Restrictive covenants in old agreements can still apply

Restrictive covenants in old agreements can still apply

Post-termination restrictive covenants in franchise agreement that has previously expired can still apply.

It is fairly common, after a franchise agreement has expired, for a franchisor and franchisee to continue to do business with each other as before, without entering into a written agreement to extend or renew the franchise for a further term. This has resulted in conflicting case law over whether restrictions in the written franchise agreement to prevent the franchisee from competing apply when the franchise finally ends and, if so, when they start to apply; is it when the original agreement expired or when the franchise relationship ends?

In the latest case of PSG Franchising Ltd v Lydia Darby Ltd, the High Court ruled in favour of the franchisor. It held that various restrictions did apply and were enforceable even though their meaning was ambiguous and could be interpreted as being too wide to be enforceable. In coming to its decision, it applied established employment law principles on restrictive covenants to business to business relationships. It held as follows:

(i) one restrictive covenant (not to compete within a territory) which was ambiguously worded was enforceable; and

(ii) it dismissed the franchisee’s argument that another restrictive covenant (not to provide services which are the same or similar to customers) was too wide.

In this case, the franchisee was running a property search business pursuant to a franchise agreement which ran for a 5 year fixed term. The franchise agreement included restrictive covenants that would apply for 1 year following its termination. When the term expired, the franchisor continued to allow the franchisee to run the business for a further 17 months. At the end of this period, they formally agreed to terminate their relationship by entering into a deed of surrender which sought to apply the restrictive covenants contained in the original franchise agreement. The franchisor subsequently discovered that the other party had set up in competition with the franchisor within 6 months following the expiry of the original franchise agreement. The franchisor applied to have the restrictive covenants in the original franchise agreement enforced and was successful.

The general legal position is that provisions that restrict a person’s freedom to carry on their trade or business following termination are unenforceable as they are viewed as a restraint of trade. The exception to this rule is that a restriction intended to protect a business’s legitimate interests is permitted, provided it is no wider than is necessary to protect those interests. The important points to note in this case are as follows:

(i) where a restriction has 2 possible different interpretations (1 enforceable and 1 unenforceable), then provided that no amendment is required, the enforceable interpretation may apply (where it is in line with commercial common sense and is interpreted in the same way as what a reasonable person would have understood it to mean); and

(ii) the judge commented that if the deed of surrender had not expressly referred to the restrictive covenants contained in the original franchise agreement, he would still have found that the restrictive covenants continued to apply with effect from the point where the parties’ relationship had terminated (and not when the term of the written franchise agreement had expired).

The above case offers little comfort to franchisees who continue to run a franchise after the written franchise agreement has expired and who may have thought that the non-compete restrictions ceased to apply because no new formal agreement had been entered into. Where they have any concerns over the drafting or meaning of the restrictions it is advisable to take proper legal advice before signing the agreement at the outset, while bearing in mind that the law can change and alter the position during the life of the franchise. Whereas, a franchisor should also seek legal advice periodically to ensure that their franchise agreements are kept up to date. Also, where a franchisor wishes to allow a franchisee to continue to operate the business after the original franchise agreement has expired they should formally document the new agreement.

Image by ‘Gajus‘ under a Creative Commons licence.