Game Over for Restrictive Covenants?
On the 30th June 2022 the Court of Appeal handed down its judgment in the Dwyer (UK Franchising) Limited v Fredbar Limited and Shaun Bartlett ( EWCA Civ 889) – a judgment that was awaited with bated breath by the franchising community. Here, Natalia Shvarts explains the enforceability of restrictive covenants and questions the future of franchising as we know it.
The reason that this case stirred up so much interest is because the appeal was all about the enforceability of the restrictive covenants – namely the clause that prohibits the ex-franchisee from operating identical or similar business within the same territory following the termination of the agreement.
The accepted norm is that restraint of trade clauses or restrictive covenants, as they are more commonly known, are considered to be contrary to public policy and as such, the burden of proof is on the party seeking to rely on such clauses to show that the clauses are necessary to protect their legitimate interests and extend no further than is reasonably necessary to achieve that purpose.
The judge in the first instance concluded that in Mr Bartlett’s specific case, given the circumstances, the restrictive covenants in his franchise agreement went much further than was necessary and as such were unreasonable and therefore unenforceable. The Franchisor appealed against the decision.
On appeal, the judge upheld the original decision that the restrictive covenants were unreasonable and therefore unenforceable.
So is this “the end of franchising” as we know it? Do we need to start re-writing franchise agreements and what does this judgment mean for franchisors?
Whilst, at a glance, franchisors may be tempted to panic, I actually think that this judgment could be helpful both to franchisors and the franchise industry as a whole.
In summing up, the judge emphasised that his decision was down to the specific circumstances of this particular case and that it does not follow that all restrictive covenants are unreasonable and unenforceable. In fact, the judge went on to add that had the circumstances been different, the outcome could have been different. This is indeed very helpful because we now have some clear examples of the factors that the court is likely to consider when assessing if a restraint is reasonable or unreasonable.
Whilst there is no magic formula according to the judge in this case, if a franchisor is seeking to use restrictive covenants to stop its former franchisee from competing with it after termination, the franchisor may wish to consider the following aspects:
How long was the ex-franchisee operating as a franchisee? If the franchisee has only been operating a short time, then they are less likely to present a real risk to the franchisor as compared against an ex-franchisee who may have operated for 5 or more years and is likely to know the system much better!
Reason for termination – although this was not a factor cited by the judge, this is a useful point to consider as it links to the logic above. If the franchise agreement was terminated because the franchisee was not performing, perhaps there was a competency issue, then, again such franchisee is less likely to constitute a real risk and would simply be yet another minor competitor.
Trading history of the territory and location of the neighbours. To what extent was the brand known within the territory where the ex-franchisee was operating prior to that ex-franchisee starting to trade? Were there any existing customers within the territory and how far is the nearest neighbouring franchisee located? In this case, the nearest neighbour was almost 40 miles away across the Cardiff bay – so geography will also play a part – and whilst the judge accepted that the franchisor had national reputation and therefore has some goodwill within the territory, such goodwill was only limited. This might be different if there were multiple close neighbours who would be affected by the ex-franchisee becoming a competitor.
Absence of legal advice was raised yet again as a point. This is something that franchisors can very easily address by reviewing their recruitment practices. Not only should prospective franchisees be given sufficient time to consider the terms of the franchise agreement but they should be strongly encouraged to obtain expert legal advice.
Character and nature of the business – if this is a business which is fast moving or if the franchisor has introduced significant changes to its system since the franchise agreement was terminated (meaning that the ex-franchisee would not have access to the new/updated information) then this would indicate that the ex-franchisee is less of a threat. Namely, what is the shelf life of your business secrets and know-how?
Ability and capability of the ex-franchisee – in this case the judge emphasised the point that during the initial training the franchisor had identified that the franchisee was struggling and needed more support than others. The judge went as far as concluding that the franchisor should have seriously considered at that stage whether it should have terminated the franchise agreement at that point as it seemed that perhaps the franchisee was unsuitable yet franchisor did not do so. In not doing so, the franchisor should have been aware that the risk of this franchisee failing was greater.
Legitimate interest – what is the franchisor’s legitimate interest and specifically what is the damage being done by the actions of the ex-franchisee?
This will be a balancing exercise for a franchisor and the outcome in each case may be different depending on which was the scales are balanced. And as such, this is not about restrictive covenants being “pointless” (although they must be drafted properly in the first instance and there are perhaps improvements to wording that can be introduced as a result of this judgment) but this is more about their application and the franchisor’s and franchisee’s conduct.
Whether to pursue or not to pursue a franchisee or ex-franchisee should be a decision that is made after carefully considering the risks involved. Ultimately just because you have the right to sue, doesn’t mean you should choose to do so.
In summary, this is not the end of restrictive covenants but an opportunity for franchisors to review their practices. The wording of the franchise agreement can be adjusted to improve the franchisor’s chances of the successfully enforcing its restrictive covenants but equally important will be how the franchisor acts in practice that will determine the success of the outcome.
By Natalia Shvarts