to obtain or refute support for the validity of the non-competition covenant. For example, the definitions in the franchise agreement of the following terms might be relevant: “franchise”; “franchised business”; “business”; “system”; “standards”; “network”; “procedures”; “competitor”; “competing brand”; “control”; “methods of operation”; “secrets”; and “proprietary information”.
Often, these terms are related to the non-competition covenant either by express reference in the clause itself or by necessary implication.
Nature of the franchise system
Courts might also examine actual elements of the franchise system and its operation, such as the following:
- the services, products and unique elements of the system;
- the confidential information, franchisor’s know-how, unique methods, trade secrets and procedure used in the system;
- the franchisor’s efforts and expenditures to develop the market;
- the franchisor’s reputation and goodwill in the market;
- customer demographics;
- the training and other information provided to franchisees; and
- the nature of the franchisee’s competing business that is said to be in violation of the non-competition clause.
Examining and assessing all these contractual and practical aspects often comprises a key part of the legal analysis to determine whether a non-competition covenant will be enforceable in the particular circumstances of a dispute.
Ben Hanuka is a franchise lawyer and principal of Law Works P.C., a Toronto corporate law boutique with expertise in international and regional franchise disputes, international arbitration and the hospitality industry.
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