By Joseph P. McGuire

On August 6, 2013, the North Carolina Court of Appeals issued an opinion clarifying whether the level of judicial scrutiny for a non-competition provision in a franchise agreement should follow the standards for such a provision in an employment contract or the standards for such a provision in a contract for the sale of a business. The issue is significant because it is well-established under North Carolina law that non-competition agreements contained in an employment contract are more closely scrutinized than those contained in a contract for the sale of a business, due to concerns that employees have only their labor to sell and may more readily accede to an unreasonable restriction at the time of their employment than franchisees.

In the case before the Court of Appeals, Outdoor Lighting Perspectives Franchising, Inc. v. Harders, (No. COA12-1204), the plaintiff franchisor appealed an order from the North Carolina Business Court declining to enforce a non-competition provision in a franchise agreement authorizing franchisees to engage in the design, construction, and installation of residential and commercial outdoor lighting products. The franchise agreement prohibited the defendant franchisees from operating another outdoor lighting business within a specified area for a period of two years beginning on the date upon which the franchise agreement terminated or expired.

After expiration of its franchise agreement and upon learning that the defendants were operating an outdoor lighting business, the plaintiff franchisor filed suit to recover damages and injunctive relief. The defendants successfully moved to have the dispute designated for hearing by the Business Court, which is a trial court with offices in Raleigh, Greensboro and Charlotte that specializes in deciding complex business cases. Upon hearing the plaintiff’s motion for a preliminary injunction, the trial court ordered the franchisees to return and refrain from using certain allegedly proprietary information of the franchisor, including customer-related information, manuals and similar protected items. However, the trial court denied the plaintiff’s request for the issue of a preliminary injunction prohibiting the former franchisee from operating an outdoor lighting business. The franchisor appealed the denial of a preliminary injunction.

On appeal, the franchisor urged the Court of Appeals to adopt the standard generally utilized in cases arising from the sale of a business to evaluate the non-competition provision in the franchise agreement, while the franchisees argued that the greater scrutiny applicable to non-competes in employment contracts should govern. Finding that the franchisor-franchisee situation is a hybrid that differs from both the employer-employee and the sale of business arrangements, the Court pointed out that a franchisee is likely to possess a skill set that makes him capable of earning a livelihood in a variety of different businesses, and yet a franchisor is likely to retain and sell to a new franchisee some portion of the good will built up by the departing franchisee. Accordingly, the Court adopted elements of the tests utilized in both the employee-employer and the business sale contexts to analyze the validity of a non-compete in a franchise agreement.

The Court of Appeals concluded that the proper standard in the franchisor-franchisee context is whether the non-competition provision is no more restrictive than is necessary to protect the legitimate interests of the franchisor, with the relevant facts to be considered being 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. In applying this new standard, the Court determined that the geographic scope of the restriction at issue was not reasonable in prohibiting the defendants from engaging in the outdoor lighting business within the territory assigned to any of the franchisor’s affiliates, especially since two of the affiliates were engaged in lines of business totally unrelated to outdoor lighting. In that the non-competition agreement was impermissibly broad, the Court of Appeals concluded that the trial court correctly determined that the franchisor had no likelihood of success on the merits and affirmed the denial of the franchisor’s motion for a preliminary injunction.

The analysis by the appellate court indicates a flexibility to consider the substance of a hybrid contract that does not fit neatly within prior case law involving either the employer-employee or the sale of business situations, and provides helpful guidance to franchisors and franchisees in evaluating non-compete provisions in their franchise agreements