Restraints position not all tied-up

Two well-established New Zealand franchise systems have recently come under the spotlight of the High Court: Video Ezy (Video Ezy International Pty Limited v Red Bond Limited) and Mike Pero Mortgages (Mike Pero New Zealand Ltd v Heath and others). In both cases, the Courts upheld restraints of trade on an interim basis, pending the outcome of a trial on the substantive issues.

At first sight, the cases appear to be a clear victory for franchising. I suggest a better analysis, though, is that they are a victory for those two franchisors – but there are still plenty of grey areas for other franchise systems. 

The existing law

A quick refresher on restraints. Restraint of trade clauses are common in franchise agreements to prevent an existing or former franchisee from exploiting the knowledge he or she has gained in running a franchised outlet and using the franchisor’s intellectual property to set up in competition with the franchisor or other franchisees. However, restraints of trade are not enforceable unless they are shown to be reasonable. This is a question to be decided on a case-by-case basis because there is no ‘one size fits all’ in franchises.  First, it must be shown that the franchisor has a ‘legitimate interest’ justifying the protection of a restraint of trade clause. Second, it must be shown that the clause goes no wider than necessary to protect that ‘legitimate interest’.

So what constitutes a legitimate interest?

Exactly what amounts to a legitimate interest came under close scrutiny of the Court of Appeal in the sKids case (sKids Programme Management Ltd v McNeil) in 2013. This case is possibly one of the few New Zealand cases to examine the point closely with the benefit of full argument as part of a trial. It is important to note that it did so in the context of determining the substantive issues in the case, rather than merely determining an interim injunction (as in the recent Mike Pero and Video Ezy cases). In interim proceedings, the Court only looks at whether there is a serious question to be tried that a restraint can be upheld, and does not make substantive findings.

The point of mentioning sKids is that having an updated, unique and relevant procedures manual and other relevant documents was regarded as key to whether or not there was a legitimate interest. The Court said:

 ‘Skids franchisees were provided with material including an operation manual, a policy and procedures manual, onsite manuals, a pricing structure, employment documentation, enrolment documentation, and Programme modules amongst other things. Materials that were provided were subject to ongoing revision. Specialised material was made available to enable franchisees to obtain CYFS accreditation. While the base material that constituted the inputs to franchise documents was widely available, the standard documents could not have been created without work and thought.’

 In the sKids case, the thoroughness of the franchisor was critical to their winning the case. However, operations manuals are not professionally-prepared in every franchise system, nor are they always unique, relevant or updated, for that matter. In fact, whether the manuals are of any use or not has been central to many franchise disputes.

A cornerstone of franchising is having a system of business methodology capable of being franchised. If that system is not professionally or adequately documented, and regularly reviewed, then franchisors walk a very tight rope when they ask the Courts to accept that they have a legitimate interest to protect by granting a restraint on trading activity.

What do the latest cases mean?

The outcomes of the two recent cases were in many respects fairly predictable. Video Ezy and Mike Pero Mortgages are examples of solid, long-standing New Zealand systems with, apparently, comprehensive, relevant and documented systems in place. They also operate in markets where barriers to entry are such that new franchisees in a particular territory are likely to need a decent breathing space to get a hold in the market without the distraction of a competing ex-franchisee. Without question, those franchise systems would, on this basis, have been readily able to demonstrate a serious question to be tried regarding the necessary ‘legitimate interest’ justifying the protection of a restraint.

It’s more tricky, though, with franchise systems where operations and other manuals are not completed, are hugely outdated, are not comprehensive or – simply put ­– are just not relevant.

I hasten to add that a legitimate interest is not merely drawn from an operations or process manual, of course; it might justifiably arise from trademarks and other intellectual property. But those rights are, of course, amply protected by the relevant legislation and also by other clauses in franchise agreements; they do not necessarily require the added protection of a restraint of trade clause because they are well protected elsewhere.

So, whilst there have been two good victories recently for the two franchise systems concerned, in my view there is still plenty of scope for restraints to continue to be challenged where the legitimate interest does not meet the required threshold. The message to franchisors is clear: make sure your manuals, systems and processes are up-to-date and relevant. It’s not just best practice – the future of your franchise may depend upon it.

We welcome links from other websites to this article. Please note that this article is copyright © Eden Exchange NZ Holdings Limited, Franchise New Zealand magazine and Franchise New Zealand On Line. While it may be downloaded for personal use, no part may be reproduced on any other website, in electronic or printed form or in any other form whatsoever.