Legal Challenges to Restraint of Trade Clauses in Franchising: What Franchisees Need to Know
Restraint of trade clauses are common in franchise agreements and are designed to protect the...
Restraint of trade clauses are included in franchise agreements to stop the franchisee from competing with the franchisor, during the term of the franchise agreement, and after the franchise agreement ends.
A restraint of trade clause will not necessarily apply or be enforceable. Consequently franchise disputes often arise over the enforcement of restraints.
Contents
Restraint of Trade has no effect - clause 23 Franchising Code
Restraints are generally contrary to public policy
What is a Legitimate Interest?
Restraints not necessarily enforceable
Clause 23 of the Franchising Code of Conduct (the Franchising Code) sets out a series of circumstances in which a restraint of trade clause contained in a franchise agreement has no effect after the franchise agreement expires. That is, in certain circumstances, after the franchise agreement expires, the franchisor cannot stop the franchisee from competing with the franchisor.
Broadly, the franchise agreement must have expired and the franchise agreement must not allow the franchisee to seek compensation for goodwill, or alternatively, if the franchise agreement allows the franchisee to seek compensation for goodwill, the compensation must be inadequate.
There are further conditions which we have set out in our factsheet.
However, even if a restraint clause is not deemed to be ineffective by virtue of clause 23 of the Franchising Code of Conduct it may still be unenforceable.
Except for franchise agreements where New South Wales law is applicable, restraints of trade are contrary to public policy and void unless they can be justified as being reasonable. In New South Wales the Courts can determine what would be reasonable in the circumstances (and read down the restraint of trade clause so that it is reasonable).
“Reasonable” in this context means that the restraint provides no more than adequate protection to the person seeking to enforce the restraint. The reasonableness of the restraint is determined at the date of entry into the franchise agreement.
This means that if a franchisor wishes to stop a franchisee from competing with the franchisor (ie the franchisor wishes to enforce the restraint clause) the franchisor would need to convince a Court that at the date that the franchise agreement was entered into, the restraint of trade clause was reasonable and necessary to protect the franchisor's "legitimate interests".
At the same time, a restraint of trade clause cannot be against the public interest.
In order to assess whether the restraint provides “no more than adequate protection” the Court must first assess what the legitimate interest is that the restraint clause is trying to protect.
Examples of a legitimate interest which can be protected include goodwill, customers and confidential information.
While a franchise agreement may list one or more of goodwill, customers or confidential information as a legitimate interest, a Court will make its own assessment of whether there is a legitimate interest to protect.
We have set out below a number of cases where the Court held that there was no legitimate interest to protect and accordingly the relevant restraint of trade clause was not enforceable.
In this case the franchise agreement was terminated after the franchisee had operated the franchise business for a year and a half. The franchisee (using a different corporate entity), immediately commenced operating a similar business from the same premises. The franchisor sought to enforce the restraint of trade clause in the franchise agreement.
The restraint of trade clause:
The franchise agreement also contained provisions dealing with the confidentiality of the franchisor's information and the protection of the franchisor's intellectual property on termination of the franchise agreement. The franchisee had complied with these provisions.
The Court found that it was not reasonable for the franchisor to enforce the restraint of trade provisions given that:
In this case the franchisees operated Blockbuster video/dvd stores in Noosaville and Nambour in Queensland for a period of approximately 10 years. After the respective Blockbuster franchise agreements expired, the franchisees continued to operate the businesses under a different name.
Relevantly, the franchisees had prior to their entry into the Blockbuster franchise agreements, operated video stores under a different brand at each of the franchised locations.
Blockbuster did not purchase the goodwill in these businesses when the franchisees entered into the Blockbuster franchise agreements.
After the Blockbuster franchise agreements expired, the franchisor tried to stop the franchisees from operating the businesses and sought to enforce the restraint of trade clauses included in the respective franchise agreements.
The franchisor indicated that the legitimate interest that it was seeking to protect through the respective restraint of trade clauses was "goodwill".
The Court made an assessment of the goodwill owned by each of the franchisees and the franchisor in the businesses at the date that the franchise agreements were entered into. While the franchisees had significant goodwill in the businesses (as the businesses had already been operating under a different brand), the only goodwill that the franchisor had at the time that the parties entered into the agreements was the goodwill in the "Blockbuster" brand (the franchisor had not purchased the franchisee's goodwill). However, the goodwill in the "Blockbuster" brand existed independently of the businesses. Consequently, at the date that the franchise agreements were entered into, the franchisor had no legitimate interest to protect.
The Court also found that to the extent that during the currency of the franchise agreements the parties expected Blockbuster to acquire goodwill in connection with the businesses as a result of the use of the Blockbuster Systems in the businesses, Blockbuster further had no legitimate interest to protect because the franchisees could not use any part of the Blockbuster System after the expiry of the franchise agreements.
If there is a legitimate interest to protect, the Court will then assess whether the restraint provides no more than reasonable protection.
Whether a restraint of trade is reasonable is usually considered by looking at:
If a restraint of trade clause is drafted too widely, or if there is another way to protect the interests of the party trying to enforce the restraint of trade clause, the clause may not be enforceable.
A cascading provision is a provision which includes a number of alternatives, usually in relation to time (eg 2 years, 1 year, 6 months) and area (eg Australia, State, Territory).
It is common to see cascading provisions included in restraint of trade clauses.
The idea of a cascading provison is that those parts of the restraint clause that are considered to be unreasonable because the time period is too long or the area is too large are severed (deleted) from the clause.
However, just because a restraint of trade clause is read down to the shortest time period and the smallest area, does not mean that it will automatically be valid.
The restraint was a cascading clause providing that the franchisee could not operate a similar business, within the franchisee's territory or within a 5 km radius of the franchisee's territory, or within the territory of another franchisee, or within a 5km radius of that territory.
The smallest area covered by the restraint was the franchisee's territory. The franchisee's territory was a large area which was sparsely populated.
The Court found that there was no evidence that the franchisee was known in large parts of the territory and found that the geographical area of the restraint was too wide.
The restraint was unenforceable and the franchisee was allowed to operate a competing business.
In New South Wales it is not strictly correct to say that a restraint is against public policy and void. As a result of the Restraint of Trade Act 1976 a restraint is valid to the extent that it is not against public policy.
In New South Wales, in order to determine whether the restraint is valid, the actual alleged breach is considered, rather than the restraint of trade clause as a whole.
If the alleged breach is not against public policy, the Supreme Court has the power to "read down" the restraint of trade clause, in certain circumstances if the clause is not reasonable.
The Court considered certain principles to be applied when considering whether a restraint of trade clause is valid:
As can be seen restraint of trade clauses are complex. Just because a franchise agreement contains a restraint of trade clause does not mean that the clause will apply or will be enforceable.
When drafting a restraint of trade clause the particular circumstances of the franchise system must be considered. Standard clauses are unlikely to be enforced by a Court.
Disclaimer
The information in this article is general in nature and is not intended to address the circumstances of any person or other entity. Although we do our best to provide timely and accurate information, we do not guarantee that the information in this article is accurate or that it will continue to be accurate in the future.
Restraint of trade clauses are common in franchise agreements and are designed to protect the...
Copyright © 2021 Haarsma Lawyers