KNOW THE LIMITS

It is key for a franchise buyer to understand restraint clauses.

Most franchise agreements contain a restraint of trade or restrictive covenant clause, usually with the intention of restraining a franchisee and its guarantors from competing with the franchisor both during the term of the franchise agreement and for a period of time after its termination.

Usually, a particular geographical area is specified.

It is important for a franchise buyer to understand restraint clauses because they can significantly impact business interests the franchise buyer may already have, and limit what the franchise buyer can do after the franchise agreement ends (including if they sell the franchise business).

Here are three examples:

1. If the franchise buyer owns an independent fast-food business and wants to keep that and buy a similar franchise business, the restraint clause may prevent the buyer from owning both businesses at the same time as the independent outlet would be regarded as competition.

2. If the franchise buyer is a qualified auto mechanic and buys an auto-mechanic franchise, the restraint clause may prevent the franchise buyer from owning another similar business after the franchise agreement ends.

3. If the franchise buyer owns an

independent beauty salon and converts it into a franchised beautysalon business, the restraint clause may prevent the franchise buyer from converting the business back to an independent salon after the franchise agreement ends.

Franchisors usually include restraint clauses in their franchise agreements because they want to protect their goodwill. In other words, they don’t want to teach a franchisee everything they know about running their business and help them build a successful business only to then have the franchisee leave and open a competing business.

Usually, a restraint clause will prohibit a franchisee and its guarantors from being involved in a competing business

How much can a franchisor restrict your business activities during and after your term as a franchisee?

for a particular period of time and within a particular geographical area. These are often referred to as the “restraint period” and “restraint area”. For example, the restraint period could be one year after the franchise agreement ends, and the restraint area could be within a 10km radius of the franchisee’s premises.

Importantly, a restraint clause is only enforceable against a franchisee and its guarantors if it is reasonable. It needs to be judged as a reasonable and necessary action to protect the franchisor’s legitimate business interests, taking into account the franchisee and guarantors’ right to earn a living and the public interest in ensuring a competitive market.

The clause usually refers to the period of time and area within which the franchisor needs the former franchisee to be restrained from competing so the replacement franchisee can settle into the business, become established and build relationships with the former franchisee’s customers or clients.

A clause that restrains a franchisee from running a competing business for 10 years anywhere in Australia after the franchise agreement ends would probably be considered unreasonable, and therefore unenforceable. However, a clause including a restraint period of one year within a 10km radius of the franchisee’s premises could be considered rational and enforceable. The scope of the restraint must also be practicable.

What is considered reasonable will vary from business to business and depend on the circumstances of a particular case. There are no standard periods nor geographical areas that the law or the courts have stated will be reasonable and therefore enforceable in all cases. Because of this, restraint clauses sometimes include options. For example, the restraint period may be three years, two years or one year after the franchise agreement ends, and the restraint area a 20km, 10km or 5km radius of the franchisee’s premises.

This enables a court to choose which time period and geographical area it considers appropriate to protect the franchisor’s legitimate business interests in a particular case, and therefore increases the likelihood the restraint clause will be enforceable. These are known as cascading or ladder clauses.

If a franchisee or its guarantors breach a restraint clause by, for example, opening a competing business immediately after the franchise agreement ends, the franchisor may be entitled to obtain an injunction to stop the franchisee and/or guarantor from running the competing business, and/or an order that the franchisee and/ or guarantor pay the franchisor damages for losses resulting from the breach.

If the former franchisee has sold the business to a new franchisee, the new franchisee may also be entitled to the same remedies if the sale agreement included a restraint.

There have been some changes to the law relating to the enforceability of restraints:

1. The Franchising Code of Conduct now

states that a restraint in a franchise agreement dated after January 1, 2015, will have no effect after the franchise agreement expires if:

1. the franchisee has asked to extend the franchise agreement on substantially the same terms as those contained in the franchisor’s current franchise agreement

2. the franchisee was not in breach of

any agreement with the franchisor 3. the franchisee had not infringed the intellectual property of, or a confidentiality agreement with, the franchisor

4. the franchisor does not extend the

franchise agreement

5. and either:

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

• the franchise agreement did not allow the franchisee to claim compensation for goodwill in the event it was not extended.

2. The unfair contract terms law now applies to some franchise agreements dated on or after November 12 2016, and provides that overly broad restraint clauses may be considered unfair contract terms and will therefore not be enforceable.

3. A franchise buyer should carefully review proposed restraint clauses so they know the limits before entering into a franchise agreement.

A clause that restrains a franchisee from running a competing business for 10 years anywhere in Australia after the franchise agreement ends would probably be considered unreasonable, and therefore unenforceable.