The franchised location is one of the most important aspects to be considered by franchisors and franchisees when entering into a franchise agreement and this article will examine the advantages and disadvantages of owning, leasing or subleasing premises in a particular location in New Zealand. Franchise agreements which are complex legal documents must be carefully drafted, in particular when covering the leasing or otherwise of premises vital to the franchise system.
Different Ways to Structure the Relationship amongst the Franchisor, Franchisee and Landlord in New Zealand
Rarely do franchisors want to own the building in a particular location. Invariably they will lease premises and leases in New Zealand must comply with the Property Law Act 2007. However, McDonald’s Corporation is different and it is one of the biggest real estate companies in the world with over US$35 billion invested in real estate. McDonald’s started doing things a little differently almost from the beginning when the company started franchising in 1956 and it had a clear vision of using property to accrue wealth and not just from the sales of burgers. Ever since then the method has remained virtually unchanged.
Franchise agreements are complex legal documents and they impose many obligations on both the franchisor and the franchisee. Such agreements invariably cover the leasing of premises unless a mobile franchise is involved.
It is essential for the franchise agreement to cover obligations in relation to premises or site of the franchised operation. Some franchisors want to take the lease and control the physical site while other franchisors do not want anything to do with the leasing of premises unless there is a default. Those franchisors would allow a franchisee to take a lease of premises from a landlord.
Possible Structures
Invariably in New Zealand a franchisor requires a franchisee to enter into a lease of the premises. However, if a franchisor wishes to control the location of its franchised operations in the best and most effective way is for a franchisor to take the head lease from a landlord and have a direct relationship with that landlord.
If a lease is entered into between a landlord and franchisee then the Special Conditions of Lease which appear below should be included in the lease documentation. A franchisor may wish to control the location of its franchised operations. The best and most effective way to do this is for a franchisor to take the head lease from a landlord and to have a direct relationship with that landlord. When the franchisor is ready to appoint a franchisee to a specific location and premises then it can either grant a sublease or a licence to occupy the premises. In New Zealand subleases are commonly granted and a franchisee will then be invited to pay the rent directly to the landlord. If a sublease is entered into then the landlord would have normally to provide its written consent but the franchisor would be primarily obligated to perform and abide by the covenants in the head lease.
Franchisee to take the Lease
If the franchisor does not wish to take the head lease in order to decrease its rental liability position then it would arrange for a franchisee to take the lease from the landlord. Only when a brand is well known and has a track record will landlords usually agree to this as they would prefer to have the franchised brand as the principal obligator under a lease. Most landlords in New Zealand will agree to this but normally not if the leased premises are in shopping malls.
If a franchisor is to take the lease of the premises then special clauses should be included in the franchise agreement to cover the scenario if and when a franchisee should breach the franchise agreement in the future resulting in termination of the agreement. In that case, if the franchise agreement does not contain clauses which allow the franchisor to take over the lease or to have step-in rights then the franchisor loses the premises and the franchised location.
Possible Clause
As I have said above, it is important that the landlord of the premises includes some special conditions in the Deed of Lease and they might read as follows:
“1. Assignment to the Franchisor
1.1 Termination of Franchise AgreementNotwithstanding anything to the contrary contained in this lease, the landlord, the tenant and the franchisor agree that if the franchise agreement (“Franchise Agreement”) between the tenant as franchisee and the franchisor (together with its successors and assigns) is terminated for any reason then the franchisor or its nominee shall have the right (“Option”) to take an assignment of this lease and the following provisions shall apply:
(a) The franchisor may advise the landlord of its intention to exercise the Option and as soon as practicably possible following receipt of that correspondence, the landlord shall provide to the franchisor a full statement (“Landlord’s Statement”) setting out all funds and outstanding obligations owing by the tenant to the landlord. The franchisor shall then have thirty days after receiving the Landlord’s Statement to exercise the Option by written notice (“Option Notice”) to the landlord and tenant.
(b) No assignment of this lease contemplated by the Option Notice shall take effect until the landlord has received payment of all rent and outgoings arrears (if any) and a deed of assignment of lease which deed of assignment of lease shall:
(i) where the assignee/nominee is a company other than the franchisor, then as security for that assignee’s/nominee’s obligations under the lease, provide for either the personal guarantees of its directors or a bank guarantee for a sum equal to three months’ rent¹ plus GST at the then current rental; and
(ii) be executed by the franchisor (as assignee) and the tenant (as assignor) or as otherwise executed pursuant to special condition 1.3.
(c) As soon as practicable after receiving the deed of assignment of lease executed pursuant to special condition 1.1(b)(ii) above, the landlord shall execute the same and provide a copy to each of the franchisor and the tenant without delay.
(d) For the avoidance of doubt, the franchisor shall not be obligated to procure personal guarantees in favour of the landlord as security for its obligations under the lease where it exercises the Option.
1.2 Exercise of Option
The parties agree that the landlord and the franchisor may rely on the Option Notice and that assignment of all the tenant’s rights under this lease to the franchisor shall take place from the date that the last requirements set out in special condition 1.1(b) above have taken place.
1.3 Execution of Lease Assignment
(a) The tenant shall if requested to do so by the landlord and/or the franchisor execute all deeds and documents necessary to effect and perfect assignment of the lease to the franchisor and such assignment shall include provisions obliging the franchisor to perform the tenant’s obligations under this lease from the date of service of the Option Notice.
(b) The tenant appoints the franchisor as its lawful attorney and in its name and on its behalf to do all acts, deeds and things whatsoever to execute the assignment of this lease to the franchisor and to assure and transfer to the franchisor all of the tenant’s rights and interest in the lease so as to give efficacy of the provisions of the whole of special condition 1 above.
1.4 Subletting/Occupation Licence
(a) The franchisor shall be entitled without consent of the landlord to grant to any franchisee of the franchise network either a licence to occupy or a sublease to occupy all of the premises.
(b) Where the franchisor triggers either of its abovementioned rights, it shall prior to commencement of the licence/sublease:
(i) enter into and procure that its occupation licence holder/sublessee enters into an occupation rights document/sublease which document requires the occupation rights holder/sublessee to honour all of the obligations of the tenant under the lease; and
(ii) provide the contact details of the occupation licence holder/sublessee to the landlord.
(c) The franchisor shall ensure that the landlord’s reasonable costs associated with the franchisor exercising its rights under this special condition 1.4 are paid either directly or by the occupation licence holder/sublessee.
2. Default by Tenant
2.1 Default NoticeIf the landlord gives any notice to the tenant in respect of any breach of the tenant’s obligations under this lease (“Default Notice”) then at the same time as the Default Notice is given to the tenant the landlord must give a copy of the Default Notice to the franchisor which has the right if it so desires, to remedy the breach during a period of an additional ten days after the end of the period during which the tenant may cure the default set out in the Default Notice.
2.2 Bankruptcy or Insolvency
If the default under the Default Notice arises by reason of the bankruptcy or insolvency of the tenant or the appointment of a receiver over the tenant’s assets or any part of them then the franchisor shall be entitled to serve on the tenant an Option Notice within the meaning and intention of special condition 1.1 above and subject to exercise of the Option by the franchisor the tenant shall have no further rights under this lease.
3. Assets of the Tenant
The landlord and the tenant acknowledge and agree with the franchisor that where the Franchise Agreement has been terminated, the franchisor may at any reasonable time during the term of the lease enter the premises to remove any:
(a) indicia which form part of the intellectual property licensed to the tenant by the franchisor;
(b) property of the franchisor;
provided that the franchisor complies with the landlord’s reasonable requirements in respect of undertaking such works and provided further that the franchisor will be liable for making good any damage caused to the premises by the franchisor or its authorised agents through the removal of its property.
4. Non-Variation
The provisions contained in these special conditions cannot be varied without the express written consent of the franchisor.
5. Limitation of the franchisor’s execution of this lease
5.1 The landlord acknowledges and agrees that:(a) the franchisor is executing this document solely for the purpose of acknowledging the provisions contained in these special conditions; and
(b) the execution of the lease by the franchisor does not oblige it to perform any of the terms and conditions in the lease except as specifically contemplated by these special conditions.
5.2 The parties agree that the provisions contained in these special conditions are intended to confer a benefit upon the franchisor for the purposes of the Contract and Commercial Law Act 2017².”
The clauses as quoted above would allow the franchisor to step in and operate the franchisees or install a new franchisee in the location upon expiration or termination of the franchise agreement. The franchisor’s rights to take over a business under the franchise agreement may conflict with the landlord’s rights to terminate the franchisee/tenant for non-payment of rent. The franchisor could try to negotiate a new lease with the landlord upon termination of the franchise agreement but there would be no guarantee that the terms could be agreed between the franchisor and the landlord. The clauses as drafted or any similar clauses would give certainty to a franchisor to be able to take over the premises and to step into the shoes of the terminated franchisee. When the franchisor “steps in” to the franchisee’s lease and gains control of the property, it may also want to take possession of the fixtures, fittings and equipment left behind by the franchisee subject to those assets not being mortgaged or charged in favour of a lender.
“1. The franchisee shall take a lease of the premises at the cost of the franchisee direct from the landlord of the premises and any premises must be approved in advance by the franchisor. The franchisor shall provide assistance to the franchisee in relation to the layout of the premises and related matters. Such lease shall make provision, inter alia, for:
(a) reasonable notice by the landlord of the premises to the franchisor of any default by the franchisee of any of the terms of the sublease or the head lease;
(b) the right of the franchisor to enter upon the premises and remove or obliterate or destroy (as appropriate) any or all of the signs, logos, colour schemes, telephone numbers, marketing and promotional material and any other matter or thing associated with or in any way whatsoever capable of identifying the business;
(c) the obligation for the premises to be used solely for the business; and
(d) strict compliance by the franchisee of all the terms contained in the head lease.
The franchisee shall ensure that the Special Conditions of Lease as set out in attached Schedule are incorporated into the lease of the premises and the franchisee shall always strive to obtain the landlord’s approval to include all such terms in the lease. The franchisee shall at all times perform and observe the terms, conditions and covenants contained in any lease, sublease or other contract of tenancy under which the franchisee occupies the premises. Further, any breach of the lease, sublease or other contract of tenancy by the franchisee shall be deemed to be a breach of this agreement.
2. The premises shall be developed and fitted out by the franchisee at its own cost and in accordance with the provisions of the manuals and any written directions of the franchisor.”
Relationship of the Parties
It is well understood in franchising that the relationship of the parties is of the utmost importance. I always include good faith clauses in franchise agreements which I draft and they are simple but effective – each party shall act loyally and in good faith towards the other at all times. No one should misunderstand the intention of such a clause.
When entering into a franchise agreement, location is one of the most important aspects which a franchisor and a franchisee must consider. The franchisor will have devoted substantial time, energy and resources into identifying new development markets and in checking the viability of specific properties and locations which may be suggested by the franchisee. Nothing lasts forever and any franchise agreement is for a term of years usually with some rights of renewal. However, upon the expiration or termination of the franchise agreement it is common for the parties to have competing interests when it comes to the real estate from where the franchised business is operated.
Event of Default
All franchise agreements contain termination clauses. Invariably, if a franchisee fails to do or does anything or permits or causes anything to be done as a result of which the lease of the premises at which the franchisee conducts the business is terminated then that would constitute an event of default under the franchise agreement. It follows that if a landlord should terminate a lease or sublease because of default then the franchisor would terminate the franchise agreement using that ground of default as the reason why the agreement should be terminated. Usually, there would be an immediate termination with no opportunity to remedy or cure the breach.
Step-In Deed
In some franchise systems a franchisor will require a Step-In Deed to be executed between the franchisor, the franchisee and the landlord. Such a Deed would cover the rights and obligations of the parties which would remain in full force and effect until the expiry of the lease or until the date of assignment, whichever is later in time. If the franchisee should breach a term of the lease, then the landlord would send a notice to the franchisor and the franchisee within five days of becoming aware of the breach. In the breach notice, the landlord would identify the clause of the lease breached and the action which the landlord proposes to take. The landlord and the franchisee would acknowledge and agree that the lease should not be surrendered without the prior written consent of the franchisor.
It is important to note that the franchisor has the right and is under no obligation to take any steps or action to rectify any breach or obligation under the lease, nor does it guarantee the performance of the lease by the franchisee. Such a Deed would also confirm that the franchisee has continuing obligations to pay all sums owing to the landlord, perform all of its obligations under the lease and ensure that the premises are kept in good and tenantable condition. Invariably in such a lease situation, a landlord would require a bank guarantee from the tenant for a sum equal to three or six months’ rent at the then current rental amount.
Lease Term
Both the franchisor and the franchisee will want to see the lease term match the franchise agreement term as far as possible. The parties cannot have the situation where there is a term of years remaining under the franchise agreement and there is no property from which the franchisee can operate the business. Having no approved location is an event of default under most franchise agreements. Initial lease terms may not match the franchise agreement terms but they may match if renewal terms are exercised. For example, a five year lease term with a five year renewal is consistent with a ten year franchise agreement term. New franchisees may seek shorter terms to provide flexibility and limitation of damages if there is an early termination. In California where post-term non-competes are typically unenforceable, the franchisor is especially well served in preventing the franchisee from having its lease term extend beyond expiration or termination of the franchise agreement.³
Notice and Opportunity to Cure
A notice clause provides the franchisor with the right to receive copies of all written communications from the landlord at the same time the notice is sent to the tenant. In this way the franchisor may monitor the tenant’s compliance with its lease. Usually with any notice provision is the franchisor’s opportunity to cure alleged defaults and the cure right should be an option and not an obligation. If such a cure is made by the franchisor, it should not be deemed to have assumed the lease obligations unless it expressly agrees to do so in writing. Franchisors usually will not step in to cure only technical defaults as they are obviously more concerned where there is a likelihood of the tenant’s default resulting in a termination of the lease. The right to receive notice of default allows the franchisor to prevent the landlord from terminating the lease. By curing a default giving rise to termination, a franchisor may avoid eviction and the prospect of a replacement tenant capitalising on its local goodwill.
How do the New Zealand Courts handle post-termination issues involving real estate? A good example is the case of Supatreats Asia Pte Ltd v Grace & Glory Ltd.⁴
This case involved the Wendy’s Sundae franchise. The head franchisor advised the New Zealand master franchisee and all franchisees that they were wanting to change their approved supplier for ice cream. The franchisor proposed to change to a new Australian supplier, away from the existing New Zealand supplier. This was challenged by the master franchisee and the franchisees, and the master franchisee and franchisees treated the agreement as being at an end and set up a competing brand. Individual franchisees purported to surrender their agreements and converted their stores to the new brand, Shake Shed. Wendy’s took action to restrain the master franchisee and the franchisees from these competitive activities. After being served with interim injunction proceedings, the franchisees continued rebrand, with the effect that by the time of the hearing, most had rebranded from Wendy’s Sundae to Shake Shed.
Materials put in evidence by the master franchisor supported the assertion that there was a marked similarity between the master franchisor’s stores and the stores run by the franchisees under the new branding. Most franchisees leased premises from their respective landlords but the franchise agreements contained step-in rights. With the master franchise agreement having been terminated, the master franchisor sought to enforce the post-termination provisions of the franchise agreement. One of these provisions was that all franchise agreements held by the master franchisee would need to be assigned to the master franchisor. The master franchisor sought orders from the Court seeking to restrain any of the defendants from trading as the new branded business.
The defendants made the submission that the master franchisor repudiated the franchise agreements by insisting on its franchisees using a nominated supplier. There was no record of the basis for that submission, but it is assumed that this would have been developed on the grounds of a lack of good faith. That said, there is no record in the judgment which highlights or mentions any dishonesty or lack of integrity on the part of the master franchisor or even any evidential matter which might have suggested a lack of consultation, or an improper or arbitrary motive. By the time the case came before the Court, it was clear that the full roll-out of the new brand was largely completed. The system involved a large number of franchisees, not all of whom were before the Court. In finding that the balance of convenience was in favour of the master franchisor, and in granting the injunctions, his Honour Wylie J stated that he regarded it as significant that the defendants had rebranded with their eyes open and despite express notice from the master franchisor.
The case Zadeh v Jeihani⁵ in 2020 is also worthy of discussion. This case involved an unsuccessful application for an interim injunction restraining the termination of a subtenancy and the eviction of the subtenant. The plaintiff worked at one of the defendant’s kebab shops known as Kebab Serai at Milford in Auckland. The business was not doing particularly well and the defendant owed the plaintiff money. The defendant issued a notice under the Property Law Act 2007 alleging the existence of a sublease and a breach of the sublease by the non-payment of weekly rental of $900. The facts are involved but for the sake of this analysis the application for an interim injunction included restraining the termination of the plaintiff’s subtenancy and the eviction of the plaintiff. Justice Muir decided that there was no serious answer to the defendant’s proposition that the plaintiff’s tenure of the premises was as a sublessee so the injunction was declined.
Covenants against Competition
During the term of the franchise agreement, a franchisee is normally prevented from carrying on any competing business and may also be prevented from carrying on any other business, as his or her full time and attention is critical to the success of the franchise business.
The franchise agreement will also almost invariably contain a restraint of trade that will apply to the franchisee following the termination or expiration of the agreement or the sale of the franchise business to a third party. The length and area provisions of the restraint will normally be set out in a schedule and they will be subject to general legal principles governing restraints of trade.
The courts have recognised that it is reasonable for a person in the position of the franchisor to impose a contractual restraint upon any competitive conduct by a franchisee. Contractual restraints of this type are known as ‘restrictive covenants’ or ‘agreements in restraint of trade’.
Such agreements must not exceed the boundaries of the courts’ notion of reasonableness. There are two competing principles that govern the courts’ decision-making process. The first principle is that it is reasonable for a person to stipulate that if he or she is willing to disclose all secrets of how to establish a particular business enterprise, then the recipient of the information cannot immediately terminate the contract and set up a competitive business, using the information that it has received during the course of the educational process. If the courts did not provide protection to franchisors in such situations, there would be no incentive for the owners of established businesses to share their secrets with others and enhance their business skills.
The second principle is that it is important for the well-being of the community that every individual should, in general, be free to advance his or her skills and earning capacity. The way these two conflicting principles are resolved is to require that a restrictive covenant must be ‘reasonable’ in its terms before it will be enforced.
The current position in New Zealand is set out in section 83 of the Contract and Commercial Law Act 2017 which states as follows:
(1) The court may, if a provision of a contract constitutes an unreasonable restraint of trade, –
(a) delete the provision and give effect to the contract as amended; or
(b) modify the provision so that, at the time the contract was entered into, the provision as modified would have been reasonable, and give effect to the contract as modified; or
(c) decline to enforce the contract if the deletion or modification of the provision would so alter the bargain between the parties that it would be unreasonable to allow the contract to stand.
(2) The court may modify a provision even if the modification cannot be effected by deleting words from the provision.
What this means in practice is that if a franchise agreement provides for a three year period of restraint when a two year period would be considered to be reasonable, the covenant would be enforced to the extent that it could be rewritten by the court as being confined to a two year term. The ability of the courts to modify excessive restraints is constrained by the principle that terms that could never have been considered reasonable will not be modified. The reason for this is that it is considered to be contrary to public interest that a person should be able to intimidate a contracting party by stipulating for a wholly unreasonable constraint and then have the court come to its rescue and rewrite the contract so that it falls within the boundaries of reasonableness. This is the doctrine of restraints that are in terrorem (ie, contracts that ‘terrorise’ a contracting party). If a franchisor could only ever have reasonably sought a two year restraint within a five kilometre radius of the business from which the person established a goodwill, a nationwide restraint for six years could never be regarded as reasonable and the courts would refuse to enforce a clause to implement the latter restraint, even if it was in the franchise agreement.
What then is a reasonable restraint? There are two factors: area and time. For a franchise that teaches making coffee and running a café, an area of restraint would typically be confined to the area in which the franchisee is likely to establish goodwill. A person who establishes a café in a city is likely to establish goodwill that extends perhaps 200 to 400 metres from the site. There are so many other competing cafés that the goodwill would not extend much further than that.
The duration of a restrictive covenant should be such as will enable a franchisor to interpose a new operator who will have a reasonable time to secure the retention of the customers. In the case of a café, it is unlikely that this will extend beyond two years.
Some recent cases involving restraints and which also impacted on the premises of franchised locations are set out below.
Water Babies International Limited v Williams & Ors⁶
The application was for an interim injunction against Kelly Williams, a former franchisee in Wellington, as the first respondent, Silvana Tizzoni as the second respondent and Coral and Aquamarine Limited as the third respondent. In essence, the franchise agreement with Kelly Williams expired and it was not renewed. However, she was devious and involved a relative, Silvana Tizzoni, and her company to operate a similar business in Wellington under the name of Swim Babies. There was extensive correspondence between Kelly Williams and Stewart Germann Law Office with the result that Water Babies UK instructed the issue of interim injunction proceedings. The case was heard at the High Court at Wellington on 3 June 2020 and on 10 June Justice Doogue delivered his judgment and issued an interim injunction restraining Kelly Williams from divulging confidential information and requiring written undertakings from Kelly Williams and Silvana Tizzoni. Interestingly, the judge issued a minute two days later correcting some of the text of the orders that were initially incorrect. The case has been settled but the judgment confirms the importance of restraint on competition clauses in franchise agreements in New Zealand.
M and L Holdings (2012) Limited v Whenua Productions Limited & Anor⁷
The plaintiff was the area franchisee of a business that provided photography services to real estate agents to assist in the marketing of properties, and the system is known as Open2view. It granted the first defendant the right to operate a franchise in an area described in the agreement as Auckland South. The defendant decided to stop operating the business and when the plaintiff discovered that the defendant had abandoned the business and was carrying on the same business under another name using the same customers in the territory, brought proceedings in the High Court seeking an injunction restraining the defendant from breaching the restraint of trade provisions, an account of profits, damages and costs.
No opposition was filed and the interim injunction was granted unopposed. The High Court expressed doubt that a restraint covering an area of 50 kilometres beyond the franchise area was a reasonable restraint but it accepted that its reasonableness was seriously arguable. The interim injunction granted extended to 50 kilometres. Subsequent to the granting of the injunction, the lawyers negotiated a settlement that involved the defendant paying a sum of money to the plaintiff and also undertaking not to carry on a similar business within 50 kilometres of Auckland South.
Mad Butcher Holdings Limited v Standard 730 Limited & Ors⁸
This case relates to the enforceability of restraint of trade clauses in relation to the Mad Butcher franchise system.
Standard 730 Limited, as the franchisee, had been a franchisee of the Mad Butcher franchise system at Whangarei since 1987 and the franchise agreement came to an end on 4 January 2019.
Mr Wightman of the franchisee initially indicated to Mad Butcher that he intended to set up a butcher’s training school. However, on 7 January 2019 he advised the franchisor that instead he would continue to trade as an independent butcher.
Mr Wightman had by then arranged with the landlord to stay in the premises on a monthly tenancy after the lease expired.
After the franchisee commenced trading as an independent butcher, legal proceedings were filed seeking an interim injunction to restrain the franchisee from trading.
The franchisee argued that he was not in breach of the restraint of trade clause because there was no other Mad Butcher franchise store in the Whangarei area and that he was not in competition with the franchisor. He said that the franchisor had no intention of establishing another Mad Butcher franchise in Whangarei and therefore there was no legitimate interest to protect in the Whangarei area.
Gault J found there was a strong argument that the plain meaning of the restraint of trade clause was that it applied regardless of whether there was an existing Mad Butcher franchise store in the designated area. The judge acknowledged that there was some force in the franchisee’s alternative argument that the restraint could be unreasonable if the franchisor had no intention of competing or continuing business in the region.
The judge also dealt with the issue of whether, if the franchisee was able to establish a breach by the franchisor that would have justified cancellation of the franchise agreement, the franchisee would not be bound to perform the ongoing restraint and he accepted that such a proposition was arguable and referred to Health Club Brands Limited v Colven⁹.
Gault J concluded that his initial impression was that the franchisee would have an uphill battle establishing breaches by the franchisor sufficient to release the franchisee from performing ongoing obligations in the franchise agreement; and he determined that the balance of convenience lay in favour of the franchisor, finding that damages would not necessarily be an adequate remedy for the franchisor.
The franchisee subsequently filed an application for leave to appeal the interlocutory judgment issued by Gault J to the Court of Appeal and for a stay and the application was opposed by Mad Butcher.
At the hearing, the judge gave his reasons in more detail for an interim injunction and then looked at the argument for leave to appeal. The judge said that he was ‘conscious that I am being asked to review the correctness of my own decision … I must assess whether there is an arguable error …. I have not identified an arguable error’.
The judge dismissed the application for leave to appeal and the previous orders were confirmed.
Mainland Case
A case involving employment and a purported breach of a restraint of trade clause was Mainland Digital Marketing Limited v Willetts.¹⁰
Background
Willets and Nordek Myers (the defendants) were franchisees of Mainland Digital Marketing Limited (“MDM”). MDM provided visual media services to the real estate industry, including photography, videography, floorplans and internet marking services.
The defendants did not renew the franchise agreement in 2019 and were employed by Bayleys (an MDM client) after the expiry of the franchise agreements. MDM’s initial application for injunctive relief for breach of the restraint provisions was unsuccessful. The court did not make any finding as to the interpretation of the contract, but suggested that the parties apply to the court to determine whether the defendants’ employment with Bayleys breached clause 38.2 (being the relevant provision) and Appendix 1 of the franchise agreements.
The Issue and the Law
Under clause 38.2, the franchisee could not be involved in a business considered to be a market competitor or an imitation of the franchised system or similar to the franchised business or restraint business. Appendix 1 contained a non-solicitation clause for the geographic location for business dealings in the same type of business (Real Estate Photography, Floor Plans, Sign Boards, and Real Estate Internet Marketing) for a period of 2 years from the date of termination. Restraint Business was defined in the agreement as “collectively and individually the Franchised Business, or a business operating in the Restraint Area that is the same or similar to the Franchised Business or each separate business or actively specified in the Schedule”.
Franchised Business was defined as “the marketing and supplying to Clients real estate digital photography and the promotion of lead based real estate marketing services and other complimentary (sic) products and services”.
MDM argued the defendants breached clause 38.2 by providing real estate photography to Bayleys, a market competitor. Although the term ‘employees’ was not included in clause 38.2, ‘agents’ could cover this as the defendants were carrying out services as representatives or agents of Bayleys. The defendants argued that MDM was relying on goodwill as the relevant proprietary interest, but under the agreement goodwill belonged to the franchisee. The defendants were ‘greenfield franchisees’ and developed the goodwill themselves. Clause 38.2 was not meant to restrain all business but to restrain the franchisees from leading a business venture with a market competitor or imitation of the franchise system. Finally, ‘agent’ could not be extended to include employees.
They further argued that there was no breach as the business dealings had to be the same type of business as the franchised business, meaning relationships between businesses, not employees. Although Bayleys provided a photography service, it did not provide the same services as MDM.
The High Court was told the Willets and Myers and Open2view franchise agreement came to an end in March 2019 and that MDM owed the defendant $69,000. Courts frown on restraints of trade; they limit business activity and the wording of any restraint is closely examined. If there is any ambiguity, it is construed against the person seeking to enforce the restraint.
The court found that there was no breach of clause 38.2 as the clause did not exclude the defendants from working as employees. However, it found that Bayleys which was carrying on a similar business could be considered a market competitor. Restraint Business included “each separate business or activity specified in the Schedule” and meant that it could include only the provision of real estate photography. Franchised Business also included the specific business being undertaken by the photographer franchisees. Bayleys provided real estate photography services. There was no requirement that Bayleys had to provide that service exclusively to any other business activities.
The court found that Appendix 1 was breached. Solicitation did not have to be overt. It could also mean a presence and willingness to do business with another person. Bayleys announced to staff and clients that the defendants would be working for Bayleys and the defendants solicited vendors through their Linkedin page. The court accepted that this was solicitation in the broadest sense. The court also stated that business dealing was not just a commercial relationship between businesses, but implied transactions where there would be monetary gain or potential monetary gain. Each time the defendants asked to provide real estate photography, for a Bayleys agent they were indirectly facilitating a business deal.
Relief
Justice Nation said that there was no wording in the sub-franchise agreements that clearly prohibited the defendants from providing photographic services as employees for a former Open2view client. Restraint wording indirectly prohibiting such employment would require a full trial so the High Court refused an interim injunction blocking their continued employment with Bayleys.
Conclusion
The case emphasizes that the enforcement of restraints of trade clauses is not easy and each case depends on the particular facts.
Post-Termination Obligations
Many franchise agreements contain post-termination obligations that require a franchisee to assign the lease of the premises to the franchisor upon request. Such a clause will not assist a franchisor where there is no longer any lease in place but simply a holding over arrangement and the case of Foodstuffs North Island Limited v Ravla Trading Limited¹¹ is right on this point.
Background
Ravla Trading Limited (“RTL”) was a Four Square grocery franchisee in Gisborne, New Zealand. The parties entered into a franchise agreement in 2008 in which Mr Ravla was an approved operator and both Mr and Mrs Ravla were guarantors. The parties entered into a further agreement in 2017 where Mr Ravla was an approved operator and that agreement also included clauses prohibiting RTL from damaging the goodwill of Foodstuffs or being involved in a business that competed with Foodstuffs or the franchised business, with RTL needing the prior written approval of Foodstuffs to sell the franchised business. The agreement contained a right of first refusal for Foodstuffs to purchase the business and the termination clause stated that no party could terminate the agreement except as expressly provided in the agreement.
When the 2008 agreement was signed RTL held a lease of the premises. Without the knowledge of Foodstuffs, RTL purchased the building in 2016 and in July 2019 transferred the building into the Ravla Family Trust (“the Trust”).
In June 2019 RTL wrote to Foodstuffs, advising that Mr Ravla was ill, and Mrs Ravla was appointed to operate the business. However, she wanted to operate an independent grocery store and accordingly RTL suggested a termination date of 1 August 2019. Foodstuffs advised that it did not want to terminate the agreement and as RTL had no right to terminate it unilaterally, it had to sell the business to an approved purchaser. Alternatively, it was interested in taking the head lease and operating the store.
When Foodstuffs refused to consent to the proposal there was a period of silence from RTL during which time it was later discovered that the ownership of the premises had been transferred to the Trust.
The Issue and the Law
The case came before the High Court at Gisborne as an interim injunction application to restrain RTL and the Trust from taking any steps to transfer to any party the franchised business or any interest or right of possession in respect of the premises. Justice Ellis granted the injunction and was of the view that it was seriously arguable that RTL’s intention to transfer its business to some new entity was an anticipated breach of the agreement in that it was without the consent of Foodstuffs and without first offering it to Foodstuffs. The Judge also said that the transfer of the premises by RTL to the Trust was for the purpose of avoiding its obligations under the franchise agreement and the Trust itself was a sham insofar as the transfer of the premises was concerned.
As to the balance of convenience, Justice Ellis was of the view that there was little undue prejudice that might be suffered by RTL whereas, by contrast, Foodstuffs would suffer damage to the goodwill of its brand and its goodwill at the premises.
Conclusion
The case serves as a strong warning to franchisees that courts are willing to investigate any sham arrangements where they have as their outcome the avoidance of contractual obligations under a franchise agreement. Any franchisee wishing to follow a similar course of action is advised to seek expert legal advice and explore other options for not to do so is dangerous.
Issues at the End of a Franchising Relationship
Issues may arise on a termination or expiry of the franchise relationship. The meaning of the term “expiry” and “termination” may not be clear from the agreement and may give rise to different consequences. The legal nature of a continuing relationship post-expiry before an agreement is renewed, abandoned or otherwise brought to an end may also be an issue. Renewal may be on the terms of the franchisor’s then current franchise agreement which may be quite different from the original franchise agreement. Covenants in restraint of trade must protect a legitimate interest of the franchisor and may have to be tested for reasonableness between the parties and in the public interest. The issues of the premises and any lease must also be considered.
Managing Goodwill Issues in Franchising
“Goodwill” is a difficult concept and it is usually divided into three categories as follows:
- Site or locale goodwill;
- Commercial goodwill; or
- Personal goodwill.
The achievement of a formula for allocating goodwill to the respective parties is virtually impossible and the most appropriate solution is dictated by commercial best practice.
The issues may be best examined in the context of non-renewal of term. The decision of a franchisor not to renew a franchise may be promoted by various considerations. The business in question may be unsatisfactory because of the poor operational skills of the incumbent franchisee. The franchisor will be confronted with the need to either substitute an effective operator in what is at that time a business with little or no goodwill, or to close the venture entirely. On the other hand, the success of the franchise may have been sufficient to encourage the franchisor to seek to resume the site as an operation conducted under its own management.
In conclusion, a franchisor must have the right to assume operation of a franchised location which is controlled by a franchisee. Careful drafting of relevant clauses in franchise agreements is crucial to a franchisor being able to fulfil this objective.
¹ Generally accepted practice in leases in New Zealand.
² New Zealand statute – Contract and Commercial Law Act 2017.
³ California Business & Professions Code, section 16600 states: “Except as provided every contract by which anyone is restrained from engaging in a lawful profession, trade or business of any kind is to that extent void.” CAL BUS. & PROF. CODE § 16600.
⁴ [2018] NZHC 1612.
⁵ [2020] NZHC 1577.
⁶ Water Babies International Ltd v Williams & Ors [2020] NZHC 1289.
⁷ M and L Holdings (2012) Ltd v Whenua Productions Ltd & Anor [2020] NZHC 2541.
⁸ Mad Butcher Holdings Ltd v Standard 730 Ltd & Ors [2019] NZHC 589.
⁹ Health Club Brands Ltd v Colven Botany Ltd & Ors [2013] NZHC 428.
¹⁰ Mainland Digital Marketing Ltd v Willetts &Anor [2019] NZHC 1201.
¹¹ Foodstuffs North Island Ltd v Ravla Trading Ltd [2019 NZHC 2357.
