How a recent Georgia Supreme Court ruling affects franchisors in Georgia Featured

8:00pm EDT March 26, 2010

Last summer, the Georgia Supreme Court issued a decision that has damaged the ability of franchisors to protect their brands and business models from being duplicated by former franchisees. In response, a new bill (HR 178) has been presented in the Georgia House of Representatives. HR 178 proposes an amendment to the Georgia Constitution that allows more latitude in enforcing agreements that regulate competitive activities between franchisors and franchisees, and give courts the authority to limit the scope, geographic area and duration of competitive activities in franchise relationships.

In Atlanta Bread Company International Inc. v. Lupton-Smith et al., the Atlanta Bread Company sued a former franchisee who had been terminated for allegedly violating his franchise agreement with Atlanta Bread. The agreement prohibited the franchisee from operating another bakery/deli business whose methods of operation are similar to Atlanta Bread. During the term of the franchise agreement with Atlanta Bread, Lupton-Smith began operating a P.J.’s Coffee & Lounge in Atlanta. The Georgia Supreme Court ruled that this provision of the franchise agreement constituted an unreasonable restraint on trade.

“In the franchise context, a non-compete agreement requires that a franchisee not start a competing business within a certain geographic area for a specified amount of time,” says Ellen Taylor, an attorney at Baker, Donelson, Bearman, Caldwell & Berkowitz PC. “But the Georgia courts have routinely said that these types of agreements are unenforceable and constitute unfair restraints of trade designed to lessen competition.”

Smart Business spoke with Taylor about the ruling and how the proposed constitutional amendment could make the Georgia business climate friendlier to franchising.

What are the facts of the recent ruling of the Georgia Supreme Court?

In Atlanta Bread Company v. Lupton-Smith, the franchisor terminated the franchise agreement because the franchisee violated key provisions of the franchise agreement by opening a competing business within the same geographic area while he was still operating an Atlanta Bread Company franchise. But the court ruled that these provisions were subject to strict scrutiny, and were unenforceable and constituted an unreasonable restraint on trade. The court further rejected Atlanta Bread Company’s attempts to ‘blue pencil’ the agreement by striking out only those portions found to be unreasonable. The court stated ‘such restraints, no matter the nomenclature assigned to them, are disfavored in this state as a matter of public policy.’

In response to this decision, the proposed HR 178 will ask Georgia voters to decide whether to enact changes to current constitutional provisions governing competition in commercial and employment relationships. Such changes will make it easier for franchisors in Georgia to protect their investment in their business model.

How could the ruling negatively impact franchisors considering moving into Georgia?

This proposed constitutional amendment highlights the competing interests of a franchisee’s freedom to contract and a franchisor’s investment in its methods of training franchisees to operate the business. From a public policy standpoint, the current constitutional provision, and its interpretation by Georgia courts, discourages businesses from franchising in the state. It tells franchisors, especially those with knowledge-sensitive franchises, that when they operate and train franchisees in Georgia, the knowledge and skill they impart will not be protected. It also signals to franchisees that there is no intrinsic value in purchasing a franchise, as the franchisor’s efforts to protect its business model will not be enforced.

If this constitutional amendment is not passed, it will have a chilling effect on businesses deciding to franchise their operations in Georgia. Franchisors with Georgia operations will be forced to charge a high premium for unrestrained competition or they will choose to operate in other states.

Why would a franchisor shy away from Georgia if the courts can’t enforce non-compete covenants in franchising agreements?

A franchisor is selling a business model, and if someone can copy it without any concern about running afoul of any restrictive covenants of a franchise agreement, there’s no real assurance that the business model will be protected. That could have a significant impact on a business’s decision to come to Georgia. The ruling could also potentially expose existing franchisees in the state to unfair competition. A franchise contract is like the long-term lease of a business model, and if someone can take that model and open up a competing business, other franchisees will no longer see value in the franchise model. What is the incentive to operate a franchise in Georgia when someone can take everything you have and start their own business?

What action is the Georgia Legislature taking in light of the Georgia Supreme Court’s ruling?

It is considering a bill to amend the Georgia constitution. HR 178 proposes a constitutional amendment in which the General Assembly may authorize judicial enforcement of contracts that limit the competitive activities between or among employers and employees, distributors and manufacturers, lessors and lessees, partnerships and partners, franchisors and franchisees, sellers and purchasers of a business or commercial enterprise, or two or more employers. If passed, this bill will allow the courts to enforce franchise agreements that limit competitive activities. The resolution would allow the enforcement of contracts that restrict competition so long as the contract is reasonable in duration, geographic area and line of business. It would also allow the courts to ‘blue pencil’ or modify contracts to achieve the intent of the parties instead of throwing out the entire agreement based on one unenforceable covenant.

Ellen Taylor is an attorney at Baker, Donelson, Bearman, Caldwell & Berkowitz PC. Reach her at etaylor@bakerdonelson.com or (404) 221-6507.