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Getting the balance right – Inquiry into the Franchising Code of Conduct

Background

In March 2018, the Senate referred an inquiry  (Inquiry) into the operation and effectiveness of the Franchising Code of Conduct (Code) to the Parliamentary Joint Committee on Corporations and Financial Services (Committee). Since 5 April 2018, the Committee has been receiving submissions from franchisees (many on a confidential basis), franchisors and the Franchise Council of Australia (FCA).

The overwhelming majority of submissions received by the Inquiry have been from franchisees – and these have largely been critical of the franchising sector and its regulation. The response from the FCA has been to advocate for greater disclosure to prospective franchisees and to mandate a requirement that franchisees seek professional advice from franchise industry specialists before entering into a franchise agreement.

In this article, we summarise some of the key issues coming out of submissions to the Inquiry and outline our views on those issues and the solutions proposed by participants.

Some of the key issues arising from franchisee submissions to the Inquiry include complaints regarding:

New business models, products and pricing strategies

Submissions to the inquiry by former franchisees reveal that franchisees feel as though they lose control of their business when new business models, products and pricing strategies are introduced by franchisors. While solutions put forward by franchisees to this issue were varied, the majority of submissions called for franchisors to collaborate with its franchise network and seek input on new business models and pricing strategies prior to implementation.

The FCA, in its submission, emphasised the need for a greater focus on franchisees seeking professional advice from franchising specialists prior to entering into a franchise agreement and centred, in particular, on franchising business models and processes.

In our view, the development and implementation of new business models, products and pricing strategies are essential for ensuring the longevity of a franchise network. Over time it is inevitable that markets and consumer sentiments change and so franchisors must have the flexibility to respond to those changes – particularly as franchise agreements can extend over 10 – 20 years in some systems. In retaining this flexibility, however, franchisors must ensure that the introduction of a new business model or pricing strategy has been adequately tested in appropriate markets.

The FCA’s suggestion of greater advice being provided to franchisees would assist franchisees in understanding that the ability to make changes to a franchisee agreement is a key part of buying into a franchise network, and allows them to consider the franchisor’s obligations to them when doing so. We assume that this recommendation is made on the basis that prior to signing a franchise agreement, franchisees would better understand the risks associated with potential changes that the franchisor can make to products, services and strategy. The franchisees are then in a position to make an informed decision on the level of risk they are willing to accept (before entering into the franchise agreement). We agree that this suggestion has merit.

Having made the decision to enter into the franchise agreement, the next obvious question is whether the common law, the Code or other legislation (such as the Australian Consumer Law) provide adequate protections to franchisees when new business models, products, services and strategies are being rolled out into the network. Currently, in the absence of other express contractual terms, the law only requires franchisors to ensure that their franchise operations give franchisees a reasonable opportunity to run a profitable operation: it is not the responsibility of the franchisor to ensure that all of its franchisees are profitable. Otherwise, there are no specific legal requirements with which franchisors need to comply when implementing a new business model or pricing strategy.

At best, franchisees would have to rely on the law of unconscionable conduct and the obligation to act in good faith to seek protection from, or compensation for badly thought out or executed changes to their franchise system in the form of new products, services or strategies. In our view, (depending on the situation) this may require franchisors to:

  • carry out appropriate tests and modelling to ascertain the likely impact of the new products, services or strategy on their franchisees
  • test the new model at a number of locations that are representative of the network as a whole
  • ensure the likely impact on franchisees is thoroughly considered during the decision-making process
  • regularly update and consult with  franchisees on the progress and likely effect of the model.

In our experience, successful well-established franchise systems do these things as a matter of course, as they make good business sense. The challenge for the Inquiry is whether there is a need to further protect franchisees by legislating to enshrine these standards and, in doing so, create further protections for franchisees and, if so, how they could possibly do so without tying the hands of franchisors and stifling innovation and change.

Unfair contract terms

Submissions to the Committee by franchisees reveal widespread discontent with the perceived power imbalance of franchise agreements in favour of franchisors. The FCA has encouraged franchisors to consider approaching franchise agreements with a greater willingness to amend, mitigate or remove terms alleged to be unfair.

The FCA also recognised the value of the amendments to the Australian Consumer Law for unfair contract terms in protecting franchisees. In its submission, the FCA noted that many franchisors have already updated and amended their franchise agreements to ensure that terms of the franchise agreement are in place for the purpose of protecting the legitimate interests of the franchisor.

The prevalence of unfair contract terms in small business contracts has been widely publicised. In ACCC v JJ Richards & Sons, the Court held that terms in the standard form contracts used by JJ Richards to engage small businesses were unfair and therefore void. A contract term is unfair and will be declared void and unenforceable under section 24 of the Australian Consumer Law if the term:

  • would cause a significant imbalance in the parties’ rights and obligations under the contract
  • is not reasonably necessary to protect the legitimate interests of the party advantaged by the term
  • would cause financial or other detriment to a consumer if it were relied on.

In its submission to the Inquiry, the Australian Competition and Consumer Commission (ACCC) recommended that the Code prohibit terms requiring franchisee to reimburse franchisors for the cost of preparing the franchise agreement on the basis that this may dissuade franchisees from seeking to negotiate amendments to proposed franchise agreements. The ACCC also emphasised the work that they are already doing in this area to lift understanding and compliance in the sector of the unfair contract terms regime.

In our view, it is important that franchisors ensure their franchise agreements do not confer excessive rights on the franchisor to change aspects of the franchise relationship, business model or operations manuals without a legitimate business requirement – particularly for the drafting of restraint clauses, geographical exclusivity, leasing arrangements, significant changes to marketing fund contributions and post-termination obligations. There is a risk that if they fail to do so, key terms of their agreements may not be enforceable, which could be disastrous for franchisors.

Given the importance of having franchise agreements that are clear and enforceable, we think it is likely that the perceived power imbalance will reduce over time. This is particularly the case given the ACCC’s emphasis on enforcement in this area and the high degree of likelihood that we will see at least one major franchise system prosecuted for having unfair contract terms in the next 12 – 18 months.

Disclosure

Predictions of the likely financial performance provided by franchisors to franchisees prior to entering into the franchise agreement have been a common complaint in franchisee submissions to the Committee. In particular, franchisees have complained that they have been misled by the franchisor as to the potential performance of the franchise and the state of the business overall. Franchisees have called for increased transparency by the franchisor on the overall financials of the franchise network and the existence of any failed stores within the franchise network.

In contrast, the FCA has taken the view that it is ‘unfair, unreasonable and unachievable for a franchisor to be expected to provide information on the likely financial performance of a franchise and worse-case scenarios’.[1] The FCA has recommended more rigorous compliance by franchisors with the existing Code and an enforcement regime that is strictly adhered to and monitored by regulators.

In our view, providing franchisees with adequate disclosure before entry, and upon renewal of a franchise agreement is essential to avoiding disputes. Disclosure by franchisors of current information that will assist a franchisee in running a franchised business is an essential part of a successful franchisor/franchisee relationship.

However, we note that financial disclosure is heavily regulated by Division 2 of the Code and franchisors need to tread carefully when providing disclosure of financial and performance information. Under section 20 of the Code, franchisors must ensure that disclosure of earnings information (in the form of a projection or forecast) is provided with a clear disclaimer that franchisees cannot guarantee or warrant the performance of any franchise outlet. Franchisors should also make it very clear (perhaps beyond the minimum requirements of the Code) that the performance of a store is heavily influenced by circumstances outside of the control of the franchisor – such as the business acumen and management experience of the franchisee.

In our view, this is an area where the Inquiry may be tempted to increase the obligations on franchisors for disclosure of financial information and there may well be an argument that where current and historical financial information for a site exists, then it should be provided to the franchisee as an aid to assist the franchisee to making their own decisions about whether or not the franchise represents a good investment for them.

Dispute resolution

As evidenced by submissions to the Inquiry to date, a common source of franchisee frustration is the belief that franchisors are operating from a comparatively advantaged position in terms of legal capability and financial resources. Franchisees have complained that the dispute resolution process often takes too long and that the franchisor is unreasonable during settlement negotiations. Franchisees have proposed that the Code be amended to ‘even the playing field’ of financial inequity by providing additional resources to assist franchisees through the dispute resolution process. The FCA has taken the view that in addition to obligations under the Code, franchisors need to ensure that internal dispute and grievance resolution processes supplement the regulatory framework.

Resolving disputes is regulated under Part 4 of the Code, which requires franchise agreements to prescribe a complaint handling procedure that outlines the actions a party can take to support the resolution of a dispute including:

  • attending and participating in meetings at reasonable times
  • not taking action during the dispute, including by providing inferior goods, services, or support, which has the effect of damaging the reputation of the franchise system
  • not refusing to take action during the dispute, including not providing goods, services or support, if the refusal to act would have the effect of damaging the reputation of the franchise system
  • if a mediation process is being used to try to resolve the dispute, by:
    • making the party’s intention clear, at the beginning of the process, as to what the party is trying to achieve through the process
    • observing any obligations on confidentiality that apply during or after the process.

There is no doubt that the dispute resolution and litigation processes can be time consuming and costly exercise. However, the Code already provides for a mediation process to assist the parties to come to an early resolution of matters on mutually acceptable terms. In most instances, this process does lead to good outcomes though with a degree of compromise on both sides, which some franchisees can find hard to accept. The issue for the Inquiry is how to address the small number of cases where franchisors do not approach the mediation in good faith – and to do so in a way that doesn’t undermine the current high level of success of the mediation process. In our view, change in this area should be approached with extreme caution.

The Committee is due to report its findings by 30 September 2018.

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

 

AUTHORS
SHAUN TEMBY 2CM BW JPG 2015 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

[1] FCA submission at page 12

Background

In March 2018, the Senate referred an inquiry  (Inquiry) into the operation and effectiveness of the Franchising Code of Conduct (Code) to the Parliamentary Joint Committee on Corporations and Financial Services (Committee). Since 5 April 2018, the Committee has been receiving submissions from franchisees (many on a confidential basis), franchisors and the Franchise Council of Australia (FCA).

The overwhelming majority of submissions received by the Inquiry have been from franchisees – and these have largely been critical of the franchising sector and its regulation. The response from the FCA has been to advocate for greater disclosure to prospective franchisees and to mandate a requirement that franchisees seek professional advice from franchise industry specialists before entering into a franchise agreement.

In this article, we summarise some of the key issues coming out of submissions to the Inquiry and outline our views on those issues and the solutions proposed by participants.

Some of the key issues arising from franchisee submissions to the Inquiry include complaints regarding:

New business models, products and pricing strategies

Submissions to the inquiry by former franchisees reveal that franchisees feel as though they lose control of their business when new business models, products and pricing strategies are introduced by franchisors. While solutions put forward by franchisees to this issue were varied, the majority of submissions called for franchisors to collaborate with its franchise network and seek input on new business models and pricing strategies prior to implementation.

The FCA, in its submission, emphasised the need for a greater focus on franchisees seeking professional advice from franchising specialists prior to entering into a franchise agreement and centred, in particular, on franchising business models and processes.

In our view, the development and implementation of new business models, products and pricing strategies are essential for ensuring the longevity of a franchise network. Over time it is inevitable that markets and consumer sentiments change and so franchisors must have the flexibility to respond to those changes – particularly as franchise agreements can extend over 10 – 20 years in some systems. In retaining this flexibility, however, franchisors must ensure that the introduction of a new business model or pricing strategy has been adequately tested in appropriate markets.

The FCA’s suggestion of greater advice being provided to franchisees would assist franchisees in understanding that the ability to make changes to a franchisee agreement is a key part of buying into a franchise network, and allows them to consider the franchisor’s obligations to them when doing so. We assume that this recommendation is made on the basis that prior to signing a franchise agreement, franchisees would better understand the risks associated with potential changes that the franchisor can make to products, services and strategy. The franchisees are then in a position to make an informed decision on the level of risk they are willing to accept (before entering into the franchise agreement). We agree that this suggestion has merit.

Having made the decision to enter into the franchise agreement, the next obvious question is whether the common law, the Code or other legislation (such as the Australian Consumer Law) provide adequate protections to franchisees when new business models, products, services and strategies are being rolled out into the network. Currently, in the absence of other express contractual terms, the law only requires franchisors to ensure that their franchise operations give franchisees a reasonable opportunity to run a profitable operation: it is not the responsibility of the franchisor to ensure that all of its franchisees are profitable. Otherwise, there are no specific legal requirements with which franchisors need to comply when implementing a new business model or pricing strategy.

At best, franchisees would have to rely on the law of unconscionable conduct and the obligation to act in good faith to seek protection from, or compensation for badly thought out or executed changes to their franchise system in the form of new products, services or strategies. In our view, (depending on the situation) this may require franchisors to:

  • carry out appropriate tests and modelling to ascertain the likely impact of the new products, services or strategy on their franchisees
  • test the new model at a number of locations that are representative of the network as a whole
  • ensure the likely impact on franchisees is thoroughly considered during the decision-making process
  • regularly update and consult with  franchisees on the progress and likely effect of the model.

In our experience, successful well-established franchise systems do these things as a matter of course, as they make good business sense. The challenge for the Inquiry is whether there is a need to further protect franchisees by legislating to enshrine these standards and, in doing so, create further protections for franchisees and, if so, how they could possibly do so without tying the hands of franchisors and stifling innovation and change.

Unfair contract terms

Submissions to the Committee by franchisees reveal widespread discontent with the perceived power imbalance of franchise agreements in favour of franchisors. The FCA has encouraged franchisors to consider approaching franchise agreements with a greater willingness to amend, mitigate or remove terms alleged to be unfair.

The FCA also recognised the value of the amendments to the Australian Consumer Law for unfair contract terms in protecting franchisees. In its submission, the FCA noted that many franchisors have already updated and amended their franchise agreements to ensure that terms of the franchise agreement are in place for the purpose of protecting the legitimate interests of the franchisor.

The prevalence of unfair contract terms in small business contracts has been widely publicised. In ACCC v JJ Richards & Sons, the Court held that terms in the standard form contracts used by JJ Richards to engage small businesses were unfair and therefore void. A contract term is unfair and will be declared void and unenforceable under section 24 of the Australian Consumer Law if the term:

  • would cause a significant imbalance in the parties’ rights and obligations under the contract
  • is not reasonably necessary to protect the legitimate interests of the party advantaged by the term
  • would cause financial or other detriment to a consumer if it were relied on.

In its submission to the Inquiry, the Australian Competition and Consumer Commission (ACCC) recommended that the Code prohibit terms requiring franchisee to reimburse franchisors for the cost of preparing the franchise agreement on the basis that this may dissuade franchisees from seeking to negotiate amendments to proposed franchise agreements. The ACCC also emphasised the work that they are already doing in this area to lift understanding and compliance in the sector of the unfair contract terms regime.

In our view, it is important that franchisors ensure their franchise agreements do not confer excessive rights on the franchisor to change aspects of the franchise relationship, business model or operations manuals without a legitimate business requirement – particularly for the drafting of restraint clauses, geographical exclusivity, leasing arrangements, significant changes to marketing fund contributions and post-termination obligations. There is a risk that if they fail to do so, key terms of their agreements may not be enforceable, which could be disastrous for franchisors.

Given the importance of having franchise agreements that are clear and enforceable, we think it is likely that the perceived power imbalance will reduce over time. This is particularly the case given the ACCC’s emphasis on enforcement in this area and the high degree of likelihood that we will see at least one major franchise system prosecuted for having unfair contract terms in the next 12 – 18 months.

Disclosure

Predictions of the likely financial performance provided by franchisors to franchisees prior to entering into the franchise agreement have been a common complaint in franchisee submissions to the Committee. In particular, franchisees have complained that they have been misled by the franchisor as to the potential performance of the franchise and the state of the business overall. Franchisees have called for increased transparency by the franchisor on the overall financials of the franchise network and the existence of any failed stores within the franchise network.

In contrast, the FCA has taken the view that it is ‘unfair, unreasonable and unachievable for a franchisor to be expected to provide information on the likely financial performance of a franchise and worse-case scenarios’.[1] The FCA has recommended more rigorous compliance by franchisors with the existing Code and an enforcement regime that is strictly adhered to and monitored by regulators.

In our view, providing franchisees with adequate disclosure before entry, and upon renewal of a franchise agreement is essential to avoiding disputes. Disclosure by franchisors of current information that will assist a franchisee in running a franchised business is an essential part of a successful franchisor/franchisee relationship.

However, we note that financial disclosure is heavily regulated by Division 2 of the Code and franchisors need to tread carefully when providing disclosure of financial and performance information. Under section 20 of the Code, franchisors must ensure that disclosure of earnings information (in the form of a projection or forecast) is provided with a clear disclaimer that franchisees cannot guarantee or warrant the performance of any franchise outlet. Franchisors should also make it very clear (perhaps beyond the minimum requirements of the Code) that the performance of a store is heavily influenced by circumstances outside of the control of the franchisor – such as the business acumen and management experience of the franchisee.

In our view, this is an area where the Inquiry may be tempted to increase the obligations on franchisors for disclosure of financial information and there may well be an argument that where current and historical financial information for a site exists, then it should be provided to the franchisee as an aid to assist the franchisee to making their own decisions about whether or not the franchise represents a good investment for them.

Dispute resolution

As evidenced by submissions to the Inquiry to date, a common source of franchisee frustration is the belief that franchisors are operating from a comparatively advantaged position in terms of legal capability and financial resources. Franchisees have complained that the dispute resolution process often takes too long and that the franchisor is unreasonable during settlement negotiations. Franchisees have proposed that the Code be amended to ‘even the playing field’ of financial inequity by providing additional resources to assist franchisees through the dispute resolution process. The FCA has taken the view that in addition to obligations under the Code, franchisors need to ensure that internal dispute and grievance resolution processes supplement the regulatory framework.

Resolving disputes is regulated under Part 4 of the Code, which requires franchise agreements to prescribe a complaint handling procedure that outlines the actions a party can take to support the resolution of a dispute including:

  • attending and participating in meetings at reasonable times
  • not taking action during the dispute, including by providing inferior goods, services, or support, which has the effect of damaging the reputation of the franchise system
  • not refusing to take action during the dispute, including not providing goods, services or support, if the refusal to act would have the effect of damaging the reputation of the franchise system
  • if a mediation process is being used to try to resolve the dispute, by:
    • making the party’s intention clear, at the beginning of the process, as to what the party is trying to achieve through the process
    • observing any obligations on confidentiality that apply during or after the process.

There is no doubt that the dispute resolution and litigation processes can be time consuming and costly exercise. However, the Code already provides for a mediation process to assist the parties to come to an early resolution of matters on mutually acceptable terms. In most instances, this process does lead to good outcomes though with a degree of compromise on both sides, which some franchisees can find hard to accept. The issue for the Inquiry is how to address the small number of cases where franchisors do not approach the mediation in good faith – and to do so in a way that doesn’t undermine the current high level of success of the mediation process. In our view, change in this area should be approached with extreme caution.

The Committee is due to report its findings by 30 September 2018.

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

 

AUTHORS
SHAUN TEMBY 2CM BW JPG 2015 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

[1] FCA submission at page 12