Restraint of trade covenants are commonly included in franchise agreements to protect the goodwill associated with a franchise system, and the franchisor’s brand.
There is a widely held view amongst franchisors that restraint clauses will be enforced by courts as a matter of right. Unfortunately this is not the case. Additionally, in the light of recent case law it is important for franchisors to recognise the limitations of restraint clauses, and to take these into consideration both during drafting and when seeking to enforce them. This short article highlights some of the learning of the Madgwicks Franchising team in this tricky area.
Generally speaking, restraint clauses seek to prevent current and former franchisees from conducting business in competition with the franchise during the term of and for a period of time following the expiration of the franchise agreement. Most restraint clauses impose this obligation within a particular geographical area and for a specified period of time.
What many franchisors do not realise, is that courts approach restraint clauses on the basis that they are unenforceable. A court will not enforce a clause that is considered anticompetitive, or restricts someone’s ability to legitimately derive income from their chosen profession. However, a reasonable restraint will be enforceable. For a restraint to be reasonable; “it must afford no more protection than adequate protection to the party in whose favour it is imposed” (Herbert Morris Ltd v Saxelby  1 AC 688 at 707). In other words, if there is another way of protecting the franchisor’s interests, or the clause goes beyond what is reasonable to protect those interests, it is unlikely that the restraint will be upheld.
Onus of proof
The burden will be on a franchisor seeking to enforce a restraint clause to demonstrate to the court that the restraint is reasonable. As well as considering whether a particular restraint clause is reasonable, a court will also look at the interests of the parties to the franchise agreement, and the interests of the public, in order to determine whether the restraint is enforceable.
Legitimate interest to protect?
In order to enforce a restraint provision, the franchisor must demonstrate that it has a legitimate interest to protect. Accordingly when drafting the restraint, consideration must be given to the nature of the interest that the franchisor is seeking to protect.
For example, where a franchise agreement contains other clauses designed to protect the franchisor’s intellectual property, a restraint clause designed to protect intellectual property alone is unlikely to be held to be reasonable. The case of EzyDVD Pty Ltd v Lahrs Investments Qld Pty Ltd & Ors illustrates this point.
In EzyDVD, the franchisor sought to enforce a restraint provision following the expiration of a franchise. After the licence ended, the sole director of the former franchisee commenced operation as a new retail DVD business under a different name, but from the same premises.
The court considered that because the agreement itself provided a comprehensive level of protection for the franchisor in relation to its IP and confidential information (and the clauses relating to the delivery up of that material had been complied with by the franchisee), the restraint clause was not reasonably required to protect the franchisor from the possibility of the franchisee’s use of the confidential information. This was particularly so as the court considered that whatever confidential information was retained by the franchisee would be retained on a short-term basis, and was unlikely to be used in the new business. The court found that the clause was invalid as it was unreasonable.
In the EzyDVD case the wording of the particular restraint clause was also problematic, as it referred to the protection of IP and confidential information, but not goodwill. Had the restraint referred specifically to the protection of the franchisor’s goodwill, the result may well have been different.
By contrast, the earlier case of Raine & Horne Pty Ltd v Adacol Pty Ltd & Ors illustrates that the courts may be willing to uphold a restraint clause where the clause is designed to protect the franchisor’s goodwill, and significant goodwill has been built up in the franchised business over a period of years, notwithstanding that the goodwill has been contributed to by a former franchisee. In this case, the franchisor terminated the franchise agreement after the franchisee converted its office to a Ray White franchise and then continued to operate a real estate business from the same premises. The court held that the franchisor had an interest in the franchise itself, over and above the revenue it derived from it. The court recognised that this interest included the right at the end of the franchise agreement to enter into a new franchise agreement with a new franchisee to take over the existing territory.
The court was of the view that the franchisor had the right to exercise this ability without having to do so in the face of competition from the former franchisee operating as a Ray White franchisee from the same site.
However the 2009 case of BB Australia Pty Ltd (Blockbuster) v Karioi Pty Ltd NSWSC 1089 took a much more restrictive approach. In this case, after converting his two privately owned video stores to Blockbuster franchises, Karioi de-branded the stores on expiration of the term of the franchise agreement and continued to operate from the same premises.
The court held that given that the franchisee had operated a video rental business from the premises prior to becoming a Blockbuster franchisee, there was insufficient goodwill in the site attributable to the franchisor to support the restraint. The court took the view that due to the adequate protection of the franchisor’s intellectual property afforded by other clauses in the franchise agreement, the protection of the intellectual property was not a legitimate interest that needed to be protected by the restraint.
Recent cases where franchisors have sought to enforce restraint provisions such as the Blockbuster case and others have demonstrated the increasingly narrow approach that courts have taken towards upholding restraints. It is clear that if there is not a legitimate interest to protect or the franchisor interests are adequately protected by other means, the court will be reluctant to enforce the restraint provisions. In order to avoid having to rely upon restraint provisions that may ultimately turn out to be very costly and difficult to enforce, we strongly recommend that franchisors look first to other commercial and legal avenues to protect their interests.
- smart system design that is difficult to replicate;
- low cost supply chains and efficiencies of scale making it difficult for others to compete commercially;
- ensuring that the intellectual property in the system and the brand is unique and properly identified and protected other than by way of restraints; and
- maintaining control over the business site where the franchisor does not hold the lease via a step in rights with the lessor.
If on the other hand it is the intention to rely upon restraint provisions they require careful consideration and drafting from the very outset if they are to have any chance of being effective.
Madgwicks’ Franchising team has experience across a variety of franchise industries representing both franchisors and franchisees.