No-Poach Agreements Land Franchisors in Hot Water

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Restraints of Trade

A wave of class-action antitrust lawsuits raises questions about the legality of “no-hire” provisions that certain franchised food businesses use, write Mary N. Strimel, Emre N. Ilter, and Matt Evola of McDermott Will & Emery. The authors examine prior antitrust litigation involving franchise businesses and hiring restraints, and analyze the key points that courts will have to confront in resolving the current round of cases.

Mary Strimel Emre Ilter Matt Evola

By Mary N. Strimel, Emre N. Ilter, and Matt Evola

Mary Strimel is a partner in the Washington office of McDermott Will & Emery, where she advises and defends clients on criminal cartel, mergers and acquisitions, class actions, and other antitrust matters. Ms. Strimel was an attorney with the Justice Department’s Antitrust Division for more than a decade, including as the founding chief of a criminal enforcement section launched in Washington. Ms. Strimel thanks her co-authors Emre N. Ilter and Matt Evola for their invaluable assistance.

If the Justice Department’s Antitrust Division and the Federal Trade Commission intended to raise alarms with their October 2016 guidelines regarding employer no-poach and wage-fixing agreements, they have certainly succeeded. Those guidelines clarified that DOJ would criminally investigate and prosecute employers who agreed, in “naked” no-poach agreements, not to recruit or hire each other’s employees (in this context, “naked” agreements are “separate from or not reasonably necessary to a larger legitimate collaboration between the employers.”). The guidelines also indicate that wage-fixing agreements among employers will be prosecuted criminally.

Besides causing much ink spilled in the antitrust press, the guidelines have triggered a wave of class-action lawsuits against franchisors alleging that restrictions on franchisees’ recruitment of employees from other franchisees violate the antitrust laws. So far, restaurant chains including Carl’s Jr., McDonald’s, and Pizza Hut have found themselves in the crosshairs of such suits.

The franchise restaurant class-action cases raise untested issues of how far commercial collaborators can go to restrict their competition for employees. A September 2017 New York Times story pointed to a recent study indicating that more than half of all companies with more than 500 franchise stores in the U.S. impose some kind of lateral recruiting restriction, according to their annual financial filings. Success for the plaintiffs in these cases is far from assured, but the cases highlight a potential large-scale litigation risk for all U.S. franchise operations.

Allegations of Recent No-Poach Antitrust Plaintiffs

The February 2017 lawsuit by Luis Bautista and Margarita Guerrero, two former shift leaders at Carl’s Jr. franchisee-owned restaurants in Los Angeles, is typical of the allegations in this recent wave of cases. The plaintiffs allege that Carl’s Jr. Restaurants LLC and Carl Karcher Enterprises LLC require all franchisees to agree to a “no hire” provision that prevents one franchisee from hiring employees at the level of shift leader or higher from other franchisees without the advance written consent of the franchisor. In contrast, the suits against McDonald’s and Pizza Hut allege a no-hire agreement cooling-off period lasting six months. In the Pizza Hut case, franchisees that violate the no-hire provision are alleged to owe liquidated damages to the franchisor equal to twice the hired employee’s annual compensation.

The Carl’s Jr. complaint deals exclusively with California state law, while the other complaints allege that the conduct of the franchisors violates Section 1 of the Sherman Act, which prohibits agreements in unreasonable restraint of trade. The no-hire provisions are alleged to depress employee wages, restrict employee mobility, and reduce benefits and job growth opportunities for employees.

Anticipating defense arguments regarding putative economic integration of the Carl’s Jr. franchise system (explained later), the plaintiffs allege that the Carl’s Jr. franchise model is “designed to encourage franchise competition,” provides no geographic exclusive territories for franchisees, and that competition “purportedly extends to employment matters.” The other lawsuits have similar allegations designed to show that the franchisees operate in competition against each other, as well as against company-owned stores.

‘Agreeing’ for Purposes of the Sherman Act?

The linchpin of a lawsuit alleging a Sherman Act restraint of trade is a showing of agreement. Yet it is not a foregone conclusion that a franchisor and its franchisees are capable of “agreeing” for purposes of establishing a violation of Sherman Act § 1. Nor is it clear that a unilaterally imposed contract term constitutes an “agreement.”

The U.S. Supreme Court held in Copperweld Corp. v. Independence Tube Corp., 467 U.S. 752 (1984), that a parent company and its wholly-owned subsidiary were incapable of conspiring under the Sherman Act. The court reasoned that because unilateral conduct was not intended to be covered by the Sherman Act, the conduct of a parent and its wholly-owned subsidiary must fall outside the reach of Section 1, else a single firm’s conduct be subject to scrutiny whenever the coordination of two employees was involved.

Following Copperweld, some franchisors have argued that a franchisor and its franchisees should be treated as a single economic entity incapable of forming an agreement in restraint of trade for Sherman Act § 1 purposes. This argument gained traction in 1993 in the Ninth Circuit in the case of Williams v. I.B. Fischer Nevada, 794 F. Supp. 1026 (D. Nev. 1992), aff’d, 999 F.2d 445 (9th Cir. 1993). In that case, the plaintiff alleged that franchise agreements requiring that Jack-in-the-Box managers could not be hired at another Jack-in-the-Box restaurant for six months without permission from the previous restaurant owner were in violation of Sherman Act § 1. The district court held that the franchisor’s control over the franchisees, in addition to their common economic goals, “make them a single enterprise, incapable of competing for purposes of Section 1 of the Sherman Act.” On appeal, the Ninth Circuit agreed, holding that “[t]o be capable of conspiring, corporate entities must be sufficiently independent of each other.” The court held that while this was a fact-specific determination, the district court had correctly held that the franchisor and its franchisees constituted a common enterprise.

In the years following the Williams ruling, several federal courts outside the Ninth Circuit reached similar decisions, holding that franchisees and franchisors cannot conspire in restraint of trade, either because they are the same economic entity, or because the franchise agreement was a “take it or leave it” agreement unilaterally imposed by the franchisor. E.g., Hall v. Burger King, 912 F. Supp. 1509 (S.D. Fla. 1995); Search Int’l, Inc. v. Snelling & Snelling, Inc., 168 F. Supp. 2d 621 (N.D. Tex. 2001), aff’d, 31 F. App’x 151 (5th Cir. 2001); Mfr. Direct, LLC v. Directbuy, Inc., No. 205 CV 451 (N.D. Ind. 2007).

But in 2010, the U.S. Supreme Court held in American Needle v. National Football League, 560 U.S. 183, that the NFL, composed of 32 separately owned, franchised football teams, was not “categorically beyond the coverage of § 1.” When the NFL granted an exclusive license to Reebok for the manufacture of team-labeled apparel for all 32 teams, American Needle argued that the agreement violated the Sherman Act. In determining that the NFL teams could be capable of a Section 1 agreement, the Supreme Court used a “functional analysis” that examines the whole economic picture of the business model at issue:

  • “The key is whether the alleged ‘contract, combination ..., or conspiracy’ is concerted action — that is, whether it joins together separate decisionmakers. The relevant inquiry, therefore, is whether there is a ‘contract, combination ... or conspiracy’ among ‘separate economic actors pursuing separate economic interests,’ such that the agreement ‘deprives the marketplace of independent centers of decisionmaking,’ and therefore of ‘diversity of entrepreneurial interests,’ and thus of actual or potential competition.”

To the extent that franchisors had understood Copperweld to provide themselves blanket protection from antitrust suits regarding conduct with franchisees, American Needle indicated that there was a more nuanced test to be applied as to whether a franchise operation could be subject to the Sherman Act. The application of the Copperweld holding to the franchise model was not settled by this case, as a settlement was reached before the lower court could reach the merits of applying the American Needle test. Though the Supreme Court did not overrule Copperweld, and the single economic entity defense remains viable, American Needle could complicate the efforts of businesses hoping to find a definitive safe haven from Sherman Act § 1 civil suits through the Copperweld doctrine. The American Needle test creates the possibility that a franchisor and franchisee could be found to be subject to the Sherman Act if a court were to find that they were separate economic actors.

Per se v. Rule of Reason v. Quick Look Analysis

If a court were to hold that a particular franchisor and its franchisees do not meet the Copperweld test and are capable of entering a Sherman Act agreement, how would the court likely analyze a restraint on hiring imposed by the franchisor?

To determine whether a given restraint of trade is “unreasonable,” courts first consider whether the restraint is ancillary and reasonably necessary to a pro-competitive integration of economic activity between the parties. If the restraint reduces output or increases prices but is unrelated to any joint economic activity, then courts will typically condemn it as a per se illegal naked restraint. For example, in the High Tech Employees Antitrust Litigation, a court considered an alleged no-solicit agreement among unrelated employers such as Adobe, Apple, Google, and Lucasfilm. See In re High-Tech Employee Antitrust Litig., 856 F. Supp. 2d 1103, 1122 (N.D. Cal. 2012). The plaintiffs in those cases alleged that the employers had agreed not to cold-call each other’s employees in attempting to recruit them, and the court found that these allegations adequately pled a per se antitrust claim. (The cases settled before the court could reach a final decision on whether to apply the per se rule or the rule of reason. However, the court seemed to accept that the effect of the restraint would be to depress wages and employee mobility.)

On the other hand, if a restraint makes economic activity possible that could not take place in the absence of the restraint, or contributes to an efficient outcome — for example, a no-solicit agreement that is necessary for a consulting agreement to be viable between two parties — then courts will typically examine the restraint under the far more forgiving “rule of reason” standard. For example, the DOJ conducted its own enforcement to prohibit no-hire clauses in the high-tech cases mentioned earlier; in its final consent judgment, the DOJ specifically exempted from coverage no-direct-solicitation clauses to the extent reasonably necessary for mergers, contracts with consultants, auditors, outsourcing vendors, and the like. See Final Judgment, United States v. Adobe Systems, Inc., et al. , 1:10-cv-01629, Mar. 18, 2011, at ¶ V.A. In applying the rule of reason, courts balance the anticompetitive effects of a particular restraint against its pro-competitive justification, all in the context of a properly defined relevant antitrust market.

In some cases involving horizontal agreements with limited justification, courts apply a truncated rule-of-reason analysis known as the “quick look,” under which the court assesses whether “an observer with even a rudimentary understanding of economics could conclude that the arrangements in question would have an anticompetitive effect on customers and markets.” California Dental Ass’n v. F.T.C., 526 U.S. 756, 770 (1999).

The franchise restaurant no-hire cases will present challenges to an adjudicating court. Clearly, there is valuable joint economic activity occurring between a franchisor and its franchisees in providing a common product, brand, and quality of service to the customer. Restraints that promote interbrand competition, such as those that ensure uniformity of the franchise’s products and service quality, are routinely upheld. And in a recent settlement of a no-poach enforcement case outside the franchise context, the DOJ specifically permitted the parties to enter “reasonable” no-solicit agreements that are ancillary to a legitimate business collaboration. See United States v. Knorr-Bremse AG and Westinghouse Air Brake Technologies Corp., Apr. 3, 2018. Yet franchise operations are a mixed arrangement of collaboration and competition. As noted earlier, franchise agreements may encourage individual franchisees to compete with one another in many respects. Courts will need to consider the role of hiring limitations in promoting the efficient operation of the franchise system.

Potential Pro-Competitive Justifications

Whatever level of scrutiny the court applies in the franchise fast-food cases, the plaintiffs will likely point to alleged harms from lost competition among franchisees for their labor and the resulting potential for lost mobility and depressed wages. They will assert that the per se rule is appropriate because a franchise model can operate just as well without the hiring restriction; the only difference is that the franchisees will have to pay higher (in their view, more competitive) wages. Defendants, for their part, will likely argue that the no-hire rules are integral to their franchise model and are designed to prevent free-riding on training investments by the franchisees. For example, the defendants could demonstrate that franchisees incur costs to provide specialized training to management-level employees, such as sending the employees to corporate classes and providing one-on-one training for skills that relate only to that franchise system. If other franchisees could free-ride on those specialized investments by hiring away managers after those training costs had already been incurred, no franchisee would have the incentive to provide the specialized training and the entire franchise system (including the employees) would be worse off. (Such an argument recalls the justifications that franchisors have successfully used regarding vertical territorial restrictions under the antitrust laws: allowing franchisees to reap the benefit of their investments provides a net benefit to competition.)

Plaintiffs will likely argue that the training investments for traditionally lower-wage jobs such as shift leader are not sufficient to require protection by a no-hire agreement. However, if a court were to agree that the franchise cases should be assessed under the rule of reason, an entire new line of argument opens up to the defendants: relevant market definition. Under the rule of reason, a plaintiff must plead a relevant antitrust market and allege harm to competition in that market (not just harm to the plaintiff) to survive a motion to dismiss. In the franchised food cases, defendants have argued vigorously that the relevant labor market extends beyond just one franchise chain, and is far broader than plaintiffs can plausibly claim was harmed by a single no-hire clause. By arguing plausible pro-competitive benefits, the defense can refocus the court on the pros and cons of the no-hire provisions in a broader market that includes all fast-food jobs, all restaurant jobs, or even all lower-wage jobs in a particular geographic market.

Takeaways

Although the outcome of the current group of no-hire class-action suits in the franchised food industry cannot be predicted, it is apparent that these suits are likely to multiply. These cases may expand into nonfranchised businesses, as well, as demonstrated by a recently filed suit relating to the chicken farming industry.

Franchise businesses should carefully look at any employment restrictions in their franchise agreements, such as nonsolicitation or no-hire agreements. Overbroad restrictions are likely to be challenged, and even narrow agreements with substantial justifications could face scrutiny. Franchisors who wish to consider using such provisions should consult with experienced antitrust counsel beforehand to discuss potential litigation exposure.

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