Selling a Business to Franchise: What went wrong in Watt v Shepherd?

By Alicia Hill, Principal and Harrison Breer, Law Clerk

The recent decision of Watt v Shepherd (No 2) [2021] FCA 826 concerned the sale of a group of pharmacies with the plan of creating a franchising business. In the negotiations of the sale, many representations were made to the owner regarding future growth and profitability of the franchise business, as well as their business expertise and ability to get funding. The judge in this case ultimately found that these representations were misleading and unconscionable, ordering that the franchise agreements be made void and further investigations take place into the personal liability of the purchasers.

Background:

Espie Watt (‘Watt’) built up and operated a pharmacy business which comprised of 15 retail pharmacies across New South Wales and the Australian Capital Territory (‘Watt Group’) .

The head office for the business was conducted by the Second Applicant, Mazzawattie Pty Ltd, which had been the trustee of the Snowy Mountains Services Unit Trust (‘SMSUT’) and to which Watt was the guiding mind and will.

Watt owned the business name the Bush Chemist, which was later transferred to RX Holdings Pty Ltd (‘RX’), and also owned the trademark and a leaf design.

Two of the 15 pharmacies in Watt’s business traded under the name ‘Bush Chemist’, whilst the other pharmacies traded under the name ‘Summit’. The Head Office provided various services to the pharmacies.

On about 21 April 2016, Phillip Shepherd (‘Shepherd’) and Mark Steidle (‘Steidle’) approached Watt and made a proposal to purchase the Watt Group head office and to create a franchising business utilising the 15 pharmacies currently in the Watt Group as franchisees.

The parties engaged in a series of negotiations, with Shepherd and Steidle making multiple representations as to the future prospects and operation of a proposed franchising business to be conducted by a company called Summit Pharmacies Group Pty Ltd (‘SPG’), of which Shepherd and Steidle’s company, RX, was to be the sole shareholder.

The representations:

Over the course of 11 months, Shepherd and Steidle made a significant number of representations in order it was argued to induce both Watt and the 15 pharmacies to become franchisees of SPG.

Shepherd and Steidle representations included:

• That they had a wealth of corporate experience and know-how in the area of franchising
• Shepherd would pay $2 million for the transfer of the head office, and a further $2.08 million in cash to the franchisor as operating capital for the franchising structure
• Watt would have a financial interest and participation in the franchisor, derive income and progressively reduce his workload
• Shepherd had access to $200 million in investment funds to drive the growth of the enterprise
• SMSUT would retain $2 million of shares in the franchise in consideration of its transfer of the head office operations
• Shepherd would increase the number of franchisees, and within six months have obtained franchise agreements of 100 pharmacies, and within three years, 550 pharmacies
• That participation by individual franchisees would deliver financial benefits by enhancing buying power and lowering prices
• That the value of the franchisor and financing structure would be in the range of $900 million – $1.2 billion within five years
• That they had substantial backing and investments in order to ensure growth of the franchising structure and get more franchisees
• That they had a financial backer known as Catalyst Wealth who would sign a convertible note
• That each participating pharmacy in the franchising business would have savings that would exceed the total fees payable to the franchisor within six months

The franchise agreements that were given to the respective pharmacies contained franchise fees that Shepherd, Steidle, RX and SPG knew were not affordable or financially sustainable for the individual pharmacies, and that their participation in the franchising structure would not result in financial benefit to those pharmacies unless there were a substantial reduction in those fees.

Shepherd and Steidle were also aware that Watt was under the impression that these fees were temporary to assist with the cashflow for the first six months of operation, and would be lowered once new franchisees were brought in.

RX provided a misleading balance sheet to a company called Symbion Ltd to induce Symbion to engage in commercial dealings with them.

Court Findings:

The Court found that Shepherd and Steidle:

• did not agree to make any reduction in fees payable under the franchise agreements;
• did not provide working capital of $2.08 million;
• did not obtain any growth in the number of franchisees.
• no funds were received through a convertible note from Catalyst.
• never delivered any profit or financial benefit to any of the applicants as franchisees or otherwise within the franchising structure.

The Court also found that:

• each of the representations relating to finance of the franchising business was in trade or commerce, and therefore deemed to be misleading and deceptive within the meaning of s18 of the Australian Consumer Law (‘ACL’);
• the future representations including about growth and savings were held to be misleading under ss 4 and 22A of the ACL. SPG was also found to not act in good faith or comply with the applicable industry code;
• Shepherd and Steidle also engaged in unconscionable conduct under s21 of the ACL through the various representations and the issues relating to the franchise agreements.

Rares J’s reasoning:

Once loss or damage has occurred due to misleading or deceptive conduct, or unconscionable conduct, the affected party is able to obtain appropriate relief under the ACL.

Shepherd and Steidle unsuccessfully argued that Watt was unable to prove loss or damage because their evidence was not admissible, arguing (amongst other things) that their claim “lacked precision and used a scattergun approach, pleading a large number of individual representations made over a lengthy time period”.[1]

Rares J ultimately held that this argument was misconceived and struck it out. His Honour held that “… all of the representations were made and were misleading and, in respect of those representations that related to a future matter, were made without reasonable grounds”.[2]

In reliance on Wilson J’s judgement in Gould v Vaggelas (1983) 157 CLR 215, Rares J held that “a false representation need not be the sole inducement to cause the representee to act on it. It suffices so long as the representation played some, if only a minor, part or made a contribution to the formation of the contract in issue”.[3]

Furthermore, Rares J held that while Shepherd and Steidle were acting in their capacity as an officer of RX and SPG, they were also acting for their own benefit and on their own behalf in making each of the representations.

Again, relying on Gould, Rares J held that “… the mere fact that an individual who is a representor uses a corporate vehicle to achieve an object for him or her does not free the representor from direct responsibility for making a misleading statement or engaging in conduct that is… unconscionable, and that is a cause of another person being induced to act to his, her or its detriment”.[4] Shepherd and Steidle were therefore found to be personally liable for their respective conduct in making representations to Watt.

Outcome:

Rares J ordered:

• each of the franchise agreements in issue was deemed voided on and from 30 June 2018;
• RX do all things necessary to assign the ownership (including sole administrator rights) of both the website and business name of Bush Chemist back to Watt;
• leave be granted to both the parties to file and serve any evidence they deem necessary in order to work out a quantum of damages and appropriate relief.

Lessons:

There are many lessons that can be learned from this case.

Firstly, this case illustrates the importance of appropriate and accurate representations when dealing with other parties. It is always important to have reasonable grounds for the representations that are made as a Court will always determine whether reasonable grounds did exist if representations have been made.

Secondly, a false representation need only play some, if only a minor role, in order to induce an individual into an agreement. It does not have to be the sole or main purpose for entry into the agreement.

Finally, this case also serves as a lesson to sellers of a business to ensure they conduct their required due diligence to ensure that they are fully informed about the transaction and the purchaser. Doing so will allow for any red flags to be dealt with prior to the sale going through, rather than having to seek a court’s assistance to unwind a transaction.

If you have any questions about any of the issues raised by this case, or franchising more generally, then please contact Alicia Hill on (03) 8540 0292 or alicia.hill@mst.com.au

 

[1] Watt v Shepherd (No 2) [2021] FCA 826, 56.

[2] Ibid 65.

[3] Ibid 67.

[4] Ibid 69.