Restraint of Trade Clauses in Franchise Agreements

Restraint of Trade Clauses

Franchise agreements will nearly always contain a restraint of trade or non-competition clause which operates 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.

In this article we consider some of the factors which are important in considering whether a restraint is likely to apply.

Restraint of Trade Clause has no effect

Clause 23 of the Franchising Code of Coduct sets out a series of circumstances in which a restraint of trade clause contained in a franchise agreement has no effect after the agreement expires.

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. For a copy of our factsheet click here.

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.

Restraints are generally contrary to public policy

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. “Reasonable” in this context means that the restraint provides no more than adequate protection to the person seeking to enforce the restraint. At the same time, a restraint of trade clause cannot be against the public interest.

What is a Legitimate 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.

Case Study – BB Australia Pty Ltd (Blockbuster) v Karioi Pty Ltd [2010] NSWCA 347

The franchisee had two video stores which it converted to Blockbuster franchises. When the franchise agreements ended, the franchisee de-badged and continued to operate independent video stores. Blockbuster tried to enforce the restraint of trade clauses in the franchise agreement. The Court held that because the franchisee already had goodwill in the stores prior to entering into franchise agreements with Blockbuster, Blockbuster did not have sufficient goodwill in the stores to warrant protection. The Court also decided that Blockbuster’s intellectual property was sufficiently protected by other clauses in the franchise agreement.

Case Study – EzyDVD Pty Ltd v Lahrs Investments Qld Pty Ltd & Ors [2009] QSC 227

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:

  • provided that the franchisee would be restrained from operating a similar business for 6 months after the termination of the franchise agreement within a radius of 5 km from the franchise business premises, and 1km from any other EzyDVD store.
  • stated that the purpose of the restraint was to protect the confidential information and intellectual property provided by the franchisor to the franchisee during the course of the franchised business.

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:

  • the restraint provisions identified that the purpose of the restraint was to protect the franchisor’s confidential information and intellectual property, and
  • the franchisee had already complied with the provisions contained in the franchise agreement dealing with the confidentiality of the franchisor’s information and the protection of the franchisor’s intellectual property.

What is Reasonable?

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:

1-the scope of the activity restrained,

Any restriction should be limited to the scope of the franchised activity. For example, if the franchisee operated a noodle bar franchise, a restraint which applies to “operating a restaurant” or “operating a cafe” is likely to be invalid.

2-the geographical area covered,

The geographical area should not be larger than necessary to protect the legitimate interest. For example, if the legitimate interest to be protected is the goodwill of the franchise business, then the area in which the franchise business was operated will be relevant to a consideration of what is reasonable.

3-the duration of the restraint.

If the legitimate interest includes the protection of goodwill or customers, the Court may consider whether the restraint period allows a sufficient time for the new franchisee to establish a relationship with the customers of the business.

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.

Cascading Provisions

It is common to see cascading provisions included in restraint of trade clauses. 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).

The idea of a cascading provison is that those parts of the 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.

Case Study – Murray Pest Management Pty Ltd V A & J Bilske Pty Ltd [2012] NTSC 05

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.

New South Wales Position

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.

Case Study – Hunter v Koulouris [2011] NSWSC 887

The Court considered certain principles to be applied when considering whether a restraint of trade clause is valid:

The reasonableness and validity should be assessed at the time of entry into the contract.

A restraint will be more favourably regarded in the case of a sale of a business and its goodwill than an employee/employer relationship.

The Court gives considerable weight to what parties have negotiated and included in their agreements, but a clause stating that the restraint is reasonable is not conclusive.

Restraints not necessarily enforceable

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.

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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.

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