Restrictive Covenants – What next?

 The Judgment of the Court of Appeal in Dwyer (UK Franchising) Limited -v- Fredbar Limited & Shaun Bartlett  is causing questions to be asked throughout the franchising community.  Given the same Court’s decisions in two other recent cases (Quantum Advisory) and, a week before the Dwyer judgment, the case of Credico, the decision is not surprising.

The three Judgments need to be read together to understand the impact on franchising because all are consistent with the direction of travel that the Court of Appeal have taken the concept of restraint of trade provisions.  Quantum Advisory dealt with a complex restructuring of companies within a group and the business that was operated.  Credico involved a direct marketing company seeking to enforce in-term and post-termination restrictive covenants against its former agent.  As we know, Dwyer dealt with the Drain Doctor franchisee who flipped the signs after wrongly attempting to terminate a franchise agreement.  The Court in Dwyer stated that franchising is not a ‘special case’.  It’s decision to reject the enforceability of a one-year post-termination covenant was based on the individual facts of that franchisor, that franchisee and that franchise agreement.  But there will be principles from Dwyer, Quantum and Credico which impact franchisors’ decisions about when they could seek an injunction to restrain trade post-termination and how such clauses should be drafted in future.

Restraint of Trade

 Before considering the specific details of the Dwyer case it is useful to remind ourselves of the well-established principles unaffected by the recent three cases.

All covenants (contractual promises) in restraint of trade are, as a starting point, unenforceable at common law, and are enforceable if they are reasonable with reference to the interests of the parties concerned and of the public.  That doctrine can apply to restraints operating during the period of the contract as well as post-termination, although such covenants that apply during the duration of the contract are far less likely to be challenged.

The doctrine of restraint of trade gives rise to two tensions:- the freedom to contract and the freedom to trade.  To what extent parties, otherwise free to trade, are able to restrict themselves from doing so is a question the courts have long had to deal with, where the ability or right to trade (through a business arrangement or employment contract), comes with conditions that restrain competitive activity.

The key is what is reasonable between the parties, which involves an analysis of what is reasonable for the franchisor but also the franchisee.

Up to now, franchise lawyers have focussed on the franchisor’s position, knowing that a restrictive covenant should go no further than is reasonably required to protect the franchisor’s legitimate business interests.

Those business interests are the preservation of knowhow, the preservation of confidential information and the protection of goodwill, usually being goodwill in the brand and with customers built up in a franchisee’s territory by them through operating the franchise (although it can also include previous goodwill prior to the franchisee taking over the territory and wider reputation).

The Franchisor’s Perspective

 Up until Dwyer, recent published decisions, most of which were in relation to interim injunctions, where there may have been less judicial scrutiny, dealt with franchisors seeking to enforce a one-year post-termination restrictive covenant.  That one year has been utilised for decades because of EU competition law, which remains English competition law now that we are out of the EU.  However, that one year is a limit and a franchisor still has to establish that one year is required as a post-termination restraint period to protect its goodwill. That is often put on the basis of the time needed to recruit, train and launch a new franchisee, whilst giving them a ‘clear start’ in the business, before the ex-franchisee is allowed to compete.

There is no presumption that one year is necessary.  A franchisor must explain in each case why the period they seek is required.  The time from recruitment to launch may be longer in some businesses than others.  For example, a care business requires the franchisee to be CQC registered which can take months.  An unregulated business activity may not face the same hurdles and the time from recruitment to launch is much quicker.

In Dwyer, the court have also considered what goodwill needs preserving, arguing that the longer a period of time the franchisee actually trades, the larger that goodwill is likely to be.  Conceptually that is correct.  Goodwill in a brand-new territory may be modest during the first couple of years of trading, but will hopefully be much more substantial at the end of a five-year term.  However, goodwill does not start to be built when the franchisee begins to trade.  Goodwill might be pre-existing, most obviously in a resale scenario, but also where there may have been a short gap between one franchise coming to an end and another starting in the same territory.  There may also be the franchisor’s goodwill whose national reputation and brand is such that a new franchisee will build up much more quickly than one who operates under a relatively unknown brand.

Therefore, franchisors should evaluate what protection they need in each case.  That would be ideal if every franchise agreement was individually negotiated and written, but that is not the reality.  Franchisors work on standard form contracts for good reason, to ensure that all franchisees are adhering to the same system, enjoy the same rights and are subject to the same obligations.

The Court of Appeal endorsed the views of the trial judge proposing a graduated restrictive covenant.  For example, one that was applied for six months post-termination if the franchise terminated within two years, and up to one year if it went the full five years or indeed was renewed (my example, not the Court’s).  That may be very difficult, particularly in circumstances where some franchisees grow faster than others and it is not easy to predict what the goodwill would be when the contract is signed.  It might be possible to include a ‘write-down’ clause in the contract, enabling the franchisor to choose to enforce a shorter duration restrictive covenant, dependant upon when the need arose to enforce it.

The Franchisee Perspective

Recalling the doctrine that it must be in the interests of the parties concerned, the court will also take into account the interests of the franchisee.  A court will not enforce any restrictive covenant simply to restrain an individual from utilising the skills they have legitimately acquired as a result of being a franchisee.  Someone who has learned to be plumber through operating a franchise cannot be restricted from being a plumber in the future simply because he acquired those skills as a result of the franchisor’s training and his work.  Confidential information and knowhow would not extend, as concepts, to override that general rule unless the individual would have to utilise confidential information and secret and substantial knowhow in order to fulfil that trade post-termination.  However, that would be in rare circumstances.  The 2010 decision of Pirtek -v- Joinplace is a very useful exposition of how knowhow can operate in a restraint of trade context.

When considering what is reasonable from the franchisee’s perspective, these three cases all reinforce each other.

If the parties are on equal terms and have equal bargaining power, they should know their own business best.  The court would be less likely to interfere in the terms of the contract they have agreed.

However, where there is inequality of bargaining power and where the parties contract on a standard form of agreement, the court will look far closer at the factual circumstances and the impact upon the franchisee of the restrictive covenant.

Where there was a significant risk of failure, and if that failure would have a potentially devastating impact on the individual franchisee’s circumstances, that would strongly suggest there was an inequality of bargaining power.

Franchisors should now record their views, at the time that each franchise agreement is signed of what the parties consider the risk of failure for a franchisee to be and what impact such failure would have on the franchisee.  Franchisors should now very strongly encourage franchisees to take legal advice before they sign.  That has been good practice for many years, but I suggest it might almost be a condition of a franchisee entering into an agreement, that they get legal advice on it and understand what it is they are signing up to.

The mere fact the franchisee took legal advice would not itself make a covenant reasonable from a franchisee’s perspective.  But it would be a relevant factor when the court assesses reasonableness between franchisor and franchisee.

Conclusion

 The reality is that the Dwyer decision, along with those in Quantum and Credico will not impact all franchisors or all franchisees.  They will particularly apply in circumstances where the franchisor is a large business, the franchisee is a start-up single operator in a new territory and where the franchisee is stretching themselves financially to both acquire and launch the business.

In those cases, in particular, franchisors should be very careful to consider what is reasonable for the franchisee in respect of the restrictive covenant, whilst still taking an informed view as to what duration of covenant they need for their own protection.