Court Holds Franchisee Accountable for Acts That Harmed the Goodwill and Reputation of the Franchise System

09/20/2016 / Nic Puechner

The U.S. District Court for the District of Arizona recently issued a decision supporting franchisors’ right to protect their legitimate business interests from franchisees who perform “overnight switches” to competing businesses. The court specifically held that enforcement of non-compete agreements are “necessary to protect [franchisors’] legitimate business interests, including [their] confidential information, trade secrets, and good will,” reasoning that “[t]he goodwill that [a franchisee] acquired from performing work as a . . . franchise belongs to the franchisor.”

One challenge consistently faced by franchisors is the question of how to protect the franchise system after a franchisee leaves or otherwise does business in a competing industry outside of the franchisor’s system. This issue was recently addressed when the U.S. District Court for the District of Arizona was asked to determine whether a franchisee’s actions taken both during the term of the franchise agreement and after the expiration of the agreement harmed the goodwill and reputation of the system.

In ReBath LLC v. New Eng. Bath Inc. et al. the court granted a franchisor’s motion for preliminary injunction against its former franchisee, enjoining the franchisee from using confidential information obtained during operation of the franchise, displaying trademarks and logos, and operating a competing business in violation of the noncompete clause.

In 2014, ReBath learned that one of its franchisees, New England Bath Incorporated (“NEBI”), had undertaken bathroom remodeling contracts outside of its exclusive territory in direct violation of a territory restriction contained in the franchise agreement. The agreement required the franchisee to forward leads outside of its territory to the appropriate franchisee and allowed ReBath to recover liquidated damages in the event of a violation. When ReBath demanded damages pursuant to the agreement, NEBI refused to pay. Shortly thereafter, when the franchise agreements between the parties expired, NEBI failed to comply with its post-term obligations. Instead, it made an “overnight switch” to a new name while remaining in the same location; continued to use ReBath logos and trademarks; failed to turn over the franchise operating manual and customer contacts; and continued to use websites bearing the ReBath name and customer testimonials that resulted from installing ReBath products.

The franchise agreement between ReBath and NEBI contained standard temporal and geographic restrictions against operating a competing bathroom remodeling company. NEBI argued that because it was undertaking both kitchen and bathroom remodeling contracts in its new business, it was an entity distinct from its former franchisor and, thus, not a competing business. It also claimed that the restrictive covenants in the franchise agreement were unreasonably broad and that it was entitled to utilize truthful testimonials from customers whose work NEBI had actually performed, whether or not that work occurred while NEBI was a ReBath franchisee. The court disagreed and found the noncompete obligations contained in the franchise agreement enforceable in their entirety, handing the franchisor a decisive win and reinforcing the longstanding and foundational principle that a franchisor is entitled to protect its “legitimate business interests.”

The court determined that, because the restrictive covenants in the agreements between ReBath and NEBI were constructed in such a way as to limit only the portions of NEBI’s business in direct competition with its former franchisor, the covenants were not overly broad and were reasonable in geographic and temporal scope. This decision affirms the importance of tailoring the scope of restrictive covenants in a franchise agreement to “legitimate business interests.”