The challenge for a business when drafting a restrictive covenant is that if it seeks to constrain the other party's freedom to operate too much or for too long in the interests of protecting its own business, the courts may refuse to enforce the restriction. Two recent Court of Appeal rulings highlight some of the hazards in relation to post-termination non-compete obligations in B2B agreements. We look at what happened in these cases and what this means for businesses at both ends of these obligations.
Post-termination non-compete clauses in B2B agreements: what's the Court of Appeal up to?
Overview
12 month post-termination non-compete in franchise agreement was unenforceable
Dwyer v Fredbar (2022) concerned a restrictive covenant preventing a franchisee from competing with the franchisor in the franchise territory itself and within a 5 mile radius of that area for a period of 12 months from termination of their agreement. The Court of Appeal agreed with the High Court that the provision was unenforceable under the common law doctrine of restraint of trade (which requires such restrictions to be reasonable, both as regards the legitimate interests they are designed to protect and the wider public interest).
Previous cases had suggested that 12 month post-termination non-compete obligations in franchise agreements would generally be upheld, provided they were subject to appropriate limitations as regards the activities and geographic area covered by the restraint. So why did both the High Court and the Court of Appeal find that the clause in this particular case was unenforceable?
Inequality of bargaining power
The franchisor, Dwyer, operating under the "Drain Doctor" brand, was the largest emergency plumbing and drainage company in the country – whereas the franchisee, Mr Bartlett (operating through a limited company, Fredbar) was essentially a "man with a van" with no previous experience of running a franchise. The Court of Appeal took the view that this meant that there was significant inequality of bargaining power and made their relationship more akin to one of employer and employee. The franchisor also took on Mr Bartlett as a franchisee despite having concluded that he was unlikely to succeed and knowing that if the business failed, the family home was likely to be at risk (as Mr Bartlett had invested all his savings and taken out a loan). The Court of Appeal upheld the High Court's ruling that the restrictions were excessive in part because they effectively prevented Mr Bartlett from using his skills as a plumber to earn in a living in the area where he lived (and thus avoid the prospect of having his home repossessed by his lender).
Goodwill and the impact of early termination
This was the first "Drain Doctor" franchise in the territory (part of Cardiff). The Court of Appeal accepted that the national profile of the Drain Doctor brand meant that the franchisor already had some goodwill in the territory and that in principle, it was legitimate to seek to protect this by imposing a post-termination restrictive covenant. However, the 10 year franchise agreement was terminated after not much more than 18 months – and during this period, its performance was well below the levels suggested in Dwyer's projections. As a result, relatively little additional goodwill had been built up in the territory on the franchisor's behalf; against this background, the Court of Appeal agreed with the High Court that a 12 month restriction was disproportionate.
Does this mean that all 12 month post-termination non-competes in franchise agreements are at risk?
The Court of Appeal stated that: "[i]t does not follow that the 12 month restriction would be unreasonable in every Dwyer franchise agreement. Where a franchisee was well-established and successful or where Dwyer could show cogent evidence of the need to protect its goodwill, a court might well conclude that the restriction was reasonable." This should provide some comfort to franchisors, since 12 month post-termination non-competes are fairly common and have been upheld in previous cases. In particular, franchisors can probably be less concerned about scenarios where:
- the franchise has been established longer (e.g. it predates the involvement of the current franchisee) and has performed reasonably well; and/or
- the franchisee is a more substantial business in its own right; for example, in some sectors it is fairly common for quite large corporates to act as franchisees and in these cases, a finding of inequality of bargaining power would be unlikely.
But that leaves the question of what to do about situations where there is either inequality of bargaining power or termination at a relatively early stage, before significant new goodwill has been built up (which is a particular concern in the case of new franchises). Here the Court of Appeal made some suggestions on drafting, which we discuss in section 4 below.
6 month post-termination non-compete in marketing agreement also unenforceable
Credico v Lambert (2022) concerned an arrangement between Credico, a provider of face-to-face marketing services and a smaller firm, S5 Marketing, which effectively acted as a subcontractor. Credico organised campaigns on behalf of clients such as charities or providers of broadband or energy services. It would then contract with smaller players such as S5 Marketing which would implement these campaigns in particular geographic areas around the country. Credico's agreement with S5 Marketing contained a restrictive covenant prohibiting the latter from working for a competitor of Credico for 6 months after termination (the prohibition applied within a 10 mile radius of S5 Marketing's principal place of business).
No legitimate interest to protect
The Court of Appeal ruled that this restriction was unenforceable because Credico had no legitimate interest to protect. For example, in contrast to a franchise arrangement where the franchisee operates under the franchisor's brand, S5 Marketing had not built up particular goodwill in the area on behalf of Credico. Nor was it the case that S5 Marketing had acquired special knowledge from its work on behalf of Credico – it had simply been commissioned to organise face-to-face marketing campaigns in the area, using its existing local knowledge. The Court of Appeal conceded that there might have been a legitimate interest in preventing S5 Marketing working on campaigns for competitors of Credico's clients – because in such a scenario, S5 Marketing could be said to have gained a particular advantage from its knowledge of campaigns being organised by Credico. However, the restriction went considerably further than this and was disproportionate by reference to that interest.
What would be a legitimate interest?
Credico argued that S5 Marketing had been in receipt of confidential information, proprietary business know-how and training about how to organise campaigns effectively. This could have amounted to a legitimate interest, as is often the case in relation to franchise agreements (where the franchisee benefits from the franchisor's expertise in how to run the business). However, in this case, the judge at first instance was not persuaded that Credico had imparted any meaningful knowledge that S5 Marketing could take advantage of when organising future campaigns for competitors of Credico.
The Court of Appeal also noted that in previous cases where similar restrictions had been upheld, a legitimate interest had been found to exist where customers would have loyalty to the business which was the subject of the restriction. For example, it noted that this was a factor in One Money Mail v Ria Financial Services and Wasilewski (2015), which concerned money transfer services. One Money Mail had provided its agents with considerable support including training. However, customers' loyalty was generally to the agent as an individual rather than to the money transfer system's brand. In that case, the Court of Appeal accepted that the only way that One Money Mail could protect the investment it had made in supporting its agents was to impose a post-termination non-compete (also of 6 months' duration). The Credico case was different because it involved, for example, door-to-door sales or setting up "pop up" booths in locations such as shopping centres; this activity was unlikely to generate any customer loyalty from members of the public.
It's also worth noting that the Court of Appeal did not take issue with the High Court's finding that a non-compete obligation during the term of S5 Marketing's contract with Credico was justifiable; this was on the basis that Credico was entitled to expect S5 Marketing to devote itself to servicing Credico's clients during that period. However, for reasons explained above, the attempt to impose a post-termination non-compete was not justified.
So much for restraint of trade - what about the Competition Act 1998?
In both the cases considered in this briefing, the restriction was found to be unenforceable because it was in breach of the common law doctrine of restraint of trade. But restrictions of competition between businesses can also be unenforceable if they breach the Chapter I prohibition of the Competition Act 1998.
Indeed, there is at least one case where the court ruled that a 12 month post-termination non-compete in a franchise agreement could, in principle, fall within the scope of that prohibition - although the court ultimately decided that it was justified in order to protect the franchisor's know how (see Pirtek v Joinplace (2010)). As this outcome suggests, a challenge under the Competition Act 1998 may often produce the same answer as a challenge under the common law doctrine of restraint of trade. However, the tests are not exactly the same and in our view, there could be circumstances where a clause which was acceptable under the law on restraint of trade would be unenforceable under the Competition Act 1998 – see, for example, this briefing on restrictive covenants in favour of anchor tenants.
Competition Partner Stephen Whitfield commented:
"For businesses seeking to challenge restrictive covenants, the Competition Act can sometimes offer an additional tool – so it's somewhat surprising that there are so few cases in the English courts considering its application to non-compete obligations. Our view is that it would be a mistake to ignore the Act entirely in structuring non-compete obligations - particularly where you are putting in place a network of agreements which all contain similar restrictive covenants or where the territory involved could be said to amount to a significant part of the UK."
Key takeaways
In our view, these cases don't indicate a radical departure from the way that the courts have approached restrictive covenants in the past – but they do suggest that it is unwise to assume that previous cases where a similar restriction has been upheld will invariably be followed.
Drafting lessons if you want to impose a restrictive covenant
For businesses such as franchisors looking to impose restrictive covenants on trading partners, there are two key lessons when it comes to drafting:
- Always ensure that there is a legitimate interest to protect – without that, the restrictive covenant will be unenforceable, as in Credico (see section 2 for discussion of what may amount to a legitimate interest)
- Even where there is a legitimate interest to protect, the extent of the protection which would be regarded as proportionate may vary depending on the circumstances. For example, the clause in Dwyer could have been enforceable with a different franchisee operating in an established territory, but not where there was significant inequality of bargaining power and termination occurred early in the life of the franchise.
The Court of Appeal's drafting suggestions
The outcome in Dwyer highlights the difficulty of drafting a clause which is likely to be enforceable in most, if not all, eventualities. However, the Court of Appeal had two suggestions as to how the clause in the franchise agreement could have been drafted differently with a view to overcoming this problem:
- A sliding scale on duration so that in the case of a start-up franchise which comes to an end fairly quickly and limited goodwill has been built up, the duration would be much shorter than 12 months; and
- A provision for the restricted business (in this case, the franchisee) to make a written request to disapply the restrictive covenant (or, possibly, have its scope reduced).
As regards this last suggestion, the Court of Appeal may have had in mind that such a clause would probably trigger the exercise of a contractual discretion by the other party. According to well established case law, a contractual discretion must be exercised honestly and in good faith, for a proper purpose and not in a manner which is arbitrary, capricious, perverse or irrational. In practice, this would be likely to require the party seeking to impose the restriction to consider carefully whether it was still justified in the particular circumstances of the case.
That said, the Court of Appeal's drafting suggestions would add a degree of complexity and uncertainty to the clause. Some businesses may take the view that, in the majority of cases where they would be concerned about enforcing a restrictive covenant, their existing drafting is likely to stand up to challenge (based on previous case law) – and they can live with the risk that it may occasionally prove to be unenforceable.
"Blue pencil" drafting
It is also usually worth bearing in mind the so-called "blue pencil test" i.e. the ability for a court to decide that certain parts of the clause are unenforceable, but the remainder can be read (and enforced) as if the "offending parts" had been deleted (provided of course that it still makes sense). However, we would caution against over-reliance on this when drafting restrictive covenants. In some circumstances, a court may be wary of applying the blue pencil test where it thought that the party seeking to impose the restriction was effectively trying to "hedge its bets" - for example, by expressing the duration of the non-compete as successive periods of 3 months up to say, 2 years in total, and expecting the court to decide exactly how long was permitted under restraint of trade law.
Points to consider if you are being asked to agree to a restrictive covenant
If you are being asked to agree to a restrictive covenant, it is often worth reminding counterparties that – as shown by these two cases - the English courts will normally look very carefully at whether the restriction is justified – and if they conclude that it isn't, they will refuse to enforce it. In particular, even where there is equality of bargaining power, the law on restraint of trade does not permit restrictions which go beyond what is reasonable to protect the other party's legitimate interests. Similarly, it may also be worth drawing attention to the potential for breach of the Competition Act 1998, as outlined in section 3 above.
How we can help
We regularly advise on all types of commercial agreements including franchising, marketing, agency and distribution arrangements. When it comes to provisions such as restrictive covenants, our Competition and Commercial, IP & Technology teams work closely together to provide you with tailored and pragmatic advice.
