Introduction
Facts
High Court
Court of Appeal
Comment
On 30 June 2022 the Court of Appeal dismissed a franchisor's appeal against a High Court decision which had declared that the restrictive covenants in its franchise agreement were unenforceable.(1)
The appeal concerned the enforceability of post-termination restrictive covenants in a 10-year franchise agreement between the franchisor and one of its former franchisees, the first respondent. The second respondent was a director and shareholder of the first respondent and guarantor of its obligations under the franchise agreement.
The Court held, among other things, that the High Court:
- had been right to conclude that, on the particular facts of the case, the 12-month restriction in the franchise agreement was unreasonable and unenforceable; and
- had not erred in concluding that any unreasonable part of the restrictive covenant could not be severed.
For further details on the High Court decision, see "Court rules against franchisor in dispute over enforceability of post-termination restrictive covenants".
This case has significant implications for a substantial number of franchise systems in the United Kingdom that operate with individual/inexperienced franchisees on standard form franchise agreements. One of the key takeaways (discussed below) is that there is no general rule that a 12-month post-termination restrictive covenant will be enforceable and that, consequently, franchisors should not categorise post-termination restrictive covenants as a "boilerplate" issue.
In 2018 Dwyer (UK Franchising) Ltd (Dwyer), the franchisor of the Drain Doctor, a substantial plumbing and drain repair services franchise, entered into a franchise agreement (the agreement) with Fredbar Limited (Fredbar) and Mr Bartlett as guarantor. Fredbar was run solely by Bartlett, who had formed the company expressly for the purpose of becoming a Drain Doctor franchisee.
The agreement granted Fredbar the exclusive right to trade within the specified territory for 10 years. It also provided that for a period of one year after termination or expiry, neither Fredbar nor Bartlett were permitted (either directly or indirectly) to be "engaged concerned or interested in a business similar to or competitive with" the Drain Doctor business within the territory or a radius of five miles from the territory (the restrictive covenants).
In July 2020, Bartlett purported to terminate the agreement, citing various conduct by Dwyer, and, in alternative, asserted that he no longer intended to be bound by its terms. At around the same, Bartlett ceased operating the Drain Doctor business and began to operate a competing business in the territory.
In August 2020, Dwyer terminated the agreement and sought, among other things, damages and injunctive relief to restrain breach of the restrictive covenants.
On 11 May 2021, the High Court held the restrictive covenants were unreasonable and unenforceable. Dwyer appealed this decision on the grounds that:
- in concluding that the restrictive covenants were unenforceable, the judge had erred by considering irrelevant and impermissible factors; and
- the judge had erred in concluding that any unreasonable part of the restrictive covenant could not be severed.
The Court of Appeal affirmed the High Court's decision that the restrictive covenants were unenforceable on the grounds they did not strike a reasonable balance between freedom to contract and freedom of trade, and were far more extensive than what was required to provide reasonable protection. While the Court of Appeal confirmed a franchisor is "entitled to protect the goodwill of the business upon termination of a franchise by a post-termination restrictive covenant which does not exceed what is reasonably required for that purpose", a court should consider a number of factors in assessing the reasonableness of a restriction, including:
- the factual and contractual background;
- the relative bargaining strength of the parties; and
- the circumstances of franchisees.
The Court of Appeal judgment drew the following conclusions on the nature of the franchise relationship and the interplay of restrictive covenants:
- Franchise agreements are not a special category of agreement when considering the doctrine of restraint of trade.
- Where there is inequality of bargaining power, it is "not only relevant, but is a significant factor in determining reasonableness".
- The inequality can alter the standing of a franchise agreement, and it may be more akin to a contract of employment than to a contract for the sale of a business.
- Issues of enforceability and reasonableness are to be determined at the time that the franchise agreement was entered into – that is, "what the parties: '(objectively) intended or contemplated, consequent on the contract, at the time the contract was made as well as the contract terms'".
- "[E]ach case has to be assessed on its own facts and there cannot be some general rule that a twelve month restriction in franchise agreements is reasonable".
In this case:
- Bartlett had no previous experience of plumbing and drainage work or of being a company director prior to signing the agreement;
- there was no evidence of any discussion or negotiation of the restrictive covenants to take into consideration the specific circumstances surrounding the agreement, which had to be accepted or rejected in its standard form without amendment; and
- as a result, Bartlett had not taken legal advice.
This will sound very familiar to number of franchise systems in the United Kingdom that recruit franchisees with little or no prior relevant business experience (partly because of the belief that the licensed "system" is so strong that direct prior experience is not a determinant of success).
Other relevant circumstantial facts were that:
- Bartlett had invested all his savings in the franchise business and would have no other source of income (except his partner's relatively small one) should the franchise business not succeed. He would thus be at risk of losing the family home;
- the franchisor had suspected that the franchisee would fail, but had decided to give Bartlett a chance;
- the franchisor had no prior trading history in the contractual territory (which is relevant to the concept of protecting goodwill); and
- the franchisor had provided projections calculated using averages obtained from data regularly submitted by Dwyer's franchisees. There was no research specific to the contractual territory, and nor was there any filtering out to take account of how long a franchise had been in existence.
On these facts, the restrictive covenants were unreasonable because:
- the failure of the franchisee had been foreseeable, the projections had been way off the reality and the franchisor had known that the financial consequences of failure could be dire for Bartlett;
- at the time that the agreement was entered into, Dwyer had no goodwill in the territory. The restrictive covenants failed to distinguish between terminations at an early stage of the agreement and terminations towards the end of the 10-year term when the goodwill to be protected was likely to be substantially more valuable;
- at the time of termination of the agreement, the franchise had only been running for 18 months, four of which had been during the pandemic with limited earnings that were far less than the projections, so a 12-month restriction was unreasonable;
- the restriction was not capable of being overridden with the franchisor's consent; and
- the argument that 12 months was required to give a new franchisee a clear run was "a lawyer's construct".
Furthermore, the second restriction was held to be unreasonable because there would be no goodwill to protect within the extended area as Fredbar had not provided services in any part of it. The fact that Fredbar could be permitted to work outside the territory in limited circumstances did not mean it would be reasonable to prohibit engagement, concern or interest outside the territory regardless of whether any goodwill had been established there.
The Court of Appeal held that the unreasonableness of the restrictive covenants could not be remedied by the application of a "blue pencil".
The Court of Appeal held that in other circumstances, such as where a franchisee was well established and successful or where the franchisor could show cogent evidence of the need to protect its goodwill, a court might conclude that the 12-month restriction was reasonable. The Court of Appeal judgment considered a long line of authorities on this issue, including the Court of Appeal's decision in ChipsAway International Ltd v Kerr(2) and the High Court's decision in Carewatch Care Services Ltd v Focus Caring Services Ltd.(3)
This case highlights that the enforceability of post-term restrictions in English law franchise agreements depends on the specific circumstances surrounding each individual agreement.
Franchisors need to be mindful of the type of franchisee they are recruiting and the specific circumstances relating to their appointment and ongoing performance.
While it is understandable for franchisors to maintain uniform contractual terms across the network, and to be seen to enforce those terms, for franchise systems that are of a similar profile to Dwyer (and that must surely mean a significant number of franchise systems which are members of the British Franchise Association (BFA)), franchisors should consider the following takeaways:
- Review the standard franchise agreement and consider whether some of the harder edges really need to be that hard.
- Ensure that franchisees understand the legal relationship they are entering into. Even if the contract is non-negotiable, a proper disclosure document or list of frequently asked questions is useful, as is mandating that a franchisee takes legal advice and/or completes some form of induction course on what franchising is before entering into the agreement (the BFA runs such a scheme).
- If there is a question mark over a franchisee's likelihood of succeeding, consider putting in place additional support to minimise the risk of failure.
- Ensure that projections are tailored to the franchisee territory, and that the franchisee actively engages in the process of business planning.
- Consider making changes to the restrictive covenants. Consider linking the duration of the restriction to the period of time during which the franchisee operated the business, and consider the geographical scope of the restriction.
- Make a careful consideration of the facts before enforcing rights under a franchise agreement.
For further information on this topic please contact Gordon Drakes at Fieldfisher LLP by telephone (+44 20 7861 4000) or email ([email protected]). The Fieldfisher LLP website can be accessed at www.fieldfisher.com.
Victoria Dubenkova, trainee solicitor, assisted in the preparation of this article.
An earlier version of this article was first published by Lexis Nexis.
Endnotes
(1) Dwyer (UK Franchising) Ltd v Fredbar Ltd and another [2022] EWCA Civ 889.