Thursday, July 1, 2010

Does Law 75 govern the validity of a non-compete obligation in a franchise agreement when it does not specifically regulate the conduct at issue?

Plain language provides that a “distribution contract” includes the relationship established to distribute merchandise or provide a service by means of a “concession” or a “franchise” in the Puerto Rico market. 10 L.P.R.A. Sec. 278(b). It is plain that Law 75 applies to a franchise agreement.

But does Law 75 regulate the enforceability of contractual provisions in a franchise agreement without the triggering event of a termination or impairment or where Law 75 is silent on the issue?

At least with respect to a non-compete obligation in a franchise agreement, the answer is No. In Franquicias Martin’s BBQ v. Garcia de Gracia, 2010 TSPR 71 (P.R. May 10, 2010), the Supreme Court of Puerto Rico invalidated a non-compete provision in a franchise agreement, not under Law 75, but applying the Civil Code. The Civil Code provides that agreements are enforceable on their terms unless contrary to good faith, "morals" or public policy. Finding no provision in Law 75 that regulates the validity of a non-compete agreement, and suggesting that Law 75’s public policy is not implicated without an unjustified termination of the agreement, the court turned to the Civil Code, which is the primary source of law.

In the opinion, the court relegated Law 75 to a footnote (n. 10): “Law 75 of June 24, 1964, as amended, 10 L.P.R.A. Sec. 278, is limited to regulating the termination or non-renewal of a distribution contract without just cause, and is applicable to those persons that fit within the imprecise definition of a distributor.” (translation ours).

The court could not have meant that Law 75 does not apply to franchise agreements because the statutory definition of distributor is “imprecise”. After all, plain language in Law 75 includes a franchise relationship within the definition of a distribution contract.

What the court does suggest is that Law 75 does not come into play merely because a distribution or franchise agreement is at issue in the case. The court’s opinion suggests that Law 75 would not apply where: 1) the agreement has not been impaired or terminated without just cause, or 2) there is no provision in Law 75 specifically governing the legality of the contested provision at issue (in that case, the non-compete obligation).

Thus, for example and consistent with existing case law, a provision in a distribution agreement allowing the unilateral or automatic termination, non-renewal, or expiration of the agreement clashes with the specific provision in Law 75 expressly requiring just cause. Law 75 would apply in that situation as the contractual provision violates the statute and public policy requiring just cause.

On the other hand, the court’s opinion leaves room for argument that, where Law 75 does not specifically “preempt” or “regulate” the provision at issue in a franchise or distribution agreement, Law 75’s public policy is not at stake simply because there has been an unjustified termination, impairment or non-renewal of the agreement. Thus, in that scenario, the Civil Code remains the primary legal source to determine the enforceability of a contractual provision that is not specifically governed by Law 75. A narrow exception may be an arbitration provision which is governed solely and preempted by the Federal Arbitration Act and the Supremacy Clause although Law 75 regulates the enforcement of arbitration clauses in distribution contracts.

Applying the Civil Code may have important repercussions on the outcome of a franchise or distribution dispute. The Civil Code presumes both the existence of good faith and the validity of contractual obligations. The burden of proof is on the party challenging the enforcement of a contract.

It remains to be seen how far the court's footnote goes in determining the rule of decision in franchising and distribution issues under Law 75.