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Auditing Franchisees for Compliance – Tips for Effective Auditing

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By Sofia Lozanova, Lawyer, MST Lawyers

Conducting audits of a Franchisee’s compliance with all relevant aspects of the franchise business is now more important than ever.  However, what happens if, during an audit, a Franchisor uncovers breaches or behaviour that is contrary to the franchise agreement or even illegal?  It is important for Franchisors to follow appropriate protocols to achieve the best outcomes.

The Audit Powers

A Franchisor’s entitlement to audit Franchisees is ordinarily a contractual right, contained within the provisions of its franchise agreement.  Such clauses allow the Franchisor to:

  • randomly audit the Franchisee’s books of account and other records;
  • attend the Franchisee’s premises at any time, with or without prior notice, to:
    • inspect the premises
    • assess the quality of employees
    • observe the operation of the business; and
  • audit the Franchisee to assess performance and compliance with the franchise agreement.

Before a Franchisor decides to audit a Franchisee, it must ensure that it reads and complies with its own procedural obligations set out in the franchise agreement. This will avoid challenges to the Franchisor’s ability to enforce its rights if the audit reveals non-compliant behaviour.

In many cases, the Franchisor is required to advise or put its Franchisees on notice of any upcoming audits in writing and provide its Franchisees with an adequate period to comply with the audit.

However, some franchise agreements may heavily rely on manual systems and on data reported by the Franchisees to assess performance and compliance.  In this instance, there is the risk that the Franchisee’s own record keeping might be scant, such that the results of any audit are not fruitful. It is, therefore, essential that the Franchisor also audit the Franchisee’s compliance with record-keeping obligations and, if found to be inadequate, provide further training on business record keeping requirements to effectively utilise any audit powers.

What to do if breaches are found following an audit?

Before taking any action, a Franchisor must consider the following:

  1. Was the evidence relating to the alleged violation obtained lawfully through the audit process?
  2. How serious is the breach (i.e. can it be dealt with by providing the Franchisee with training, or is it of such a serious nature that it warrants termination)?
  3. Are they required to issue the Franchisee with a written direction or notice to comply before taking any further steps?
  4. What does the franchise agreement say about the alleged breach (i.e. is it a breach of a fundamental and essential term of the franchise agreement or is it one capable of remedy)?

 Example Scenario

Consider this scenario:

  • A Franchisor has advised a Franchisee that it will appoint an independent auditor to audit the Franchisee’s sales
  • In complying with the audit request, the Franchisee:
    • produces computer records, cash register records, copies of invoices and other documents recording its business expenses to the Franchisor; and
    • provides the Franchisor with access to the business premises to conduct the financial audit
  • While the Franchisor is attending the business premises, it notices that the state of the business premises is less than satisfactory
  • The Franchisor suspects that there are multiple breaches of the Food Act 1984 (Vic) (Act), as well as its own compliance procedures
  • Without advising the Franchisee, the Franchisor records its visit to the premises as evidence of the various breaches of the Act, which it considers are particularly serious and which may form the basis of a termination of this franchise agreement
  • The Franchisor may wish to terminate the franchise agreement not only based on its most recent discovery of non-compliance but due to numerous complaints the Franchisor has received from customers concerning this Franchisee in the past
  • The Franchisor is concerned that due to the number of alleged breaches, it will take the Franchisee too much time to remedy each and every breach. It is also concerned that in the meantime, a member of the public may become unwell after consuming the Franchisees product or the Franchisor may receive another customer complaint; disastrously affecting its reputation. The Franchisor is of the view that to protect its brand, it must terminate the Franchisee immediately.

However, does the Franchisor have a valid right to terminate the Franchisee without notice?

What can the Franchisor do?  

Consider on what basis the Franchisor is permitted to terminate the franchise agreement. 

The Franchisor also needs to be aware of the restrictions imposed on immediate termination under the Franchising Code of Conduct (Code).  The Code permits immediate termination of the franchise agreement on eight grounds only, those being:

  1. the Franchisee no longer holds a licence that it must hold to carry the franchised business; or
  2. the Franchisee becomes bankrupt, insolvent under administration or an externally-administered body corporate; or
  3. the Franchisee, if a company – becomes deregistered; or
  4. the Franchisee voluntarily abandons the franchised business or the franchise relationship; or
  5. the Franchisee is convicted of a serious offence; or
  6. the Franchisee operates the franchised business in a way that endangers public health or safety; or
  7. the Franchisee acts fraudulently in connection with the operation of the franchised business; or
  8. via an agreement between the Franchisor and Franchisee.

In this scenario, the Franchisee was initially notified that the Franchisor would be conducting a financial audit only. 

The Franchisor obtained evidence to support the Franchisee’s termination for alleged breaches of the Act from its audit (which was initially for the sole purpose of financial auditing). 

The Franchisor did not notify the Franchisee of its intention to conduct a more general audit of system compliance or the collection of other evidence which it might use against the Franchisee in the future.  In fact, it failed to notify the Franchisee that it recorded the inspection.

In these circumstances, it may appear that the Franchisor is entitled to immediately terminate the Franchisee for operating the franchise business in a way that endangered public health or safety (based on the breaches of the Act).  However, the Franchisor needs to satisfy itself of the seriousness of the alleged breaches and whether they are on the lower end or higher end of the spectrum of offences (i.e. are they breaches of the Act which are not necessarily considered to be major offences?).  If they are on the lower end of the spectrum, then it would not be recommended that the Franchisor immediately terminate the franchise agreement as there may not be an immediate endangerment of public health or safety.

Depending upon the terms of the franchise agreement it would be prudent in these circumstances to serve the Franchisee with a notice to remedy the breach and subject to the amount of training already provided and systems support offered, offer additional training before the Franchisor seeks to terminate.

Where the breach is not an immediately terminable offence, it is also important that the Franchisor provides the Franchisee with an opportunity to respond to the allegations made against it and remedy any breaches, if they are capable of remedy. 

In this situation, it is recommended that the Franchisor write to the Franchisee (either formally due to the serious concerns or more informally if the situation warrants it) and provide the Franchisee with an opportunity to respond.

Of course, the nature of the breach and the ability to remedy it will determine the actions required; considering factors like the public health and safety, the potential damage and impact to the brand and other Franchisees, repeat offences and demonstrated behaviour of non-compliance. Other factors to be considered include the breach of the systems as well as the circumstances of each case. 

In some cases, the Franchisor would be entitled to take more drastic action, such as serving the Franchisee with a notice terminating immediately, in others the Franchisor may simply ask the Franchisee to participate in more training.

Other Factors To Consider

There are additional factors that need to be considered before action is taken by a Franchisor, such as whether the Franchisor has provided:

  • adequate education to its Franchisees regarding a particular issue in its system through training;
  • access to franchise policy and procedure manuals detailing the processes and Franchisor’s expectations of the Franchisee. If the policies have changed over time has the Franchisor notified Franchisees of the changes and provided further education or training around the changes; and
  • peer support groups of Franchisees for practical mentoring and reference.

Lessons for the Franchisor

  1. Ensure if you are exercising your audit powers that you make it clear the scope of the intended audit. We recommend not limiting the notice provided to one item, e.g. a financial audit as in the example above, but leave it as a general audit. You can choose not to audit other aspects of the business if you think there is no need but this gives you the basis to look at all aspects of the franchise and provide the Franchisee notice of the intention to do so.
  2. Given the ACCC’s expanding powers, Franchisors who conduct audits of their Franchisees are recommended to maintain records and copies of those audits and any action taken thereafter. These records may be required if any decision is challenged and needs to be defended in Court or a tribunal, or in case the Franchisor is itself, audited by the ACCC. 
  3. Consider the seriousness of any breaches and match the level of your action to the degree of seriousness.

 For more information, please contact our  Franchise or Dispute Resolution and Litigation team by email or call Sofia Lozanova on 03 8540 0200 if you would like to discuss this in further detail.