I. Trade secrets/confidential information- the key ingredient in a franchise relationship
As Franchising becomes the internationalisation structure of choice for more and more businesses, the need for franchisors to take a harmonised and globally effective approach to the protection of their know-how is more important than ever before.
Franchising is an on-going relationship that transcends the typical contractual grant of intellectual property rights and equips the franchisee with proven methods of exploiting the intellectual property rights together with the provision of continuous support and advice. Naturally, apart from sharing the brand name, the franchisor’s know-how - its trade secrets which comprise the format and lay the foundation for success for each franchisee’s business - must certainly be shared with the franchisees too.
Therein lies the greatest risk to the franchisor. The risk that either exfranchisees use those trade secrets to compete with the franchisor after any post termination non-compete clauses are exhausted or disenchanted franchisees leak the know how to their family or other affiliates in order to enable them to compete with the franchise (the so-called “spring board” effect). In contrast to the other intellectual property rights such as trademarks or patents, trade secrets cannot be registered. As such, before a franchisor can obtain legal protection for its trade secret, it needs to first establish that the information it seeks to protect is indeed a trade secret or at the very least, has a quality of confidence.
In the franchising context, the use or sharing of trade secrets is typically governed by the contractual agreement where the franchisor agrees contractually to disclose relevant and sometimes sensitive and valuable information to the franchisee, as it operates the franchised business.
The focus of this article is two-fold: for one, it chronicles the approaches employed by a few major jurisdictions in protecting trade secrets – the integral recipe of any franchise; and for another, it proposes several approaches that transcend jurisdictional boundaries which franchisors may consider employing to protect their trade secrets.
II. What are trade secrets?
Despite the global recognition of the importance and need to protect trade secrets, regrettably, this area of law remains fraught with uncertainties. Owing to the amorphous nature of trade secrets, there is no precise definition of what constitutes a trade secret.
Even if a certain piece of information was initially deemed to be a trade secret, it does not correspondingly mean that it will remain a trade secret forever. A trade secret may lose its status or quality of confidence over time if the information becomes available to the public. To put simply, whether a piece of information will be regarded as "confidential" depends on the factual matrix at the point in time where protection is sought. To put an end to the common myth, simply attaching the label of confidentiality on any piece of information would not in itself be sufficient to accord protection.
Nonetheless, in light of the global shift towards greater recognition and thus protection of trade secrets, the law in classifying what constitutes confidential information, has transcended traditional categories of information (i.e. documents, financial statements, manuals) to include business methodologies and concepts. From as early as the 1980's there has been established case law to support the view that an "entire methodology for conducting a tanning studio constitutes a trade secret”, as the methodology contained more specific information than what was generally found in general industry manuals or reports.3The methodology in that case included “employee recruitment and training, studio layout, cash control, advertising, accounting, marketing, promotion, and site selection,” which incorporated “knowledge and information gained concerning the success and value of different approaches to the various aspects of the indoor sun tanning business".
In the same vein, business concepts might be considered to be a trade secret and thus warrant legal protection if there is substantial degree of thought and work put into developing that concept4.
Despite the absence of any internationally accepted definition of a trade secret, there remains some overarching principles that are generally applicable in defining what constitutes a trade secret. We have outlined below, a sampling of the major jurisdictions to assess how "trade secrets" are treated.
(A) The United States of America (the "US")
In the US, the Uniform Trade Secrets Act ("UTSA") and the US Restatement of Torts provides some legislative guidance on what constitutes trade secrets. The UTSA defines trade secrets as “information, including a formula, pattern, compilation, program device, method, technique, or process, that:
- derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and
- is the subject of efforts that are reasonable under the circumstances to maintain its secrecy. 5
The US Restatement of Torts also identifies six useful factors in determining whether a piece of information constitutes a trade secret:
- the extent to which the information is known outside of the business;
- the extent to which it is known by the employees and others involved in the business;
- the extent of measures taken to guard the secrecy of the information;
- the value of the information to the business and to competitors;
- the amount of effort or money expended in developing the information; and
- the ease or difficulty with which the information could be properly acquired or duplicated by others.
As not all the US states have enacted the UTSA, the law on trade secrets in the US is yet to be harmonized. Nonetheless, with specific legislation protecting trade secrets in place, this paves the way for future harmonization of trade secret protection within the US.
(B) The European Union (the "EU")
The increasing recognition on the importance of harmonising the definition of 'Trade Secrets' is perhaps most evident when the European Commission published a proposal for a Trade Secrets Directive ("Directive") in 2013. Chiefly, this proposed directive seeks to create a more practical tool to encourage and protect innovation in Europe and to minimize unfair competition by harmonizing the law on trade secrets in the EU. This new initiative is timely as the current position on the law of trade secrets in Europe differs from country to country with one-third of the European countries lacking specific legislation protecting trade secrets.
The main purpose of the Directive is to institute a harmonized framework to protect against the unlawful acquisition, use and disclosure of trade secrets.
To kick-start the harmonization of the law of trade secrets in the EU, Article 2 of the Directive introduces a harmonized definition of 'trade secrets' across the EU as information which:-
- is secret in the sense that it is not, as a body or in the precise configuration and assembly of its components, generally known among or readily accessible to persons within the circles that normally deal with the kind of information in question;
- has commercial value because it is secret; and
- has been subject to reasonable steps under the circumstances, by the person lawfully in control of the information, to keep it secret6.
Although the general concepts are not unfamiliar, the ultimate aim is to protect commercially valuable information where its unlawful use will undermine business or financial interests, the business ability to compete, strategic positions or scientific and technical potential.
To meet this aim, the Directive will provide a minimum framework which includes legal remedies such as injunctions, delivery up or destruction orders and damages as well as ensure that confidentiality is protected throughout any Court process.
Further, under the Directive, it is now possible to enforce the protection of trade secrets against unlawful use by third parties, including passive receivers of a trade secret that should know or later obtain knowledge of the infringement, even if the third party initially acted in good faith. Also, the holder of the trade secret can take action against the infringer and enforcement is not limited to the ultimate owner of the information.
The latest iteration of the Directive which was published on 26 May 2014 was formally presented to the European Council on 20 January 2015. Given that significant amendments have already been made to the last iteration of the draft Directive, it is unlikely that there will be significant revisions from now until publication of the final draft7. Moreover, given that the Directive has received support from the business community across the EU and accords with the minimum protection levels prescribed by the TRIPS Agreement, it is likely that this Directive will be enacted in the near future.
The Directive once enacted is a positive step towards paving the way for harmonizing the protection of trade secrets across the EU. That said, whether the Directive will be successful in better ensuring that trade secrets are protected still remains to be seen. Ultimately, much turns on the implementation of the Directive by the individual member states as well as the level of integration of the Directive with the existing laws in each member state.
In the interim, franchisors should review the contractual protections they have in place with their employees, potential and/or current franchisees and business partners to consider whether their trade secrets are adequately protected in view of the changing practicalities around the handling and dissemination of information.
(C) The People's Republic of China ("PRC")
Despite being a civil law jurisdiction, the definition of trade secrets in PRC which is codified, largely mirrors Article 2 of the EU Directive.
Article 10 of the Anti-Unfair Competition Law ("AUCL") in China defines trade secrets as having these elements:
- technical information and operational information which is not known to the public;
- capable of bringing economic benefits to the rights owners;
- has practical applicability; and
- which the rights owner has undertaken measures to keep secret.
"Information not known to the public" has been interpreted by the PRC Supreme People's Court as information that is unknown to and difficult to obtain by the relevant person in the relevant field. Correspondingly, the Chinese Court has also interpreted limbs (ii) and (iii) of Article 10 of the AUCL to refer to any information which has actual or potential commercial value and can bring competitive advantages to the rights owner.
(D) Common law position in United Kingdom ("UK") and Singapore
In most common law jurisdictions, such as the UK and Singapore, the law on trade secrets is not codified. As such, trade secrets are protected under the law of confidential information.
Case law jurisprudence suggests that information will generally qualify as a trade secret if:-
- it is unique to the business;
- has commercial value;
- has value because it is kept secret (i.e. the information is not common knowledge in the industry, extends beyond the franchisee and/or its employees' current skill set and experience, and that it would be costly, difficult and time-consuming to develop it); and
- has been protected by reasonable security measures, such as having the information kept under "lock and key" conditions.
The following categories of information have also been recognised by the common law courts as trade secrets:-
- Technical/scientific information;
- Manufacturing methods and processes, recipes, formulas;
- Product information and new product development plans;
- Business systems, formats, or methods (including marketing plans and strategic information);
- Occupancy levels, average daily rates, discounting policies, rate levels, longterm contracts, marketing plans and operating expenses in a hotel industry;
- Financial, legal, and human resource information;
- Staff manual, operational manual of the franchise;
- Know-how necessary to operate a particular operation;
- Customer and supplier lists;
- Specially designed computer software and proprietary computer technology; and
- Prospective franchisee information.
In Singapore, the law on trade secret protection is heavily influenced and shaped by English jurisprudence. As such, in line with English law, information will be considered to be protectable as "confidential information" if the following elements are satisfied:
- the information possesses the necessary quality of confidentiality;
- the information must have been imparted or received in circumstances importing an obligation of confidentiality; and
- there must have been an unauthorised use of the information and detriment.8
The Overarching Principles
Based on the foregoing, even if there is no unifying code stipulating the definition of what constitutes a trade secret, there is commonality in the definition as legislated in various jurisdictions. Therefore, the common threads for information to be considered a trade secret can be distilled as follows:
- the relevant information must be secret (i.e. it must not be generally known or be easily accessible by the public); and
- the information must have been subject to reasonable steps by its proprietor to keep it secret.
Once franchisors have identified the aspects of their business that are fundamental and which they wish to protect, it is equally important for potential franchisors to ensure that their secrets remain secret and proprietary to them, even as they expand and grant franchises internationally.
Generally, prevention is the common theme running through all the safeguards discussed below. Once confidential information has been leaked, even if legal measures can be readily taken to restrain further conveyance and use of the information, practically speaking, there is little that the proprietor of the confidential information can do to prevent the information from operating on the minds of those it has been shared with or to salvage any goodwill that may have been lost. Even if the information will not be used in its original form, the unauthorised use of the confidential information might spur innovation that might unjustly enrich the 'unauthorised user' and in turn, might potentially cause detriment to the franchisor's business.
III. Practical safeguards
At the pre-franchise stage, especially in the course of negotiations, it may be inevitable that some confidential information is shared with the potential franchisee in order to entice the potential franchisee into entering the franchising arrangement.
To this end, the franchisor can ensure that any trade secret shared in the course of negotiations will be kept confidential by procuring appropriate Non- Disclosure Agreement(s) ("NDA") prior to commencing negotiations. In addition to the NDA acting as a safeguard to ensure that trade secrets are not disclosed during negotiations, the obligations in the NDA would survive even if negotiations are unsuccessful.
A typical NDA would comprise of the following:
- The laundry list of the types of information that are considered to be confidential;
- The disclosure period (i.e. information not disclosed during the disclosure period is not deemed to be confidential);
- The time period for which confidentiality must be maintained;
- The obligations of the recipient of the confidential information;
- The types of permissible disclosure;
- The consequences of breach of the NDA (i.e. injunctive relief and/or payment of damages); and
- The law and jurisdiction governing the parties.
Apart from an NDA, the relationship between the franchisor and franchisee will typically be governed by the franchise agreement.
In drafting the franchise agreement, care must be taken to define with precision the rights granted to as well as the obligations assumed by the franchisee, including the exclusivity of such rights, the rights to grant sub- franchises and the territorial divide of the rights granted to the franchisee.
It is common to include appropriate safeguards to prohibit the franchisee from sub-licensing, misappropriating or improperly disclosing any of the intellectual property rights to any other person or using, or exploiting them outside of the stated objectives of the franchise and to maintain the obligation of confidentiality at all times.
To ensure that the confidentiality clauses are effective in protecting trade secrets, care must be taken to draft these with precision. In this regard, it is possible for the franchise agreement to envisage 2 levels of confidentiality obligations – one for during the subsistence of the franchise arrangement; and another for posttermination of the franchise agreement.
In respect of the confidentiality obligations post-termination of the franchise agreement, in order to avoid the clause being classified as an unreasonable restraint of trade clause and thus unenforceable, care must be taken to ensure that the period of which the franchisee is obliged to maintain its confidentiality is reasonable and the confidential information which the franchisee is prohibited from disclosing and making use of is defined with precision9.
A review of the jurisprudence on this subject points to the inevitable conclusion that the lack of specificity can be fatal in a claim for breach of confidence, as it is essential for the court to know what information the franchisor is requesting to be restrained, and thereby framing an order to restrain it.10
Apart from the contractual safeguards to protect the franchisor's trade secrets or confidential information, the following is a list of practical steps potential franchisors can take to better safeguard their assets:-
- Conduct an IP audit to identify aspects of its business which the franchisor considers to be information that is integral to its success and which it regards as its trade secrets. During the course of the IP audit, where possible, sequester the confidential information such that it is separated from information which can be ordinarily circulated within the franchisee company.
- Upon completion of the IP audit, the next step is to ensure that the requisite agreements are entered into, including franchise agreements/NDAs/licenses (hereinafter collectively referred to as the "Agreements").
- To optimally protect the franchisors' trade secrets post-termination, there should be appropriate effective post-termination restrictions and confidentiality undertakings that will survive the post-termination of the franchise. These covenants will not only protect the franchisors' trade secrets but will also prevent the franchisee's use of the know-how generated from using those trade secrets for a period of time posttermination. The latter can be achieved by including 'grant back' provisions, where the franchisee and/or relevant entity agrees to grant back to the franchisor improvements in the new technologies, techniques or processes developed by the franchisee, where appropriate.
- As most jurisdictions do not protect trade secrets obtained from reverse engineering, some protection can be accorded to the franchisors in this regard by including covenants in the Agreements prohibiting franchisee and its affiliates, assigns, successors, licensees from obtaining the franchisor's proprietary information through “reverse engineering” (i.e. decompiling or disassembling any materials containing the franchisor's trade secrets/confidential information).11
- As a further measure to ensure that the franchisors' trade secrets will not be exploited, franchisors can consider including "in-term covenants" that prohibit the franchisee's association with or interest in a competing business during the subsistence of the franchise agreement.
- Other "in-term covenants" to protect confidential information can include requiring the franchisee's management to (a) restrict access of confidential information to only the relevant employees and to maintain a clear data log of such personnel and the information accessed; (b) keep the confidential information under "lock and key"; and (c) prevent employees from using cloud storage and their own data storing devices when handling confidential information.
Apart from the above-stated contractual measures, to further protect its trade secrets, the franchisor may want to consider incorporating the following policies to govern the franchise relationship so that the franchisee is required to:-
- Attend regular meetings and/or training sessions to be continually educated and instructed in relation to their responsibilities to maintain the secrecy of the franchisor's confidential information and trade secrets, and the technical skills required of them to safeguard such confidential information in the course of their work (i.e. knowledge on data security);
- uphold a "high security" culture within the franchisee company;
- ensure that all computers and photocopiers/scanners are passwordprotected and encrypt all electronic communications containing or referring to confidential information;
- for employees who work remotely, to ensure that they adhere to the security arrangements for accessing, managing and storage of the franchisor's confidential information; and
- ensure that the materials used in the course of the franchise are shredded regularly and subject to stringent safeguards, and make sure that the information has not been revealed in advertising materials, press releases or on the internet.
IV. Compliance audits
With the requisite contractual safeguards in place, the last step in ensuring effective protection of trade secrets is for franchisors to conduct regular compliance audits.
The right of the franchisor to conduct such compliance audits can be contractually enshrined in the franchise agreement.
The purpose of the compliance audits is to ensure that all the contractual safeguards are being correctly implemented and adhered to by the franchisee and its employees. Pursuant to the outcome of every audit, the franchisor can work together with the franchisee to refine the processes to improve the protection of the trade secrets.
Therefore as the wise traditional adage goes, "prevention is better than cure". Prevention is key in protecting a franchisor’s trade secret. Any trade secret that has been leaked into the public domain could potentially cause irreparable damage to the business. That said, it will be commercially and economically unviable for a franchisor to over-protect its information for fear of any leakage causing irreparable detriment to the business.
As a commercially sensible measure, franchisors should examine their businesses and operators carefully and identify the core information which forms the core of its business model or is integral to its business. It is this information that would warrant protection by the law.
While the uncertainties in this area of law would mean that there is no 'specific formula' to guarantee the preservation of secrets under any circumstances, secrets can remain secret as long as the potential franchisor
- employs the accurate contractual safeguards;
- implements the protection practices as outlined above during the subsistence of the franchise arrangement such as conducting regular compliance audits on its franchisee to ensure that the protection practices are properly implemented and followed and to collaborate with the franchisee to refine processes; and
- takes prompt legal action in the event of breach.
In view of the progress made by the various jurisdictions in seeking harmonization of the trade secret laws or in according greater protection to trade secrets, franchisors should leverage on such a development in the law of trade secrets and assess or re-assess the steps that they may need to take in order to protect their trade secrets. It is our view that a well thought-out contractual framework building from the results of the IP audit and strengthened by regular checks to ensure that the terms of the contract are adhered to would be sufficient to deal with most eventualities stemming.
First published in Asia Franchise & Business Opportunities, the world's only English-Chinese bilingual franchise magazine that is highly popular all over Asia since March 1994.