Franchising is the licensed practice of using another company’s successful business. This business is typically recognisable through the quality and uniformity of the products or services offered, and the operating system used, including the design, decor, colour scheme and style of outlets. The franchisor as a supplier allows an operator, or a franchisee, to obtain and use the benefit of the knowledge, skill, experience of the franchisor including the latter’s trademark to distribute the franchisor’s goods. In return, the franchisee as operator pays the supplier a fee.
Non-compete clauses cannot be considered lawful if they are such as to drive out the franchisee from business
The practice of franchising is thus an alternative to building chain outlets. Chain outlets share a brand and usually have a standardised business method, but contrary to a franchise, have a central management system.
Franchise agreements often contain a combination of different vertical restraints concerning the products being distributed, in particular non-compete clauses. They come in the form of a prohibition on the franchisee during the duration of the agreement from carrying on any other business in the market. Other non-compete clause apply to the period after a franchise agreement has been terminated, whereby the franchisee agrees not to enter into or start a similar trade in competition against the franchisor for a specified period of time after termination of the franchisor-franchisee relationship.
These non-compete clauses are considered as material to the conclusion of an agreement between a franchisor and a franchisee, given that generally the franchisor will have established substantial reputation and goodwill in its business from which the franchisee will be benefiting directly, albeit at a cost in the form of a franchise fee.
Franchise agreements normally contain licences of intellectual property rights relating, in particular, to trademark use, knowhow for the use and distribution of goods or services, as well as continued technical assistance to the franchisee from the franchisor.
These non-compete clauses are generally subject to competition law, as their effect is to restrict the franchisee’s freedom of business activities and to prevent other franchisors from distributing their products or services through the franchisee. EU competition law prohibits agreements between undertakings that may affect trade between EU member states and which have as their object or effect the prevention, restriction or distortion of competition within the common market.
Against this backdrop, the Court of Appeal of Burgos in Spain made a preliminary reference to the Court of Justice of the European Union regarding the scope of application of these non-compete clauses. This reference arose from proceedings initiated by a franchisor against its franchisee in which the former claimed compensation for the unilateral termination by the latter of a franchising agreement and breach of the non-compete clause, which was valid for the duration of the agreement and extended to one year after its termination. The non-compete clause covered the entire territory assigned to the franchisee under the agreement.
One of the questions that the court had to decide was whether the non-compete clause was exempt under the Block Exemption Regulation on Vertical Restraints, as applicable at that time. That Regulation was valid until 2010 and has since been superseded by a new one that will in turn be valid until 2022. The same wording is used in the new Regulation and therefore the court’s ruling handed down recently is still topical.
The old Regulation exempts a post-term non-compete obligation, provided certain requirements are met.
These include the condition that the non-compete obligation is limited to the premises and land from which the franchisee has operated during the contract period. The Spanish court referring the case to the CJEU inquired whether this limitation referred to the physical space from which the franchisee operated while the agreement was in force or whether this covered the entire territory assigned in the contract.
Applying the literal interpretation to the wording used in the Regulation, the court considered that non-compete clauses are allowed to benefit from the block exemption only if their geographic scope is restricted to the physical space from which the contract goods or services were sold. Non-compete clauses cannot therefore be considered lawful if they are such as to drive out the franchisee from business.
jgrech@demarcoassociates.com
Josette Grech is an associate with Guido de Marco & Associates and heads its European law division.