Recent restraint of trade victory for franchisor

A recent decision of the High Court has delivered a Restraint of Trade victory to a franchisor.

The case was Para Rubber Ltd v Bailey, decided in the High Court at Palmerston North in August 2012.

The franchisee had commenced its association with the franchisor in the 1980’s, initially as an employee, then becoming a licensee, and finally becoming a franchisee in 1996.

As is typical with franchise agreements, there was a restraint of trade clause. The director of the franchisee, Mr Bailey, was a guarantor and he also agreed to a personal restraint of trade obligation.

The restraint of trade clause provided that, on termination, Mr Bailey was prohibited from engaging in a competing business for one year from termination, within a 5 kilometre radius of the premises and a 2 kilometre radius of the territory.

On 4 May 2012, the franchisee gave notice that it was terminating the franchise agreement. Mr Bailey set about incorporating three new companies, with himself and his wife being directors and shareholders of one company and his wife being a sole director and shareholder of the other two. The business was re-branded and these companies were involved in trading the new business.

The franchisor sought an interim injunction to restrain Mr Bailey from breaching his restraint of trade obligations.

The legal action was commenced against the franchisee, Mr Bailey and the three new companies but the interim injunction appears to have only been sought against Mr Bailey.

This case was of immediate interest to me because I have often seen ex-franchisees incorporating new companies with their wives / husbands as directors, believing that in doing so, their activities will completely avoid the umbrella of a restraint of trade prohibition. As this case shows however, that is potentially a very dangerous misapprehension.

It also needs to be mentioned that this case came before the Court by way of an application for an interim injunction. In such cases, the Court does not make substantive and final findings on whether a restraint is enforceable. All it is required to consider in relation to the merits of the claim is whether or not there is a “serious question to be tried” that there has been a breach of a restraint of trade clause. This is a threshold standard of evidence that needs to be met.

In the decision, the Judge recorded Para Rubber’s very commercially put argument that although separate companies had been set up, the practical reality of the operation is that they were all being conducted as one business.

On the issue of the restraint of trade clause, Mr Bailey accepted Para Rubber was entitled to the protection of its business model. Unlike in earlier decisions, where the issue of “protectable interest” can be the subject of hot contest, that matter therefore appears to have been readily accepted by the franchisee.

On the issue of whether there was a serious question to be tried, the Judge found that there was a serious question to be tried that the restraint was being breached by Mr Bailey.

Having established that aspect, the Judge then went on to consider where the balance of convenience lay. The question of the balance of convenience always sits at the heart of any interim junction case. In simple terms, it involves the Judge weighing up and balancing the respective interests and possible irreparable harm to both parties in the event an interim injunction is granted. Issues like whether or not in applicant would be adequately compensated in damages are also considered to be relevant at this point.

On the balance of convenience, the Judge concluded that lay in favour of the franchisor, for a variety of reasons, including that damages would not be an adequate remedy to Para Rubber because the assessment of damages would be difficult (typically this is always the case with breach of a restraint of trade clause) and, further, there were doubts about Mr Bailey’s ability to pay.

The Judge noted that Para Rubber would have lost the ability to secure a new franchisee because of the competition from Mr Bailey’s new business. The judgment records that an application from a potential franchisee to reopen the Para business in Palmerston North, subject to the success of the restraint of Mr Bailey, had been received. The Judge therefore accepted the Para Rubber could lose that potential franchisee in the event Mr Bailey was not restrained.

Taking all matters into account, it was found that it was in the interest of justice to grant the interim injunction against Mr Bailey.

This case would possibly have been an expensive lesson to the franchisee and Mr Bailey. It highlights the level of risk that is faced when franchisees proactively terminate agreements and set about restructuring and rebranding, without the consent of the franchisor. Once that journey is commenced, it is very hard to go back and franchisees need to think very hard about setting off down that path.

The case has certainly delivered a victory to franchisors feeling the effect of some uncertainty in this area. It does however need to be remembered that this was merely an interim injunction, where substantive issues are not finally ruled.