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Articles Retail 21st Feb 2017

Franchising & Restrictive Covenants: Retail e-brief February 2017

Restrictive covenants are commonplace in contracts where one party is selling their business. They are a contractual safeguard ensuring valuable stakeholders are not poached from a business by an ex-employee entering into competition with their old place of work. Yet, while they are frequently incorporated into commercial contracts, the recent case involving a dispute between a national hairdressing chain and a local franchisee owner Rush Hair Ltd v Hayley Hayley Gibson-Forbes and S.J. Forbes Limited brought to light a number of issues in the context of franchising and Share Purchase Agreements:

  • How long can you restrict another Party from setting up in competition?
  • Can you prevent them also from enticing staff away, and if so, for how long?
  • Can an individual hide behind a company structure to avoid any restrictions?

The following bulletin aims to provide some insight to these questions in light of the most recent decision delivered by the High Court.

How long is too long when it comes to restrictive covenants in your contracts?

The Acid test is what is reasonable and commercially necessary to protect the businesses legitimate interest whilst balancing this against preventing someone from making a living. In the most recent case, the High Court upheld two restrictive covenants placing two-year restrictions. But the Court also highlighted this could only be so in the right circumstances.

Will restrictive covenants agreed by a corporate seller also bind the director and shareholder personally?

It has long been thought that restrictions on a company only bind the company and that without clear language to the contrary, they should not also be taken by implication to bind a director/shareholder of that company.This is consistent with the basic legal premise that the company is a separate and distinct legal entity.

However, in this case the court decided that the restrictions on the company should also be imposed on the director and sole shareholder, as to do otherwise would make a nonsense of the agreement and would allow the director and shareholder to evade or frustrate the agreement.

In this particular case, an individual set up a limited company through which she purchased a hairdressing business franchise. The hairdressing franchise was very successful. Some years later the individual then sold the franchise back to the franchisor for £40,000 and entered into a Settlement Agreement terminating her employment.

In the Sale and Purchase Agreement there was a clause which provided that ‘’the Seller shall not at any time during the period of two years from Completion, canvas, solicit, entice, employ 3 named individuals. There was also a separate restriction preventing the Seller for a period of 2 years directly or indirectly being engaged concerned employed or interested in any capacity whatsoever in a business which carries on a similar business to that being sold’’.

The former director and shareholder then set up a competing business through a new company and engaged one of the named individuals as a Consultant. She sought to argue that she was not in breach of the Sale and Purchase Agreement because it was a new company that had set up in business and the new company that had then engaged the individual.

The court however decided, given the background, that the only commercially sensible interpretation of the covenants was that they were intended to prevent a situation where the owner of the franchisee company, whether as an individual or through a new corporate vehicle, set up a rival hairdresser in close proximity and solicited key staff – thus drawing away customers.

So where does this leave Franchisors and, for that matter, anyone buying or selling their businesses?

Franchisors are now in a strengthened position when entering into Sale and Purchase Agreements and franchise agreements.

With the courts willing to add “teeth” to restrictive covenants where commercially sensible, individual directors of franchised businesses cannot hide behind the corporate structure to defeat restrictions which on a common sense interpretation should apply to them.

Finally, it is also a reminder to franchisees to take these clauses seriously. In the recent case, the restriction was against setting up a competing business within two years of the sale, within a two-mile radius and on employing specific people from the previous business in that new business. The judge enforced this obligation stating it did not unreasonably restrict the ex-franchisee’s ability to set up/conduct business elsewhere, given the restriction was only two miles. Had the ex-franchisee here understood the true scope of the restrictive covenant a great deal of legal expense could have been saved.

The content of this page is a summary of the law in force at the date of publication and is not exhaustive, nor does it contain definitive advice. Specialist legal advice should be sought in relation to any queries that may arise.

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