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Fine tuning the obligation of good faith – lessons for franchisors

It has been a turbulent year for the franchising sector – media coverage from the Senate Inquiry into the operation and effectiveness of the Franchising Code of Conduct (Code), including allegations of unfair treatment of franchisees within high profile franchise systems (such as Caltex, Gloria Jeans and Brumby’s Bakery), has shone a light on what can go wrong within a franchise relationship. At the heart of many of the franchisee complaints to the Inquiry has been the claim that the franchisor has not acted in good faith in dealings with them.

As such, it is timely that the issue of good faith in a franchise context has recently been considered in Federal Court proceedings brought by the Australian Competition and Consumer Commission (ACCC) against Ultra Tune Australia Pty Ltd (Ultra Tune). While some aspects of the case are somewhat unusual and peculiar to this business, other aspects are all too common in a franchise system where Code compliance falls beneath the necessary standard. The case is also of interest as this is the first occasion that the ACCC has prosecuted a franchisor for acting in ‘bad faith’. In this case, the Federal Court found that Ultra Tune’s breaches of the Code and the Australian Consumer Law (ACL) were so serious as to warrant a $2.6 million penalty.

Despite the obligation to act in good faith being enacted as a statutory obligation under the Code since 1 January 2015, these are the first proceedings brought by the ACCC against a franchisor alleging a breach of the Code in its dealings with one of its franchisees. In this article, we will look at what went wrong for Ultra Tune, and focus on how franchisors can avoid breaching their obligations to act in good faith under the Code.

Background

The proceedings were commenced by the ACCC, which claimed that Ultra Tune did not act in ‘good faith’ in its dealings with a prospective franchisee when negotiating entry into a franchise agreement for an Ultra Tune franchise, due to conduct that included failures in disclosure, the provision of false information and breaches of the Code and ACL.

The Court found that:

  • In early 2015, a prospective franchisee, Mr Ahmed, became interested in purchasing an Ultra Tune franchise and ultimately selected a site in Parramatta, NSW.
  • Between May 2015 and August 2015, Mr Ahmed had various meetings with Ultra Tune’s State Manager for NSW, Mr Tatsis. In the course of the parties’ dealings with one another, Mr Tatsis made various key representations to Mr Ahmed about the Parramatta site, including representations about the:
    • rent for the site
    • age of the franchise
    • price that was payable for the franchise
    • equipment that would be included with the franchise.
  • Towards the end of the negotiations, Mr Tatsis was keen to secure a $33,000 deposit from Mr Ahmed to show that he was serious about the franchise, and Mr Tatsis put Mr Ahmed under pressure to make that payment. During that time, Mr Tatsis represented to Mr Ahmed that the requested deposit was unconditionally refundable.
  • After paying the deposit and attending training, Mr Ahmed was given the Franchise Agreement and Disclosure Document for the site. Those documents contained information that contradicted Mr Tatsis’ representations concerning the franchise business that Mr Ahmed had agreed to acquire.
  • By September 2015, Mr Ahmed’s concerns about the deal, the franchise, and the accuracy of the various precontractual representations made to him by Mr Tatsis caused him to decide he no longer wished to continue with the purchase of the franchise, and he requested the return of his deposit. Ultra Tune refused to return the deposit to Mr Ahmed.
  • In November 2015, Mr Ahmed lodged a complaint with the ACCC that opened the door to its investigation into Ultra Tune’s compliance with its disclosure obligations.

Following Mr Ahmed’s complaints, the ACCC investigated Ultra Tune’s conduct and found that (in addition to the conduct complained of by Mr Ahmed) it had failed to meet the statutory deadlines each year for updating both its Disclosure Document and the annual financial statements prepared for its marketing fund. While beyond the scope of this article, the case provides much needed guidance for franchisors on the level of detail required to be included by franchisors in annual marketing fund statements.

The Court’s findings

The obligation to act in good faith under clause 6 of the Code applies to any matter arising in relation to the Code or a franchise agreement. This obligation extends to all aspects of the franchising relationship from pre-contractual negotiations, contractual performance and dispute resolution through to termination of an agreement.

In this case, in its dealing with a prospective franchisee, Ultra Tune was found to have acted in bad faith by:

  • failing to honestly disclose information about the history of a franchise site
  • making misrepresentations to the franchisee about how long the franchise had been open, the rent payable and the purchase price of the franchise
  • putting pressure on the franchisee to pay a deposit before providing documentation relevant to the purchase of the franchise
  • requiring the payment of the deposit and subsequently treating the deposit as non-refundable without making it clear to the franchisee that the money would be treated as non-refundable
  • making a decision to expend the deposit immediately towards signage and equipment without any apparent need for such urgency
  • failing to repay the money to the franchisee, or failing to cooperate with the franchisee to recover the money from the person who received the benefit of the equipment purchased.

The pecuniary penalties ordered against Ultra Tune for its Code compliance failures relating to the Disclosure Document and marketing fund totalled $1.1 million. The penalties for the contraventions against Mr Ahmed, were calculated as follows:

Conduct Penalty imposed
Failure to act in good faith $54,000
Making false or misleading representations to the effect that the deposit was unconditionally refundable $1,000,000
Making false or misleading representations that the franchise had been ‘open for about six months’ $300,000
Failure to give documents to a franchisee or prospective franchisee $50,000
Making false or misleading representations as to the price of the rent $50,000
Making false or misleading representations as to the price of the franchise $50,000
Total $1,504,000

Once again, while outside the scope of the article, one of the key concerns of the Court when setting these penalties was the need for both specific and general deterrence. Importantly, the Court was willing to impose the maximum possible penalties in some instances due to its finding that senior Ultra Tune executives had falsified records to avoid prosecution and had sent these to the ACCC, as well as (initially) relying on them at trial.

How can franchisors avoid breaching their obligation to act in good faith?

While franchisors are required to consider the rights and interests of franchisees, this does not mean that franchisors are required to act in the interests of the franchisee. Franchisors are not prevented from acting in their own commercial interests provided the parties act reasonably in all circumstances.

Importantly, the Ultra Tune decision affirms that a party to a franchise agreement (including a prospective franchise agreement) will not be in breach of the obligation to act in good faith if a party has regard to its own ‘legitimate commercial interests’. As we discussed in our previous article on the Federal Court’s ‘Pizza Hut’ decision, good faith and reasonableness are considered by the Court as interrelated concepts and the Court will look to the behaviour and conduct of the parties ‘is not honest, capricious, arbitrary or for an extraneous purpose‘ in determining whether the conduct of a franchisee goes beyond protecting its legitimate commercial interests.

Franchisors should ensure that decisions made in dealings with franchisees have legitimate business objectives that can be substantiated by the franchisor and avoid conduct that is dishonest, coercive or unnecessarily uncooperative.

In particular, franchisors can minimise the risk of being found to be in breach of the duty to act in good faith under the Code by:

  • ensuring prospective franchisees have been provided at an early stage of negotiations, with a copy of the Code, the franchisor’s Disclosure Document and a copy of the franchise agreement
  • ensuring that sales persons responsible for negotiations with prospective franchisee are aware of their obligations under the Code and do not make representations on behalf of the franchisors that are untrue or cannot be fulfilled
  • disclosing relevant information to a prospective franchisee about the franchise network (such as the history of a franchise site) and ensuring that information is accurate and complete
  • resolving disputes with current or prospective franchisees in a timely manner and in accordance with representations made by the franchisor and agreed processes.

If you would like more information, please contact a member of our Consumer Markets & Franchising team.

AUTHORS
  Shaun Temby | Partner
Tel +61 2 9291 6287
shaun.temby@maddocks.com.au
Natalie Wendon | Lawyer
Tel +61 2 9291 6275
natalie.wendon@maddocks.com.au

It has been a turbulent year for the franchising sector – media coverage from the Senate Inquiry into the operation and effectiveness of the Franchising Code of Conduct (Code), including allegations of unfair treatment of franchisees within high profile franchise systems (such as Caltex, Gloria Jeans and Brumby’s Bakery), has shone a light on what can go wrong within a franchise relationship. At the heart of many of the franchisee complaints to the Inquiry has been the claim that the franchisor has not acted in good faith in dealings with them.

As such, it is timely that the issue of good faith in a franchise context has recently been considered in Federal Court proceedings brought by the Australian Competition and Consumer Commission (ACCC) against Ultra Tune Australia Pty Ltd (Ultra Tune). While some aspects of the case are somewhat unusual and peculiar to this business, other aspects are all too common in a franchise system where Code compliance falls beneath the necessary standard. The case is also of interest as this is the first occasion that the ACCC has prosecuted a franchisor for acting in ‘bad faith’. In this case, the Federal Court found that Ultra Tune’s breaches of the Code and the Australian Consumer Law (ACL) were so serious as to warrant a $2.6 million penalty.

Despite the obligation to act in good faith being enacted as a statutory obligation under the Code since 1 January 2015, these are the first proceedings brought by the ACCC against a franchisor alleging a breach of the Code in its dealings with one of its franchisees. In this article, we will look at what went wrong for Ultra Tune, and focus on how franchisors can avoid breaching their obligations to act in good faith under the Code.

Background

The proceedings were commenced by the ACCC, which claimed that Ultra Tune did not act in ‘good faith’ in its dealings with a prospective franchisee when negotiating entry into a franchise agreement for an Ultra Tune franchise, due to conduct that included failures in disclosure, the provision of false information and breaches of the Code and ACL.

The Court found that:

  • In early 2015, a prospective franchisee, Mr Ahmed, became interested in purchasing an Ultra Tune franchise and ultimately selected a site in Parramatta, NSW.
  • Between May 2015 and August 2015, Mr Ahmed had various meetings with Ultra Tune’s State Manager for NSW, Mr Tatsis. In the course of the parties’ dealings with one another, Mr Tatsis made various key representations to Mr Ahmed about the Parramatta site, including representations about the:
    • rent for the site
    • age of the franchise
    • price that was payable for the franchise
    • equipment that would be included with the franchise.
  • Towards the end of the negotiations, Mr Tatsis was keen to secure a $33,000 deposit from Mr Ahmed to show that he was serious about the franchise, and Mr Tatsis put Mr Ahmed under pressure to make that payment. During that time, Mr Tatsis represented to Mr Ahmed that the requested deposit was unconditionally refundable.
  • After paying the deposit and attending training, Mr Ahmed was given the Franchise Agreement and Disclosure Document for the site. Those documents contained information that contradicted Mr Tatsis’ representations concerning the franchise business that Mr Ahmed had agreed to acquire.
  • By September 2015, Mr Ahmed’s concerns about the deal, the franchise, and the accuracy of the various precontractual representations made to him by Mr Tatsis caused him to decide he no longer wished to continue with the purchase of the franchise, and he requested the return of his deposit. Ultra Tune refused to return the deposit to Mr Ahmed.
  • In November 2015, Mr Ahmed lodged a complaint with the ACCC that opened the door to its investigation into Ultra Tune’s compliance with its disclosure obligations.

Following Mr Ahmed’s complaints, the ACCC investigated Ultra Tune’s conduct and found that (in addition to the conduct complained of by Mr Ahmed) it had failed to meet the statutory deadlines each year for updating both its Disclosure Document and the annual financial statements prepared for its marketing fund. While beyond the scope of this article, the case provides much needed guidance for franchisors on the level of detail required to be included by franchisors in annual marketing fund statements.

The Court’s findings

The obligation to act in good faith under clause 6 of the Code applies to any matter arising in relation to the Code or a franchise agreement. This obligation extends to all aspects of the franchising relationship from pre-contractual negotiations, contractual performance and dispute resolution through to termination of an agreement.

In this case, in its dealing with a prospective franchisee, Ultra Tune was found to have acted in bad faith by:

  • failing to honestly disclose information about the history of a franchise site
  • making misrepresentations to the franchisee about how long the franchise had been open, the rent payable and the purchase price of the franchise
  • putting pressure on the franchisee to pay a deposit before providing documentation relevant to the purchase of the franchise
  • requiring the payment of the deposit and subsequently treating the deposit as non-refundable without making it clear to the franchisee that the money would be treated as non-refundable
  • making a decision to expend the deposit immediately towards signage and equipment without any apparent need for such urgency
  • failing to repay the money to the franchisee, or failing to cooperate with the franchisee to recover the money from the person who received the benefit of the equipment purchased.

The pecuniary penalties ordered against Ultra Tune for its Code compliance failures relating to the Disclosure Document and marketing fund totalled $1.1 million. The penalties for the contraventions against Mr Ahmed, were calculated as follows:

Conduct Penalty imposed
Failure to act in good faith $54,000
Making false or misleading representations to the effect that the deposit was unconditionally refundable $1,000,000
Making false or misleading representations that the franchise had been ‘open for about six months’ $300,000
Failure to give documents to a franchisee or prospective franchisee $50,000
Making false or misleading representations as to the price of the rent $50,000
Making false or misleading representations as to the price of the franchise $50,000
Total $1,504,000

Once again, while outside the scope of the article, one of the key concerns of the Court when setting these penalties was the need for both specific and general deterrence. Importantly, the Court was willing to impose the maximum possible penalties in some instances due to its finding that senior Ultra Tune executives had falsified records to avoid prosecution and had sent these to the ACCC, as well as (initially) relying on them at trial.

How can franchisors avoid breaching their obligation to act in good faith?

While franchisors are required to consider the rights and interests of franchisees, this does not mean that franchisors are required to act in the interests of the franchisee. Franchisors are not prevented from acting in their own commercial interests provided the parties act reasonably in all circumstances.

Importantly, the Ultra Tune decision affirms that a party to a franchise agreement (including a prospective franchise agreement) will not be in breach of the obligation to act in good faith if a party has regard to its own ‘legitimate commercial interests’. As we discussed in our previous article on the Federal Court’s ‘Pizza Hut’ decision, good faith and reasonableness are considered by the Court as interrelated concepts and the Court will look to the behaviour and conduct of the parties ‘is not honest, capricious, arbitrary or for an extraneous purpose‘ in determining whether the conduct of a franchisee goes beyond protecting its legitimate commercial interests.

Franchisors should ensure that decisions made in dealings with franchisees have legitimate business objectives that can be substantiated by the franchisor and avoid conduct that is dishonest, coercive or unnecessarily uncooperative.

In particular, franchisors can minimise the risk of being found to be in breach of the duty to act in good faith under the Code by:

  • ensuring prospective franchisees have been provided at an early stage of negotiations, with a copy of the Code, the franchisor’s Disclosure Document and a copy of the franchise agreement
  • ensuring that sales persons responsible for negotiations with prospective franchisee are aware of their obligations under the Code and do not make representations on behalf of the franchisors that are untrue or cannot be fulfilled
  • disclosing relevant information to a prospective franchisee about the franchise network (such as the history of a franchise site) and ensuring that information is accurate and complete
  • resolving disputes with current or prospective franchisees in a timely manner and in accordance with representations made by the franchisor and agreed processes.

If you would like more information, please contact a member of our Consumer Markets & Franchising team.

AUTHORS
  Shaun Temby | Partner
Tel +61 2 9291 6287
shaun.temby@maddocks.com.au
Natalie Wendon | Lawyer
Tel +61 2 9291 6275
natalie.wendon@maddocks.com.au