Good Faith, Good Business: Lessons From The Pizza Hut Litigation

By Benjamin Caddaye, Law Clerk and Alicia Hill, Principal, MST Lawyers.

The requirement to act in good faith is an important term implied by law into contracts and franchise agreements. What exactly the term requires and how far it extends has been the subject of many judicial decisions over the past two decades. The requirement that a franchisor exercises its discretions under a franchise agreement reasonably, and in good faith was given a thorough review in the Full Federal Court case of Virk Pty Ltd (in liq) v YUM! Restaurants Australia Pty Ltd [2017] FCFCA 190. The case concerned the franchisor of the Pizza Hut franchise, Yum and 190 of the 200 independent franchisees in respect of a strategy to increase market share by reducing prices and simplifying the product offering. The case illustrates the Court’s approach to determining whether the implied term has been breached, and is indicative of the expectations of those exercising a discretion under a franchise agreement.

Background

On 4 June 2014 YUM! Restaurants, the subsidiary of global giant Yum Brands Ltd which holds the master franchise for the Pizza Hut and KFC businesses throughout Australia announced to its franchisees the decision to implement a ‘Value Strategy’. The context of the move was that Pizza Hut had and was continuing to lose market share to its biggest competitor, Domino’s Pizza. The Strategy aimed to stem the decline in sales and increase the number of transactions per store. Yum intended to use its powers within the franchise agreement to set maximum prices and determine the menu to decrease the range of products into two pizza ranges as well as reduce the price points of those ranges from $9.95 to $4.95, and $11.95 to $8.50. With the successful testing of the Strategy in the ACT, Yum wanted to deploy it to all stores in Australia.

The independent franchisees of Pizza Hut stores were concerned that the value strategy would make their franchises unprofitable and financially unviable. On 10 June 2014, 80 franchisees applied to the Federal Court to obtain an injunction preventing the rollout of the value strategy. To obtain such an injunction, the franchisees were required to demonstrate that there was a serious question to be tried, damages would be inadequate, and the balance of convenience favoured the granting of the injunction. Justice Jagot refused to grant the injunction, holding that the franchisees’ case was weak and that any loss they would suffer could be calculated and paid by way of damages.

The Diab Proceedings

Class Action proceedings were subsequently commenced in 2016, with Diab Pty Ltd, the franchisee of six stores in Sydney as the representative Applicant of approximately 190 franchisees around Australia. This action claimed that Yum had breached their contractual duties to the franchisees, including implied terms in the franchise agreement in adopting the Value Strategy. The statement of claim noted two implied terms in the franchise agreement:

A duty to cooperate to achieve the aim of in the franchise agreement; and

A duty to comply with standards of conduct that are reasonable having regard to the interests of the parties to the franchise agreement.

The Applicant also alleged that Yum had been negligent, and engaged in unconscionable conduct contrary to the Competition and Consumer Act 2010 (Cth).

The case was unsuccessful, with Justice Bennett finding that Diab did not establish that Yum had breached its obligation to act in good faith in implementing the Value Strategy and consequently had not engaged in negligence or unconscionable conduct.

The Virk Proceeding

Diab Pty Ltd resolved its dispute with Yum and was no longer a party to the class action. In early 2017 Virk Pty Ltd, another franchisee, became the representative Applicant and appealed the decision of Justice Bennett to full Federal Court. Virk appealed on 14 grounds, but specifically of note were the grounds relating to the implied terms of good faith. On appeal, Virk contended that Bennet J had erred in applying the subjective test of whether Yum had acted dishonestly or in bad faith, or with reckless disregard for the franchisees when determining whether they had breached the implied term of good faith and reasonableness. Instead, the Applicant contended that an objective test should have been used, and when the Value Strategy was considered objectively, the maximum prices were not reasonable.

Findings of Gilmour, Nicholas and Moshinsky JJ 

The three Judges of the Full Federal Court affirmed the findings of Bennett J. It was argued that there was an implied term in the franchise agreement that required Yum to act ‘honestly and with fidelity to the bargain’ and that the discretion to set maximum prices had to be exercised ‘in good faith and reasonably, with reasonable care’.

They found that good faith and reasonableness were a composite implied term. There was no requirement for the Court to inquire as to whether the conduct of Yum was both in good faith, and as a separate inquiry whether it was reasonable. Their Honours held that where the Court finds that a party has acted in good faith, or finds an absence of bad faith, the consequence is that the exercise of power must also necessarily have been reasonable.

Bennett J, at trial, had found that Yum had not acted dishonestly, its conduct did not equate to a lack of fidelity to the bargain, and that there was no question of bad faith, dishonesty, capriciousness, arbitrary or unconscionable conduct. Therefore, as a lack of bad faith and dishonesty had been established the prices set under the value strategy were in good faith, and there was no scope to assess whether the prices were reasonable as a separate and distinct requirement of the implied term.

The appeal was subsequently dismissed on all 14 grounds.

Consequences

The decision of the full Federal Court is of great importance to franchise business operators, especially franchisors. The Court has indicated that as long as the discretionary powers under a franchise agreement are exercised in good faith, that will in itself satisfy the implied term to act in good faith, reasonably, with reasonable care. Therefore, there is no space for an argument that conduct which was in good faith is unreasonable, strengthening the position of franchisors when faced with a dispute regarding the implied term.

If you or your business has any concerns regarding the implied term of good faith or the issues raised in this article, please feel free to email Alicia Hill, an Accredited Commercial Litigation Specialist in Victoria and Queensland, or call +61 3 85400200.