Franchising – Is it time to review your restrictive covenants?

Such clauses are the cornerstone to any franchising arrangement. They protect the franchisor against an exiting franchisee who may make formidable competition if left unrestricted in its ability to trade against the franchisor once the franchise agreement expires or terminates.  

Restrictive covenant clauses work by restricting a franchisee’s ability to compete with the franchisor during the term of the franchise agreement, and for a set period after that agreement has terminated.

Some typical observations from restrictive covenants we often come across:

1. They prevent a franchisee from soliciting or being in business with franchise customers, franchise employees, and other franchisees in the network.
2. They prohibit a franchisee from being involved in a business which is in competition with a franchisor.
3. They apply to the franchisee’s limited company, and to the franchisee as an individual.
4. They can be limited to the franchisee’s respective territory, but are sometimes national, such as in the case of “online franchises”.
5. They set a non-compete period, which is often 12 months after the expiry or termination of a franchise agreement.

As for the general position in law, the validity of restrictive covenants generally rests on the following test:

• There must be a legitimate interest the franchisor is seeking to protect;
• The restraint must not be wider than is reasonable to protect that interest; and
• The restraint must not be contrary to the public interest.

Many cases where restrictive covenants are challenged will turn on the second limb – i.e. is the covenant reasonable in scope and duration, or does it go further than necessary to protect the franchisor’s legitimate interests? Historically, the courts have been more willing to uphold such restrictive covenants in commercial agreements between commercial parties (such as a franchise agreement), than they have in an employment setting, where there is a significant imbalance of power between employee and employer.

In a franchising context, however, there have been several recent case law developments that serve to highlight that restrictive covenant clauses will depend heavily on the facts of a dispute. Whilst on their face they may appear typical and market standard (and therefore typically enforceable), the opposite may well turn out to be true when properly analysed.

This position was highlighted no more clearly than in the 2022 Court of Appeal decision Dwyer (UK Franchising) Ltd v Fredbar Ltd (2022). This is a case all franchisors should be aware of as it has significant implications for franchisors.

The facts

The case involved the franchisor, Dwyer (UK Franchising) Ltd, who operated the “Drain Doctor” plumbing franchise, and Fredbar Ltd, the franchisee company owned by Mr. Bartlett. The franchise was, as the name alludes to, a market leading emergency plumbing and drainage franchise with a network of 30 franchisees.

Mr.Bartlett had no prior experience in the industry. The franchise business would be his sole source of income – he had minimal assets and a mortgage and family to support. He had no previous experience in the industry but undertook a course with the franchisor. The franchisor took a view that the franchisee was likely to be unsuccessful but took a chance regardless. All financial projections were general to other franchisees and there was no specific research for the franchisee’s area.

On the franchisor’s assurances, the franchisee entered into a franchise agreement with a 10-year fixed term based on the franchisor’s assurances of commercial viability. However, the business inevitably struggled, and the franchisee terminated the agreement within a year. It was held that the termination was a repudiatory breach by the franchisee, and that the franchisor had validly terminated the agreement in accepting this repudiation.

However, the franchisee had set up a competing business within his franchise territory, something his non-compete clauses did not permit. The franchisor attempted to enforce its 12-month non-compete clause.

What did the court hold?

The Court of Appeal found that the restriction was unreasonable and unenforceable.

When assessing reasonableness, the court was entitled to consider the factual and contractual background. A significant factor of this was the imbalance in bargaining power between the franchisor and the franchisee. The non-compete clause must be astutely examined by the court and only upheld if objectively reasonable to the parties. 

The franchisor was a market leading franchise in its industry area. The franchisee, on the other hand, had placed all his savings into the business and borrowed money from the bank. He had no previous experience, and had been presented with a “take it or leave it” agreement. The court was entitled to have consideration of the degree of risk faced in the event of failure and suggested that Mr.Bartlett’s franchise agreement was more akin to an employment contract than a contract for the sale of a business.

Furthermore, there had been no franchises in the franchisee’s territory prior to the franchisee taking it on, and limited goodwill had been developed given his business was underperforming and had done so for a proportion during Covid when he was self-isolating.

Therefore, based on the facts (in particular the contractual position and the bargaining positions of the parties), the court held the non-compete clauses were not enforceable.

Whilst this decision is a notable one, it does not set a new legal precedent. The court was clear to restrict the decision to the facts of the case. Analysis of the peculiarities of a particular must always be made.

What should you take away from this?

1. A standard precedent will not suffice

Franchisors must think carefully about how to impose restrictive covenants. They must be reasonable in the context of the parties’ aligned interests and the inequal relationship that exists. It is not good enough to simply insert a standard non-compete clause without critical application to the franchisor’s business and the franchisee’s particular circumstances. How established is the network, how long is the fixed term, what is the nature of the franchise, and what experience does the franchisee have?

2. The balance of power matters

The court has established that the bargaining power of the parties really matters in the context of franchise agreements and restrictive covenant clauses. Franchisors must consider how they can address such inequality. Providing support and information at the outset, coming to the negotiating table, allowing franchisees to take independent legal advice, and offering support are all ways to improve the reasonableness of a restrictive covenant.

3. Mitigating the risk of unenforceability

Should a franchisor be faced with a franchisee termination or exit situation, they must give careful thought to what actual competition risk the franchisee poses to them, and weigh up the competing considerations of (1) being seen to enforce their covenants for the stability of the network and (2) engaging in a potentially messy, and expensive, dispute. For example, if a franchisee is exiting the franchise early into their initial term, or is not performing adequately, they may well pose less risk than a well-established and successful franchisee. Equally, it may be that there are concerns over the enforceability of a restrictive covenant in a specific scenario (noting that the reasonableness of a covenant is judged at the time it was entered into, not the time when it may be breached). In such circumstances, it may therefore be appropriate to agree a reduction in scope and strength of the non-compete - perhaps reducing the duration from 12-months to 6-months. This could improve prospects of reasonableness, and therefore enforceability, of the newly agreed covenant. It may also have the added benefit of smoothing any exit deal the parties are seeking to agree.

4. Unenforceable non-compete clauses can create big problems

A well drafted franchise agreement will typically have a severance (or so-called “blue pencil”) clause, providing that different restrictive covenants will each form separate contractual obligations. Therefore, if one particular covenant is judged to be unreasonably wide, it will not render other covenants unenforceable as well. Without such protection, in the worst case a franchisor’s entire set of post-termination covenants could be rendered unenforceable in its entirety. That is a major problem – without any post-termination protection, a franchisor could be leaving themselves wide open to immediate competition. Worst still, they could become embroiled in litigation with franchisees which is ultimately unsuccessful, which will cost time, resource and money, as well as potential adverse PR. 

What should you do next?

Franchisors should review their franchise agreements to assess whether their restrictive covenants are reasonable, and therefore enforceable. A franchisor should keep such covenants under constant review, particularly at the point of renewal, and stress test the covenants against a range of scenarios.

This is a complex and developing legal landscape. Your franchise agreement is the bedrock of your franchise network, and the only legal foundation for its operation. It needs to be right otherwise there can be dire consequences for your franchise.

Weightmans is ideally placed to advise you on your franchise agreements:

• We are BFA registered.
• We are a top 40 law firm.
• We advise both franchisees and franchisors from all backgrounds. Therefore, we understand both sides deeply, and this keeps us one step ahead.
• Our advice to franchisors is multi-disciplinary. We draw from a depth of commercial, corporate, competition, and litigation experts to ensure your advice is technically and tactically strong. It is tailored to your situation.
• We advise on franchise agreements, franchisee exits, and general franchising legal matters for franchisees and franchisors.