When a franchise relationship comes to an end and the Franchise Agreement is terminated (amicably or otherwise), one common area of dispute is over the enforceability of the post-termination restrictions in the Franchise Agreement.
The rationale behind restrictive covenants
The purpose of a post-termination restrictive covenant in a Franchise Agreement is to protect the legitimate goodwill of the franchisor. During the term of the Franchise Agreement, the franchisor will have provided the franchisee with confidential know-how and assistance. Therefore, the purpose of a post-termination restrictive covenant is to prevent the ex-franchisee from using that know-how for the benefit of the franchisor’s competitors (including the ex-franchisee) after the termination of the Franchise Agreement.
However, one of the key requirements of a post-termination restrictive covenant is that, in order to be legally enforceable, the proposed restraint on trade must be no wider than is “reasonable” to protect the franchisor’s legitimate interest. Even if only part of a restrictive covenant is considered to be “unreasonable”, the whole restrictive covenant will be unenforceable unless the “unreasonable” part can be severed from the rest of the restrictive covenant.
Perhaps unsurprisingly, because this is such a fact-specific issue, disputes over the enforceability of post-termination restrictive covenants in Franchise Agreements often end up in Court.
Dwyer (UK Franchising) Ltd v Fredbar Ltd
One of the most important recent cases on these issues was Dwyer (UK Franchising) Ltd v Fredbar Ltd. The case was initially considered by the High Court, and although it found in favour of the franchisor in relation to several issues relating to the early termination of the ten-year Franchise Agreement, the most interesting part of the High Court’s judgment arguably related to the dispute over the enforceability of the post-termination restrictive covenants.
In essence, the disputed restrictive covenants stated that the franchisee could not, for a period of one year following the termination of the Franchise Agreement:
- be involved in any business similar to, or competing against, “the Drain Doctor Business” in either:
- the franchise territory (which in this case was Cardiff), or,
- a five-mile radius of the territory.
The term “the Drain Doctor Business” was (quite surprisingly) not expressly defined anywhere in the Franchise Agreement, and so first of all, the High Court had to determine how that term should be interpreted. On this point, the High Court ruled that, in the context of the restrictive covenants, the term “the Drain Doctor Business” should be interpreted as meaning the business of “plumbing and drainage”.
This interpretation in turn meant that the restrictive covenants sought to prevent the ex-franchisee from having any involvement in any “plumbing and drainage” business in Cardiff, or within five miles of Cardiff, without exception. This would mean that the restrictive covenants prevented the ex-franchisee from even acting as a subcontractor or employee of any other “plumbing and drainage” business within the relevant area, even when any such sub-contracting and/or employment would have no detrimental effect on the franchisor’s protected goodwill.
On that basis, the High Court ruled that the restrictive covenants were unreasonable in the circumstances, especially as they seriously increased the risk that the ex-franchisee would become unemployed if the Franchise Agreement was terminated, thereby depriving him and his family of its primary source of income.
The High Court added that not only was the scope of the restrictive covenants unreasonable (as it went beyond what was “reasonable” to protect the franchisor’s interest), but the geographic extension of the restrictive covenants to a five-mile radius beyond the franchise territory was also itself an “unreasonable” radius. Specifically, because the franchisee has never provided the franchise services outside of the franchise territory, there was no goodwill within that extended radius for the franchisor to reasonably protect.
As this was not a case where the High Court considered that it was possible to sever the “unreasonable” parts of the restrictive covenants from the reasonable parts, the High Court ruled that the restrictive covenants were entirely unenforceable.
The Court of Appeal
The franchisor then appealed the High Court’s decision to the Court of Appeal, but the Court of Appeal upheld the High Court’s earlier decision and reaffirmed that the restrictive covenants were unenforceable.
In addition to the comments previously made by the High Court, the Court of Appeal also noted that the duration of the restrictive covenants (i.e. a period of one year from the date of termination of the Franchise Agreement) was itself an “unreasonable” duration, as it was longer than was “reasonably” necessary to protect the franchisor’s legitimate interests.
The Court of Appeal also clarified that the “inequality of bargaining power between the [parties] is not only relevant, but is a significant factor in determining reasonableness”. Given that in this case the franchisor had significantly more contractual bargaining power than the franchisee at the time that the Franchise Agreement was signed, it was another significant factor that the Court of Appeal took into account in finding that the restrictive covenants were “unreasonable”.
The Court of Appeal also noted that the restrictive covenants did not distinguish between a case of early termination of the Franchise Agreement, and the situation if the Franchise Agreement had run for the full intended ten-year term. In the present case, the Franchise Agreement had been terminated early (after only around 18 months of operation), and so the actual loss of commercial goodwill was negligible.
Lessons to be learned
While this case, like most disputes over restrictive covenants, is very fact-specific, there are still a number of lessons that can be learned from both the High Court’s and the Court of Appeal’s judgments.
Firstly, because the restrictive covenants did not expressly define the precise nature of the work it was restricting (because the term “the Drain Doctor Business” was not defined anywhere), it left it open for the Courts to rule that it covered any and all “plumbing and drainage” businesses. If the restrictive covenants had attempted to narrow the scope of the work they sought to restrict to only what was “reasonable” to protect the franchisor’s interest, then the restrictive covenants may have potentially been considered enforceable.
Similarly, if the restrictive covenants had not been drafted so widely (so that (a) they prevented the ex-franchisee from acting as a subcontractor or employee, and (b) they applied for a full year following termination, in circumstances where both of these restrictions went beyond what was reasonably required to protect the franchisor’s goodwill), then the Court may have considered the restriction to be reasonable.
Equally, when considering issues such as the geographic scope of a restrictive covenant, this case makes it clear that you should consider whether or not the franchisor actually has any goodwill to protect (for example, either within an extended radius, or if there has been an early termination of the Franchise Agreement after a relatively short time), bearing in mind that restrictive covenants will only be enforceable when they are no wider than is “reasonable” to protect the franchisor’s legitimate goodwill.
As the High Court judge commented in the Dwyer case:
“These [restrictive covenants] do not strike a reasonable balance between the freedom to contract and the freedom of trade. They are far more extensive than was required to provide reasonable protection”.
These principles will continue to determine any further cases that reach the Courts over the enforceability of any such restrictive covenants.
Lord Justice Arnold in the Court of Appeal also reinforced the fact that each franchise relationship has to be considered on its own facts:
“It is inescapable, however, that not all potential franchisees are equal … Given that inequality of bargaining power is not merely relevant but significant, a franchisor … must proceed accordingly. [The franchisor] did not have to take on [the franchisee]. Even if it did, it did not have to impose its standard form of agreement upon him. Even if it wanted to impose a standard form of agreement, it did not have to have a ‘one-size-fits-all’ restrictive covenant”.
The clear message from the Court of Appeal, therefore, is that franchisors should give real consideration to the restrictive covenants that they seek to impose on a specific franchisee, rather than simply adopt a ‘one-size-fits-all’ approach.
If you need advice in relation to the drafting of post-termination restrictive covenants in franchise agreements, or if you are involved in a dispute over the interpretation or enforcement of the same, our specialist franchise disputes team can assist you.
For more information on this or any other issue relating to franchise disputes, please contact Michael Axe by emailing Michael or by calling him on +44 (0)1628 502448.
This article is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from taking any action as a result of the contents of this article.