The Enforcement of Restrictive Covenants Against Non-Contracting Parties

  • April 05, 2022
  • Idan Erez, Hoffer Adler LLP

Restrictive covenants are a common feature of franchise agreements. They are intended to restrict the ability of existing and departing franchisees to exploit the knowledge and expertise they acquired from the franchisor, for the purpose of competing with the franchisor. Restrictive covenants can take different forms, but most commonly appear in franchise agreements as non-competition and non-solicitation clauses. These clauses are intended, respectively, to prohibit franchisee from operating a business that competes with the franchisor’s system, or from soliciting to a competing business the franchisor’s (or sometimes other franchisees’) employees or customers.

Well-drafted restrictive covenants restrict not only the competitive freedom of the franchisee, but also of the franchisee’s principals. Ideally, the principals are personally made parties to the franchise agreement that contains the restrictive covenant. This practice ensures that there exists a sound contractual basis, founded on the principle of privity, to bind the franchisee’s principals to the contract’s restrictive covenants.

Canadian courts, primarily but not only in Ontario, have demonstrated a repeated willingness to impose the terms of a restrictive covenant not only on the parties to the franchise agreement in which the covenant is contained, but also on persons who are not parties to that contract. This article will (i) discuss the jurisprudence in which courts both inside and outside of Ontario have considered whether to bind non-contracting parties to the terms of restrictive covenants contained in franchise agreements; and (ii) identify the underlying principles that appear to animate the courts’ approaches.

THE ONTARIO EXPERIENCE

Ontario courts have demonstrated a general willingness to bind non-contracting parties to the terms of a contractual restrictive covenant, notwithstanding the plain lack of privity.

In a brief decision from 2001, Ontario Duct Cleaning Ltd.[1], the court granted the plaintiff franchisor an interim injunction restraining the defendants from operating a competing business. The defendants included the franchisee and its principal, who were parties to the franchise agreement, but also a new company that was not a party to the franchise agreement. That new company had been incorporated by the franchisee’s principal and was the vehicle through which the competitive business was now being conducted. The court held that it was appropriate to include the non-party new company within the injunction order because “the company was formed for the purpose of enabling [the franchisee’s principal], under this corporate cloak, to compete with the plaintiff when [the franchisee’s principal] had undertaken not to do so.”[2]

Another brief decision, the Bulk Barn[3] decision from 2003, concerned a husband and wife who were shareholders of a corporate franchisee. The franchise agreement contained a restrictive covenant in the form of a non-competition provision that bound the franchisee’s shareholders; however, the husband and wife had not disclosed to the franchisor that the wife was also a shareholder and, as a result, she did not end up signing the agreement. After the term of the franchise agreement expired, the wife incorporated and began to operate a competing business through a new company. The franchisor successfully moved for an order temporarily restricting the wife and her corporation from continuing the business. Granting the order and effectively enforcing the non-competition provision against the wife, the court held that the wife should be viewed “as if she had signed” the said covenant, because she “must have known that she was affected by the franchise agreement… and she should not now be forgiven for trying to circumvent her legal obligation to the plaintiff.”[4]

In the 2010 Bark & Fitz[5] decision, the franchisor successfully sought an interlocutory injunction restraining a number of franchisees and their principals from terminating or breaching their franchise agreements. While the claims against the franchisees were straightforward and based on the parties’ underlying contractual rights and obligations, the claims against the principals were less obvious: as Justice Karakatsanis, as she then was, observed, the principals were not parties to any contracts and had not even guaranteed their franchisees’ contractual obligations. Nonetheless, the franchisor claimed that the principals themselves were not entitled to operate in breach of the non-competition provisions contained in the contracts to which the principals’ franchisees were parties. Granting the injunction against (most of) the principals, the court held that, at least for the limited purposes of a request for an interlocutory injunction, the franchisor had raised a serious issue requiring a full trial: “If the non-competition clause did not bind the principal of the corporate franchisee, that clause would be effectively meaningless: the principal could simply start a new corporation.”[6] Leave to appeal from the injunction decision was denied.

In the 2013 Pet Valu Canada Inc.[7] decision, the franchise agreement contained a non-competition provision that applied against both the corporate franchisee and its sole principal. One month before that franchise agreement was terminated, that principal’s spouse incorporated another company and the two spouses were proven to have used that new company to open up a competing store nearby to the previous franchised store. The franchisor sought a temporary order from the court restraining not only the franchisee and its principal, but also the principal’s spouse and his new company (who were not parties to the franchise agreement) from operating that competing store, pending a full trial. The court granted that order, finding that there was “a transparent effort by all of the defendants to avoid the restrictive covenants.”[8]

As something of an outlier when compared with the foregoing decisions, the court in the 2007 Second Cup Ltd.[9] decision dismissed altogether the franchisor’s motion for an interlocutory injunction restraining the defendants from breaching certain restrictive covenants in the franchise agreement. In this case, the franchisee’s principals were spouses, but only the wife had entered into the franchise agreement because, allegedly, the principals had not disclosed to the franchisor that the husband was also a shareholder. After the term of the franchise agreement expired, the husband opened up a competing business nearby to the premises out of which the franchisee had operated. The husband operated that competing business through a new corporation of which he was the sole director and shareholder. The franchisor sought to enjoin the husband and his new company from competing. As against the husband, the claim was that he ought to have been bound to the non-competition provision in the franchise agreement because he was an undisclosed shareholder and, if he had been disclosed, would had to have signed the agreement. As against the new company, the claim was that the company was intentionally created to enable the wife to breach her non-competition agreement.

The court was not prepared to issue an injunction against any of the defendants. The difficulty for the franchisor was that no party was able to produce a fully signed copy of the franchise agreement. In those circumstances, the court was prepared to consider the franchisor, the franchisee, and the wife as parties to an oral agreement, the main terms of which could be evidenced by four years’ worth of conduct during which the parties operated in an obvious franchise relationship; however, the court could find no evidence of conduct showing that the husband and wife had acceded to the terms of the restrictive covenant.

THE APPROACH OF COURTS OUTSIDE OF ONTARIO

The question of non-contracting parties’ liability under a restrictive covenant in a franchise agreement does not appear to have been widely considered outside of Ontario.  

In the 2006 Saint Cinnamon Bakery[10] injunction decision, the New Brunswick Court of Queen’s Bench declined to impose the terms of a restrictive covenant contained in a franchise agreement on the non-contracting father of one of the principals of the contracting franchisee or the company through which he operated a seemingly competitive business. The court’s decision not to subject the father or his company to the restrictive covenant was noteworthy because the court also found that (i) the non-contracting company had originally been incorporated by the contracting franchisee’s principals, who then relinquished their positions as directors to the father; and (ii) the contracting franchisee’s principals were involved in the operation of the competing business after the franchise agreement had been terminated. Moreover, the court considered the Ontario Duct Cleaning decision, in which the non-contracting party was made subject to the restrictive covenant.

In declining to make any order against the father or the father’s company, the court in Saint Cinnamon Bakery noted that it was not persuaded that the father’s company had been incorporated for the purpose of defeating the franchisee’s and the franchisee’s principals’ obligations under the restrictive covenant in the franchise agreement. The court also noted that the father’s company had been incorporated before the franchise agreement had been entered into. The court summarized its conclusion as follows:

It would be a travesty of justice if [the franchisee’s principals] were permitted to employ an artificial creature of statute, a corporation, to circumvent and avoid the very restrictions which they have bound themselves to observe. However, this is not the situation. At the present time, I conclude that it is [the father] who is the owner and operator of [the seemingly competing business]. He has not bound himself to observe any non-competition covenant.[11]

More recently, the British Columbia Court of Appeal came to the opposite conclusion in the 2022 decision, Garcha Bros Meat Shop Ltd.,[12] from that reached by the New Brunswick court in Saint Cinnamon. The franchisor in Garcha Bros successfully sought an injunction imposing the terms of a restrictive covenant contained in a franchise agreement not only on the contracting franchisee and its principals, but also on non-contracting parties. The non-contracting parties consisted of a cousin of one of the principals of the franchisee and the new company through which the cousin was operating a competitive business out of the same premises following termination of the franchise agreement.

The court hearing the injunction request granted the injunction against all of the defendants, including the non-contracting parties. The court articulated two bases for enjoining the non-contracting parties: first, that they were alter-egos of the franchisee, and second, that they had colluded with the franchisee to defeat the restrictive covenant. The injunction was upheld on appeal. The Court of Appeal saw no basis to interfere with the lower court’s finding that a conspiracy to defeat a non-compete was a sufficient legal basis to extend the terms of a restrictive covenant to non-contracting parties. Interestingly, the Court of Appeal considered the question of whether it was more appropriate “to deal with the problem not by applying the contractual provision to the non-signatories, but by enjoining them from continuing with their conspiracy to operate a business in violation of the restrictive covenant”, but the Court chose not to decide that question.[13]  

WHAT CONCLUSIONS CAN BE DRAWN FROM THE JURISPRUDENCE?

The Ontario jurisprudence, at least, demonstrates a clear tendency on the part of the judiciary to bind non-contracting parties to non-competition provisions in a franchise agreement when the following conditions are satisfied:

  1. those non-parties are not at arm’s length to the original franchisee or its principals, and
  2. those non-parties can be convincingly characterized as operating the competing business in an attempt to circumvent the non-competition undertaking.

The Garcha Bros decision of the B.C. Court of Appeal, is consistent with that line of Ontario cases and gives the trend some welcomed appellate authority.

While the tendency of those courts to bind non-contracting parties to non-competition provisions in a franchise agreement is clear enough, it should nonetheless be considered in the context of a number of caveats.

First, the foregoing decisions arose out of requests for injunctive relief, which are, by their nature, urgent hearings argued on the basis of incomplete evidentiary records and sometimes without the benefit of fulsome legal argument. It may well be that a court would be more circumspect about binding a non-contracting party to a restrictive covenant in a franchise agreement if that court were given the opportunity to deliberate on that question with the benefit of a complete record and less urgent or more robust argument.[14]

Second, the Ontario decisions, at least, do not always disclose a clear legal basis for binding the non-contracting parties to the restrictive covenants contained in the franchise agreement. While the courts plainly appear motivated to do justice in the face of sometimes brazen attempts by franchisee-related parties to defeat the restrictive covenants at issue, the courts’ reasoning does not always identify a recognizable legal basis for the result of their decisions. For instance, it is difficult to understand on what legal theory rests the court’s conclusion in Bulk Barn that the non-signatory wife should be viewed “as if she had signed” the franchise agreement (absent evidence of conduct supporting a finding that she had orally agreed to the franchise agreement). By contrast, the legal rationale behind the court’s conclusion in Pet Valu seems more coherent, to the extent that it can be understood as being based on a finding that the signatories and non-signatories conspired to defeat the restrictive covenant at issue.

The Garcha Bros decision more squarely scrutinizes the underlying legal bases by which third parties can be bound to the terms of restrictive covenants contained in a franchise agreement that they did not sign. The theory that the non-contracting parties are engaged in a conspiracy with the contracting ones appears to offer a particularly coherent rationale by which to enjoin the non-contracting parties, because it gives rise to non-contractual remedies and therefore does not need to offend notions of privity: the non-contracting parties may simply be enjoined from continuing to participate in the conspiracy.

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About the author

Idan Erez is a commercial litigator with Hoffer Adler LLP. His practice includes a strong emphasis on franchising and involves acting for both franchisors and franchisees across a wide range of industries. Idan is called to the bar in Ontario as well as the State of Georgia. He has appeared successfully in the Ontario Superior Court and Divisional Court as well as in the Superior Court of British Columbia and the Alberta Court of Queen’s Bench. Idan has an Honours Bachelor of Science in Molecular Genetics and Molecular Biology.

 

[1] Ontario Duct Cleaning Ltd. v. Wiles [2001] O.J. No. 5150 (S.C.).

[2] Id. at para. 7.

[3] Bulk Barn Foods Ltd. v. Faber, [2003] O.J. No. 5553 (S.C).

[4] Id. at paras. 3 & 7.

[5] Bark & Fitz Inc. v. 2139138 Ontario Inc., 2010 ONSC 1793, leave to appeal ref’d ((2010), 188 A.W.C.S. (3d) 1019).

[6] Id. at para. 46.

[7] Pet Valu Canada Inc. v. 1381114 Ontario Ltd., 2013 ONSC 5361.

[8] Id. at para 9.

[9] Second Cup Ltd. v. Niranjan [2007] O.J. No. 3409 (S.C.) [Commercial List].

[10] Saint Cinnamon Bakery Ltd. v Cimat Recycle Inc./Recylage Cimat Inc., 2006 NBQB 420.

[11] Id. at para. 63.

[12] Garcha Bros Meat Shop Ltd. v. Singh, 2022 BCCA 36.

[13] Id. at para. 62.

[14] It is notable that the injunction granted by the lower court was stayed pending its appeal: Garcha Bros Meat Shop Ltd. v. Singh, 2021 BCCA 134; this result perhaps reflects a potential hesitancy on the part of the courts to grant injunctions in these circumstances without the benefit of full records.

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