The Importance of Accurately Disclosing Payments Payable by Franchisees (Disclosure Document Item 14)
By Carmen Wu, Lawyer
In the case of Enterprises Pty Ltd v Ultimate Franchising Group Pty Ltd (Final Hearing)  FCA 420, Thawley J in the Federal Court of Australia found that the franchisor, Ultimate Franchising Group Pty Ltd (UFG) engaged in misleading and deceptive conduct when providing inaccurate establishment costs and income projections to franchisees.
Pursuant to a Master Territory Agreement, UFG is the Australian franchisor of the American franchise, Ultimate Fighting Championship (UFC) Gyms.
In 2016 UFG began setting up the franchise and recruiting prospective franchisees. At the time of the discussions there was only one franchisee – Wetherill Park – which had not commenced trading.
This case was initiated by the Balcatta, Blacktown and Castle Hill UFC franchisees which alleged that UFG made misleading and deceptive representations to induce them into entering into UFC Franchise Agreements, and that their establishment costs exceeded the upper limit of $800,000 that was represented.
The representations were separated into two categories – ‘income representations’ and ‘establishment cost representations’. Some of the representations included:
- that the gross annual income and gross profit for each franchise could be calculated based on the ‘cash flow template’ excel spreadsheet provided by UFG. The spreadsheet contained formulas for operating expenses based on the number of memberships and cancellations, and could forecast the gross income.
- that the gross annual income would be $1,248,830, with the gym growing by 100 – 150 new members per month.
- That the range of establishment cost for the building, construction and fit out of the franchise were accurate; and
- That the range of establishment cost for the lease or purchase of equipment of the franchise were accurate.
It was held that no income representations were made to the Balcatta franchisee, as UFG merely provided a ‘template’ excel spreadsheet which the franchisee could populate with different membership numbers and weekly fees. UFG had communicated that the spreadsheet could be used as a ‘working hypothesis and not as something could be guaranteed or necessarily even likely’. Even if the representations were made out, his Honour viewed that the franchisee used their financial expertise to undertake their calculations and did not rely on UFG’s representations or the spreadsheet.
Conversely, the Blacktown franchisee had no experience in owning a gym. The Court found UFG’s conduct to be misleading despite the franchisee having obtained advice from an accountant and business adviser. UFG had revised the franchisee’s Cash Flow document which doubled the estimated gross income based on a significantly higher growth in memberships and no cancellations despite having no reasonable grounds for making such assertions.
Establishment cost representations:
The Court found that UFG’s representations that the upper limit of the establishment costs would be $800,000 were misleading. At no point throughout UFG’s discussions with franchisees did it advise that the upper limit would be exceeded.
At the time when the Wetherill Park franchise was close to opening, UFG informed the Balcatta franchisee that updated establishment costs would be ‘per our original estimations’. This was incorrect, as the Life Fitness gym equipment were treated as an ongoing expense for the Wetherill Park franchise rather than an establishment cost as conveyed in the Disclosure Document. The Life Fitness gym equipment alone was approximately $360,000 so there was no reasonable basis to convey that equipment costs could be as inexpensive as the lower limit of $300,000.
His Honour noted that UFG could have amended the Disclosure Document to reflect the actual costs incurred by the Wetherill Park franchise, rather than providing misleading and inaccurate costs estimates to prospective franchisees.
The Franchise Agreements and related personal guarantees were set aside, and UFG was ordered to pay damages to the franchisees. The damages awarded ‘places the [franchisees] in the position which they would have been had the contravening conduct not occurred’ and reflected the costs incurred in setting up the franchise and the net operating losses incurred in running the franchise.
There are substantial risks in providing projections about the financial earnings, growth or sales potential of a franchise because there are severe consequences if the projections are inaccurate.
It is important for franchisors to understand the differences between establishment costs and ongoing operational costs and to disclose these expenses in the correct section of their Disclosure Document to avoid misleading franchisees.
The estimated cost ranges in Item 14 of the Disclosure Document should reflect the absolute lower and upper limits of costs, with evidence retained by the Franchisor to indicate how the ranges was calculated.