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COURT OF APPEAL UPHOLDS
RESTRAINT OF TRADE
ON FRANCHISEE

by Deirdre Watson,
last updated 27/08/2012

August 2012 - A recent Court of Appeal decision has upheld the right of a franchisor to enforce a restraint of trade clause, but reduced the period applicable to just three months

Many advisors with an interest in restraint of trade clauses in franchising have been keenly following the passage through the Courts of a case decided in 2011, in which the High Court found that the franchisor’s restraint of trade clause was unenforceable (SKids Programme Management Ltd v McNeil).  The High Court decision was appealed and, on 23 July 2012, the Court of Appeal handed down its decision.

This article deals with some of the restraint of trade aspects of the decision.

It is well-accepted law in New Zealand (and elsewhere in the Commonwealth) that contractual terms that contain a restraint of trade provision are prima facie void and therefore unenforceable. That cornerstone tenet of restraint of trade law has its origins in public policy, being a reflection of what is considered desirable in the public interest. 

The needs of the ‘public interest’, however, equally dictates that in not every case should restraint of trade clauses be unenforceable. Therefore, where the party seeking to enforce the restraint (eg, the franchisor) establishes that a restraint is reasonable, it may nevertheless be enforced.

The starting point is that the franchisor must show that it has a ‘protectable interest’ to justify the imposition of a restraint. That, of course, will generally always be the case where the franchisor provides use of branding, logos, other intellectual property, updated specialist knowledge and assistance, and updated and current operations manuals which normally (at least in a perfect world) contain all the secrets and business methodology as to how the system works.

The more critical aspect, and that least properly understood in my experience, is that, once it is established the franchisor has a ‘protectable interest’, a restraint of trade clause must go no wider than necessary to protect that interest. It must not restrain activity over a geographic area or for a period of time which is over and above what might be considered reasonable in order to genuinely protect a franchisor’s interest.

In assessing whether a restraint of trade clause is reasonable, the restraint is not examined in isolation; other terms of the franchise agreement come into the mix. In particular, the other provisions of the agreement which protect the franchisor’s intellectual property and provide for the franchisor to have some ongoing control over the franchise, such as a right of election to buy the franchise business or assets at the end of the term or the right to control the lease relating to the franchised business.

As to the duration of a restraint, a rule of thumb I have sometimes heard expressed (bearing in mind that every system needs to conduct its own enquiry as to what is reasonable) is: how long would it take to set up a new franchisee in the territory?

The High Court decision in the McNeill case

In 2011, the McNeill decision shone the restraint of trade spotlight brightly in the direction of franchise agreements. In that case, a franchisor (sKids) endeavoured to enforce a two-year restraint over an ex-franchisee who appeared to be conducting the same business as that operated under the franchised system.

On the restraint of trade issue, the High Court dealt a double-whammy blow to the franchisor. It found that:

a) The franchisor had no protectable interest which would justify a restraint. It effectively found that there was nothing particularly confidential about the ‘unsophisticated’ system which would warrant protection by any restraint; and

b) If there was a protectable interest, the relevant period of the restraint should be only three months, not two years.

The Court also found that in any event, the restraint had not been breached.

The Court of Appeal decision

It will come as a considerable relief to franchisors that the Court of Appeal recently overturned the finding that there was no protectable interest in the sKids system. It found that there was goodwill in the name (sKids), that benefits were offered to franchisees including a franchise support person, that there was national marketing, a conference and meetings, an online enrolment facility, monthly training opportunities for franchisees and their staff, discounted rates for insurance and an accounting package. It found that there was value in sKids assistance with seeking CYFS accreditation.

That aspect of the decision is positive and I expect will be welcomed by many franchisors, where they invest a similar effort into their systems.

However, having found that there was a protectable interest, the Court of Appeal found that the relevant period of the restraint should only be three months, not two years, noting that the franchisor would be able to set up a new franchisee using existing sKids goodwill in that time.

Where to from here?

It would be wrong to think the McNeill decision has changed the law or departed from existing legal principle.

It has always been the case that a franchisor in New Zealand may be able to demonstrate a protectable interest. Earlier decisions, referred to in the Court of Appeal decision in the Mcneill decision, have confirmed that.  Seen in that light, the McNeill decision is merely an example of the way in which the law is applied, taking into the account the facts and circumstances of that particular case.

The Court of Appeal decision is, however, a sobering reminder to franchisors and advisors of the need to thoroughly address the following questions, when drafting franchise agreements and setting up systems:

a) What, if any, is the protectable interest owned by a franchisor?

b) Is a restraint necessary to protect the ‘protectable interest’ of the franchisor or can this be adequately achieved by use of other controls, including:
- The franchisor retaining control of the lease which is the subject of the franchise;
- The franchisor retaining control of telephone numbers on termination.
- The franchisor retaining the right to request all intellectual property, including manuals to be returned to it on termination, and for franchisees to cease using any intellectual property;
- The franchisor having the right to elect to purchase the franchised business, assets or any part thereof on termination.

c) Where a restraint is necessary, what realistic and reasonable length / geographical coverage is necessary to protect that interest?

The overriding message is that care and consideration needs to be given to fixing and defining any restraint of trade clause, in conjunction with retaining the services of a suitably qualified franchise consultant and lawyer. In my view, gone are the days of plucking an automatic ‘two years’ out of the air simply because that is the duration most commonly expressed in other franchise agreements.

What is your opinion of the decision? Is three months long enough to recruit, train and establish a new franchisee? Should franchisees be subject to restraints of trade at all? Is the cost of enforcement higher than the practical benefit? We welcome healthy debate - use the comments function below to add your input.

Our thanks to Deirdre Watson for this summary.

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