Restraint of Trade Cases - Franchise Law Update

Recent Cases on Restraints of Trade in a Franchising Context.

General Principle

It is well established that a contractual provision that is otherwise valid will be void as contrary to public policy if it imposes an unlawful restraint of trade.  In Nordenfelt –v- Maxim Nordenfelt Guns & Ammunition Company [1894] AC 535, Lord McNaghten put it this way:

“The public have an interest in every person carrying on his trade freely:  so has the individual.  All interference with individual liberty of action in trading, or restraints of trade of themselves, if there is nothing more, are contrary to public policy and, therefore, void.  That is the general rule, but there are exceptions: restraints of trade and interference with an individual liberty of action may be justified by the special circumstances of a particular case.  It is a sufficient justification, and indeed it is the only justification, if the restriction is reasonable – reasonable, that is, in reference to the interest of the parties concerned and reasonable in reference to the interest of the public, so framed and so guarded as to afford adequate protection to the party into whose favour it is imposed, while at the same time it is in no way injurious to the public (565).”

That statement has been accepted as representing the law in Australia:  see Lindner –v- Murdochs Garage [1950] 83 CLR 628, Buckley –v- Tutty [1971] 125 CLR 353 and Peters (WA) Ltd –v- Petersville Ltd [2001] 205 CLR 126.

The starting point is that restraints are contrary to public policy and, therefore, void unless in the special circumstances of the particular case:

1. The restraint is reasonable as between the parties.
2. The restraint is reasonable having regard to the public interest in competition.

The assessment of these two tests of reasonableness is made against the facts and circumstances at the time the agreement was made not at the time the agreement is sought to be enforced or damages claimed for breach.

The onus of establishing that as between the parties, the restraint is reasonable, having regard to their respective interests, lies on the person seeking to rely on the restraint, and the onus of establishing that it is nevertheless contrary to public interest lies on the person who asserts that:  Herbert Morris Ltd –v- Saxelby [1016] 1 AC 688.

In New South Wales, but not in any other state or territory, the court may read down an otherwise void restraint of trade – section 4 Restraints of Trade Act 1976.

Typically proceedings relating to restraints are not actions for damages for breach, but injunctive proceedings to either enforce or declare void the restraint.  Often they are interlocutory applications and are, therefore, affected by a range of attendant discretionary issues relevant to equitable remedies.  Care, therefore, needs to be taken in looking to reported decisions for guidance because they inevitably turn on their own facts.

Raine & Horne Pty Ltd –v- Adacol Pty Ltd [2006] NSWSC 36 – Restraint Affecting a Franchisee Following Termination of Franchise Agreement

This was an application for interlocutory injunctive relief.  Much of the judgment deals with the discretionary nature of injunctive relief (whether damages are an adequate remedy, balance of convenience, etc).  An interlocutory injunction would effectively determine the substantive matter.

Adacol conducted a Raine & Horne franchise at Brighton and Ramsgate in Sydney’s southern suburbs.

The franchise agreement contained the following clause:

“29.1 - The franchisee and the (guarantors) agree they will not for a period of 12 months after termination (for whatever reason) of this deed, conduct or be in any way employed or interested in any real estate agency business which carries on business substantially within a 5km radius of the premises.”

The franchise agreement had been terminated by the franchisor because Adacol “voluntarily abandoned the franchise business or the franchise relationship” prior to the end of the term.

Adacol continued to run the business from the premises and entered into a Ray White franchise agreement before the end of the Raine & Horne term and before the Raine & Horne franchise agreement was terminated.  It was a condition of the Ray White franchise agreement that franchise fees be waived until the end of the Raine & Horne term. 

The issue for the court was whether the restraint of trade is void because of the public interest in competition or whether Raine & Horne was able to show the restraint is no wider than is reasonably necessary to protect its legitimate interests. 

The issue from a franchising perspective is that the court’s attention was drawn to the nature of the interest a franchisor claims in the business of a franchisee.

The court considered the characterisation of restraints in a number of cases relating to employees and then observed “the adaptation of those principles to the franchise context requires some care”.

The court observed that the restraint could be complied with if Adacol conducted a real estate agency business outside of the 5km radius, even if it serviced customers located within, sold or managed properties within the 5km radius, or serviced customers who had previously been customers of the business.

Neither party addressed the Restraints of Trade Act 1976 and the case appears to have proceeded on the basis that the franchisor either had a legitimate interest to be protected or it did not.  There was no issue of reading down the restraint.

The court found that a franchisor has the following interests to be protected by a restraint of trade:

1. Its direct interest in receiving franchise fees under the franchise agreement.  In this case, Adacol proposed to continue to pay the franchise fees until the end of the term so to that extent this interest was addressed, or not at risk.
2. An interest in the franchise itself over and above the revenue it derives from it.  For example, if the franchise comes to an end by effluxion of time, it is open to Raine & Horne to enter into a new franchise agreement with another franchisee to establish what would be in substance a takeover of the existing Raine & Horne business, without competition from the former franchisee.  This is something quite significantly different to building up a new franchise business in the teeth of competition from the existing franchisee in the very location.  Support for this interest was found in the assignment provisions of the franchise agreement, which provide for the franchisee to be restrained from competing with the purchaser (in addition to any restraint the purchaser negotiates with the former franchisee).
3. Raine & Horne has significant goodwill in an existing business built up over many years, notwithstanding that goodwill had been contributed to by Adacol.

Having come to the conclusion the franchisor had a legitimate interest in the business of the franchisee, the Court had no trouble coming to the view the restraint was enforceable.

Master Class Enterprises Pty Limited –v- Bedshed Franchisors (WA) Pty Limited [2008] WASC 67 – Restraint Affecting Franchisee During Term of Franchise

Bedshed carries on business as the franchisor of retail stores, principally in Western Australia, but to a lesser extent in other states, which trade under the name “Bedshed”.   Bedshed has been engaged in that business since 1985 and there are currently more than 30 Bedshed stores around Australia.  Most, but not all, stores are franchised.  There are a number of “company stores”.

Masterclass is a franchisee conducting a store at Claremont, a western suburb of Perth.

Mr and Mrs Cary are the directors and shareholders of Masterclass.  They guaranteed the franchise agreement.

On 1 March 2007, Masterclass entered into an agreement to sell Bedshed Claremont to BRPL.  The directors and shareholders of BRPL are Mr and Mrs Nixon and their son.  The agreement was subject to Bedshed’s consent to the assignment.

After some negotiation, Bedshed ultimately refused consent to the assignment because the directors (and proposed guarantors of the franchise agreement) of BRPL would not commit to compliance with clause 6.2 of the franchise agreement, which provided as follows:

“The [Bedshed Claremont business] and the [premises at which it is carried on] shall at all times be under the direct supervision of the franchisee or the guarantor, except for short temporary absences and reasonable vacations from time to time (in which case the business shall also be under the direct, or on-premises supervision of a fully trained employee – manager approved by the franchisor).” 

Masterclass sought as a mandatory injunction requiring Bedshed to consent to the assignment and a declaration that clause 6.2 of the franchise agreement was an illegal restraint of trade, or at least, that its practical effect was a restraint of trade in that if the guarantors were committed to full-time supervision of the business, they had no time to conduct any other business or occupation.  The submission was that the requirement was both more than what was reasonably required to protect the legitimate business interests of Bedshed and anti-competitive.

Prior to the sale, Mr and Mrs Cary had moved to Bunbury, 175 km south of Perth.  They had reduced their involvement in the business to the point where it was effectively being managed on a full-time basis by an employed manager.  Whilst not directly referred to in the judgment, one can infer no complaint had been made by Bedshed about this arrangement for managing the store.

BRPL and the Nixons had proposed that the manager take a 5% share and be appointed a director of the company and that she guarantee the franchise agreement.  In a separate agreement, the Nixons then were to indemnify her in relation to any claims arising out of the conduct of the business.

The court looked at the recitals to the franchise agreement and a number of other clauses in both the franchise agreement and the operations manual and came to the conclusion that the purpose of clause 6.2 was to ensure that the person responsible for the day-to-day conduct had a substantial interest in the business (as owner or guarantor) and to enhance the effective management of the business as opposed to it having the intention or the effect of a restraint of trade.

Allegra of North America Inc –v- Stevens [2008] BCSC 1220 – Restraint on Former Franchisee Following Sale – Canadian Case

The law in Canada is remarkably similar to Australia in that a restrictive covenant will only be enforced if it is reasonable between the parties and with reference to the public interest in competition.

The defendants had been franchisees of a “Signs Now” franchise in Chilliwack.

There had been previous litigation between a former franchisor and the franchisee that was resolved.  Subsequently a breach notice issued and ultimately the franchise agreement terminated. 

The application made to the Court by the franchisor was to enforce a restraint to prohibit the former franchisee from operating a “bucket truck” business.  A bucket truck is a cherry-picker.

Signs Now franchisees manufacture signs.  Many (but not all) provide maintenance and installation services as well. 

The restraint provision in the franchise agreement provided as follows:

”… the franchisee and franchisee’s principals shall not engage in any business or principal activity including the sale of signs, or which is similar to or competitive with any Signs Now centre …”

The franchisor’s case was that the bucket truck business was competitive with a Signs Now centre.

The former franchisees argued that the definition and scope of activity to be prohibited is uncertain.  They argued in the alternative that if it was not uncertain, it must be read down to refer to only the manufacture or retail of signs and not the maintenance and installation on the basis that not all Signs Now franchisees provide installation and maintenance services.

The Court looked at the offering memorandum (disclosure document), the recitals to and other provisions of the franchise agreement, the operations manual and other IP of the franchisor, to assess the extent to which the franchisor had a legitimate business interest to protect and whether the restrictive covenant was reasonable. 

Notwithstanding the franchise agreement referred to “confidential information materials, trade secrets, knowledge and unique methods of business or procedures”, the Court found whilst there were some methods, procedures and other IP, they were not comprehensive.  In particular, although numbers of franchisees were providing maintenance and installation services, there was little or no specific franchisor IP relating to these services.

The Court stopped short of finding that the restraint was void and did not address the submission in relation to reading down.  It found that because the bucket truck services were not core services of the franchise network they were not caught by the restrictive covenant. 

Paul Kean - Solicitor, MCW Lawyers (from a session of the National Franchise Convention 2008)