Restraints of Trade in Franchise Agreements
The following article was written by Mark Sherry and was first published in the Business Franchise Australia and New Zealand magazine, and has been reviewed and updated in April 2020.
A common mistake that people make when entering into a franchise agreement is to only focus on the matters that affect them at the time of purchase. In particular, they look at things like the cost of the franchise and what they will receive for the franchise fee, the ongoing payments due under the franchise agreement and what they need to do to set up their business. It can be a frenetic time where there is a need to find, lease and fit out premises, employ staff and do everything else that needs to be completed to open in short order.
However, due to the distractions immediately in front of them and the excitement of owning their own business many people forget to pay attention to what happens when a franchise ends. This is human nature and quite understandable but it is certainly not the wise course of action. Time needs to be spent looking at how a franchise might come to an end (whether it is through the expiry of time, the sale of the business or termination by either the franchisor or the franchisee) and the impact that this will have on the franchisee after the franchise has ended.
Franchise agreements tend to have very specific provisions that detail what brings about a right to end the agreement and what a franchisee must to at that time. There are obligations on the franchisee to hand over client lists, business contact details and all of the franchisor’s intellectual property. An exiting franchisee must be seen to not inhibit or detrimentally act to affect the goodwill of the franchisor and its brand. Invariably too, there are obligations on the franchisee not to do certain things. In particular, there is normally an obligation on a franchisee to not compete with the business they have exited. In many franchise systems this obligation goes even further so that there is an obligation not to compete with any other franchise in the franchise system, no matter where it is located.
This can have far-reaching consequences for someone who is trained in a specific line of work. It can mean that after they exit a franchise they find that there are limited opportunities for them to work. This is especially the case where their franchisor has a mature system with franchises geographically spread far and wide. Some former franchisees may choose to “run the gauntlet” and start to work or trade in breach of their restraint of trade obligations in the hope that they would be deemed unenforceable or that the franchisor will not find out or, if they do, that they won’t take action.
However, there have recently been a couple of high-profile court cases in New Zealand dealing with just this issue. It would be fair to say that neither ended particularly well for the franchisee.
The first case involved a gym franchise in Auckland. It involved a franchisee of the Club Physical franchise system electing to leave the system and rebrand their fitness clubs and operate them under a new brand name, Jolt Fitness. When the franchisor took action to stop this the franchisee made all sorts of allegations against the franchisor, insinuating, amongst other things, that it did not receive proper support from franchisor and, therefore, it had no choice but to leave the system to keep its business viable. The courts found this hard to fathom, given that the franchisee had actually started with one franchise and then purchased another two franchise outlets over time as they were offered for sale on the open market. The judge pointed out that it was illogical for someone to keep purchasing something they felt was not being run in a proper way.
The judge further concluded that it would be extremely difficult for the franchise system to try and break back into the territories again by starting afresh when the existing Jolt Fitness clubs were operating. The operator of Jolt Fitness saw the writing on the wall, in that they had breached their restraint of trade obligations in the franchise agreement, so they entered into an agreement with the franchisor to allow Club Physical to take the sites back over, purchase the gym equipment and take over the staff. The gyms were then rebranded back to Club Physical gyms.
The other case which has recently been in court is one involving the franchise system Safe Kids in Daily Supervision (‘SKIDS’). In that case, a master franchisee simply decided not to renew her franchise agreement, and instead set up in competition with the SKIDS franchise system. She had spent a considerable period of time in the system, and had taken what she had learnt out into the market place in opposition to it. Not surprisingly, SKIDS were not particularly happy with this, and went to the courts for relief. Initially, in the High Court, the judge found that the restraint of trade provisions in the franchise agreement were not enforceable because the franchise business was not particularly complex. This decision created some consternation in the franchise community as it potentially opened the door for the confidential information and systems of franchisors to be abused on a wide scale.
However, SKIDS appealed this decision, and in the Court of Appeal the High Court’s decision was overturned. It was found that franchisors were entitled to protect their businesses from exploitation. Whilst the system of childcare was not particularly complex, it was found that the former franchisee had breached her obligation to protect confidential information and she had misused some of the documents that had been provided during the existence of the master franchise agreement. In fact, the Court of Appeal found that the former franchisee had flagrantly breached her obligations. She had denied under oath that she had copied confidential information and as a result she exposed herself to a significant award for damages too.
The message to take from these two cases is that when entering into a franchise agreement, a franchisee needs to do so with an open mind and only after considering all issues, including having an appropriate exit strategy right from the start.
If by entering into a franchise system there is a chance the franchisee will be restricted in the future from operating or trading in the industry that they have training, qualifications and experience in because of the provisions of the franchise agreement they are entering into, then they will need to give serious consideration as to whether the restriction at the end is worthwhile. If they are restricted from competing against the franchisor after leaving the franchise system, whether in the specific territory that they have operated in or in all territories that the franchisor has franchises operations in, that can mean significant upheavals for the franchisee and their family, especially if they have limited work opportunities and need to relocate to avoid the scope of the restraint provisions.
It is imperative that appropriate legal advice is taken when a person is considering entering into a franchise, because the restraints on trade can be one of the hidden barbs that can catch them down the track. It is too late to try and deal with the issue after the fact, and taking appropriate advice from a franchise knowledgeable lawyer at the outset is the ideal solution. That way the transaction can be entered into with full knowledge of the implications.