Franchising – Restrictive Covenants

What are they?

When a franchisor and franchisee set off on a new relationship, the franchisor will wish to ensure that its business interests are fully protected should the relationship sour for any reason.  Accordingly, a well prepared franchisor will have a franchise agreement which contains a number of different forms of restrictive covenant.  Such a covenant would restrict the franchisee’s activities in some way.  They might, for example, prevent a franchisee from being involved in other businesses, from setting up in competition,  from soliciting business of existing of former customers.

As might be apparent from the above examples, there are two main forms of “restrictive covenant”: (a) those which apply during the term of the franchise agreement, and (b) those which expire at the end of the term of the franchise agreement.  Typically, when discussing restrictive covenants, the latter is usually the form referred to.

Restrictive covenants are incredibly common, not only in franchising, but in distributorship, agency, and other forms of commercial agreement.  Indeed, they are particularly common in employment contracts, especially for more senior members of staff that have access to confidential information.

Are they enforceable?

The short answer is – sometimes.

Insofar as those covenants which fall into the former class, i.e. those which continue during the terms of the franchise agreement, they tend often to be enforceable.  Any difficult in enforcing restrictive covenants of this nature tend to arise in connection with their application post-termination, and this is what this article focuses upon.

There are two key sources of law in relation to post-termination restraints.

European Law

EU (and English) competition law prevents an agreement which has, as its object or effect, the restriction of competition which may affect intra-community trade.  The EU and the English positions are principally the same in this respect.

Post-termination restrictive covenants are outside of the prohibition on restrictive agreements under EU competition law so long as the covenants are essential for the protection of know-how and assistance provided to the franchisee by the franchisor.

There is a useful analysis of the principles derived from the ECJ’s decision in Pronuptia in High Court’s decision of Pirtek (UK) Limited -v- Joinplace Limited (t/a Pirtek Darlington).  It may be therefore that a franchisng arrangement that has no know-how and assistance to protect would result in these covenants being unenforceable unless they are able to take the benefit of the so called de minimis provisions or the vertical restrains block exception.  Generally, where the market shares of the franchisor and franchisee are each 15% or less, provided agreement contains no “hard core” restrictions relating to pricing, territorial or resale terms, the de minimis provisions are likely to apply.  As to the Block Exemption, this exempts franchise agreements so long as the neither the franchisor nor the franchisee has a market share of more than 30%, again, so long as there are no so-called “hard core” restraints.

Domestic Law

Under English law, restrictive covenants must be reasonable if the court is to expected to enforce them.  As a matter of public policy, in any type of contract, a clause which seeks to restrain trade unreasonably is unenforceable.  The starting position is that the clause is unenforceable unless those seeking to rely on it demonstrate its reasonableness.

In order to be reasonable, and thus enforceable, the following must apply:

i.  the restraint must serve to protect a legitimate interest of the franchisor;

ii.  the restraint must be reasonable to protect that interest, in that it must be:

• for a reasonable duration only;
• for a reasonable geographic location; and
• cover only those activities which are reasonably necessary.

Clauses which do not comply with any of the above are likely to be unenforceable.

What would a Court do?

Specialist advice should always be sought as no two cases are ever the same.

In Chipsaway International Limited -v- Kerr [2009] the Court enforced a post-termination restraint in a franchise agreement on the basis that the 12 months restriction was entirely reasonable in the circumstances to protect the franchisor’s goodwill and know-how.  Additionally, the court concluded that the franchisor had a legitimate interest to protect by preventing competition within a territory to provide it with an opportunity to re-sell the area without the hindrance of competition for a limited period.

Restrictive covenants are much more likely to be enforceable if limited to the franchise territory in which the franchisee marketed and carried on its business.  The wider the geographical scope of the case, the more unlikely the court will be to enforce it.  A good example of this can be seen in Kall Kwik Printing (UK) Limited -v- Rush [1996], where the court enforced a restraint within 10 miles of the franchisee’s premises, but refused a wider national restraint.

The onus is always on the franchisor to show that the provisions are reasonable and necessary.  Where there is an inability to do that, they will fail to be enforceable.