UK: Non-Compete And Step-In Clauses: High Court Carewatch Case Confirms Their Validity

Last Updated: 11 November 2014
Article by Babette Märzheuser-Wood, Sam Szlezinger, Robyn Chatwood and Alex Haffner

Recently, the English High Court handed down its judgment in the carefully-watched Carewatch case 1

The case considered the validity of the non-compete and step-in clauses in a franchise agreement which a franchisor had sought to enforce against its former franchisee.

The High Court confirmed that the leading case at the Court of Justice of the European Union (CJEU) on non-compete provisions in a franchise agreement, Pronuptia2, remains good law. Franchisors will be relieved that the position has not changed and so post-termination non-compete clauses in a franchise agreement (which restrict competition) will be valid if they are necessary to protect the franchisor's legitimate business interests.

The step-in provisions in the Carewatch agreement had entitled the franchisor to operate the franchised business on termination from the premises and to buy certain franchisee assets. The High Court commented that they were not "particularly stringent or onerous"3 and they were upheld. However, the franchisor did not have a right to buy the franchised premises from the franchisee as the agreement had simply failed to provide for the possibility. The oversight is an expensive lesson.

The background facts to the case

The background to the case had a surprising start. Carewatch Care Services (Carewatch) first received notices to terminate the franchise agreement from one of its franchisees, Focus Caring Services (Focus). Focus had since 1999 operated a number of the franchised outlets. Carewatch is the second largest provider of home care services in the UK, operating through both directly-owned and franchised outlets.

Carewatch may not have thought, when the franchisee terminated, that it would need to rely on the Court (after a six-day trial) to enforce the post-termination non-compete clauses in the franchise agreement. The dispute arose in 2013 when Focus decided to start operating competing home care services under different brand names (Purely Care and Poppy Care) while the Carewatch franchise agreement was still on foot. Focus had taken this step as it was aggrieved that Carewatch had decided to operate company-owned outlets in Focus's non-exclusive territory. Carewatch considered Focus to be in breach of the franchise agreement and initially efforts were made by both parties to resolve matters. However negotiations broke down and Focus decided to terminate its franchise agreement.

In its termination letter, Focus agreed that it would comply with its post-termination obligations to extricate itself from the Carewatch franchise system, but stated that it was not prepared to comply with the post-termination non-compete obligations. Focus argued that the provisions which prohibited Focus for a period of 12 months after termination from either competing with Carewatch in the territory covered by the franchise arrangements or from soliciting any of its employees/customers were void and unenforceable under competition law.

Competition law and franchise agreements: the Pronuptia test

By way of background, EU and UK competition rules prohibit provisions in commercial agreements which restrict, prevent or distort competition. Taken out of context, a non-compete obligation risks breaching these rules on the basis that the parties effectively agree not to compete with one another within a defined territory. At worst, such a restriction can amount to market-sharing, which is regarded as one of the most serious breaches of competition law.

Nevertheless, competition law recognises that a rigid approach to non-compete restrictions undermines the very basis on which many commercial arrangements are entered into and the legitimate commercial bargain which the parties are willing sign up to.

This is particularly true of franchise agreements. Franchisors necessarily provide and enable their franchisees to take advantage of the franchisor's established business name, know-how and business methods. In return, the franchisor reasonably expects the franchisee not to take that knowledge and reputation and use it for the benefit of the franchisor's competitors.

The leading case on the relationship between the competition law rules and franchise agreement is Pronuptia de Paris4 - a case which arose out of a dispute between the French owner of a wedding goods franchise system and its German master franchisee. In this case, the CJEU held that there are certain restrictions in franchise agreements which are necessary to ensure the proper functioning of a franchise system and so fall outside the competition law rules altogether. These are provisions which are essential to:

  1. ensure that the know-how and assistance provided by the franchisor to the benefit of the franchisee does not benefit the franchisor's competitors; and
  2. maintain the identity and reputation of the franchise network.

When giving its judgment however, the CJEU stated that it should be confined only to distribution franchises, being those where a franchisee sells products under the franchisor's name. However, the principles adopted by the CJEU have since been applied more widely to other types of franchise and so are relied upon by franchisors as a "safe harbour" from competition law for a wide range of restrictions/obligations which are typically included in franchise agreements, including non-compete provisions.

Applying the Pronuptia test in Carewatch

Focus argued that the non-compete covenants in its franchise agreement with Carewatch went further than permitted under the competition law rules. If that argument had been accepted by the Court, the provisions which breached the competition law rules would be deemed void and unenforceable from the moment the agreement was made. This would have prevented Carewatch from enforcing them.

The judge in Carewatch considered the Pronuptia test that held that a non-compete covenant which prohibited a franchisee from opening a business of the same or similar nature in the relevant area where it can compete directly with a member of the franchise network was permissible so long as such provisions apply only for a "reasonable" period after the termination of the franchise agreement.

The Carewatch parties did not dispute that the scope of the non-compete obligations was reasonable (these were limited to businesses which directly competed with the franchisor's business). However, the reasonableness of the 12-month duration of the non-compete was disputed. The Court stated, considering the relevant precedents5 and applying the Pronuptia test, that an analysis of the specific facts was required to determine whether, on termination of the agreement:

"the know-how and assistance provided by the franchisor to the franchisee is of an extent likely to turn that franchisee into an effective competitor".

For Carewatch, the judge was in no doubt that this test was satisfied - particularly in light of the facts that Focus's owners had taken on the Carewatch franchise without any prior knowledge or experience of the care industry and that it was the know-how and assistance provided by Carewatch which had enabled Focus to build its profitable business in an industry characterised by the highly personal relationship between care providers and their customers.

The result was that the Court upheld the non-compete covenants in its franchise agreements and gave Carewatch the injunction against Focus which it had sought to prevent Focus's owners from establishing and operating the competing business.

Step-in rights

Another aspect of the case was to do with the franchise agreement's step-in provisions. These gave rights to the franchisor, on termination of the franchise agreement, to purchase certain assets of the franchised business from the franchisee and to enter the franchised premises and operate the franchised business. The parties were in dispute about whether the franchisor was entitled to buy the franchise property on termination in order to give business efficacy to its rights to step-in and operate the business following termination. The High Court upheld the step-in rights but noted that that they failed to provide for the possibility that the franchised premises might be freehold premises owned by the franchisee - this was described as an oversight. As a result, the franchisor did not have the right to buy the freehold. The Court noted that the franchisee was nevertheless obliged to give up possession of the property to enable Carewatch to take over and run the franchise and for that purpose, Carewatch needed no more than a licence to occupy the property. The case emphasises the importance to spell out clearly in the agreements the various scenarios and the specific entitlements of the parties after termination.

Lessons to be learnt from the case

The case provides franchisors with useful guidance on when non-compete restrictions will be enforceable and is an important reminder of the interaction between the UK/EU competition rules and franchise agreements.

There are two main lessons from the Carewatch case:

  • It emphasises that provisions in a franchise agreement which restrict competition will be permitted only if necessary to protect the franchisor's legitimate business interests. Where called upon to determine the validity of a restriction, a court will look beyond the language of the franchise agreement and focus on the relevant circumstances under which the franchise agreement is performed and whether the franchisor should be entitled to the level of protection sought. Franchisors should ensure that any restrictions imposed on its franchisees from the outset are justified.
  • The case emphasises the importance of thinking through the various scenarios and rights that the franchisors will require following a termination. The rights to purchase assets of the former franchisee need to be clearly articulated in the agreement.

Footnotes

1 Carewatch Care Services Ltd v Focus Caring Services Ltd & Ors [2014] EWHC 2313 (Ch).
2 Pronuptia de Paris GmbH v Pronuptia de Paris Ermgard Schillgalis [1986] ECR I-353.
3 Above no. 1, at [85].
4 Pronuptia de Paris GmbH v. Pronuptia de Paris Ermgard Schillgalis [1986] ECR I-353.
5 Pirtek (UK) Limited v Jointplace and Ors [2010] EWHC 1641 (Ch).

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