Ontario Court Upholds Broad Franchise Non-Compete Restriction

Case and Decision in a Nutshell

The corporate franchisee had earlier taken over the franchise agreement from the original franchisee by way of a resale.

As part of the resale, the franchisee’s two principal owners executed personal covenants agreeing, among other things, to comply with the restrictive covenant in the franchise agreement.

The restrictive covenant included a broad non-compete restriction similar to those typically found in many Canadian franchise agreements. At its core, it prohibited the franchisee from directly or indirectly operating a “similar business” within a 30-mile radius of any MEDIchair location in Canada, for a period of 18 months after termination.

After the franchise agreement expired in January 2015, the corporate franchisee de-branded the business and continued to operate it on the premises under a different name but with the same merchandise and employees.

The franchisor, MEDIchair LP, brought a court application to enforce the non-compete covenant against the corporate franchisee and the two individual principals.

The franchisee and its individual principals argued that the restrictive covenant was unenforceable on the basis that (i) it comprised a restraint of trade and was ambiguous, and (ii) the disclosure document did not contain a copy of the executed franchise agreement.

The Ontario Superior Court of Justice granted the franchisor’s application in full, thereby restraining the former corporate franchisee and the two individuals from continuing to operate their business.

On the issue of the validity of the non-compete covenant, the court applied the overall traditional legal framework for the analysis, that (i) the franchisor bore the onus of establishing the reasonableness of the restrictive covenant, (ii) an ambiguous restrictive covenant will be prima facie unreasonable and unenforceable, and (iii) the four-part public policy in a restraint of trade analysis in the 1982 Ontario Court of Appeal decision of Tank Lining Corp. v. Dunlop Industrial Ltd. (1982). The court concluded that the restriction was valid and enforceable.

Among other things, the court ruled that the words “similar to” in the restrictive covenant were not ambiguous, as the franchisee submitted. In doing so, the court rejected the franchisee’s position that the franchise system as a whole carried varying lines of products, with stores selling different lines.

Instead, the court focused on the similarity between the franchisee’s store before and after it was de-branded: the store carried the same line of products before and after the franchise expiration. On this basis, the court distinguished this case from others where former franchisees began offering services outside the normal scope of those offered within the franchise system.

With respect to the restriction of a 30-mile radius, the court found that the restriction was reasonable. It relied, among other things, on the fact that the franchisee corporation obtained a seemingly far more restrictive covenant as against the original franchisee as part of the resale transaction – for a five year period and a 100 kilometer radius of the store.

The court did not give much weight to evidence that the franchisor was not planning to replace the de-branded franchised location in Peterborough within the 30-mile radius. Rather, the court relied on the fact that the former franchisee had benefited from the system for nearly two decades and the existence of a franchise location in Whitby, which although outside of the 30-mile radius, was relatively nearby.

With respect to the disclosure document, the court proceeded on the basis that it did not include the franchise agreement, as the franchisee claimed, but found that this did not entitle the franchisee to any relief. It held that the resale to the franchisee was not “effected by or through the franchisor” and therefore, under subsection 5(7)(a) of the Arthur Wishart Act (Franchise Disclosure), 2000, the franchisor was not obligated to provide a disclosure document.

Critique

This is one of the first franchise non-compete decisions to apply the reasoning of the Supreme Court of Canada in its September 2013 decision, Payette v. Guay, relating to commercial restrictive covenants (see the Law Works Franchise Blog article analyzing the Payette Supreme Court decision: Supreme Court Favours Enforcing Commercial Non-Compete Covenants).

On the issue of the court’s interpretation of the restrictive clause and the words “similar to”, the court did not undertake a detailed factual and legal analysis of the relevant multitude of factors relating to the franchise system, as done in established franchise law authorities.

It may very well be that even under a more inclusive analysis that takes into account the uniqueness of the franchise system, the nature of the various lines of products in the system, and the typical catchment area of each location within this system, among others, the words “similar to” would be held unambiguous and lead to the same result, but no comprehensive analysis was undertaken.

The court’s decision appears to have been largely driven by the following two key factors, on which it seems to relied to override other factors:

• the lengthy period of almost two decades that the franchisee had operated within the system, and
• the identical nature of the business after the franchise termination.

With respect to the court’s reliance on the more restrictive covenant that the franchisee obtained from the former franchises as part of the resale, no reasons were provided why the resale restrictive covenant was comparable in principle to a franchise covenant in favour of a franchisor across an entire franchise system:

• The resale restrictive covenant between the original and successor franchisees is the type of a “pure commercial” arrangement in the sale of a business that fits neatly within the Supreme Court’s analysis in Payette. The Supreme Court inPayette distinguished the analysis as it applies to a pure commercial arrangement from other relationships, such as an employment relationship. A franchise relationship is neither a pure commercial arrangement nor an employment relationship. It sits somewhere on a spectrum between these two extremes. It remains unclear how the Payette analysis fits within the range of factors that are typically considered in franchise decisions, or even the fewer factors that were considered in this case.
• The resale restrictive covenant is by its nature limited to one location – the business that was the subject of the resale. By contrast, the restrictive covenant in the context of the franchise relationship is made with respect to multiple and often numerous locations across a large region, in this case Canada; often locations existing at the date of termination and which were non-existent at the time of providing the covenant.

Given these differences in the contexts of the two restrictive covenants, they should not be viewed as analogous. It remains unclear why in principle a business resale restrictive covenant may be legally instructive with respect to the interpretation of a franchise restrictive covenant.

On the issue of the disclosure document, the court provided scant reasons in support of its conclusion that no disclosure document was required. The reasons do not provide particulars about the resale transaction and how the franchisor’s role was passive.

As was held by the first Ontario decision on this issue, Tutor Time Learning Centres, a franchisor who imposes a key condition to the resale that is in addition to the resale conditions in the original franchise agreement, is deemed to have ‘effected’ the resale.

Among other things, the decision in this case did not address the effect of the personal guarantee that the franchisee’s individual principals signed, and whether this was done under a condition in the original franchise agreement, or whether this was a new condition that the franchisor may have imposed at the time of the resale.

This decision adds to the pragmatic line of franchise law jurisprudence interpreting restrictive covenants. However, further analysis, particularly in light of Payette, will be likely required in future cases with respect to the many issues affecting the enforceability of franchise restrictive covenants.

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