In a recent case
[1], the New South Wales Court of Appeal considered the rights of a franchisor after the end of a franchise agreement. In particular, the court considered:
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whether the parties’ rights and obligations were governed by the clauses that dealt with termination, or the clauses triggered by expiry; and
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the enforceability of the restraint of trade clauses to prevent the ex-franchisee from carrying on the same business under its own brand at the same locations.
The Court findings illustrate the need for clear and consistent communication when bringing a franchise relationship to an end, and the challenges in presenting a compelling argument in support of enforcing a restraint of trade clause.
Background
Karioi, the franchisee, signed 2 franchise agreements in April 1998 to convert their existing video store businesses to Blockbuster video stores. After the agreements expired in April 2008 Karioi, with Blockbuster’s approval, continued as a Blockbuster franchisee at both locations while the parties negotiated the basis on which the agreements might be renewed. The parties did not reach agreement so the relationship ended in August 2008.
The case looked at:
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whether the parties’ rights and obligations were based on the agreement having “been terminated” or “expired”
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the enforceability of the restraint of trade clauses to prevent Karioi from carrying on business as a non-Blockbuster video store at the same locations.
Termination versus expiry
The Franchise Agreements provided certain rights that applied on termination and others (less onerous to the franchisee) that applied on expiry.
In considering whether the agreement had expired or been terminated, the court concluded that the correspondence between the parties was inconsistent in describing the legal relationship between the parties during the period after the expiry of the term until the Franchisee stopped being a “Blockbuster” franchisee. Although some correspondence referred to termination, the courts concluded that overall the parties’ communications showed an understanding that Karioi would continue to operate as a Blockbuster franchisee until either it renewed or the negotiations around renewal concluded without coming to an agreement. If negotiations failed, Blockbuster’s consent to Karioi’s ongoing operation of the franchises would be withdrawn, so the franchises would “expire”. Factors which influenced the finding of “expiry” rather than “termination” were:
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Blockbuster’s statement in correspondence that if the agreement came to an end, it would consider exercising the option to acquire the assets of the business under a clause which only applied upon expiry; and
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the franchise agreements’ references to “termination” being entirely connected with default on the part of the franchisee.
Action Items for Franchisors on termination/expiry
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Franchisors need to understand the implications of expiry and termination (particularly termination for breach) under their agreement.
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When communicating with a franchisee, be clear and consistent about the basis on which you are bringing the agreement to an end.
Restraint of trade
Blockbuster’s ability to enforce the restraint of trade clause in full (to prevent Karioi from carrying on a non-Blockbuster video shop in the two locations) depended on establishing a legitimate interest which should be protected by the restraint clause. The court also looked at whether the restraint of trade clause was necessary to prevent the ex-franchisee gaining an unfair advantage over any new franchisee setting-up in the same area.
Was the restraint clause necessary to protect Blockbuster’s goodwill?
Blockbuster argued that there were 3 facets of goodwill:
In considering the enforceability of the restraint clauses, the court observed that both parties knew, at the time of entering into each agreement, that upon expiry of the franchise:
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Blockbuster could obtain an interest in the location-based goodwill of the business (which it could then protect through the restraint clause) by exercising its options to purchase the assets and leasehold interests from the franchisee; and
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specific clauses dealing with use of confidential information and industrial property after expiry would protect Blockbuster’s interest in its branding and other intellectual property.
The Court found that:
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To the extent that Blockbuster’s goodwill derived from its brand and systems, it was protected by prohibitions on the use by the ex-franchisee of Blockbuster’s intellectual property and confidential information after the end of the franchise agreement.
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Blockbuster could not claim that it had goodwill arising from the location of the shops because Karioi already had the rights to occupy the premises before making the franchise agreements and Blockbuster had not sought to take over those locations.
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Leaving aside the issues of IP/brand, and location, which were sources of goodwill which could be protected by other clauses of the Agreement, the Court found that there was no other source of goodwill in the business (such as “patronage of the stores”) to attract the additional protection of the restraint of trade clause.
Was the restraint clause necessary to prevent the “old” franchisee maintaining an unfair advantage over a “new” one?
The court noted other franchising cases where it was found that the franchisor needed time to obtain a substitute franchisee for the franchised territory and the new franchisee needed time to become established, so that direct competition by the former franchisee should be prevented by means of the restraint clause.
In the present case, the court found that there was no evidence of any reason, apart from the location of the stores, why customers would patronise a non-Blockbuster store conducted by Karioi after the end of the agreement rather than a Blockbuster store operated by a substitute Blockbuster franchisee. Indeed, the court noted that the Blockbuster brand would potentially be a significant feature in attracting customers to a new Blockbuster outlet rather than a store conducted by Karioi under its own brand.
Therefore Blockbuster had no need of the additional protection of the restraint of trade clause from the perspective of taking an “unfair advantage” away from the franchisee.
Action items for franchisors on restraint of trade
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Courts may not uphold a restraint of trade clause where there are alternative ways of safeguarding goodwill. Franchisors need to understand the sources of “goodwill” in the business that their franchisees carry on and ensure that their agreement allows them to protect each of the main sources of goodwill.
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If franchisors do not avail themselves of the rights which allow them to gain control of sources of goodwill (IP, premises) they may find that they cannot rely on the restraint of trade clause unless there are other legitimate interests (for example, protection from the ex-franchisee having a “head start”) to protect which are outside the ambit of those specific clauses.
For further information please contact:
Lis Boyce | Partner
T + 61 2 8233 9566
F + 61 2 8233 9555
[1] BB Australia Pty Ltd –v- Karioi Pty Ltd [2010] NSWCA 347
