Understanding the role of restrictive covenants in franchise agreements

Disentangling post-termination agreements can be a minefield for even the sharpest legal brain.

Understanding the role of restrictive covenants in franchise agreements

Disentangling post-termination agreements can be a minefield for even the sharpest legal brain.

Most franchise agreements usually contain restrictions preventing a franchisee from starting a similar type of business following the termination of a franchise agreement. These restrictions will stipulate a period of time, during which the ex-franchisee will be unable to trade as a new start-up business. They may also refer to regions and territories.

Such clauses are accepted as a protection for the franchisor. It will protect the franchisor’s intellectual property, the brand and the rest of the franchised network. It will also serve as a deterrent to any franchisee from acting in bad faith. If there were not any restrictions in place, on termination of a franchise agreement, it would have the potential to seriously undermine the franchisor’s business and confidentiality.

However, such restrictions can sometimes be viewed as being anti-competitive and there is always a balance to be struck. Courts will uphold these restrictions if there is a legitimate business interest to protect, and if these clauses are deemed ‘reasonable’. The term ‘reasonable’ will cover the duration of the restriction, along with any other limiting factors.

This means that the legal drafting of these agreements and documents can be the key to its legitimacy, with each case assessed on the facts. Franchisees are often unaware of the extent of the restrictions until it is too late. In one example, the courts accepted that a 12-month restriction was considered ‘reasonable’ but that the geographical five-mile exclusion zone was not.

And then there was the case of Dwyer (UK Franchising) Ltd v Fredbar Ltd. Dwyer is the franchisor of a plumbing and drain repair services company, with Fredbar Limited entering into an initial 10-year franchise agreement, The franchisee had no prior experience of plumbing or drainage work, and he had left his previous employment to start the franchise business.

Covid-19 came along to complicate matters for the new business partner who had invested all of his savings into the franchise venture. This put him at risk of unemployment, as well as problems paying his mortgage. He therefore wanted to suspend the Agreement because of his need to self-isolate.

But Dwyer brought a claim for damages against Fredbar for what they described as a breach of contract. The agreement prevented the franchisee from trading outside of their allocated franchised territory and it was this provision that was considered ‘unreasonable’.

The Court ultimately felt that these prohibitions did not strike a reasonable balance between ‘the freedom to contract’ and ‘the freedom to trade’. And there was also no evidence of any negotiation regarding restrictions, which indicated an inequality of bargaining power This case underlines the importance of drafting restrictive covenants that are likely to be considered ‘reasonable’.

But even the most ironclad restrictive covenants will provide little benefit to the franchisor if not actively policed and enforced. In the case of Senior Care at Home Ltd v Adult Home Care Ltd & Anor (2021), the franchisor obtained an injunction preventing a former franchisee from breaching restrictions in their original agreement. 

The background to this case was that the relevant local authority had lost all confidence in the care services being provided by the franchisee. The council had numerous concerns, and a subsequent thorough investigation validated their worries. In this particular case the Court placed a huge emphasis on the importance of the franchisor’s need to maintain its reputation.

It was important that the franchisor’s own relationship with the local authority did not deteriorate. Had damages been awarded, rather than an injunction, it may have set a precedent for franchisees to breach restrictive covenants. The Court understood the need for the franchisor to control its network, brand and image. 

This case illustrates the importance of franchisors’ taking a firm stance when enforcing restrictive covenants in their agreements with franchisees. The cost of enforcing restrictive covenants should not be underestimated. However, not all franchisors feel the cost is worthwhile, as it usually depends on the level of threat a franchisee may pose. Yet, to adopt this laissez faire approach, can cause problems further down the line.

The failure to act immediately – regardless of the size of the problem – could prejudice the franchisor’s ability to enforce their restrictive covenants against another franchisee in the future. This would mean that their initial ‘lenient’ approach could set an unwelcome precedent further down the track.  

Equally, franchisees should not assume that restrictive covenants in a franchise agreement are not enforceable. The consequences of misjudging a franchisor could be costly indeed. The Courts will generally enforce post-termination restrictions, provided they are reasonable and that the franchisor can demonstrate the need for their existence.

Nicola Broadhurst
Nicola Broadhurst