Do you set any restraints of trade for your franchisees? The idea of a restraint has value within the franchise relationship but there are rules to follow.

Franchisors want franchisees to be bound by a valid restraint so the franchisee does not:

• use the franchisor’s intellectual property and confidential information;
• compete with the franchisor in the market place;
• inhibit the franchisor’s ability to “bed down” a new franchisee; and
• possibly most importantly: protect the franchisor’s goodwill.

Any restraint will only be enforceable if it is reasonable. There are some general principles that govern all restraints:

1. Whether it is reasonable is a question of law not fact. 

2. It must be reasonable in regard to both the parties’ interests and in relation to public interest.  The public interest is basically that the market should be free to compete without unreasonable restraint.

3. The franchisor has the onus of establishing the reasonableness both in regard to the conduct restrained, the area and the period. The franchisee needs to show it “injures the public interest”.

4. It must be no wider than is necessary for the adequate protection of the franchisor.

5. Reasonableness will involve identifying the interests the franchisor wants to protect.  E.g.:  you cannot restrain a person from working at all. You can restrain them from operating a similar business dealing with the old clients under the Franchise Agreement or in the territory of the Franchise Agreement (with some restrictions).

6. The restraint must be reasonable at the time the agreement is entered into. It must be in the reasonable contemplation of the parties at the time the agreement is signed that the restraint would cover what is written in the agreement.  If it is too wide, the restraint will not be enforceable. In Murray Pest Management Pty Ltd v ANG Bilske the restraint was not enforceable because it covered the whole of the Northern Territory whereas the business carried on by the franchisee was restricted to Katherine.

What needs to be protected?

Franchisors need to protect their intellectual property, confidential information and goodwill. All three need to exist otherwise the situation arises as in BB Australia Pty Ltd (Blockbuster) v Karioi Pty Ltd where the court held that the franchisor did not have sufficient goodwill because the franchisee already had its own goodwill before becoming a franchisee. That is a particular issue if the franchisee rolls an existing business into a franchised business.

How to get it right?

A cascading restraint clause is still the best because it gives choices. Courts will use the ‘blue pencil test’ to cross out any parts of the cascading restraint clause which are too wide and ‘offend’ public policy. There needs to be clear alternatives so when the blue pencil is used, what is left is clear, valid and enforceable.

Think about the business. If it is a territory based business and the territory is very large, is the franchisee likely to trade in the whole area or will they be restricted to a small part of it? In that case should the clause be customer based instead? A franchise agreement can restrict franchisees from dealing with customers of the business just as easily as it restricts franchisees from trading at premises or in specified areas.

Is the time or duration reasonable?

That will depend on how often people use the business and how long it would take to ‘bed down’ a new franchisee. In some cases restraints of up to three years have been enforceable whereas in others a one year restraint was considered reasonable.

What if the franchisee breaches?

If a franchisor applies to the court for an injunction and it is granted, a franchisee breaching a restraint will be in contempt of court. In a recent case of Testel Australia Pty Ltd v KRG Electronics Pty Ltd the franchisee admitted to breaching the injunction on twelve occasions. They were fined $5,000.00 each and in default one month imprisonment. Another case from some years ago, the franchisee was actually imprisoned for three months for breaching the injunction continuously and ignoring a fine from the court.

So the consequences to a franchisee are not just they are prohibited from competing, if they breach a court order they can have significant fines or a jail term.

Changes to restraints under the new code

Clause 23 of the Franchising Code of Conduct that started 1 January 2015 does not apply to franchise agreements entered into before 1 January 2015 but will if that agreement is varied or transferred after 1 January 2015.

The restraint has no effect after the agreement expires (not not terminated or transferred) if:

(a)  the franchisee had given written notice to the franchisor seeking to extend the agreement on substantially the same terms as those:

                    (i)        contained in the franchisor’s current franchise agreement; and

                   (ii)        that apply to other franchisees or would apply to a prospective franchisee; and

(b)  the franchisee was not in breach of the agreement or any related agreement; and

(c)  the franchisee had not infringed the intellectual property of, or a confidentiality agreement with, the franchisor during the term of the agreement; and

(d)  the franchisor does not extend the agreement; and

(e)  either:

                    (i)        the franchisee claimed compensation for goodwill because the agreement was not extended, but the compensation given was merely a nominal amount and did not provide genuine compensation for goodwill; or

                   (ii)        the agreement did not allow the franchisee to claim compensation for goodwill in the event that it was not extended.

This new provision does not mean that all restraint clauses in franchise agreements entered into after 1 January 2015 will be ineffective. It will only apply at the expiry of a franchise agreement if all criteria (a) to (e) are met. It also does not restrict a franchisor from enforcing a restraint of trade clause during the term of a franchise agreement. Clauses restraining a franchisee from infringing the intellectual property of the franchisor will remain enforceable during and after the expiry of the term of a franchise agreement. The code also does not require that compensation be paid.

Actions needed

• check the franchise agreement and make sure the restraint is reasonable in area and time and the situation where it binds.
• make sure the restraint clause survives termination of the franchise agreement.
• make sure it is not more than needed to protect the legitimate business interests of the franchisor.
• include a limitation on dealing with customers of the franchised business.
• be mindful of the new Code provisions.