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RISK MANAGEMENT: WHAT HAPPENS WHEN IT ALL GOES WRONG?

by David Munn,
last updated 14/10/2013

October 2013 - David Munn looks back at a high profile court case and analyses the risks associated with restraint of trade clauses in franchise agreements.

The highly-publicised High Court case between Club Physical and a multi-unit franchisee raised a number of important issues, not least about the enforceability of restraint of trade clauses.

The Club Physical dispute commenced on 8 February 2013 when Stuart Holder, who was a multiple franchisee of Club Physical through his three Colven companies, rebranded his three gyms without warning as Jolt Fitness. Existing Club Physical members found themselves transferred to the new brand and staff were similarly surprised.

The matter went to Court on 26 February with Club Physical seeking an interim injunction against Jolt Fitness to require it to stop trading, while Jolt Fitness sought an interim injunction to stop Club Physical using the database to contact members of the three re-branded gyms.

The decision (Health Club Brands Ltd v Colven Botany Ltd and others – Feb 2013) published on 7 March was that the first injunction was granted and Jolt Fitness must immediately stop trading from its three existing premises and, in one case, within 5kms of the existing premises. The counter injunction was denied, allowing Club Physical to use the database. On appeal, a stay was granted to allow the parties to progress discussions towards an amicable resolution of the dispute. Ultimately, an agreement was reached for Club Physical franchisor Paul Richards to take over the leases and restore all three gyms as Club Physical, with original branding and classes from 30 March. The whole dispute, including High Court hearings, lasted just over seven weeks.

Calculating The Risks

One of the issues at the heart of the matter was the enforceability of the franchise agreement’s restraint of trade clauses. Such clauses are common in franchise agreements: their purpose is to protect the goodwill developed through the franchisor’s business model and to prevent a franchisee from exploiting the knowledge he or she has gained in running a franchised outlet and using it to set up in competition with the franchisor or other franchisees. The knowledge gained is considered (depending on the facts of each particular case) to be part of the protectable interest of the franchisor, communicated through training, support, systems and manuals. However, there is also the consideration that the franchisee has a right to use their own skills and experience for their own benefit. For this reason, although dependent on the specific facts of each case, enforcing a restraint can often be quite a challenge, as much case law illustrates.

In the Club Physical case, each side will no doubt have seriously wrestled with the situation they found themselves in and, amongst a variety of issues, the need to assess whether the restraints were applicable and enforceable in the particular circumstances. The decision-making leading to the court litigation was therefore the result of calculated risks on both sides.

The Franchisee’s Risk

The franchisee, Mr Holder, took a risk in cancelling his three franchise agreements and continuing to trade in the same premises with the same client members under a new name. He argued that he made that decision because the franchisor had amongst other things, breached essential terms of the franchise agreement (the duty to assist and support the franchisee) and insisted on an inflexible pricing structure combined with a misdirected advertising strategy. He alleged that these factors were driving all three of his gyms to insolvency; in other words, that the franchisor had substantially breached its obligations which justified his cancellation of the agreement.

The franchisee appeared desperate and claimed he had to take immediate action to save himself financially. However, the risk was that if he failed to make out his case against the franchisor for breach of essential terms, the action taken could amount to what is called a ‘repudiation of its obligations’ and the franchisor could then itself cancel the agreement based on that repudiation. The franchisor could then seek to enforce the trade restraint clauses in the franchise agreement and either obtain an injunction to stop the franchisee continuing to trade with his new business, or claim damages for breach of contract due to his termination of the franchise agreement, or both. If successful, particularly with the injunction, then the franchisee would be in serious trouble and possibly compounded further by continuing lease obligations.

The Franchisor’s Risk

The franchisor appears suddenly to have been faced with a notice of termination of three of its franchises at once. That was a significant proportion of the overall nine-gym network with immediate loss of revenue. As an aside, it might be noted that the franchisor may have accentuated its own risk by having permitted one franchisee to own multiple franchises at such an early stage of the franchise development.

The risk now facing the franchisor was whether they should seek to enforce their claimed rights under the franchise agreement given all the hassle, public attention and costs that would involve. The franchisor calculated that, apart from loss of revenue, by permitting the franchisee to re-brand and continue its new business, the franchisor would lose the opportunity to retain members’ loyalty to the Club Physical brand and would damage its associated goodwill.

In such circumstances, franchisors must also consider the potential for creating precedents. If they don’t enforce their agreements, they appear weak and the agreement is perceived as “toothless”. That suggests the franchisor is not prepared or able to protect the overall integrity of the franchise system and the brand for the benefit of everyone.

Given that risk, any franchisor might decide to take legal action to enforce the agreement, but they have to accept the risk that they may lose the case. Even worse, a spotlight will be shone on their own conduct in operating the franchise and how they have discharged their contractual responsibilities to the franchisee. If they are held to have given sufficient cause for the franchisee to cancel, not only may the restraints not be enforced – other franchisees will be at least unsettled and at worst encouraged to make further challenges. Such a loss may also mean their franchises are then less attractive to new franchisees.

Why The Injunction Was Granted

In the Club Physical case, the case before the High Court was an application by the franchisor for an interim injunction to stop the franchisee from operating its new businesses under a new brand within a distance of 5 km from each of the premises that had been operated as a Club Physical gym. There was also a cross-application by the franchisee for an injunction to restrain the franchisor from accessing its club members which Mr Holder claimed he had a right to now that the agreement was at an end.

The outcome of the High Court case favoured the franchisor. Her Honour Winkelmann J held that, although the draft trade restraint clauses were not properly completed in the franchise agreements and two of them had no geographical distance noted, she found for the purpose of deciding if there was a serious question to be tried that the restraint at least operated to restrict the actual business premises being used by the franchisee for its new businesses. With the third agreement, where a hand-written distance had at least been inserted, the court allowed the restraint for the 5 km distance from the premises.

By way of observation, with two of the businesses the franchisee could presumably have set up next door without restraint due to the poorly-drafted clause in those agreements.

It is important to realise that this was an urgent application for an interim injunction to stop the franchisee doing what it was doing pending the whole matter being dealt with at a later date at a full substantive trial. The judge held that there was a reasonable prospect of the franchisor ultimately succeeding in its claim for a permanent injunction, and that the trade restraint clauses were reasonable to protect the franchisor’s goodwill established by its franchise system and brand. She went on to hold that if the franchisee were allowed to continue his new business in competition with Club Physical, it would be impossible for a Club Physical franchisee to re-establish itself in the area due to the limited demand for such gyms. She concluded there was a serious question to be tried that the restraints as she applied them were reasonable.

The judge then went on to consider the franchisor’s conduct, which the franchisee alleged had given him grounds to cancel the franchise agreement. The judge found the franchisee’s evidence poorly supported its case and under the law did not substantiate such a serious step as cancellation. A significant part of the evidence of the franchisee was found to be confused and contradictory. To elect to cancel a contract under the Contractual Remedies Act, as Mr Holder did, those grounds need to be very solid. They should either relate to a representation or contract term that is considered essential, or (amongst other factors) the breach should substantially reduce the benefit or substantially increase the burden of the contract to the party that elects to cancel. To cancel without such solid grounds substantially increases the risk.

Why The Counter Injunction Was Not Granted

On the cross-application for an interim injunction to stop the franchisor accessing the member base, the judge declined to grant it because she did not consider the franchisee had made out a sufficiently serious case to ultimately be tried at a later substantive trial. This was because the agreement placed specific obligations on the franchisee to co-operate with the franchisor upon a cancellation and to ensure a smooth transition of the business.

‘This plainly contemplates that Health Club Brands will simply step into the shoes of the franchisee defendants and carry on the business with the existing customers,’ the judge noted. ‘To do this, [the franchisor] would need access to the client details and it would have to be free to contact them.’

The Outcome

Accordingly, the risk taken by the franchisee did not pay off and quite disastrous consequences were then expected to unfold. The defendants themselves had stated that in the event of the injunction being granted, ‘Mr Holder would lose his $2.1 million capital investment in the business, and [his companies] would be rendered insolvent.’

Although the franchisor won the injunction and the settlement negotiated later saw it take back the three gyms, they would no doubt have preferred to have avoided the case for many reasons. 

Factors To Consider When Assessing Risks

In assessing the risks associated for franchisors and franchisees in situations where the relationship of the parties has broken down and the continued viability of a business is seriously in question, there are several factors to consider regarding the enforceability of trade restraint clauses. Some are set out below, but the list is far from exhaustive and in every case parties affected should take comprehensive legal advice before any decision is taken.

Where a restraint of trade clause is involved, it usually comes before the court initially as an interim injunction application. An interim injunction is a temporary remedy granted at the discretion of the Court (not as of right) and intended to protect a party against loss which could not be adequately compensated by damages if that party ultimately wins at a trial which could be many months away. Based on the court’s preliminary view as to the likely result of the case at trial, an interim injunction is designed to preserve the court’s ability to give permanent remedies at the later substantive trial.

There is traditionally a need for courts to be cautious when granting injunctions. This does tend to raise a question mark in the Club Physical case as the Judge recognised that by granting the interim injunction, as she did, it would have a ‘catastrophic effect’ on the franchisee’s businesses.

Where an applicant is seeking an interim injunction, it only has to satisfy the court on two factors:

1. That there is a ‘serious question to be tried. The issue of whether there is a serious question to be tried generally will be satisfied if the applicant can show that it has a reasonable prospect of succeeding in its claim at the later substantive trial. It is usually decided based on an exchange of affidavit evidence alone and the applicant does not have to prove their case in depth, as that would take place at the later substantive trial if the case ever progressed that far (such cases often don’t, as the interim injunction is often effective enough to stop a party in its tracks – as happened with the Club Physical franchisee).

2. That the ‘balance of convenience’ favours the applicant for the interim injunction. This means that the court in its discretion will weigh the needs of the applicant for the injunction against the other party against whom the injunction is sought. The court will generally consider where the interests of justice lie in the particular circumstances of each case. A number of factors are taken into account by the court in each case but one of the most important considerations is whether compensation damages would be an adequate remedy, without the need for an injunction, if the applicant were to succeed at the future trial. In the Club Physical case, the judge thought this would not be the case due in part to the loss of the franchisor’s loyal membership in the meantime. Another factor is whether, if the interim injunction were granted and the defendant were ultimately to win, could the defendant be adequately compensated by the applicant? A further factor is whether there would be a damaging effect to third parties if an injunction were granted. In another franchise case, a court chose not to grant an injunction in part because of the flow-on effect such an action would have had upon staff, a bank and possibly a landlord.

It is generally because so many different factual considerations come into play that judges’ decisions vary from case to case. The principles of law are fairly well-established but it is their application to individual cases – and what the judge sees as just and appropriate in each case –that determines the outcome. In the Club Physical case, justice was found to favour the franchisor. It is interesting to compare this with another High Court case involving the Pita Pit franchise (PPO (NZ) Ltd v Wallace – Dec 2010). The principles unequivocally favoured a restraint of trade clause not being enforced by the grant of an interim injunction where there was a new competing business established in the same premises where a Pita Pit franchise had previously operated. One factor was that the judge saw no reason why the franchisor in the circumstances of that case may not open another outlet in the same area. Another factor was the franchisor’s own conduct, which appeared to influence the judge in reaching his decision not to grant an injunction.

Restraints Are Legitimate

Restraints of trade are recognised as being both important and legitimate in a franchise context. In one of the leading cases in this area involving Dymocks Franchise Systems (Dymocks Franchise Systems (NZ) NSW Pty Ltd v Bigola Enterprises Ltd), a restraint of trade clause was upheld in its entirety. The trial judge said (and this was not altered on appeal):

‘The franchisee is assisted in the start up and running of the business; it borrows expertise and support systems of all kinds. To put it shortly, if a franchisor could not protect its interests after termination, the franchise industry generally would collapse.’ It is interesting to note that the same attitude toward restraint clauses in franchise agreements was affirmed by the Court of Appeal in another recent case involving the SKIDS franchise (Skids Programme Management Ltd v McNeil – 2012).

Some Lessons

a) For restraint clauses to be upheld, they need to be carefully drafted. Appropriate legal advice should be taken to ensure the restraint fits the particular nature of the business and what interest clearly needs protection. In this context, the restraint should also not be more than is reasonably required (both in duration and geographical reach) to protect the franchisor’s legitimate interests (its brand, customer base and intellectual property being the principal ones). Restraints established simply to stifle competition will generally not be acceptable.

b) The parties should avail themselves of legal advice before they enter into decisions to walk away from a contract or to enforce terms of a contract like that in the Club Physical case. The effect of restraint provisions should never be underestimated. In conjunction with their professional advisors, it is essential both parties undertake a full cost benefit and risk analysis. As already stated, each case will be different with regard to how the established legal principles are applied.

c) Documents should be properly executed by all parties intended to be bound by them. It should also be very clearly stated in what capacity they are signing. It is usually not enough for a franchisee company to have signed if it is intended that directors also be personally bound to restraint obligations. It should also be clear at what stage they apply; for example, if a director retires from a franchisee company even though the franchise has not terminated or been sold.

d) If a franchisee intends to cancel a franchise agreement due to what they perceive as a failure on the part of the franchisor to perform its obligations, then the franchisee needs to be very confident that there are solid legal grounds to justify cancellation. Is the franchisor’s conduct or lack of performance sufficiently serious or deficient to justify in law the election to cancel? Once cancelled, the franchisee cannot back-track, particularly if (as with Club Physical) the franchisor treats it as a repudiation and cancels the agreement itself.

e) Surrounding clauses and definitions in the franchise agreement dealing with the consequences of termination should also be carefully considered. In addition to intellectual property such as trade marks, the franchisor may have rights to acquire the lease or plant if it does not already possess established rights to those items. Who has a right to customer lists, or software, or other valuable assets associated with the business?

f) Perhaps of greatest importance, is there a need to look at alternative dispute resolution processes first such as mediation? Many franchise agreements stipulate such an action. Obviously, in the Club Physical case the franchise relationship had broken down; one can only speculate as to why both parties did not strive together to find an alternative solution and reduce the risk of litigation.

Finally

The Club Physical case demonstrated for all to see the dangers of playing out disputes in public as well as in the courts. While the restraint clauses, and the integrity of franchise agreements, were eventually upheld, the cost, distress and brand damage sustained by both parties (as well as other franchisees) were obvious to all.

Franchisors and franchisees should be encouraged to educate themselves about the many and varied factors that go into creating a quality franchise system and network of relationships. This includes ensuring that both parties have the potential for profitable businesses. Given the many valuable resources and guidance made available by the Franchise Association of New Zealand, the Franchise Relationships Institute and this magazine and the associated Franchise New Zealand website, among others, there is no excuse for ignorance. Knowledge does not mean conflict and challenges will not arise, but it will enable them to be handled promptly and constructively. By doing so, the risk for both franchisors and franchisees will be considerably reduced.

This article was first published in Franchise New Zealand magazine Volume 22 Issue 02.

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