GA Supreme Court Strikes Down In-term Non-competition Covenant

Needless to say, the new restrictive covenant law would make it significantly easier to enforce restrictive covenants in Georgia, consistent with the General Assembly's findings that “reasonable restrictive covenants contained in employment and commercial contracts serve the legitimate purpose of protecting legitimate business interests and creating an environment that is favorable to attracting commercial enterprises to Georgia and keeping existing businesses within the state.”

Mark S. VanderBroek is a partner with Troutman Sanders LLP in Atlanta. He can be contacted at 404-885-3432 or [email protected]. Perry McGuire is an attorney with Taylor English Duma LLP in Atlanta. He can be contacted at 678-336-7208 or [email protected].

In a June 29, 2009 opinion relevant to all franchise businesses in Georgia, the Georgia Supreme Court held that a covenant in a franchise agreement prohibiting a franchisee from competing with the franchisor during the term of the agreement is judged under the same standards as a post-termination covenant not to compete, and is unenforceable under Georgia law unless it is reasonably limited in territory and in scope of restricted activities. By contrast, earlier in the year, the Georgia General Assembly passed a bill which, if enacted through passage of a proposed Georgia constitutional amendment in 2010, would make it easier to enforce a restrictive covenant in Georgia and would specifically permit enforcement of in-term restrictive covenants without limitations on scope of activity, duration, or territory.

Supreme Court Strikes Down In-term Non-competition Clause

In Atlanta Bread Company International, Inc. v. Lupton-Smith, No. S08G1815 (Ga. June 29, 2009), the Supreme Court considered the enforceability of a restrictive covenant in a franchise agreement providing that during the term of the agreement “neither Franchisee nor any Principal Shareholder, ' may, without prior written consent of Franchisor, directly or indirectly engage in, or acquire any financial or beneficial interest in ', advise, help, guarantee loans or make loans to, any bakery/deli business whose method of operation is similar to that employed by store units within the [franchise] System.” During the term of the franchise agreement, the franchisee opened a coffee shop and lounge that the franchisor alleged amounted to a bakery/deli with a similar method of operation, leading the franchisor to terminate the franchisee's franchise agreements for violating the in-term covenant.

On competing motions for summary judgment, the trial court conceded that Georgia law was “unclear” regarding the enforceability of an in-term covenant not to compete. Both the trial court and the Georgia Court of Appeals stated that “[w]hile the threat of a restrictive covenant regarding conduct during the term of a franchise agreement is not as great as a covenant regarding conduct following termination of the franchise agreement, it is still a restraint of trade and must be evaluated for reasonableness.” Both the trial court and the Court of Appeals also concluded that the in-term covenant should be evaluated under the same reasonableness standards as a post-termination covenant not to compete, and held the franchisor's covenant to be unenforceable because it failed to include a territorial limitation; failed to specify with particularity the nature and kind of business that would be competitive with the franchisor's; and contained an overly broad activity limitation.

The Georgia Supreme Court granted certiorari to determine whether “the reasonableness standard applicable to post-termination restrictive covenants also applies to in-term restrictive covenants.” Unfortunately for franchisors, the Supreme Court answered that question in the affirmative, in a unanimous opinion. Without discussing the policy reasons for employing a different standard of reasonableness to evaluate in-term and post-termination covenants, the court concluded that:

All such restraints on trade in a franchise agreement, regardless as to when they are in effect, must be reasonable as to time, scope and territorial limitation. [cites omitted.] Accordingly, there is no distinction to be made as to the level of scrutiny applied to a non-competition clause in a franchise or distributorship agreement based on its status as being active during the term of the agreement, and this Court declines to adopt a lesser standard of scrutiny.

The court then followed Georgia's traditional refusal to modify, or “blue pencil,” overbroad restrictive covenants to render them enforceable, and held that the franchisor's in-term covenant was unreasonable, and thus unenforceable, because it lacked any territorial limitation.

Impact on Georgia-Based Franchise Businesses

The court's ruling renders invalid the in-term restrictive covenants of many franchisors with business operations in Georgia. The International Franchise Association, in connection with filing an amicus brief in support of Atlanta Bread, reviewed the in-term restrictive covenants of 42 restaurant and food-related franchises with significant operations in Georgia and determined that 32 of them did not contain any territorial limitation, which would render them unenforceable under Georgia law without any further analysis.

This ruling affects not only franchisors based in Georgia (whose franchise agreements likely contain Georgia choice-of-law provisions), but also franchisors based outside of Georgia that have Georgia franchisees. Generally speaking, a Georgia court will not honor a choice-of-law provision selecting the law of another state to the extent it would render restrictive covenants enforceable, which would not be enforced under Georgia law.

Accordingly, many Georgia-based franchisors will need to modify their franchise agreements if they want to protect themselves against the divided loyalties and conflicts of interest that can arise if a franchisee becomes involved with a competing business. Among the alternatives for franchisors are the following:

• Modify the in-term covenant not to compete to include a reasonable territorial limitation and a reasonable activity limitation that includes a reasonably specific definition of a competitive business.
• Keep an in-term covenant without territorial or significant activity limitations, and keep a general Georgia choice-of-law provision, but specify that the restrictive covenants in the agreement will be governed by the law of the state of the franchisee's business location. This would result in the in-term covenants being unenforceable against franchisees located in Georgia, but enforceable without limitations against franchisees in most other states. (Most states will enforce an in-term non-competition covenant without time, scope, and territory limitations, and are more likely than Georgia to enforce post-termination covenants.) However, for franchisors that require that litigation be brought in Georgia regardless of where the franchisee is located, there is a risk that a Georgia court may decide to apply its own public policy and not enforce the non-compete.
• Add an additional ground to terminate the franchise agreement if the franchisee engages in a competing business or activity (reasonably defined). Adding such a ground for termination should not be construed as a restrictive covenant, because it does not purport to prohibit competition ' it merely provides the franchisor with a right to terminate if the franchisee engages in certain conduct.
• Rely on a “full time/efforts” clause and/or a prohibition of use of the franchisor's confidential information and trade secrets outside of the franchise business.

GA Legislature Passes New Restrictive Covenant Bill

Georgia has long been recognized as a state that disfavors contracts that limit the right to compete. However, on April 2, 2009, the Georgia General Assembly passed a bill (House Bill 173) that reverses the long-held legal bias against enforcement of restrictive covenants and would make it far easier to enforce such covenants in Georgia. Governor Sonny Purdue (R) has signed the legislation, but the law will become effective only if the voters of Georgia ratify a related state constitutional amendment in the November 2010 general election.

The new law, if enacted, applies to employment relationships and to specified types of agreements including franchise and distribution agreements. The law would effectively reverse the Atlanta Bread opinion by providing that a restriction that operates during the term of an employment relationship or of a franchise, distributorship, or license arrangement “shall not be considered unreasonable because it lacks any specific limitation upon scope of activity, duration, or geographic area as long as it promotes or protects the purpose or subject matter of the agreement or relationship or deters any potential conflict of interest.”

Under the new law, post-termination covenants not to compete still must be reasonable in time, geographic area, and scope of prohibited activities. However, the law provides presumptions regarding the reasonableness of time restrictions depending on the type of agreement at issue. For former distributors, dealers, franchisees, or licensees, a post-termination restraint of three years or less from the date of termination of the relationship is deemed to be reasonable. And although a covenant's description of prohibited activities, products, or services still may not exceed those provided by the employee or franchisee during the term of the employment or of the franchise, the restrictions shall be considered sufficiently described if a reference to the activities, products, or services is provided and qualified by the phrase “of the type conducted, authorized, offered, or provided within two years prior to termination” or similar language containing the same or a lesser time period.

The new law would also allow judges to modify (blue pencil) otherwise unenforceable restrictive covenants by striking through offending language or rewriting clauses to create a reasonable restrictive covenant consistent with the parties' original intent “as long as the modification does not render the covenant more restrictive with regard to the employees than as originally drafted by the parties.”

Needless to say, the new restrictive covenant law would make it significantly easier to enforce restrictive covenants in Georgia, consistent with the General Assembly's findings that “reasonable restrictive covenants contained in employment and commercial contracts serve the legitimate purpose of protecting legitimate business interests and creating an environment that is favorable to attracting commercial enterprises to Georgia and keeping existing businesses within the state.”

Mark S. VanderBroek is a partner with Troutman Sanders LLP in Atlanta. He can be contacted at 404-885-3432 or [email protected]. Perry McGuire is an attorney with Taylor English Duma LLP in Atlanta. He can be contacted at 678-336-7208 or [email protected].