Don’t say it’s over -
leaving a franchise doesn't mean you can just carry on

When the agreement between a franchisor and a franchisee comes to an end, it doesn’t mean that the parties are free to do whatever they like. Most franchise agreements will contain what are called ‘restraint of trade’ clauses to prevent franchisees from using the knowledge they have gained in the franchise and the franchisor’s intellectual property to set up in competition with the franchisor or other franchisees. Two recent cases have some lessons for anyone thinking of going it alone.

From broker to broke

In the case of Mike Pero New Zealand Ltd v Heath and others, a former franchisee of Mike Pero Mortgages sought to set up his own mortgage broking business in competition. An injunction preventing him doing so was granted despite his claim that he wouldn’t be able to pay his bills if he couldn’t work as a mortgage broker.

Brief background

James Heath and a company beneficially owned by him were parties to a franchise agreement allowing him to operate as a Mike Pero Mortgages franchisee in Christchurch. The agreement included clauses where Mr Heath and his company promised that once the agreement came to an end, he and his company would not:

- Compete with Mike Pero or any of its other franchisees for a period of two years within Canterbury following termination;

- Solicit (directly or indirectly) any customer of Mike Pero away from Mike Pero; and

- Interfere with Mike Pero’s business or divulge any information concerning the business to anyone else.

In March 2015 (after some 15 years with Mike Pero), Mr Heath advised that he would not be exercising his further right of renewal under the franchise agreement.

In April 2015, an ex-employee of Mr Heath’s franchise company, Ms Smith, incorporated a company called James Heath Mortgages Limited in which she was the sole director and shareholder. Ms Smith was also Mr Heath’s de facto partner at the time.

Ms Smith also applied for accreditation to become a registered mortgage broker and in that application said the following:

- Starting from scratch due to leaving existing clients with Mike Pero Mortgages. Restrain [sic] of trade limitations;

- Very well known in the industry and a large amount of clients from previous franchise will possibly transfer over;

- Mail out to existing clients….

A website was also set up for the new company advertising mortgage broking services. Up until this time, Mr Heath’s franchise agreement with Mike Pero had not yet expired.

Mike Pero applied for an interim injunction asking the High Court (amongst other things) to restrain Mr Heath, his franchisee company, the new company and Ms Smith from being involved with providing mortgage brokering services in competition with Mike Pero. A curious and interesting factor in this otherwise run of the mill case was the involvement of Ms Smith who had no contractual obligations owing to Mike Pero.

The issue & the law

The court was asked to decide whether or not Mr Heath, his franchise company, the new company and Ms Smith should be restrained from being involved in a business that competed with Mike Pero.

It is well settled law in New Zealand that when a court is asked to make a decision on whether or not to grant an interim injunction, it must consider whether:

- There is a serious issue to be tried;

- The balance of convenience favours the granting of an injunction; and

- The overall justice of the case favours the granting of an injunction.

The court relied on several previous franchise cases concerning non-compete covenants which affirm that a franchisor has legitimate interests to protect in seeking to enforce non-compete covenants against ex-franchisees and people who have provided non-compete promises to the franchisor, even when the parties may be in dispute.

While Mr Heath put forward a number of arguments attempting to persuade the court that the restraints were unenforceable, the court considered that the restraint was enforceable against Mr Heath, his franchisee company and the new company at least until the dispute was determined at a later substantive trial.

So far as the new company was concerned, the court found that there was ample evidence demonstrating that the new company was incorporated to enable Mr Heath to compete with Mike Pero and its other franchisees, and the fact that the new company was named after him was acknowledged by the court.

The relief

The court held (mostly) in favour of Mike Pero by granting the following orders:

- That Mr Heath, his franchise company and the new company were restrained from taking any steps which would breach the non-compete obligations previously provided by Mr Heath and his franchise company; and

- All of Mr Heath, his franchise company, the new company and Ms Smith were to preserve all information they had in their possession relating to the franchised business until further order of the court.

I say mostly because the court did not impose any restraint of trade against Ms Smith as it felt it was unnecessary to do so given that if Mr Heath, his franchise company and the new company were all restrained from in any way breaching the non-compete covenants then it would follow that Ms Smith would be unable to carry on the proposed competing business in a manner that would infringe Mike Pero’s rights (given, particularly, that Mr Heath could not be involved and all Mike Pero client information and intellectual property could not be used in competition with Mike Pero).

Conclusion

This case underscores the weight that our courts place on the enforceability of non-compete clauses in franchise agreements, even where a foreseeable result of granting interim relief could have significant adverse effects on the ex-franchisee and its principals, as this extract from the judgment shows:

“While I do not minimise the adverse effects on Mr Heath and his family and the threat that it will be necessary to sell the family home after four to five months if an injunction is granted, sight should not be lost of the fact Mr Heath was aware of the restraint provisions and made the decision to terminate his relationship with Mike Pero without apparently putting in place any plan for protecting his income without breaching his agreement with Mike Pero. In this sense I am satisfied Mr Heath has brought these consequences upon himself through his own actions.”

The Video Ezy Case

In another South Island case, Video Ezy International Pty Limited v Red Bond Limited, a chain of video stores which changed its brand association after it thought its franchise agreements had expired was ordered to change its branding back to Video Ezy.

Background

Red Bond Limited and its owners, the Whelans, were party to three almost identical franchise agreements in respect to three Video Ezy outlets they purchased in 2007. Non-compete covenants were provided in each of the franchise agreements.

The franchise agreements were due to expire on 14 December 2014. That date passed and the parties appeared only to be negotiating the royalty to apply for the renewal franchise agreements. In the interim, the franchised businesses continued to operate, seemingly upon the terms of the existing agreements.

In April 2015, the company which had international rights to the Video Ezy brand terminated the agreement it had in place with the New Zealand master franchisee. All New Zealand franchisees were advised of this, together with the fact that Video Ezy International had taken an assignment of all the New Zealand franchise agreements with the intent and effect that Video Ezy International was now the ‘Franchisor’ under all the New Zealand franchise agreements.

Sometime around May 2015, Video Ezy International became aware that the Whelans’ company was rebranding its three Video Ezy stores to a competing brand. It applied to the court for an interim injunction requesting the court to enforce the non-compete covenants or, as an alternative, to order that the Whelans rebrand the outlets back to Video Ezy and otherwise comply with the terms of the expired franchise agreements until the dispute could be resolved at a full trial.

The Whelans presented several arguments opposing Video Ezy International’s application, including that:

- At the time Video Ezy International took an assignment of the New Zealand franchise agreements, the Whelans’ franchise agreements had come to an end and accordingly there were no rights capable of being assigned from the original master franchisee to Video Ezy International;

- As an ex-Green Acres franchisee attempted to argue some years ago, given that the non-compete covenants were not specifically expressed in the franchise agreements to apply as from termination, they did not apply on expiration; and

- The granting of the injunction was not necessary as, even if the Whelans lost on the substantive issues in dispute at a later trial, damages would be sufficient to cover Video Ezy’s loss in the interim.

The issue & the law

As with the Mike Pero case, the court had to apply the same three-stage test in determining whether or not to grant the interim injunction sought by Video Ezy.

As to whether or not Video Ezy was capable of receiving any benefit under the franchise agreements given those agreements had expired prior to the assignment taking effect, the court’s view was that there appeared to be satisfactory evidence to suggest that Video Ezy International could take an assignment of all rights that existed under the franchise agreements, including the right to enforce the non-compete covenants.

On the issue of whether or not it could be said that the non-compete covenants did not apply because the franchise agreements had expired rather than terminated, the court placed greater weight on Video Ezy’s position that the correct interpretation of the franchise agreements was that termination included expiration.

In respect of the Whelans’ argument that damages would be a sufficient remedy to Video Ezy if the Whelans subsequently lost on the substantive issues at trial, the court somewhat side-stepped that issue. They took the position that were the parties placed back in the position they were in prior to the re-branding, then neither party would be losing out (this was on the basis that there was no evidence of the consequences of such a decision under the Whelans’ new franchise agreement with a competitor).

The relief

The judge in this instance was attuned to the significant consequences the Whelans would face if the non-compete covenants were enforced outright and instead made orders in line with Video Ezy’s alternative request that the outlets be branded back to Video Ezy and the parties’ relationship continue upon the terms of the existing (and expired) franchise agreements until further order of the court.

Conclusion

This case again reinforces that the law in New Zealand does recognize the value of franchise brands and intellectual property and the need for a franchisor’s rights to be protected. However, franchisors need to be certain that restraint clauses in their agreement are fair and reasonable, and that agreements are properly completed if they are to withstand the scrutiny of the courts. Equally, franchisees should be aware that these clauses do mean something: you can’t just disregard them when you leave.

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