Restrictive Covenants in Franchise Agreements
Restrictive covenants are very common in all sorts of contracts. Employers will often use them to prevent employees from competing unfairly within a certain period of time following termination of their employment and franchisors will often use them to protect their goodwill and know-how in a franchise territory. The principles that apply to restrictive covenants in both an employment and franchising context are similar.
Restrictive covenants are common both during the term of the franchise agreement and for a limited period following its expiry.
In-term restraints
All restraint of trade provisions that operate during the term of the franchise agreement will usually be valid so long as they relate to the “absorption of the parties services and not their sterilisation”.[1] This will not a difficult test to satisfy: it is common that franchisors require their franchisees to spend all their time developing their franchised business.
Post-termination restrictive covenants
The position with post-termination restrictive covenants is, however, very different from those in-term and the “doctrine of restraint of trade” will apply.
This doctrine means that the starting position with any post-termination restrictive covenant is that it will be void and therefore unenforceable unless the franchisor can demonstrate that they are reasonable to protect a legitimate commercial interest other than simply preventing competition.
Hence, for a clause to be enforceable, it must (a) protect a legitimate interest needing protection and (b) be reasonable.
A franchisor will often seek to demonstrate a legitimate commercial interest to protect by referring to:
- the need to protect against unfair competitive advantage by reason of the franchisee having developed goodwill by use of the franchisor’s intellectual property;
- to protect its know-how and other intellectual property being unfairly exploited.
Neuberger J is often cited by franchisors in the Dyno Rod -v- Reeve case, in which he said:
“The [claimant franchisor] is anxious to protect its business with the area. In that connection, that the [franchise agreement] is [over], the [claimant] wishes to enter into a new arrangement with a fresh franchisee. The [claimant’s] primary concern in seeking [an injunction] is to protect its goodwill in the area and to protect its ability to enter into a fresh arrangement for such incoming franchisee and, indeed to find such an incoming franchisee …
It is obvious that the [claimant franchisor] will be likely … to have far greater difficulty in attracting a new franchisee if the [old franchisee] is known as Dyno Rod franchisee with all the Dyno Rod experience and contacts and is operating in the territory. A new franchisee has the benefit of considerable investment by the [claimant franchisor] which puts the [former franchisee] in a better position than others. Provides that it is reasonable in terms of the public interest and not unfair to the [former franchisee] in terms of time or area, the [claimant franchisor] is entitled … to ensure that his investments are protected by ensuring that unfair advantage is not taken by a [former franchisee] by for example prematurely determining the franchise agreement and setting out on his own.”
So what does a reasonable restrictive covenant look like?
There is no one size fits all approach to this issue. Much will depend upon the facts of any individual case, but it is not uncommon to see franchise agreements contain covenants restricting operation within the former franchise territory for a period of 12 months. That duration and geographical scope is likely to be reasonable.
Considerable arguments can arise on the scope and interpretation of restrictive covenants.
A leading case in relation to the scope of application of restrictive covenants in franchise agreements is Carewatch Care Services Limited -v- Focus Caring Services Limited and Others. In this case, the High Court gave guidance on what may be considered to be reasonable. As a significant provider of care services throughout the United Kingdom, Carewatch owned both its own branches and licensed its system for use by many franchisees.
In this case, the restrictive covenants restrained the franchisee for a period of 12 months from being engaged in, employed by, concerned or interested (directly or indirectly) in any business that competes with the franchisor’s business or the former franchisee’s business together with other similar restraints.
The Court held that these restrictions were entirely reasonable given the legitimate commercial interests of the franchisor, which had operations throughout the UK, not least of which is to protect its goodwill, confidential information, know-how and contacts with employees and customers of the business.
However, many other questions need to be considered to work out whether restrictive covenants are likely to be enforceable. Consider, for example, who owns the goodwill, what is the know-how for which protection is sought, has the operations manual been updated sufficiently regularly with ongoing support or training being provided as to justify the protection claimed by the franchisor? Then, consider whether the wording of the restrictions take the clause of out the requirements of reasonableness, such as, do they apply for too long, too far across the country and outside of the former franchise territory, do the definitions in the franchise agreement cause the clause to fail by virtue of its scope?
It is important for franchisors and franchisees alike to take specialist advice from franchise litigation solicitors familiar with franchise disputes, before seeking to enforce, or even resist the enforcement of, restrictive covenants in franchise agreements. Considerable costs can quickly be incurred if the wrong moves are made early on and special considerations apply to the grant of interim injunctive relief by the courts which is often where these issues are first aired between franchisor and franchisee.
For further information, please contact Craig Kelly at craig.kelly@csklegal.co.uk.
[1] Per Lord Pearce in Esso Petroleum Co Ltd -v- Harpers Garage (Stourport) Ltd [1967] 1 All ER 699
