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Pizza Hut Franchisees Unsuccessful in Class Action

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By Jack Newton, Lawyer, MST Lawyers

The long awaited decision in what has come to be known as the “Pizza Hut Class Action” was published publicly on 26 February 2016. 190 Pizza Hut franchisees sued their franchisor in relation to a decision to reduce pizza prices in 2014.

Facts

The basic facts were that Yum Restaurants Australia Pty Ltd (Yum) (Pizza Hut’s franchisor entity) determined in early 2014 to implement a new model whereby it would:

  1. reduce the range of pizzas offered for sale from four to two (reducing the total number of pizzas for sale from 27 to 17), and
  2. drop prices on the two remaining ranges from $9.95 to $4.95 and from $11.95 to $8.50 respectively.

This was known as the “Value Model”.

The Value Model

The Value Model included reductions in certain price points and was scheduled to commence on 1 July 2014. The Value Model relied on New Zealand data (in particular, the adoption of New Zealand benchmarks and labour hours), the results from the ACT trial (discussed below).

The objective of the Value Model was to increase sales by 34.5%.

The Value Model had been trialled in eight Pizza Hut franchises in the Australian Capital Territory between February and April 2014. All eight franchises were owned by the one franchisee. As part of the trial, Yum agreed to indemnify the franchisee for any losses incurred in the trial. Yum ultimately paid the franchisee almost $200,000. There was a substantial dispute between the parties as to the success of the trial.

The introduction of the Value Model was seen, from the perspective of franchisees, as a potential trigger for a “price war” with Domino’s (a Pizza Hut competitor).

Interlocutory action

After franchisees had been informed of the introduction of the Value Model, 80 of them sought urgent interlocutory relief from the Federal Court of Australia which sought to restrain Pizza Hut’s implementation of the Value Model on 1 July 2014. The application, made on 19 June 2014 was heard and determined by the Court on 24 June 2014. The Court dismissed the franchisees’ application, clearing the path for the Value Model to be implemented on 1 July 2014.

New proceedings

A fresh court proceeding was issued on 12 August 2014 which eventually proceeded to final hearing over 18 days in mid to late 2015. This second proceeding involved 190 franchisees (out of a possible 200), led by one franchisee (Diab Pty Limited and its director and majority shareholder Danny Diab) who owned and operated six franchises in the Greater Macarthur region of New South Wales and had been involved in Pizza Hut businesses since 1989.

Much of the debate turned on clauses C1 and 6.2 of the Franchise Agreement which stated:

C1 MAXIMUM RETAIL PRICE

Franchisee will not permit any Approved Product to be sold at the Outlet at any price exceeding the maximum retail prices advised by Franchisor to Franchisee from time to time.

6.2        Franchisee will participate in such national and regional advertising, promotions, research and tests as Franchisor from time to time requires and Franchisee will not have any claim or action against Franchisor in connection with the level of success of any such advertising, promotion, research or test.

The franchisees made three core allegations, namely:

  1. pursuant to clause C1, Yum was obliged to set profitable prices – in other words, Yum was obliged to fix prices that would enable franchisees to make or increase its profits;
  2. Yum was subject to the following implied duties owed by Yum under the Franchise Agreement to each Franchisee:
    a)  An implied duty to cooperate with the Franchisees to achieve the objects of the Franchise Agreements; and
    b)  An implied duty to comply with reasonable standards of conduct, taking account of the interests of both parties to the Franchise Agreement; and
  3. Yum’s conduct was unconscionable within the meaning of the Competition and Consumer Act 2010 (Cth).

Judgment

The Court found:

  1. Yum was not obliged to fix prices for each product line so each product line was profitable. The object of the Franchise Agreement was for each franchise business, not each pizza;
  2. Although Yum owed a duty to cooperate with franchisees, the duty was not breached; and
  3. Yum had not engaged in unconscionable conduct.

In effect, the Court found, as a whole, Yum’s decision to implement the Value Model was based on reasonable grounds and made in good faith on the belief that it would increase franchise profitability. Simply because the plan did not realise increased or a maintenance of profits (which were otherwise declining) did not make Yum liable for franchisees’ losses.

The evidence showed that, for the most part, Yum had carefully considered the strategy in fixing the maximum prices. No dishonesty, negligence, bad faith or recklessness had been demonstrated nor had any decisions been made capriciously or arbitrarily, although one Yum staff member involved in the analysis of the ACT trial was found to have demonstrated poor business judgment through his naivety.

The Court agreed with Yum’s submission that the Value Model included more than just price reductions. The Value Model initially included increased marketing budgets, “first to market” advantage and a consequential uplift in transactions and sales.

The Court further held that clauses C1 and 6.2 expressly made clear that:

  1. Yum had complete control over promotions and fixing maximum prices; and
  2. Yum’s liability for unsuccessful promotions was excluded.

In this case, the benefit of hindsight illustrated that the results of the Value Model were not as had been predicted. However, hindsight, although beneficial, could not be used to demonstrate that a decision made in good faith, which led to what was ultimately an unsuccessful strategy, created any liability on Yum to the franchisees.

Ultimately, the question was not whether the decision (or, in fact, the modelling underlying the decision) was right or wrong, but whether the decision was reasonable.

Critical points to take away

Some of the key points to remember, as a result of this decision, are:

  1. Typically (and expressly in this case), franchise agreements do not contain any promises that Franchisees will make a profit;
  2. There is a common law duty on parties to commercial contracts to exercise their discretionary powers (i.e. the power the set maximum prices) in good faith, honestly and with reasonable cause. In other words, clauses in franchise agreements that expressly empower one party (typically a franchisor) to make discretionary decisions must be exercised in good faith, honestly and with reasonable cause.
  3. Where decisions are proposed that (without having that intention) may adversely affect franchisees (including, for example sales and profitability), some simple steps should be followed:
    a)  first, the modelling or facts underlying the proposed decision must be based on reasonable grounds;
    b)  second, those undertaking the modelling and analysis should always be well qualified and well credentialed and, ideally, involve independent third parties for oversight;
    c)  third, the modelling and/or analysis should, if appropriate, be shared with affected franchisees;
    d)  fourth, if there is a franchise advisory council or similar body, consult with these franchisees early to get them on side;
    e)  fifth, it is wise to consult broadly with franchisees prior to the making of major decisions;
    f)  sixth, franchisors should consider what contingencies should be put in place in the event the proposed decision does not achieve its aims (i.e. it has an adverse impact); and
    g)  seventh, trials of new ideas, promotions or activities may work as a means of demonstrating the operation and/or success of the new idea or promotion.

Postscript

It remains to be seen what costs orders will be made (if any). The lead franchisee was required, in order to continue the proceedings, in January this year to lodge $1,500,000 in a bank account as security for Yum’s costs.

Given the franchisees were wholly unsuccessful, it is likely they will be ordered to pay Yum’s costs (to the extent they exceed the $1,500,000).

Please contact one of our Franchising team by email franchise@mst.com.au or by telephone on +61 3 8540 0200 for assistance or further information.