A business owner sold his franchised business.  The Agreement for Sale and Purchase included a restraint of trade clause which provided that he (or any related entity) could not compete with the franchise for a period of two years, within the lower North Island.  During that two year period, he decided that he wanted to use the skills he had gained from his time owning the franchise, and set up a similar business under a different company name.  He had thought that the franchisor would not even notice that he was trading.

The franchisor was particularly concerned about restraints of trade as they had experienced similar issues in the past, and therefore took a very hard stance on enforcing such clauses.

A restraint of trade clause can provide essential protection of your business interests.

For example, restraints of trade can prevent the value of a newly-purchased business from being eroded by the seller setting up a competing business. They can also protect the value of a franchise where ex-franchisees exploit the brand’s goodwill and business know-how by setting up competing businesses.

However, restraint of trade clauses can also be difficult to enforce.

What is a Restraint of Trade?

A restraint of trade is a clause in an agreement that seeks to prohibit a person or entity from engaging in a competing business within a certain area for a certain amount of time.

We often see people attempting to enforce restraints of trade clauses in franchises.

Are they enforceable?

New Zealand Courts have held that the general starting point for a restraint of trade clause is that it is not enforceable.

However, if the person looking to enforce the restraint can establish that it is reasonable, then it may be enforced.

A restraint of trade is reasonable if it can be shown that it is:

1. Justified by a protectable interest; and
2. Not wider than is reasonably necessary to protect that interest.

What a ‘protectable interest’ is will depend on the circumstances of each particular case.

In the franchise context, a protectable interest should not be presumed simply because of the existence of a franchise arrangement.

Franchises with strong goodwill associated with their brand who provide ‘tried and tested’ models of operation and up-to-date and useful materials and systems are likely to have a protectable interest.

Whereas, those franchises with a weaker brand and associated goodwill, failing or dying models of operation, and out-of-date or unhelpful materials and systems, may not have a protectable interest.

Even if there is a protectable interest, the restraint of trade must still not be wider than what is reasonably necessary. What is “reasonably necessary” will depend on the particular business' circumstances, but the courts have a number of established criteria that they consider when making their decision. Their criteria includes considerations such as the type of business being operated (that is, is it low-skilled or high-skilled?; is it common-place or unique?), and also the prior industry knowledge of the franchisee.  In relation to the latter, courts are less inclined to enforce lengthy restraints where the francisee was already skilled or qualified in the relevant industry. Conversely, a court is more likely to enforce a longer restraint where the franchisee gained significant knowledge of an industry from its franchisor and is proposing to use that training to directly (and immediately) compete with it.

The Courts will often reduce the boundary of restraints of trade,  for example from the entire country to the relevant territory or city, and the period of restraint from years to months.

For example, in the franchise context the Court of Appeal recently reduced a 2-year restraint of trade period to 3 months, focusing on what length of time was necessary for the franchisor to set up a new franchise in the area to take advantage of the remaining goodwill.

Overall, it can sometimes be hard to gauge whether a restraint of trade is reasonable and therefore enforceable.

With franchises, it is important not to assume that there will be a protectable interest just because there is a franchise arrangement in place. Careful consideration of a franchise’s goodwill, systems and materials are essential in determining whether any restraint of trade is enforceable.

If you are concerned that someone is breaching a restraint of trade, or if you are considering entering into an agreement that includes a restraint of trade, you should take professional advice.