Non-Competition Covenants: Important Limits on the Freedom to Contract
You’re a franchisor that has invested significant time, effort, and expense in developing a unique franchise system. In order to successfully franchise the business, you must train your franchisees on the inner workings of the franchise system and show them the standards and specifications of how the system operates. However, you want to ensure that your franchisees do not use that know-how, either during the term of the franchise agreement or afterwards, to run a competing business and damage the goodwill of the franchise system.
A franchisor faces this tough issue before ever signing its first franchise agreement: how does it protect its investment in the franchise system by ensuring that its franchisees do not use what they will learn to compete with the franchise system? The problem is solved by a franchisor requiring its franchisees to give a non-competition covenant whereby each franchisee agrees not to compete directly or indirectly with the franchised business during the term of the franchise agreement and for a defined period afterwards. If the franchisee is a corporation, the franchisor will ordinarily require the principals of the corporation to give the covenant as well.
A non-competition covenant usually contains three components:
- a geographic restriction – what area is the franchisee restricted from operating in?
- a time restriction – what length of time is the franchisee bound for?
- an activity restriction – what is the franchisee restricted from doing?
While a franchisor may want to draft a broadly worded provision to ensure maximum protection of its goodwill and franchise system, Canadian courts have not been very accommodating in enforcing covenants they consider to be overly broad. The Supreme Court of Canada has long held that non-competition clauses should only be enforced in exceptional circumstances as such clauses which restrain trade and discourage competition are against the public interest. In balancing the public interest with a franchisor’s genuine and legitimate business interests, and recognizing that a franchisee is voluntarily entering the agreement, the court will enforce a restriction only where the clause is reasonable to protect that legitimate business interest.
In enforcing a non-competition covenant, the onus is on the party seeking to enforce the covenant to show that it is reasonable in geographic and temporal scope and limited to activities worthy of protection. As such, a franchisor should be careful to define the geographic, time, and activity restrictions in the narrowest scope that is reasonably necessary to protect its interests. A non- competition covenant will likely be found unenforceable where it is too wide geographically, for too long, and too restrictive in nature.
It is also important that a non-competition covenant be unambiguous and specific in its terms. If the clause is ambiguous in any material way, courts will find it difficult to determine that the clause is reasonable and it will likely be found unenforceable. For example, for a pizza delivery franchise, stating that the franchisee is prohibited from operating “a similar or competing business” will likely be found unenforceable for its ambiguity. Such a clause may arguably seek to restrict a franchisee from operating another restaurant that may sell pizza as part of a larger menu offering. The fact that the clause may be interpreted to cover a broader range of businesses than what the franchisee was carrying on will result in the clause being objectionable. Further, Ontario courts will not “read-down” an overly broad non-competition covenant to something that is reasonable, but rather, they will find that the covenant is entirely unenforceable.
Just as a franchisor must define the activity to be protected with care, similarly, the franchisor must be reasonable in selecting the time and distance parameters of the clause. The franchisor should consider the real trading area that needs protecting and only restrict the activity long enough to allow it to re-establish itself in the trading area.
Given that a non-competition covenant cannot be used to unduly restrict a person’s ability to earn a livelihood but rather must be reasonable to protect the franchisor’s legitimate business interests, a franchisor must take extra precaution when imposing such restrictions upon its franchisees. Counsel familiar with non-competition covenants should be consulted to assist to establish reasonable safeguards to protect those interests to the extent permissible.