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Update on restraint of trade clauses in franchising

10 May 2019 - By Deirdre Watson

Restraint of trade clauses are a common commercial tool by which franchisors protect their brand, goodwill and system, following the termination of the franchise agreement. If franchises did not have the control of a restraint of trade clause, ex-franchisees could readily take and use all know-how and goodwill gleaned from the operation of the franchise business to set up new and competing businesses, post termination. Where the franchisee holds the lease of a premises-based franchise in their own name, this can be seamlessly done simply by pulling down signs and rebranding.

As is well known, contractual provisions imposing a restraint of trade are, prima facie, void and unenforceable. However, where the party seeking to enforce the provision establishes that the restriction is reasonable, it may be enforced. The party attempting to enforce the restraint must show:

  1. that there is a protectable (otherwise known as a proprietary or legitimate) interest justifying the restraint; and
  2. that the restraint goes no wider than is reasonably necessary to protect that interest – see Brown v Brown [1980] 1 NZLR 484 (CA); Richmastery v Richmastery (Central) Ltd High Court, Lang J, CIV-2005-470-951 (24 May 2006).

In an earlier article published in LawTalk 913, December 2017, pages 21-22 (“Enforcing restraint of trade clauses in franchise agreements”), I discussed the robust approach taken by the courts in support of the enforcement of restraint of trade clauses in franchising. That approach is much welcomed by franchisors who, without a doubt, regard restraint of trade clauses as an important part of protecting their legitimate interests. This approach reflects the following comments of Hammond J in Dymocks Franchise Systems (NSW) Pty Ltd v Bilgola Enterprises Ltd (1989) 8 TCLR 612:

“[274] … it was said franchisees “do not fit particularly snuggly into the master and servant situation or vendor and purchaser covenants… But they are… More akin to the goodwill cases than to the servant cases” (p 119). Indeed, it is in this context that the conveyancing analogy has often been raised – that a restriction on competition is appropriate having regard to the “re-transfer” of goodwill that takes place on the termination of the franchise agreement.

“[275] However the matter is viewed in judicial terms, I have no difficulty in holding that a franchisor in a case such as this has a protectable interest. The franchisee is assisted in the start up and running of a business: it borrows expertise and support systems of all kinds. To put it shortly, if the franchisor could not protect its interests after termination, the franchising industry generally would collapse.”

In my earlier article, I suggested that there was perhaps a “grey area zone” of franchise scenarios (BB Australia Pty Ltd v Karioi Pty Ltd [2010] NSWCA 347; MEDIchair LP v DME Medequip Inc 2016 ONCA 168) whereby it should not be readily assumed that a legitimate interest exists, in particular, in the weaker or dying systems where for example:

  • the “business model” and “support systems” have not been updated and (objectively speaking) are of no value or assistance;
  • the system is dying because the consumer fad has passed (for example, the Yogurt franchises);
  • growth is receding and exiting franchisees are not being replaced;
  • the system simply never attracted a good number of franchisees in the first place;
  • the system is one where the franchisee had an existing business of the type being operated by the franchisee prior to becoming a franchisee.

Mad Butcher Holdings Ltd v Standard 730 Ltd

A tomato sauce bottle beside a bag of hot chips

The question of enforceability of restraint of trade clauses has once again come before the High Court in the recent decision of MadButcher Holdings Ltd v Standard 730 Ltd [2019] NZHC 589.

The franchisee had been a long-standing franchisee of the Mad Butcher franchise system, having begun his involvement in 1987 in Whangārei.

His agreement came to an end on 4 January 2019. Having initially indicated to the franchisor that he intended to set up a butchers training school, the franchisee advised the franchisor on 7 January 2019 that instead, he intended to continue to trade as an independent butcher. He had, by then, already arranged with the landlord to stay in the premises on a monthly tenancy after the lease expired (also on 4 January 2019). Presumably, the lease was held in the name of the franchisee or a related entity and not the franchisor as does commonly occur with retail-based franchises.

After the franchisee commenced trading as an independent butcher, proceedings were filed seeking an interim injunction to restrain the franchisee from trading.

The franchisee argued that he was not in breach of the restraint of trade clause because there was no other Mad Butcher franchise store in the Whangārei area or anywhere north of Albany, for that matter, and that the franchisee was therefore not in competition with the franchisor. He further said that the franchisor had no intention, and no reasonable prospect, of establishing another Mad Butcher franchise in Whangārei. He argued that there was no legitimate interest to protect in the Whangārei area.

Conversely, the franchisor argued that the plain meaning of the restraint of trade clause was that it applied whether or not there was an existing Mad Butcher franchise in the designated area. It further argued that it did want to re-establish in the area but that it could not do so while the defendant was trading.

The decision

Gault J found there was a strong argument that the plain meaning of the restraint of trade clause was that it applied whether or not there is an existing Mad Butcher franchise store in the designated area.

Gault J acknowledged there was some force in the franchisee’s alternative argument that the restraint could be unreasonable if the franchisor had no intention of competing for continuing business in the region, however he noted that the restraint was to be scrutinised as at the date of the agreement, not according to subsequent events.

As an aside, if restraints could not be scrutinised as at the date of subsequent events it would mean, in the case of the failed “fad systems” or “flash in the pan systems” which spring up like mushrooms and are then gone within a few years, that this would produce the curious result that the franchisees in those systems would be prevented from competing when there was no franchisor left to compete with at all.

His Honour also dealt with the issue of whether, if the franchisee was able to establish a breach by the franchisor that would have justified cancellation of the franchise agreement, the franchisee would not be bound to perform the ongoing restraint. In Health Club Brands Ltd v Colven [2013] NZHC 428 at [32] Winkelmann J accepted that such a proposition was arguable.

Gault J concluded that his initial impression, based on the lack of particularity in evidence so far, was that the franchisee would have an uphill battle establishing breaches by the franchisor sufficient to release the franchisee from performing ongoing obligations in the franchise agreement, adding “whether they will be able to do so at trial is another matter”.

His Honour went on to determine the balance of convenience lay in favour of the franchisor, finding that damages would not necessarily be an adequate remedy for the plaintiff:

“As Holland J said in Linde Aktiengesellschaft v C W F Hamilton & Co Ltd [1988] NZHC 532; (1988) 3 TCLR 216 (HC) at 222, in normal events a party to a contract with a valid restraint of trade clause is entitled to have the clause enforced and damages would not often be regarded as an adequate remedy for the loss of the plaintiff’s contractual rights.”

Gault J also accepted that the franchisor’s lost opportunity to re-establish a franchise would be difficult to quantify, noting that damage to goodwill in franchise cases, and intellectual property cases generally, is often difficult to measure.

Conclusion

Unfortunately, the decision does not record any of the detail of the franchisee’s dissatisfaction with the system or any other issues relating to the Mad Butcher franchise generally which might have been expressed by the franchisee. It is unknown to what extent at trial this aspect will be developed and whether or not the franchisee will be able to prove that there was a breach by the franchisor of an implied or express term which met the tests for cancellation of the franchise agreement under the Contract and Commercial Law Act 2017.

Leaving aside the facts of the Mad Butcher case, there must, at least, still be room for an argument that in a failing or fad franchise system, the franchisor is not providing the requisite system, and thus there are grounds for termination. It is also difficult to understand how a franchisor with no intention whatsoever to re-establish itself in a territory post-termination could be said to have a legitimate interest in that territory.

The decision will be well welcomed by franchisors in large established systems (like the Mad Butcher) where there is always a risk that a disgruntled franchisee will look to launch off on their own business venture on termination of the franchise. It will probably also bring more clarity and certainty to this area so that practitioners are aware of the risks when advising clients about their restraint of trade obligations.

Deirdre Watson deirdre.a.watson@xtra.co.nz is a barrister and mediator specialising in franchising disputes. She is Vice-Chair of the Franchise Association of New Zealand.

Last updated on the 10th May 2019