Post termination restrictive covenants ruling – does this mean you have to amend your franchise agreement?

The Court of Appeal has ruled on the enforceability of post-termination restrictive covenants in a 10-year franchise agreement in Dwyer (UK Franchising) Ltd v Fredbar Ltd & Anor (Rev1) [2022] EWCA Civ 889 (30 June 2022).  It has upheld the decision of the High Court that certain restrictive covenants were unenforceable, due mainly to the circumstances under which they were agreed and the length of time and territory in question.

This is a noteworthy decision for franchisors and franchisees alike.  Although some in the industry may consider the decision to mean the end of restrictive covenants, it is significant that the court stated that the decisions on enforceability were to be made on a case-by-case basis.  Had the facts been different, it is likely that the decision would have differed as well. 

Franchisors have been on tenterhooks awaiting this decision because the relevant restrictive covenant related to the prohibition of a former franchisee from operating a similar business within the territory after the termination of the franchise agreement.  The decision highlights the important factors that led to the Court of Appeal finding that the particular clauses of the franchise agreement were unenforceable and may cause some franchisors to reconsider their approach to recruitment, the drafting of their agreements, or both.

It is well accepted that restrictive covenants (also known as restraint of trade clauses) are contrary to public policy and as a rule are considered unenforceable.  As a result, the burden is on the party seeking to enforce them to show they are protecting a legitimate interest and that the restriction extends no further than is reasonably necessary to achieve that purpose.

Facts

Dwyer (UK Franchising) Ltd ("Dwyer") is a substantial company with more than thirty "Drain Doctor" franchises covering over sixty territories. It describes itself as the UK's largest full-service emergency plumbing and drainage company operating in commercial and domestic sectors, and its ultimate parent in Waco (Texas) is described by Dwyer as the world's largest home service franchise business.

Fredbar Ltd ("Fredbar") was a franchisee of Dwyer from around September 2018 until the summer of 2020. Fredbar was operated solely by Mr Bartlett and he set up the company for the purpose of joining the franchise.

The issues

The Court of Appeal was asked:

• Whether the first instance judge erred by considering irrelevant and impermissible factors when concluding that the restrictive covenants were unenforceable.

• Whether the first instance judge made an error in concluding that any unreasonable section of the restrictive covenant clause could not be severed.

The relevant restrictive covenants in this case were set out in clause 18.2.1 of the franchise agreement and were as follows:

"18.2.1 Following termination or expiration of this Agreement, the Franchisee will not for a period of one (1) year thereafter directly or indirectly:

18.2.1.1 be engaged concerned or interested in a business similar to or competitive with the Drain Doctor Business within the Exclusive Marketing Territory (save for a financial interest which does not allow the Franchisee to influence the economic conduct of such a business).

18.2.1.2 be engaged concerned or interested in a business similar to or competitive with the Drain Doctor Business which operates within a radius of five (5) miles from the Exclusive Marketing Territory."

So, on the face of it, the clause itself was relatively narrow but lasted twelve (12) months.

The decision

The Court noted that a restraint of trade covenant is enforceable if the covenantee has something which is entitled to be protected and the covenant gives no more than reasonable protection for that. The issue was to be determined at the time the agreement was entered into, taking account of its expected duration.

The Court considered several factors in assessing reasonableness including the factual and contractual background and the relative bargaining strength of the parties, which necessarily involves looking at the circumstances of franchisees like Fredbar and determining if there is such a concomitant interest.

Here, the Court of Appeal held that the inequality of bargaining power between the parties was not only relevant, but a significant factor in determining reasonableness.  It was also significant that Mr Bartlett had no previous experience in plumbing and drainage work.  There was no discussion or negotiation of the restrictive covenants and Mr Bartlett did not take legal advice.

Such circumstances may be quite common with franchises, some of which are marketed on the basis of 'no prior experience' being required in view of the quality of the licensed system.

The other circumstances in this case were that:

• Mr Bartlett had invested all his savings in the franchise agreement and should it come to an end he would have no other source of income.

• Dwyer thought the franchisee may fail.

• Some of the projections by Dwyer were inaccurate or misleading.

• Dwyer had no prior goodwill in the relevant territory.

As a result, the Court of Appeal held that the restrictive covenants were unreasonable and therefore unenforceable because:

• The projections were not realistic, and the failure of Fredbar was foreseeable with dire consequences on Mr Bartlett.

• The restrictions did not consider that Dwyer would have different levels of goodwill depending on when the agreement was terminated and at the start there was no goodwill to protect. At the time of termination, Mr Bartlett had only been operating for 18 months with limited earnings.

• The restriction was not capable of being overridden by Dwyer.

• Twelve (12) months seemed an arbitrary period constructed by lawyers.  

The second restriction was found to be unreasonable because there was no protectable goodwill in the extended area outside of the territory as Fredbar had not provided services there. 

So, overall, the clause was found to be unreasonable and parts of it could not be severed. Therefore, the clause was unenforceable.

Practical point - your franchise agreement

The Court of Appeal did say that there cannot be some general rule that a twelve (12)month restriction in franchise agreements is reasonable.  But that does not mean that a twelve (12)month restriction is unreasonable in every circumstance.

Following this decision, there are a number of issues which franchisors should consider to ensure that the restrictive covenants are more likely to be enforceable:

• Improve the recruitment process by ensuring that projections are tailored to the relevant area and the franchisee understands the terms of the clause and the legal relationship with the franchisor. The franchisee should be encouraged to take independent legal advice and attend courses on being a franchisee.

• Review the clauses to see if they should be softened somehow for example limiting the period to six (6) months and ensuring that the area protected is only where the franchisee has customers.

• Link the duration of the period to the length the franchise agreement has been in force. In his short contribution to the judgment dismissing the appeal, Arnold LJ noted that franchise agreements could have a covenant, the duration of which depended on how long the franchise agreement had subsisted prior to termination (with the assumption that this would be up to one (1) year).  This is because the longer the franchise had subsisted, the greater the goodwill would have been expected to have been built up and the longer the protection would have been justified.

• If the franchisee is likely to fail, provide more support to reduce this risk and highlight these issues at the start.  

His decision is a good reminder from the Court of Appeal, that certain clauses may not be enforceable and it should prompt franchisors to review their franchise agreements and ensure that there is a legitimate reason behind each clause (particularly when it is a restraint of trade).  If the clause cannot be defended as reasonable and legitimate, the court is more likely to find that it is unenforceable

John Shaw, Associate, Intellectual Property

To see the full Full judgment, please click here.