What are your rights?

Gurmeet Jakhu explains good faith obligations and restrictive covenants in franchise agreements

Franchise agreements will contain many express terms that a franchisee is required to comply with. Recently, franchisees have argued that a term should be implied in the agreement that requires a franchisor to act in good faith in its dealings with its franchisee. English courts, however, have been quite hostile towards recognising an implied duty of good faith in all commercial contracts.

Restrictive covenants commonly feature in franchising agreements and are designed to protect goodwill and customer contacts developed in the territory once the agreement comes to an end, by restricting the franchisee from being involved in a similar or competing business and from soliciting former customers for certain time periods. A recent High Court decision has provided some clarity over whether a duty of good faith should be implied into a franchise agreement and whether restrictive covenants are robust enough to withstand challenges based on competition law. The case involved a franchisor that provided home-care services through a network of franchisees and its own corporate branches.
The franchisor started offering live-in care services and a dispute arose with one of its franchisees, who was said to be involved in a competing business that provided live-in care. The franchisee argued that they were not in breach but that the franchisor was itself in breach of an implied duty by setting up company-owned branches in competition with its franchisees.
Negotiations failed to resolve the differences and the franchisee terminated the franchise agreements, arguing that the franchisor was in repudiatory breach of the implied terms. If correct, the franchisor would not be able to enforce its non-compete restrictive covenants against the franchisee. 

The franchisee further argued that the franchisor’s restrictive covenants were not enforceable based on common and competition law, as at the time of signing the franchise agreement the franchisor was not offering live-in care services.
Following termination, the franchisee continued to trade in a similar business. The franchisor was left with little alternative other to apply to court for an order to stop the franchisee (and its two directors) from breaching the restrictive covenants. One issue that the court had to decide was the validity of the franchisee’s termination, which revolved around whether good faith was implied into the terms of the franchise agreement, as sought by the franchisee.

Implied duty of good faith In an earlier case, the High Court had said that there were certain categories of ‘relational contracts’, which it described as long-term contracts that require an ongoing relationship of dependence between the parties, like joint venture, distribution and franchise agreements, into which a court may readily imply a duty of good faith, based on the presumed intention of the parties. At the hearing involving care services, the franchisee relied on this case and argued that a number of terms, based on good faith, were implied in their franchise agreement.

The judge refused, however, on the grounds that that the franchise agreements already contained very detailed express terms and many of the implied terms proposed by the franchisee would have been inconsistent with the express provisions of the agreements. Restrictive covenants The judge was satisfied that the clauses were reasonable and enforceable as a matter of common law, as they were necessary to protect a legitimate business interest (eg goodwill). In particular, the franchisor successfully argued that the live-in care provided by the franchisee did amount to a competing business and was caught by the restrictive covenants.

This is because the term ‘business’ applied to the franchisor’s business as it continued to develop over time, including any subsequent changes, despite that at the time of signing the agreement the franchise was not offering live-in care services. The franchisee argued that the restrictive covenants were unenforceable because they breached EU and domestic competition law. In broad terms, the Competition Act 1998 prohibits agreements that have as their object the prevention, restriction or distortion of competition within the UK.

The whole point of a restrictive covenant is to prevent the franchisee from trading in the former territory, hence the covenant, is on the face of it, in restraint of trade. The franchisor successfully argued, however, that the restrictive covenants:

• Are necessary in order to ensure that the know-how and assistance provided by the franchisor does not benefit competitors, and
• Establish the control necessary to maintain the identity and reputation of the network identified by a common name or symbol,
• and so they do not constitute restrictions of competition. It is important to note that the directors had no prior knowledge or experience in the care business before entering into the agreements and the know-how and assistance provided by the franchisor to the franchisees (and its directors) was of an extent and type likely to turn them into effective competitors.

This case provides clarity going forward. The court was not persuaded that this particular franchise agreement was one to which the implied terms, as argued by the franchisee, would apply and the judgment is a useful reminder of the need for caution before challenging restrictive covenants.

Gurmeet Jakhu is a partner at Nelsons Solicitors