By: Tyler Hartney
On January 5, 2023, the Federal Trade Commission (FTC) issued a proposed rule which, if enacted, would ban most employment non-competes. The proposed rule would make it “an unfair method of competition for an employer to enter into or attempt to enter into a non-compete clause with a worker.” As it currently stands, the FTC’s definition of a “worker” specifically excludes “a franchisee in the context of a franchisee-franchisor relationship.” The public comment period on the proposed rule is open until March 20, 2023, meaning that the franchise exception is now up for debate. It is critical for the success of all franchise systems that the exception remain in the final rule.
The Franchise Exception
In the FTC’s recent publication in the Federal Register on January 19, 2023, it specifically invited commentary on the franchise exception and suggested an openness to considering its removal. In explaining the exception’s initial justification, the FTC correctly noted that “the relationship between a franchisor and franchisee may be more analogous to the relationship between two businesses than the relationship between an employer and a worker.” The FTC, however, went on to criticize franchise non-competes, claiming they “stifle new business formation and innovation, reduce the earnings of franchisees, and have other negative effects on competitive conditions,” and “many franchisees lack bargaining power in the context of their relationship with franchisors and may be susceptible to exploitation and coercion.”
The franchise relationship is not analogous to the employment relationship. Franchisors provide franchisees with licenses to use their most valuable assets, business concepts, and intellectual property, including known and trustworthy brands, as well as the know-how, tools, and assistance to successfully operate the franchised business. As a result, franchisees bypass significant entry barriers and costs associated with inventing and developing new products and services, instead enjoying instant brand awareness supported by franchisors’ experience and marketing efforts. In exchange, franchisees invest their time and capital in the franchise opportunity.
Employees Can Compete Fairly
Employees, on the other hand, typically bring their own particular skillsets to the employment relationship, which they have developed themselves through earned professional experience and investments in education and training. When employees leave, they are often hired by new employers who can compete fairly through their own established investments and distinct marketing and offerings.
In the franchise relationship, franchisors are the ones who supply the knowledge and experience necessary to operate the franchised business. As a result, franchisees do not have a justifiable expectation to continue using the means they acquired from franchisors to compete with them after the franchise relationship ends. Franchisors, on the other hand, have a justifiable expectation that former franchisees will not immediately enter into competition with them, circumventing the typical entry barriers and costs that would otherwise exist, by trading on the franchisors’ goodwill within the same geographic area as the franchised business.
The FTC’s concerns over franchisees’ bargaining power are already adequately addressed by the FTC’s existing disclosure rule and states’ authority to enact their own laws governing the franchise relationship. Under the FTC’s disclosure rule, franchisors provide franchisees with all of the information they need to make voluntary and informed decisions about their investments in the form of a Franchise Disclosure Document. Franchise agreements are less negotiable than some business transactions simply because the very nature of the franchise relationship requires uniformity across the system.
Moreover, franchise agreements typically provide franchisees with greater rights than employees. Unlike the typical at-will employment relationship, most franchise agreements establish durational terms, renewal rights, and may only be terminated for cause, providing franchisees with the opportunity to recoup their investments. And unlike employees, franchisees gain access to build businesses on the franchisors’ goodwill and brands. While employers may limit certain employees’ access to confidential information on a need-to-know basis, the franchise relationship requires franchisors to license their concept and trade secrets to successfully operate the business.
Removing the Franchise Exception Would Cause Negative Consequences for Franchise Systems
If the franchise exception is removed from the proposed rule, it would have serious negative consequences for franchise systems. Franchisees expect and benefit from franchisors protecting the systems’ integrity. Successful franchisees want franchisors to enforce their non-competes so that those who have left the system cannot unfairly compete with them, reduce their earnings, and dilute the value of their investment.
Franchisees would not invest in such turnstile systems. Franchisors would also be disincentivized from making substantial investments without reasonable assurances that former franchisees will not turn around and use their investments against them. Franchise non-competes do not stifle legitimate businesses and innovation; rather, they promote such interests and ensure fair competition by protecting the long-term and intangible investments made by both franchisors and franchisees.
When franchisees leave the system, franchisors look for new franchisees to take over their territory, which is much more difficult when former franchisees have the ability to immediately begin competing in the same area. Non-competes with reasonable geographic and temporal limitations level the playing field and provide franchisors with the time and space necessary to protect their investments and franchisees. Prohibiting non-competes would take away an important tool for franchisors to protect their systems, but it cannot and will not eliminate the underlying need to do so. In the absence of non-competes, franchisors would have to find alternative ways to protect their systems from unfair competition, which may be even more costly and less palatable. Litigation would continue and likely increase over liquidated damages, non-solicitation and non-disclosure terms, and trade secret misappropriation.
It does not appear that franchising was ever the focal point of the FTC’s proposed rule. Whatever one thinks about the equities of the franchise relationship, they are not comparable to those inherent in the employment relationship, and they are already adequately addressed by many federal and state regulations. Our firm intends to comment on the proposed rule and the importance of its franchise exception. If you have any feedback you would like share with us, please feel free to reach out.