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Franchising Cases 2016: Lessons Learned

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By Esther Gutnick, Senior Associate, MST Lawyers

2016 was an interesting year in the franchising and business sector, with the introduction of new laws relating to unfair contract terms, high-profile scandals regarding employee underpayments and the collapse of several large and previously successful retail brands.

This article provides a summary of some of the interesting franchising court cases decided in 2016 and the lessons to be learned from them.

Civic Video Case

This case involved a franchisee purporting to sell its franchised businesses to a third party (Paterson), and ceasing to operate the businesses without first seeking the franchisor’s consent.  This was found by the Court to constitute a repudiation of the franchise agreements.

In addition to discussions regarding the tort of inducing breach of contract (which will not be addressed in this article), the Court considered the principles applicable to assessing damages for repudiation of contract.

The Court of Appeal held that the franchisor was entitled to loss of bargain damages to restore its position to that which it would have been in if the franchisee had performed the franchise agreements. 

The Court did not consider it relevant that, as argued at the initial trial, the franchisee had at the time of the repudiation fallen behind in its payment of fees due under the franchise agreements and that the franchisee may not have been financially able to perform the franchise agreements for the balance of their terms.

Key learning points

Although considered by some to be a somewhat harsh decision in relation to the assessment of damages, this decision reminds franchisors that they are entitled to:

  • enforce franchisee’s contractual obligations to pay all fees due under a franchise agreement; and
  • seek damages, following the unlawful termination of the franchise agreement, for monies the franchisor would have received if the franchisee had performed the franchise agreement for the remainder of its term.

This case also serves as a reminder to franchisees that failure to comply with the terms of their franchise agreements can be severe. The franchisee, in this case, would likely have had a better result had it complied with its obligation to seek the franchisor’s prior consent to any proposed transfer of the business.

Guirguis and Michel’s Patisserie Case

In this case, the former franchisee of a Michel’s Patisserie franchise in Townsville brought a claim against the franchisor for misleading and deceptive conduct. The franchisor counterclaimed for breach of the franchise agreement (and related occupancy licence) and sought payment of royalties, occupancy costs, lease surrender costs and fees for removal of plant and equipment.

The franchisee had abandoned the franchise business on 18 July 2013 and sought to terminate the franchise agreement on 22 July 2013, although the term of the franchise agreement was not due to expire until 2022. On 25 July 2013, the franchisor issued its own termination notice on the grounds of the franchisee’s abandonment.

Prior to entering into the franchise agreement, the franchisee had signed a Deed of Prior Representations and Questionnaire.  This document invited the franchisee to detail any verbal or written statements, representations or warranties which may have been made to it and which influenced its decision to enter into the agreement.

The Deed of Prior Representations and Questionnaire listed some representations regarding lease terms, skills and ongoing support.  The franchisee did not provide any other representations which may have influenced its decision to enter into the franchise agreement, despite the franchisor sending a letter after the franchise agreement had been entered into, querying whether there were any other representations on which the franchisee had relied.

The document was central to the Court’s finding that the franchisee had not relied on the representations (if they had indeed been made).  Accordingly, the franchisee’s claims failed.

The Court found in favour of the franchisor on the counterclaim. The franchisee did abandon the franchised business and its purported termination of the franchise agreement was unlawful because it did not comply with the terms of the franchise agreement. The franchisor was awarded $650,552.24 in damages against the franchisee and its guarantors.

Key learning points

This case made it clear that in order to succeed in a misrepresentation claim, a franchisee must be able to show that it relied on the specific representations made at the time of entering the franchise agreement.  

The case also highlights that thorough risk management practices, by a franchisor, prior to entry into a franchise agreement, can assist in defending future claims made by a franchisee.

Franchisors should also take this case as a reminder to:

  • ensure that any promises and statements made to franchisees are accurate;
  • include appropriate warranties and disclaimers in franchise documentation to minimise risk and to displace potential reliance on any representations that may have been made;
  • actively encourage franchisees to seek independent advice and undertake extensive research prior to entry into the franchise agreement; and
  • consider using documents, such as prior representations statements, to provide an opportunity for the franchisee to record any representations which it believes have been made and which influenced its decision to enter into the franchise.

Tobacco Station and Freechoice Case

This matter involved tobacco product franchisor TSG Franchise Management Pty Ltd (TSG) and its market competitor, Cigarette & Gift Warehouse (Franchising) Pty Ltd, trading under the business name “Freechoice” (Freechoice).

TSG initiated proceedings against Freechoice after it made several approaches to high performing TSG franchisees, offering them financial incentives to persuade them to end their contractual relationship with TSG and join the Freechoice network.

TSG received notice from some of these franchisees stating their intention to terminate their franchise agreements and requesting pay-out figures. The franchise agreements did not include any right for the franchisees to terminate by notice.

The claim included allegations that Freechoice had engaged in:

  • the tort of procuring or inducing breach of contract by inducing TSG franchisees to terminate their franchise agreements before the fixed term contracts had expired; and
  • misleading or deceptive conduct by making false representations to TSG’s franchisees to induce them into entering into new franchise agreements with Freechoice.

The Court found that:

  • Freechoice was aware that the TSG franchisees could not terminate their franchise agreements without TSG’s consent.
  • Freechoice and the relevant terminating franchisees had been given formal notice by TSG’s lawyers that TSG did not consent to the franchisee’s purported early termination attempts.
  • Freechoice persisted in signing up terminating franchisees, arranging fit out of shops with the new branding and other interfering conduct until interlocutory injunctions were sought from a court.
  • Freechoice had calculated the net benefit of inducing these franchisees to move to Freechoice and incorporated the costs of doing so into its model and was not deterred from its strategy by the threat of legal proceedings.

The Court ordered that Freechoice be permanently restrained from inducing or attempting to induce TSG franchisees to terminate their contracts, and also ordered that Freechoice pay TSG’s costs of the proceeding.

The Court also made declarations to the effect that Freechoice had made a number of misleading or deceptive statements to TSG franchisees in seeking to procure them, thereby contravening the Australian Consumer Law, and that Freechoice had knowingly and intentionally induced the owner of two franchised stores to breach the terms of her franchise agreement with TSG.

Key learning points

Franchisors must beware of the risks of aggressive expansion tactics and should ensure that its growth strategies do not involve:

  • actively seeking to poach franchisees of their competitors in circumstances where doing so may cause those franchisees to breach existing contracts; or
  • making promises which the franchisor cannot fulfil or making any inaccurate or deliberately misleading or deceptive statements.

For franchisees, this case emphasises that fixed term franchise agreements oblige franchisees to keep the franchised business operating and remain in compliance with the franchise agreement for its full term. Franchisees cannot simply terminate a franchise agreement or exit the business without the franchisor’s consent unless the agreement provides a right to do so. Such conduct will, in most cases, constitute unlawful abandonment of the franchise and will ordinarily give the franchisor a right to sue the franchisee for damages.

Yogurberry Case

The Yoguberry case arose in the wake of the much-publicised Fair Work Ombudsman’s (FWO) investigations into underpayment of employees in the 7-Eleven and Caltex franchise networks.  The case centred around multiple contraventions of the Fair Work Act 2009 (Cth) by the employer and franchisee, Yogurberry World Square Pty Ltd (YWS).  Four employees of the Sydney CBD franchise claimed underpayment and breaches of other provisions relating to minimum shifts, record-keeping and pay slips.

The Federal Court ultimately fined YWS $75,000 for those contraventions.  In addition, the Court also found accessorial liability and imposed the following penalties on three further respondents:

  • YBF Australia Pty Ltd (YBF), the Master franchisor of the Yogurberry chain in Australia who had also previously operated the store in question, was ordered to pay a $25,000 fine;
  • CL Group Pty Ltd (CL Group), an associated company of YBF which performed accounting, payroll, operational and logistical functions for Yogurberry stores in Australia, was ordered to pay a $35,000 fine; and
  • Ms Soon Ok Oh, the sole director and secretary of the company which owns YWS and an officer of all three of the corporate respondents, was fined $11,000.

In finding secondary liability, it was significant that each respondent had specific involvement in, and knowledge of, the contraventions.

The Yogurberry decision highlights the importance the FWO attaches to accessorial liability for breaches of workplace laws. In fact, the FWO’s Annual Report for 2015–2016 shows that the FWO sought penalties against accessories in over 90% of the litigations it commenced.

Key learning points

Both franchisees and franchisors can suffer substantial brand damage as a result of FWO investigations (regardless of outcome), in addition to the actual costs incurred in paying any penalties imposed, rectifying any breaches and legal costs. 

Franchisors should bear in mind that they are very likely to be held liable as accessories to violations of workplace laws by their franchisees in circumstances where the franchisor is actively involved in functions such as:

  • establishing pay rates and conditions for employees of their franchisees;
  • the day-to-day conduct of their franchisees’ businesses;
  • performing payroll functions on behalf of their franchisees;
  • determining hours of work and leave entitlements; and
  • more general dealings with employment matters.

The Yogurberry case is a reminder that Franchisors should:

  • do what they can to ensure that all members of the franchise network comply with employment laws;
  • keep and retain adequate records relating to employment matters; and
  • cooperate with the FWO where relevant; including responding appropriately to any warnings and requests for information received from the FWO. In doing so, however, franchisors should seek appropriate legal advice to ensure that any responses provided do not prejudice their legal position.

In determining the level of involvement they intend to have on the employment activities of their franchisees, franchisors must balance their desired level of control, which may increase the franchisor’s risk of accessorial liability for any breaches, against the possibility of significant reputational damage that may be suffered even where the franchisor is not found liable.

Pastacup Case [1]

In September 2016, the Australian Competition and Consumer Commission (ACCC) instigated its first litigation under the revised Franchising Code of Conduct (Code), seeking penalties, declarations, injunctions, findings of fact and costs.

The proceedings allege breaches of the Code by Morild Pty Ltd (Morild), the franchisor of the Pastacup food franchise system and its former director Mr Stuart Bernstein, for failure to disclose that Mr Bernstein had been a director of two prior franchisors of Pastacup that had become insolvent.

The case is currently ongoing and its outcome will be reviewed with interest by members of the franchising sector.

Looking forward to the year ahead:

Interestingly, the ACCC’s latest Small Business Report, released on 25 January 2017, showed a trend of steadily declining numbers of franchising complaints received by the regulator since the commencement of the new Code in January 2015.  Members of the franchising community will be paying attention as to whether this trend continues and whether it also translates into fewer disputes and litigation in the industry.

As 2017 gears up, the franchising sector will also be watching with interest to see:

  1. the outcome of various cases instigated in 2016 which have yet to be finalised, in particular, the Pastacup case, being the ACCC’s first action seeking penalties under the revised Code;
  2. how the introduction of the new Unfair Contract Terms regime manifests in its application to franchise agreements and related documents;
  3. the form and effect of the implementation of the Harper Review recommendations, which proposed several changes to the Australian Consumer Law; and
  4. the progress of the Coalition Party’s policy to “protect vulnerable workers” which involves, among other things, proposed amendments to the Fair Work Act that will impose liability on franchisors and parent companies who fail to deal with exploitation by their franchisees.

Please contact our Franchising team by email franchise@mst.com.au or by telephone +61 8540 0200 for assistance or further information.

[1] Australian Competition and Consumer Commission v Morild Pty Ltd ACN 601 446 306 & Anor (Federal Court file number WAD436/2016)