A franchise store closes and a new store opens next door? Have you considered the ‘non-competition clause’? [Daeryun’s Biz law forum]

Controversy over clause validity after contract termination
Three requirements based on precedent must be met
Need to reach a balanced agreement from the beginning

There is a scene that is often seen in franchise contract disputes. This is a case where, after the contract is terminated, the franchise operator simply changes the signboard at the existing business location and resumes business in a similar business or opens an independent store in a nearby area. At this time, the franchise headquarters takes legal action, saying, "We violated the non-competition clause in the contract," and the franchise operator counters, saying, "The contract has ended. What's the problem?" At the center of the conflict is the ‘non-competition clause’. Is this clause valid even after the contract ends? By what standard does the court judge?

Is the non-competition clause valid even after the end of the contract?

Article 6, Paragraph 10 of the Act on Fairness of Franchise Business Transactions (hereinafter referred to as the ‘Franchise Business Act’) prohibits franchise operators from engaging in the same business as the franchisor during the period of the franchise agreement. This is to protect the operating profits of the franchise headquarters and maintain order in the franchise business. There is similar content in the standard franchise agreement for the restaurant industry established by the Fair Trade Commission. This is a clause that states that during the contract period, the franchisee cannot engage in the same type of business directly or through a third party without permission from the franchisor.

The problem arises after the contract ends. Provisions prohibiting competition for a certain period of time even after the contract is terminated or terminated may directly conflict with the ‘freedom to choose occupation’ guaranteed under the Constitution. Accordingly, the court applies fairly strict standards to the validity of the non-competition clause after termination of the contract. Among the lower courts, "Even if a franchise operator sets a period of non-competition according to an agreement with the franchisee, the validity of the agreement must be judged based on whether there are interests of the franchisee that are valuable enough to be protected by a non-competition agreement, taking into account all circumstances, such as the type of franchise business, the role and proportion of the franchisee in the business operation process, the risk of trade secrets being leaked by the franchisee after the contract is terminated, or the possibility of misappropriation of existing commercial areas." There is a ruling that states, “The person claiming it is responsible for proving all the circumstances that can recognize the validity of the above non-competition agreement” (Busan District Court 2020 Gahap 46673 ruling on July 7, 2021).

The court's general position is that in order for the ban on competition to be recognized as valid, the following three requirements must be met.

First, there must be a legitimate interest for the franchisor to protect. If the headquarters simply provided the right to use a trademark or general operating guidelines, such information is in the public domain, so it is difficult to view it as a level of benefit that justifies a ban on competition. On the other hand, if differentiated recipes, unique marketing strategies, and educational materials that are trade secrets are passed on, the value of protection is recognized. In this regard, the Daegu District Court (2022na329254, sentenced on May 10, 2023) ruled that in a case where the franchise business is subject to the duty of non-competition and sells well-known foods such as sweet and sour pork, Jjajangmyeon, and Jjamppong, the restaurant business using such menus cannot be considered to be based on the franchisee's original ideas or know-how, and the franchisee It has been determined that the information provided to franchisees under the franchise agreement is not known to competing businesses and is therefore difficult to consider as a trade secret worthy of legal protection.

Second, the period, region, and scope of industry subject to the competition ban must be reasonable. In general, restrictions such as a period of less than one year, an area within a 1 to 3 km radius of an existing store, and restrictions within the same industry are customarily permitted. If it is set beyond this, such as on a nationwide basis, for more than three years, or encompassing a wide range of industries, the court is likely to deny its effectiveness. The Suwon District Court (2023 Gahap 18730, sentenced on December 18, 2024) ruled that the contract clause prohibiting the franchisee from operating, investing or advising in the same industry in the name of the franchisee or his or her family members in any region of the country for one year after the end of the franchise contract was "invalid as it constitutes an unfair term and conditions as it broadly restricts the professional freedom of the franchisee."

Third, whether compensation was provided to the franchise operator is also an important factor. The legitimacy of the ban on competition is further strengthened if a certain amount of compensation is paid in return for restricting business for a certain period after the termination of the franchise contract, or if a structure is in place to compensate for the franchisee's losses.

Non-competition clauses must be carefully reviewed before entering into a contract.

In light of these standards, franchise operators need to carefully review the non-competition clause in the contract before signing the contract. In particular, if post-termination restrictions are included, you should check in advance whether it will conflict with the business model or industry you envision in the future. Judging simply by saying “the contract is over so it is irrelevant” is dangerous and may lead to civil liability such as penalties or compensation for damages.

It is also undesirable for franchisors to establish unreasonably broad and long-term bans on competition. Excessive restrictions may not only be legally invalid, but may also have a negative impact on brand image. There is a high risk of damaging the trust relationship with franchise operators and causing unnecessary disputes. The non-compete clause must be set within a reasonable range by comprehensively considering the characteristics of the relevant franchise business, level of know-how, and franchise business type.

The non-compete clause is an important element that constitutes the essence of a franchise business. If a franchise operator accumulates various know-how while doing business based on the systematic support and brand value of the headquarters and uses it to start similar business after the contract ends, it will be a huge loss to the headquarters. This goes beyond simple freedom of business and acts as a serious problem that can undermine the order of the entire franchise contract.

At the same time, this does not justify unconditional bans and broad restrictions. The effectiveness of the non-competition clause operates on the two axes of 'reasonability' and 'legitimacy', and the judgment always varies depending on the facts of each individual case. What is important is that both parties are fully aware of their respective rights and obligations at the time of entering into a contract and then agree to fair and balanced terms. Furthermore, it is also necessary to receive assistance from legal experts as a preventive measure before disputes arise.

Considering that franchise businesses are structured based on long-term trust and cooperation, non-competition clauses should be understood not as simple restrictions but as a device for the sustainability of partnerships and a fair competitive order. We hope that both franchisors and franchise operators will create a more transparent and sound franchise business culture based on this awareness.

[View full article]
A franchise store closed and a new store right next door?... Have you considered the ‘non-competition clause’? [Daeryun’s Biz law forum] (Shortcut)