The sticky issue of Restrictive Covenants: Part 2 Holding Over

I last broached the sticky issue of restrictive covenants in 2011 - when the courts confirmed that restrictive covenants in franchise contracts were legitimate to protect the goodwill of the franchisor provided they did not exceed a period of 12 months after the franchise contract was terminated. This case finally gave franchisors a level of certainty about the enforceability of restrictive covenants in its contracts.

This issue has recently been revisited in a case concerning the enforceability of a restrictive covenant in a franchise contract that had expired, but where the franchisee and franchisor had continued to operate the franchise anyway until, eventually, the franchisor got round to officially terminating the relationship more than a year later. In the meantime the franchisor discovered the franchisee had been operating a competing business during the period after the contract had officially expired but before they actually terminated.

In this case the franchise contract contained a clause that prohibited the franchisee from operating a competing business within the franchise territory for a year after the franchise contract came to an end. The problem was that the franchise contract officially ended a year prior to the franchisee actually ceasing to operate the business - during which time the franchisor had continued to do business with the franchisee in the same way as (allegedly) it had before. This situation is often called holding over - a five year franchise term comes to an end and the franchisor does not formally terminate the contract or insist on signing up to a new franchise contract it just continues to allow the franchise to operate as if the agreement were still in place.

There were 2 key issues

1. Were the restrictive covenants enforceable? In answer to this - the court said - yes - the restriction was within the boundaries of what was considered reasonable to protect the legitimate interest in protecting the goodwill of a franchisor in a specific area.
2. If they were enforceable - from when did they operate - e.g. - from when the contract technically expired? Or, from when the franchisee actually ceased operating the franchise. In answer to this the court confirmed that the one year restriction applied from when the franchisee actually stopped operating the franchise - in response to the franchisor actually formally terminating it (i.e. when it ended in practice) and not when the franchise contract had technically expired (i.e. when the franchise contract said the contract would come to an end.)

Word to the wise

Restrictive Covenants remain a sticky issue and if franchisors want to be able to rely on them without spending a fortune to find out if they work – make sure you 1) get your contracts checked regularly (what is legally OK now might not be legally OK later) and 2) diarise contract expiry dates and implement a contract expiry plan – renew or terminate instead of the more risky holding over.

Franchisees should also check if they are in the clear before starting competing businesses to avoid the cost, time and hassle of dealing with a legal battle with your franchisor.