Lawsuit Gives Many Lessons to Franchisees on Common Franchise Issues
In a lawsuit between a franchisor and franchisee, a wide-ranging decision from the North Carolina Business Court provides reminders of important principles in franchise disputes.
The lawsuit was filed by a franchisor against a franchisee, the franchise, and a separate, non-franchised business that had been set up by the individual franchisee. The franchisor sued for a laundry list of claims. In short, after being a franchisee for 10 years, the franchisee allegedly let his agreement expire and set up an independent business with a similar name using the customer lists, business methods, and trade secrets of the franchisor.
The franchisor and franchisee each won some claims and lost the others for various reasons, but the net result was a loss for the franchisor: an injunction was granted prohibiting him from accessing the franchisor’s information and requiring him to return trade secrets. The franchisor’s lawsuit was permitted to continue.
There are a number of lessons for franchisees in this lawsuit related to common franchise issues.
Tort Claims Against the Franchisee
Tort claims are wrongful acts like negligence, misrepresentation, other intentional wrongdoing. Although the franchisor sued for breach of contract, it also sued the franchisee in tort for retaining the franchisor’s property in violation of the franchise agreement. A nuance of North Carolina law, the Economic Loss Rule, stopped this claim from proceeding.
The Economic Loss Rule states that if someone breaches a contract, tort claims cannot be stacked on top of it if the wrongdoing was already one of the things prohibited under the contract. As the court explained:
A plaintiff must allege a duty owed to him by the defendant separate and distinct from any duty owed under a contract.
This means that the franchisor was prohibited from suing the franchisee in tort for something that was a breach of contract. That is, the tort had to be something different than what was already prohibited by the franchise agreement.
Although there are some exceptions when the obligation at issue is both in the contract and required under non-contractual legal duties, the franchisor’s claims here did not meet the exception.
The Franchisee’s Tortious Interference with Contract
A claim for tortious interference with contract occurs where someone induces a third party not to perform their obligations under a contract without good cause. The Business Court defined it in more detail as follows:
[A] plaintiff must allege: (1) a valid contract between the plaintiff and a third person which confers upon the plaintiff a contractual right against a third person; (2) the defendant knows of the contract; (3) the defendant intentionally induces the third person not to perform the contract; (4) and in doing so acts without justification; (5) resulting in actual damage to plaintiff.
The franchisor’s claim for tortious interference with contract was dismissed because there was no allegation that the franchisee induced any customers to breach their existing agreements with the franchisor. This may sometimes be a difficult claim to prove because it requires finding former customers willing to admit that they were induced to break their agreement.
Franchisee’s Interference with Franchisor’s Prospective Economic Damage
The franchisor’s claim for interference with prospective economic damages fared better. The Business Court gave the definition of this claim:
To allege a claim for tortious interference with prospective economic advantage, a plaintiff must allege facts to show that the defendants acted without justification in inducing a third party to refrain from entering into a contract with them which contract would have ensued but for the interference.
The franchisor attached an email exchange with a potential customer in which the franchisee claimed that he was “the same company, new name,” and that the customer subsequently signed a contract with the franchisee. This permitted the court to infer that there was financial loss to the franchisor.
Franchisee’s Misappropriation of Trade Secrets
The franchisee was also accused of misappropriation of trade secrets. Trade secrets are defined as consisting of “business or technical information” that:
(a) Derives independent actual or potential commercial value from not being generally known or readily ascertainable through independent development or reverse engineering by persons who can obtain economic value from its disclosure or use; and
(b) Is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.
Analyzing the allegations of the lawsuit, the Business Court explained that customer lists, pricing estimation methods, and operations guidelines qualify as trade secrets under the North Carolina Trade Secrets Protection Act, N.C.G.S. § 66-152, et seq. However, in any lawsuit for misappropriation of trade secrets, the specific secrets that are allegedly misappropriated must be described in the complaint with enough specificity to determine that was misappropriated.
Franchisee’s Violations of Non-Compete Provisions
A bright spot for the franchisee was with regard to the non-compete provision. North Carolina law “disfavors” non-compete agreements, but will nevertheless enforce them where they are in the form of a written contract that is reasonable as to time, location, and reasonably protects the employer’s “legitimate business interest.”
In this case, the non-compete was ruled invalid because it was overly restrictive. The agreement tried to restrict the franchisee from any similar business, not just businesses that competed with the franchisor. The restriction was punitive, rather than restricting a legitimate business interest, and was thus unenforceable.
After operating a successful franchise for a number of years, it is tempting for a franchisee to feel entitled to take that sweat equity and start a business independent of the franchisor’s control. This case is a reminder that it’s not always so easy – the terms of the franchise agreement govern the rights and duties of the relationship, which often leave the franchisee under the franchisor’s thumb. This is why it is important for franchisees to consult a franchise attorney if they plan on making any sweeping changes to the business.
The North Carolina Business Court’s decision is here: Window Gang v. Salinas
Fairview Law is a business law firm that represents franchisees and other business owners. We represent franchisees against franchisors related to issues like those described above. If you are purchasing a franchise, having a dispute with your franchisor, or just have other general business issues, contact us to see how we can help your business thrive.