Franchisor Cannot Enforce Restrictive Covenant In A Territory Where It Does Not Intend To Operate

The Ontario Court of Appeal released an interesting decision recently in a case involving the enforceability of a non-competition covenant in a franchise dispute involving the MEDIchair franchise system.  The court reversed the decision of a Superior Court of Justice application judge (who ruled in the franchisor’s favour) and found that the restrictive covenant in the franchise agreement was unenforceable in Peterborough.

(For an analysis of the application judge’s decision, see the Law Works Blog article “Ontario Court Upholds Broad Franchise Non-Compete Restriction”, August 23, 2015.)

The appeal decision hinged on the specific evidence that the MEDIchair franchisor ran a competing Motion Specialties brand and did not intend to open another MEDIchair store in Peterborough as long as its Motion Specialties franchisee operated in that territory.

Key facts

The franchisee operated a franchised location in Peterborough, Ontario.  The original franchisee operated that location for twenty years until 2008.  At that time, new franchisees purchased the franchised location from the original owner.  The new corporate and two new individual franchisees guaranteed the obligations of the original franchisee under the franchise agreement, including a post-termination restrictive covenant.

In 2010, the new Peterborough corporate and individual franchisees renewed the franchise agreement for a further term of five years.

By 2011, the MEDIchair franchisor had sixty-six franchised and satellite locations across Canada, and four corporate stores.

In 2012, the owner of the MEDIchair franchise purchased a group of twenty-four corporate stores mostly in Ontario and similar to the MEDIchair stores, called “Motion Specialties”.

The Peterborough franchisees’ location competed directly with one of the corporate locations that operated under the Motion Specialties banner also in Peterborough.

The franchisees claimed that the franchisor shifted its focus of attention and support to the Motion Specialties system away from the MEDIchair system.  The number of MEDIchair stores began to decline.  The Peterborough franchisees eventually commenced an action against the franchisor for its alleged failure to support the system.

In January 2015, their franchise agreement expired.  The Peterborough franchisees did not renew it.  They de-branded the location, advised their suppliers that they continued to operate their business as usual, and continued to operate the business from the same location, with the same merchandise and employees.

The restrictive covenant

The restrictive covenant in the franchise agreement applied on the termination of the franchise agreement.  It was expressed using typical restrictive covenant words commonly found in Canadian franchise agreements.  The clause sought to prevent a franchisee from operating a store similar to the franchised store within a thirty-mile radius of the franchisee’s store, or the nearest franchise store, for a period of eighteen months.

On the basis of this restrictive covenant, the franchisor commenced legal proceedings against the Peterborough franchisees to enforce the restrictive covenant.

Key evidence regarding no intention to operate in Peterborough

The key evidence was the franchisor’s admission on cross-examination that it chose not to operate a MEDIchair franchise store within the contested territory in Peterborough because it already operated a competing Motion Specialties store in the territory.

The franchisor’s representatives conceded that as long as their Motion Specialties franchisee operated in Peterborough, they would not open a competing MEDIchair location there.

Just as importantly, the franchisor did not assert that it required the restrictive covenant to protect the interests of the Motion Specialties franchisee in the territory.

Whether the words “similar to” in the restrictive covenant were ambiguous

In both the application and on appeal, the franchisees claimed that the words “similar to” in the restrictive covenant were ambiguous.  They relied on the following reasons: (i) there was no definition of the MEDIchair business in the franchise agreement, (ii) the business covers a variety of products, and (iii) different franchise locations may offer different products.

The application judge, as upheld on this issue by the Court of Appeal, dismissed these arguments on the following key grounds:

• the franchisees merely changed the name of their business but otherwise continued to operate exactly the same business as before;
• the former franchisees were bound by the same clause;
• courts regularly address restrictive covenants where the standard is a “similar” business;
• the franchisor had a legitimate interest to protect its method of operation, goodwill, products, and services from similar operations specializing in the sale or rental of home medical equipment; the similarity is therefore found by comparing not only the product line but also the method of operation and whether the franchisees were using the goodwill of the franchise system from which the had benefitted for many years.

Whether the scope of the restrictive covenant was reasonable

The Court of Appeal applied the Supreme Court of Canada decisions in Elsley v. J.G. Collins (1978) and Payette v. Guay (2013), as setting the basic principles for the enforceability of covenants in restraint of trade.  The court confirmed that both Elsley andPayette provide for different approaches as between contracts for the sale of a business and employment contracts.  The court is required to presume as valid restrictive clauses in the commercial context (such as the sale of a business), while in the employment context it was required to scrutinize the reasonableness of the covenant.

In this case, the court chose not to decide the proper level of scrutiny in a franchise relationship.  Instead, it focused on whether the franchisor had a legitimate interest that was entitled to the protection of the restrictive covenant.

There was no need to determine whether the restrictive covenant in this case (i) was entitled to a presumption of reasonableness (as done in the commercial context), (ii) required a high level of scrutiny (as done in an employment contract), or (iii) perhaps fell somewhere on a spectrum between these two ends (as is assumed in respect of franchise agreements, which are typically contracts of adhesion yet involve independent contractors in a commercial context).  As a result, there was no need to determine the reasonableness of the temporal or territorial restrictive in the MEDIchair non-competition agreement.

Instead, the court focused on whether the franchisor had a legitimate interest to protect in Peterborough in respect of the MEDIchair franchise system.  It noted that a common requirement to all levels of scrutiny is to show a legitimate interest that was worthy of the protection of a restrictive covenant.  The court applied the Supreme Court’s decision in Payette, where Wagner J. stated that the test for reasonableness is whether the clause was (emphasis in original):

…limited, as to its term and to the territory and activities to which it applies, to whatever is necessary for the protection of the legitimate interests of the party in whose favour it was granted.

In addition, the court applied its own older decision in Tank Lining Corp. v. Dunlop Industrial Ltd. (1982), where it held that in all cases a party’s entitlement to enforce a restrictive covenant was based on the protection of a legitimate or proprietary interest, such as the goodwill of a business in a commercial context or the confidential information unique to an employment.

The court stated that the franchisor had a legitimate or proprietary interest to protect the goodwill of the franchise system, including trade secrets, methods of operation, or other benefits that a franchisee obtains.  Yet, the purpose of a restrictive covenant is limited with respect to time and space: the protection is available only for a specified time and applies only within a defined territory.  After that time, the interest is no longer protected.  Similarly, this interest is not protected even during this time but outside the territory.

As a result, a franchisor has no legitimate interest to protect through a restrictive covenant where it does not operate – to do so would be contrary to public order.  The court applied the statement of Wagner J. in Payette (at para. 65): “A non-competition clause that applies outside the territory in which the business operates is contrary to public order.”

Applying these principles to the MEDIchair dispute

As noted earlier, the application judge rejected the proposition that the franchisor had no legitimate interest to protect within Peterborough, even though it did not intend to operate another MEDIchair store as long as its Motion Specialties franchisee operated there.  The application judge stated that irrespective of this fact, the franchisor was entitled to protect the integrity of the franchise system overall.

The Court of Appeal did not agree.  It was clear from the evidence that by deciding not to operate a MEDIchair store in Peterborough, the franchisor effectively acknowledged that it had no legitimate or proprietary interest to protect within this defined territory.

The court held that the application judge erred in law by focusing on the effect of the non-enforcement of the MEDIchair franchise system as a whole, without addressing the lack of interest to protect within the territory.

Protecting the franchise system as a whole v. the specific territory

Parties’ reasonable expectations

There is an important distinction that the court noted between the general reasonable expectation that a franchise system may be worthy of protection as a whole across the country, and the specific intention of a franchisor not to operate within any particular territory.

In its 1982 Tank Lining decision, the restrictive covenant applied across Canada, even though the parties only operated in some provinces.  The Court of Appeal in that decision nevertheless found that the non-competition clause was reasonable and enforceable because the parties originally expected that the business would expand across Canada: it was the parties’ intention at the time of entering into the agreement that the clause would apply across Canada.

This original intention of the parties was important in support of the reasonableness of a restrictive covenant; even in respect of areas where a franchisor may not operate at any given time, but where the parties reasonably expect that the franchisor would operate in the future.

The court distinguished the present case on the basis that the franchisor did not intend to operate a MEDIchair franchise in Peterborugh.  The court noted that the restrictive covenant was not struck down as a whole as unreasonable or unenforceable, and therefore did not impact the MEDIchair franchise system.

The restrictive covenant in the present case would have been enforceable had the franchisor of the MEDIchair system planned to continue operating in Peterborough.  But it was held unreasonable and therefore unenforceable as between these parties in respect of the Peterborough territory.