Western Canada Business Litigation Blog

Use it or lose it: Restrictive covenants in Franchise Agreements

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A recent case from the Ontario Court of Appeal suggests franchisors may lose the protection of a restrictive covenant in a franchise agreement if, at the time the franchisor wants to enforce the covenant, it can’t establish a “legitimate or proprietary interest to protect” within the territorial scope of the covenant.

In MEDIchair LP v. DME Medequip Inc., 2016 ONCA 168, the Ontario Court of Appeal refused  to enforce a restrictive covenant against a former franchisee, where the franchisor had no intention of operating or granting any further franchises in the territory.

In that case, the respondent franchisor, MEDIchair LP, operates a network of franchise stores that sell and lease home medical equipment. In 2008, the appellants purchased a MEDIchair franchise operating in Peterborough, DME Medequip Inc., and agreed to assume the obligations in a 2005 Franchise Agreement between MEDIchair and DME. The Franchise Agreement contained a restrictive covenant that prohibited the franchisee, on termination of the Franchise Agreement, from engaging in or operating “any business similar to the business carried on by MEDIchair or any of its authorized Franchisees within an area of 30 miles of the nearest MEDIchair Store business in Canada” or the Peterborough store, for a period of 18 months.

In June 2011, the franchise system was sold to Centric Health Corporation, which also purchased Motion Specialties, a group of corporate stores. One of the Motion stores operated in Peterborough and competed directly with the DME store. The franchisee alleges that after acquiring Motion, the MEDIchair franchise system declined as the corporate owners focused more on the Motion stores. Dissatisfied with the level of support of the franchise system, in January 2015, the franchisees terminated the Franchise Agreement on expiry. The now former franchisee removed the MEDIchair signage and continued to operate the same Peterborough store with the same merchandise and the same employees, under the name “Living Well Home Medical Equipment”.

The franchisor sued to enforce the restrictive covenant. In cross-examination, the franchisor acknowledged that it had no plans to open a Peterborough MEDIchair store, and that it would not seek to do so in competition with the existing Peterborough Motion store. The central issue in this case was whether the restrictive covenant could be enforced against the former franchisee given the franchisor’s stated intention not to operate in the territory.

Generally, restrictive covenants in the commercial context (as opposed to the employment context) are enforceable unless the covenant is shown to be commercially unreasonable. The Court in this case acknowledged there is a debate in franchise practice as to whether restrictive covenants in franchise agreements will enjoy presumptive enforceability, given the power imbalance between franchisees and franchisors, but did not have to resolve the issue in this case.

In the court below, the application judge considered the evidence that the franchisor had no plans to open a location or grant a franchise in the territory covered by the restrictive covenant, but was swayed by his consideration that failure to enforce the restrictive covenant could “significantly compromise” the integrity of the franchise system as a whole, and held the covenant was enforceable.

The Court of Appeal found that the application judge erred in law by focusing on the effect of non-enforcement of the covenant on the franchise system as a whole. The court found that the evidence of the franchisor’s lack of intention to operate in Peterborough showed the franchisor had acknowledged it had “no legitimate or proprietary interest to protect within the defined territorial scope of the covenant”, and therefore the covenant was “unreasonable as between these two parties in the circumstances of the particular Peterborough franchise.”

The Court also considered a second aspect of the enforceability of the restrictive covenant. In this case, the decision not to continue to operate in Peterborough arose after the parties agreed to the restrictive covenant in the Franchise Agreement. The Court resolved this “timing” issue by considering the parties’ expectations at the time of the Franchise Agreement as to what might happen in the future. The Court said:

[51] As the reasonableness of the covenant will be interpreted based on the parties’ anticipated expansion of the business when they entered into their agreement, it should similarly be interpreted to take account of the parties’ expectations at that time with respect to the future continued operation of the franchise in the territory. In this case, the clause was reasonable on the assumption and understanding that MEDIchair would want to continue to operate in the protected Peterborough area, but not if it did not.

In this case, the franchisor lost the protection of the restrictive covenant because the present direction of the franchise was not consistent with the expectations of the parties in 2005. The Court did emphasize that each case must be examined on the facts and the particular franchise agreement between the parties.

The Court considered and rejected a number of other arguments by the appellants. In particular, the Court confirmed the application judge’s finding that the franchisor was not required to provide the appellants with a disclosure document under sections 5(1) and (4) of the Arthur Wishart Act (Franchise Disclosure), 2000, S.O. 2000, c. 3 when the appellants purchased the franchise in 2008. In this case, the franchisor was only peripherally involved in the grant of the franchise – it approved the transfer of the franchise to the appellants, accepted a transfer fee and obtained personal covenants from the individual appellants to be bound by the 2005 Franchise Agreement. The franchisor was therefore exempt from disclosure requirements under the Act. Sections 5(8) of the proposed British Columbia Franchises Act contain the same exemptions from disclosure obligations when a franchise is granted by a franchisee.