Developments in Non-Signatory Liability in Franchise Agreements: Where and When Does It Apply?

This article originally appeared in The Franchise Lawyer in the Summer 2020 edition, written by Brett M. Buterick and Evan Goldman. It is reprinted here with the permission of The Franchise Lawyer.

Nearly every franchise agreement today contains a restrictive covenant preventing a franchisee from engaging in a business competitive with its franchisor during the franchise agreement term and after the franchise relationship ends. A non-compete clause can be a very effective tool to protect a franchise system and intangible assets, though it has its limits. A non-compete generally prohibits a franchisee from engaging in a business competitive with its franchisor, but what happens when a former franchisee continues using a franchisor’s system through a spouse, family member, close friend, or former employee who did not sign the non-compete and is not contractually bound to the franchisor. Will such a person be constrained under the non-compete signed by the franchisee?

The scenario is a familiar one. After termination or expiration of a franchise agreement, substantially similar business operations continue. Often, the business is operated out of the same physical location or territory as the former franchisee, offering the same or similar products and services to the same or similar customers as the former franchisee. The former franchisee, however, has no involvement, on paper in the new business (i.e. the new business is recorded, leases are assumed, and marks are all registered in the close individual’s name).

Can a franchisor enforce a contractual provision against the non-party to a franchise agreement who is, on paper, operating the competing business? The answer—it depends. As franchisors press the issue, courts across the country have been increasingly willing to extend restrictive covenants, whether the restrictive covenant explicitly mentions non-signatories or not, to non-signatories in certain circumstances, namely where a close individual is either under the signator’s control or otherwise being used to aid or abet the signator in violating the non-compete clause.

This article addresses recent case law evaluating whether to enforce non-competition clauses against non-signatories when it is alleged that the non-signatory is aiding and abetting, or acting in concert with, a former franchisee. (For a comprehensive overview of prior cases, we recommend “Covenants Not to Compete and Nonsignatories: Enjoining Unfair Conspiracies” by Michael R. Gray And Jason M. Murray, in the Winter 2006 Franchise Law Journal).

Within the past few years, several district courts addressed the issue in-depth under different factual scenarios and reached different conclusions, providing some basic take-aways for what it means to “aid and abet” or “act in concert with” a former franchisee. These courts highlighted what facts meet that threshold, including the often-emphasized closeness of the relationship to the former franchisee. The cases addressed in this article are Winmark Corp. v. Brenoby Sports, Inc. (non-compete does not extend to non-signatory), JTH Tax, Inc. v. Abikarram (non- compete extends to non-signatory), JTH Tax, Inc. v. Freedom Tax, Inc. (non-compete does not extend to non-signatory), and H & R Block Tax Servs., LLC v. Strauss (non-compete extends to non-signatory).

The Cases

Winmark Corp. v. Brenoby Sports, Inc.

In Winmark Corp. v. Brenoby Sports, Inc., the franchisor of a used sporting goods retail franchise (Play It Again Sports), moved for injunctive relief against its former franchisee, the purchasers of the former franchise’s assets who were operating a competing business, and the former franchisee’s son, who managed the competing business. Winmark Corp. v. Brenoby Sports, Inc., 32 F. Supp. 3d 1206, 1216-17 (S.D. Fla. 2014). The former franchisee testified that upon receiving notification that his Play It Again franchise was terminated, he personally installed signage rebranding the store as “Play or Trade Sport.” Id. at 1217. The former franchisee then sold the business assets to a third party, SOS Sports, Inc., d/b/a Play or Trade Sport (“SOS Sports”), owned by non-signatory, Jorge Bocca (“Bocca”). Id. The former franchisee testified he sold the franchise assets to the non-signatory for a lump sum payment and, additionally, an indefinitely continuing percentage of future Play or Trade Sport revenue. Id.

The competing business, Play or Trade Sport, operated exactly as Play it Again Sports had operated, including by offering products in a similar manner and utilizing the same point of sale and data software Play It Again Sports required its franchisees to use. Id. at 1216-17. The former franchisee’s son managed the competing business. Id. at 1217-18.

Despite the former franchisee’s continued connection to the competing business through profit sharing and his son’s management of the business, the court found with respect to the non-signatory purchasers:

Winmark has not established that non- parties Jorge Bocca and SOS Sport are an alter ego for [the former franchisee] to secretly operate Play or Trade Sport, or that these non-parties are under [the former franchisee]’s control. [The former franchisee] testified that he sold the assets of his franchise to Bocca, who is not a close friend or relative. While [the former franchisee]’s testimony that he has no affiliation to Play or Trade Sport is belied by his financial incentive for the store’s success, Winmark has not established that Play or Trade Sport is under [the former franchisee]’s control, a corporate fiction, or otherwise being used to aid and abet [the former franchisee] in violating the non-compete agreement.

Winmark, 32 F. Supp. 3d at 1221–23

In a footnote, the court stated “[t]o the extent that Winmark believes that Play or Trade Sport is wrongfully utilizing Winmark’s DRS software, then Winmark may of course consider legal action against Play or Trade Sport if it fails to desist from using the software.” Id. at n. 6.

With respect to the former franchisee’s son and manager of the competing business, the court found:

The evidence does not support a finding that [the former franchisee’s son is] operating Play or Trade Sport or [is] otherwise aiding and abetting Defendant [. . . ] in violating the noncompete agreement. Likewise, the evidence does not support a finding that Play or Trade Sport is merely an alter ego of the Defendants or is operating under Defendants’ control. While [the former franchisee’s son] is listed as a co-manager of Play or Trade Sport, [the former franchisee] testified that [his son] does not own Play or Trade Sport and is merely an employee. [. . . .] Finally, [the former franchisee’s son is not a] personal guarantor[] or owner[] of [the former franchise], and [is] therefore not bound by the non-compete covenant in the Franchise Agreement.

The Southern District of Florida found the former franchisee’s tangential relationship to the continued operation by way of his son’s managerial involvement and his own profit sharing potential was insufficient to enforce the franchise’s restrictive covenant on the purchasing entity, SOS Sports. Given the interweaving of the former franchisee’s earnings with the new entity, it seems the Southern District of Florida leaned heavily on the fact the business purchaser, Bocca, was “not a close friend or relative” of the former franchisee.

JTH Tax, Inc. v. Abikarram

Several years later, the Southern District of Florida reexamined the non-signatory issue in JTH Tax, Inc. v. Abikarram, No. 19-CV-60328, 2019 WL 2254816 (S.D.Fla. Mar. 22, 2019) and under the facts of this case reached a different conclusion. There, the franchisor Liberty Tax Service (“Liberty”) sought an injunction against Freedom Tax, Inc. (“Freedom”), a competing tax preparation business owned by the former franchisee’s wife. Id. at 1.

Plaintiffs argued the former franchisee was simply using his wife to side-step the noncompete clause in the franchise agreement. Id. at 3. Defendants defended by arguing that the former franchisee’s wife was operating an unaffiliated tax preparation business and, if Plaintiffs wished to extend the non-compete restrictions to the spouse, they could have incorporated the restriction in the franchise agreement, but did not. Id. at 2. Ultimately, the Southern District of Florida found Freedom was operating under the former franchisee’s control, was a corporate fiction, and was otherwise being used to aid and abet the former franchisee, and accordingly, entered a preliminary injunction. Id. at 3.

In reaching this conclusion, the Southern District of Florida leaned on four main facts: (1) the close relationship of the former franchisee and the manager of the new entity—i.e. the former franchisee’s spouse; (2) Freedom’s operation out of the same office that housed the former Liberty franchise and, at least for a portion of time, under the Liberty marks; (3) the former franchisee’s statement to Liberty’s investigator that he had a business interest in Freedom; and (4) the former franchisee’s significant reduction in revenues on his tax return in the year before the termination (which presumably suggested he was transitioning clients to the new entity, even before termination).

Notably, the same magistrate judge in the Southern District of Florida issued the Reports and Recommendations in both Winmark and Abikarram.

JTH Tax, Inc. v. Freedom Tax

An interesting comparison to the Abikarram case arose in JTH Tax, Inc. d/b/a Liberty Tax Service, et al. v. Freedom Tax, Inc., et al. involving the same franchisor. No. 3:19-cv-00085-RGJ, 2019 WL 2062519 (W.D.KY May 9, 2019). In Freedom Tax (unrelated to the “Freedom Tax” in Abikarram), the Western District of Kentucky denied Liberty Tax’s attempt to use the Defend Trade Secrets Act (“DTSA”) to in effect enforce a noncompete clause against a former franchisee’s “General Manager,” Adisa Selimovic, who had never signed the noncompete. Ms. Selimovic had been listed as an “officer” on the franchisee’s corporate documents filed with the Kentucky of Secretary of State, but maintained no ownership interest in the franchisee entity. The court rejected Liberty Tax’s arguments that the former General Manager should be enjoined from operating a competing business, stating “[w]ere the Court to issue an injunction effectively enforcing the Franchise Agreements’ broad non-competition clause against Selimovic, who was not a signatory to the Franchise Agreements, it would unjustifiably harm Selimovic’s ability to earn a living in the Louisville area.” Id. at *14.

H & R Block Tax Servs., LLC v. Strauss

In an earlier tax-franchise-related case, the Northern District of New York examined whether a former franchisee’s lease of the former franchise location’s office space to her former employees, who then performed tax preparation services out of that same location constituted “aiding and abetting” sufficient to apply the post termination non-compete to the non-signatories. H&R Block Tax Servs., LLC v. Strauss. H & R Block Tax Servs., LLC v. Strauss, No. 1:15-CV-0085 LEK/CFH,

2015 WL 470644 (N.D.N.Y. Feb. 4, 2015). In Strauss, the former franchisee’s franchise agreement lapsed and the post-termination covenants prohibited the former franchisee from: (1) soliciting clients to whom her franchise had provided tax return preparation services and competing with Plaintiff in the business of preparing tax returns, for a period of one year and within a certain radius of her location; and (2) leasing the premises used for her franchised business to a third party for the purpose of preparing tax returns. Id. at 1.

After termination of the franchise agreement, the former franchisee violated both prongs of the non-compete covenant by continuing to provide tax preparation services at the franchise location under a new name, and leasing the franchise office space to two tax professionals whom the former franchisee previously employed when she operated the franchised business. Id. at 1.

The Northern District of New York had no hesitation extending the non-compete to the nonsignatories, finding:

the [franchise agreement] unambiguously provides that upon termination of the franchise agreement, Defendant may not lease to any individual the premises for the purpose of conducting tax preparation services, [. . . ]and Defendant has not refuted that she is in breach of this provision. Furthermore, pursuant to Fed.R.Civ.P. 65(d)(2), a preliminary injunction may be ordered against “other persons who are in active concert or participation with” the breaching party, or her officers, agents, or employees. The evidence before the Court indicates that these tax preparers at Defendant’s location, if not her employees, are at minimum acting “in active concert or participation with” Defendant, and are thus subject to the covenants discussed herein.

Id. at 6. (internal citations omitted).

The Takeaways

The above cases suggest courts are willing to enforce a restrictive covenant against a non-signatory where:

(1) A close relationship exists between the signatory and non-signatory

  • This generally looks like a spouse, relative, or close friend.
  • This generally does not look like an individual who, prior to involvement with the signatory, was not related to, did not work for, or did not know the signatory.

(2) The former franchisee is actively involved in the new enterprise.

  • This generally looks like sharing or lending resources, allowing a new entity to offer competitive goods or services out of the former franchisee’s location, allowing use of equipment, providing financial assistance, or funneling clients to the new entity.
  • This generally does not look like a passive interest in the success of the new enterprise (i.e. Winmark).

(3) The former franchisee holds herself out as affiliated with the new business enterprise.

  • This generally looks like a statement that the former franchisee is associated with the new entity, even though, on paper, he or she may not be involved.