Friday, June 25, 2010

Whether a non-compete obligation in a franchise agreement is enforceable under Puerto Rico law depends on the reasonableness of the restriction as applied to the facts of each case.

In Franquicias Martin’s BBQ Inc. v. Luis Garcia de Gracia, No. 2009-0410 (P.R. May 10, 2010), the Supreme Court of Puerto Rico considered the validity of a non-compete provision in the context of a franchise agreement.

The court determined that Puerto Rico Law 75, which regulates distribution and franchise relationships from unjustified terminations, did not specify the norms by which to determine the validity of a non-compete obligation. Nor does Law 75 invalidate per se a non-compete obligation. For guidance, the court turned to the Civil Code’s general precept that contractual obligations are enforceable unless contrary to public policy. Finding no statutory prohibition against the enforcement of non-compete obligations, the court adopted the criteria to validate a non-compete in employment relationships.

The court set forth a four-part test to determine the validity of a non-compete obligation in a franchise agreement. First, does the franchisor have a legitimate interest in the non-compete obligation, so that its business would be substantially affected without the restriction? A relevant factor is the employee’s position and his or her ability to be able to compete against the employer in the future. Second, the scope of the restriction must be reasonable in terms of the employer’s interests, the object, place, time and clients affected. The object must be limited to activities “similar” to those carried out by the employer. Third, the term of the restriction should not exceed 12 months. When the restriction applies to a geographic area, it must be limited to that strictly necessary to prevent “real competition” with the employer. When the restriction limits the scope of clients, it must be to those that the employee serviced personally and were clients of the employer before the employee’s resignation or termination. Finally, the employer must offer some consideration as a quid pro quo for the non-compete.

On the facts of the case, the franchisor, a rotisserie-style fast food restaurant chain, established a reasonable restriction of two years (it was not per se illegal to exceed the 12 month limitation) and limited the sale of products to those “similar” to the rotisserie chicken sold by the employer. It was unreasonable, however, as the non-compete prohibited the operation of a similar business within ten miles of any restaurant of the franchisor when the employee’s competing restaurant, established in the same location previously operated by the franchisor, had only a two mile radius of operations. The court did not explain the basis supporting the conclusion that the former employee's restaurant had a two mile radius of operations. In any event, the court determined that the prohibition in the contract was on its face broader than reasonably necessary for its admittedly legitimate purpose, could not be saved, and invalidated the entire non-compete agreement as contrary to good faith and public policy.

It is debatable whether the court's decision provides certainty and uniformity by which to guide contracting parties in the future or whether it is likely to cause confusion and litigation. Given the factually intensive and variable nature of the inquiry, it is probable that litigation will be both inevitable and costly to enforce a non-compete in a franchise or distribution agreement.