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The Fundamental Aspects of the Franchise Agreement: Part 10

Written by : Joseph Adler

Restrictive Covenants

A franchisor should do its utmost to protect its investment in its franchise system. To that end, franchisors will require that the franchisee and its shareholders, directors and officers (if a corporation) and its partners (if a partnership) refrain from competing directly or indirectly with the franchisor’s business during the term of the franchise agreement (“in-term covenant”) and thereafter (“post-term covenant”). If an employee of the franchisee who is not a director or officer of the franchisee is an integral part of the franchise system, it is advisable that the franchisor require in-term and post-term covenants against competition from that person as well.

Many franchisors in attempting to prevent such competitive behaviour have incorporated into their franchise agreements language similar to the following terminology:

Franchisee shall not engage in any business operating in competition with or similar to the Franchised Business or franchise businesses similar to the Franchised Business.

However, wording such as “similar to or competitive with” is too ambiguous and broad in scope and may be void on the grounds of public policy. This is so because such a provision could be interpreted to mean that a franchisee formerly operating a donut shop may not then operate a hamburger franchise upon termination, as such franchises may be technically seen as “competitors” of each other since they may be competing for the same customers. While franchisors may legitimately wish to prevent precisely that kind of competitive behaviour, the courts may view such clauses as being too broad and restrictive in nature and therefore unenforceable.1

Generally speaking, Canadian courts favour the principle of freedom of contract. Although this is the case, provisions of this kind will only be enforced if they are reasonably necessary to protect a legitimate interest of the franchisor and are at the same time reasonable from a public interest point of view, as the courts are reluctant to enforce restrictive covenants that are “in 1 See Magnetic Marketing Ltd. v. Print Three Franchising Corp. (1991), 38 C.P.R. (3d) 540 (B.C.S.C.) where a non-competition provision was held to be too broad and therefore unenforceable. See, however, Enco Seat Covers Ltd. v. Enco Auto Trim & Glass (Newmarket) Ltd. (1993), 8 B.L.R. (2d) 20 (Ont. Gen. Div.), additional reasons at (1993), 8 B.L.R. (2d) 20n (Ont. Gen. Div.) where a three year non-competition covenant was enforced by the courts notwithstanding the use of ambiguous language not so dissimilar than the language found to be offensive by the court in the Magnetic Marketing case referred to above.

restraint of trade”. Courts will consider the geographic scope of the territory, the number of years for which the restrictions apply and the type of business activity that is being restricted. Generally speaking, the more narrow the restriction, the more likely it is that the courts will enforce such activities. This is one of those occasions where the old adage “less is more” has particular resonance.

Generally speaking, Canadian courts will likely not enforce restrictive covenants that are in excess of two (2) years and at territories that are broader than the scope of protection reasonably required under the circumstances. Furthermore, courts are more likely to enforce a restrictive covenant in a scenario involving a voluntary sale of a franchised business by a franchisee, than when the franchisee is terminated by the franchisor on a without cause basis, for example. Courts are also less likely to enforce a non-competition covenant that restricts the departing franchisee from operating in the area outside of the franchisee’s former territory, rather than a covenant that simply prohibits the franchisee from competing within the said territory. The Courts will also have difficulty enforcing a non-competition covenant in an area where the franchisor has no franchisees in operation.

The leading case in Canada regarding the enforcement of non-competition clauses in an employment scenario is Elsey v. J.G. Collins Insurance Agencies Ltd., [1978] 2 S.C.R. 916, where the Supreme Court of Canada held that:

“A covenant in restraint of trade is enforceable only if it is reasonable between the parties and with reference to the public interest. As in many of the cases which come before the courts, competing demands must be weighed. There is an important public interest in discouraging restraints on trade, and maintaining free and open competition unencumbered by the fetters of restrictive covenants. On the other hand, the courts have been disinclined to restrict the right to contract, particularly when that right has been exercised by knowledgeable persons of equal bargaining power.”

Interestingly, the Supreme Court commented that it is only in “exceptional cases” that a noncompetition covenant is justified as opposed to a non-solicitation prohibition. It is where the “proprietary interest of the employer” is in need of protection that a non-competition covenant may be in order. Arguably, a non-competition covenant will be deemed to be enforceable in the franchising context as well, given the proprietary interest that needs to be protected by the franchisor for the franchise system to survive and prosper.

Canadian courts are more likely to enforce such covenants when they involve a purchase and sale of a business, where the vendor of the purchased business is in theory compensated (i.e., by way of the purchase price) for agreeing to provide the restrictive covenants in favour of the purchaser. If an employee is terminated on a without cause basis, however, the Courts will have a more difficult time enforcing wide-ranging covenants as against the terminated employee, particularly when the employee is seen as being unfairly constrained from pursuing his or her livelihood. The Supreme Court’s analysis in Elsey, while pertaining to an employer-employee relationship, is nevertheless instructive when drafting non-competition covenants in the franchising scenario as it provides us with some guidance as to what the Courts will consider reasonable in this regard.2

One hurdle that a franchisor may face in enforcing its non-competition covenant, however, is when unequal bargaining power is evident as between the franchisor and the franchisee. In such 2 The Ontario Court of Appeal case of Lyons v. Multari, (2000) 50 O.R. (3d) (Ont. C.A.) cited Elsley with approval by holding that a non-competition covenant may be unenforceable if a non-solicitation clause is sufficient to protect an employer’s interests. Once again, franchisors are advised to seek out legal counsel when crafting these types of restrictive covenants in their franchise agreements. A case, the Courts, relying upon the reasoning of Elsley, may refuse to uphold the noncompetition covenant in favour of supporting the right of the departing franchisee to contract. Since there is a risk that the Courts may find some or all of the restrictive covenants unenforceable, drafters of these covenants will often incorporate language on the severability of these provisions of a franchise agreement. That is, where any term or condition of the agreement is considered invalid or unenforceable, all other terms and conditions of the agreement are deemed not to be affected thereby and each term and condition of the Agreement are considered to be separately valid and enforceable to the fullest extent permitted by law. In this manner, a Court may deem the offensive provision invalid, without affecting the enforceability of the balance of the agreement. 3

Finally, franchisees should acknowledge in their franchise agreements that franchisors are entitled to pursue injunctive relief should the franchisees breach their restrictive covenants and that any claims that the franchisees may have as against their franchisors shall not constitute a defence to the enforcement of any of the restrictive covenants by the franchisors.

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