Can you keep a secret: Franchising and Trade Secrets
In 2019 there were over 770,000 franchised establishments. The central aspects of franchising as a business strategy are its business format and the trademark or service mark associated with that business. The business format is expressed in a Franchise Agreement between the Franchisor and Franchisee and an Operations Manual which, together with the trademark, provides a commercially distinctive and valuable business enterprise for the Franchisee to operate. A significant amount of this commercial know-how needs to be kept confidential to avoid duplication by would-be competitors. However, since this know-how is not patentable, it can only be protected by contract as “trade secrets”.
One of the typical ways to protect trade secrets is to limit its disclosure to ensure that it is shared only on a need-to-know basis. The problem is that the Operations Manual and to a lesser extent the Franchise Agreement have to be shared with not only the Franchisee but the Franchisee’s managers and employees as well. Even the short order cook at a Kentucky Fried Chicken Restaurant has access to the Colonel’s special herbs and spices mix and precisely how to fry the chicken “the Colonel’s way”.
So how does the Franchisor and Franchisee protect these trade secrets both contractually and legally?
First and foremost, the franchise agreement between the Franchisor and Franchisee should have a thorough “Confidential Information” section which broadly identifies types of information that the Franchisor deems to be confidential. In addition to the Operations Manual, such things as unique methods, customer and supplier lists, marketing techniques and the exclusive use of the trademark(s) can all be included as confidential to the Franchise Business. As such, any unauthorized disclosure or use of such confidential information would be breach of the Franchise Agreement. In addition, Franchisee’s are often required to sign a “Non-Disclosure Agreement” (NDA) which specifically obligates the Franchisee to protect such confidential information and, just as important, requires the Franchisee to make sure its employees also take steps to protect such confidential information. The Franchisor should also include the identification and handling of confidential information in its Operations Manual.
From the Franchisee’s perspective, it is encouraged to have all its managers and employees sign NDA’s upon becoming employed by the Franchisee. However, if that is infeasible, each employee can be given access to or excerpts from the Operations Manual which addresses identification and handling of confidential information and trade secrets.
In addition, the Franchisee and its managers need to handle confidential information appropriately to protect its unintended disclosure. Operations Manuals, customer lists, special technical processes should be kept track of during the workday and kept in a secure location during non-working hours. The Franchisee and managers must also make sure that every employee or contractor is aware that certain information and documents are considered confidential and not to be disclosed except for business purposes. Wrongful disclosure or use of franchise trade secrets would be a breach of the Franchise Agreement and possible termination of the Franchise Agreement and grounds for termination of a Franchisee’s employee.
As trade secrets have become more vital to many businesses in general, and specifically to franchised businesses, many statutes have been adopted to help protect a business’s trade secrets and provide legal remedies for the wrongful disclosure or use of trade secrets.
Economic Espionage Act – With more and more companies and Franchisor’s operating globally, the need to protect trade secrets both nationally and internationally has been recognized by the passage of the Economic Espionage Act in 1996. This Act criminalizes the theft of or attempts to acquire trade secrets to benefit a foreign country. The Act provides for both monetary fines and imprisonment for the intentional theft of or attempts to acquire trade secrets.
Theft of Trade Secrets Act – This federal law was passed in 1997 and provides criminal penalties for the intentional misappropriation of trade secrets for the purpose of harming the owner of the trade secret. This Act applies to products that were manufactured or placed in interstate or international commerce. The Act applies both fines and imprisonment if violated.
Defend the Trade Secrets Act – More recently the Defend the Trade Secrets Act (DTSA) was adopted in 2016. Most notable is that the DTSA allows a civil action by trade secret owners to be brought in federal court when its trade secrets have been misappropriated. Thus, the DTSA removes the need to show diversity between states or foreign countries in order to get access to the federal courts. The intent of the DTSA was to provide the expanded jurisdiction of federal courts and promote uniformity in the decisions and appropriate remedies for misappropriation.
Uniform Trade Secrets Act – The Uniform Trade Secrets Act (USTA) was originally published in 1979 by the Uniform Law Commission. While not a statute itself, the USTA was promulgated for adoption by individual states with the goal to make state laws governing trade secrets to be more uniform. This aspect has become especially important for Franchises that operate in more than one state. California’s version of the USTA (CAUSTA) was adopted in 1984 to cover customer lists, sensitive marketing information, software, formulas and recipes, techniques, processes and other know-how which provides a Franchise with a commercial edge.
Information is most likely to be considered a trade secret if it is:
- not known outside the particular franchised business;
- known only by employees and others involved in the franchised business
- subject to reasonable measures to maintain its confidentiality
- has value due to its exclusivity to the franchised business, and
- difficult for others to properly acquire or independently duplicate.
Penalties under the CAUSTA include equitable relief such as an injunction against wrongful use of trade secrets as well as financial damages to the trademark/trade secret owner for such misappropriation. In addition, in egregious cases of misappropriation, the court can award punitive damages up to double the amount of actual damages to the trademark owner.
Unfair Competition – Not mentioned under Contractual Safeguards is the use of post-termination non-compete clauses which basically provides that an individual may not participate either directly or indirectly in the same or any similar business for a period of time (ex 2-3 years after leaving the franchised business). Imposing this prohibition would greatly reduce the former Franchisee’s or employees’ motivation to use misappropriated trade secrets to start his or her own duplicate business or assist other competitors by divulging such trade secrets. Unfortunately, California, like virtually no other state, does not allow the enforcement of post-termination non-compete provisions. However, while California does not allow post-termination non-compete provisions against former franchisees/employees, California does have an “unfair competition” statute which prohibits a former franchisee/employee from using confidential information to establish a competing business or assist other competitors to compete with the trade secret owner’s business (Calif. Business & Professions Code §17200). As a result, in California, a Kentucky Fried Chicken franchisee cannot prohibit a former employee from starting his/her own restaurant offering fried chicken. But if that new restaurant uses any of the Colonel’s special seasonings or solicits good customers he/she became aware of from his/her previous employment with the franchised business, the trade secret owner or licensee (ie Franchisor or Franchisee) may indeed have remedies against any trade secret misappropriation on the basis of unfair competition.