The ‘creative’ use by franchisors of marketing funds has been a hot button issue in the franchise sector and for the ACCC for some time. Many in the sector were surprised by the ACCC’s victory in 2019 against Ultra Tune, which significantly lifted the bar in connection with the standard of disclosure of marketing fund expenditure. These concerns have prompted the Commonwealth Government to finalise its proposed changes to the Franchising Code of Conduct (Code) to introduce further civil penalties for Code breaches concerning the misuse of marketing funds.

Given this activity, we expected that some disgruntled franchisees might apply the Court’s findings in the Ultra Tune proceedings and possibly extend them into other areas of marketing fund management and compliance. The main surprising aspect about the recently commenced action against the franchisor of the Hogs Breath Café network on this very issue, is that these types of allegations have taken so long to be tested before a court.

The relevant allegations

The franchisees allege that Hog’s Breath:

• failed to implement an advertising, public relations and promotional campaign for the benefit of all franchisees, as a result of which the patronage of the franchisees’ restaurants did not achieve economic viability
• misappropriated funds from the marketing fund, as listed below and did not provide appropriately detailed financial statements to the franchisees (as required by the Code) that would have disclosed the misappropriation:
  • more than $550,000 per year was paid to Hog’s Breath or its associates (though it is not clear for what purpose)
  • more than 50% of supplier rebates and other cash payments meant for the advertising fund were paid to Hog’s Breath
  • used the advertising fund to pay its own employees’ wages and expenses and paid an alleged girlfriend of a Hogs Breath’s director ‘consultant expenses’
  • improperly used the advertising fund to promote and develop competing restaurant brands

• redirected patronage from Hog’s Breath to its other restaurant businesses, Funky’s Mexican Cantina, Hog’s Express, Bar 89 and Hog’s Food Trucks, by directing the franchisees to remove popular Mexican style menu items from their menu at the same time as it was opening the Funky’s Mexican Cantina stores
• changed the network’s name, corporate signage and branding to ‘Hog’s Australia’s Steakhouse’, despite this not being the brand name which consumers were familiar with, which allegedly had the effect of narrowing the restaurant’s offering in the minds of consumers and redirecting patronage to the competing restaurants
• opened the various competing restaurants within the franchisees’ exclusive areas
• required franchisees to replace their existing point of sale (POS) equipment with a sub-standard system that was unsuitable for use in their businesses.

The franchisees allege that the above conduct was, variously, in breach of the franchise agreement and/or constituted unconscionable and/or misleading or deceptive conduct by Hog’s Breath. The franchisees further allege that the following sections of the Code were breached by Hog’s Breath:

• the obligation to act in good faith (clause 6)
• the obligation to provide a detailed financial statement, including items of expenditure for the advertising fund (clause 15)
• the obligation to use the marketing fund for legitimate marketing or advertising expenses, or as disclosed to or agreed by franchisees (clause 31).

As a result of these actions by Hog's Breath, the franchisees suffered loss and damage, principally by way of a significant downturn in sales.

Our take on the allegations

Alleged misappropriation of marketing funds

It is quite common for marketing funds to be used to pay external consultants to implement marketing plans and other business development activities. As such, if the alleged Hog’s Breath director’s girlfriend was genuinely a marketing consultant, then there may not have been any untoward conduct. However, the fact that the payments may not have been at ‘arm’s length’ will make it harder for Hog’s Breath to defend the allegation.

In terms of any wages and expenses paid out of the marketing funds, if they were used to pay part of the salary and expenses of marketing staff, then once again there may not have been any untoward conduct. In fact, the use of in-house marketing staff may have been the most cost-effective way to implement a marketing campaign.

However, if this expenditure was not properly disclosed to the franchisees or was disproportionate to its true value or cost, then Hog's Breath may still have breached the Code or its franchise agreement.

Competing restaurants

We suspect that the Hog’s Breath franchise agreement permits Hog’s Breath to open other (non-Hog’s Breath branded) restaurants within the franchisees’ exclusive areas, as these types of carve outs to exclusive territories are quite common. If this is the case, then the franchisees will need to establish that the new businesses don’t fall within the carve outs (on the basis that they are too similar to Hog’s Breath) or that the introduction of new competing restaurants in their territories is unconscionable despite the terms of the franchise agreement. The same type of issues arise for changes to menus and to the Hog’s Breath name.

Similar arguments have previously been tested in Australia in the Pizza Hut franchise class action some years ago. In that instance, the Full Federal Court (on appeal) upheld the right of the franchisor to make menu and pricing changes and that its conduct in doing so was permitted by the franchise agreement and also was in good faith. Key to that decision, however, was that the franchisor had consulted heavily with the franchise network on the changes and also conducted a number of pilots to justify the changes. In other words, it was able to justify its conduct as having a legitimate business purpose. Whether or not Hog’s Breath can prove that these various changes to its business model were rolled out in the same way and for a legitimate business purpose remains to be seen.

Point of sale equipment

The franchise agreement most likely gives Hog’s Breath the right to dictate the replacement of systems and equipment. However, in our view, best practice would be for the franchisor to ensure that the features and benefits to franchisees of the new system outweigh the cost of changing the old POS equipment, so as to justify its replacement. If the POS equipment was deficient (as the franchisees allege) and Hog’s Breath didn’t undertake proper testing of it or consultation regarding its introduction, then Hog’s Breath may have a problem for all the previously stated reasons.

Key takeaways

Given the ACCC and the Commonwealth Government’s recent focus on issues such as the obligation of good faith and the misuse of marketing funds, the franchise sector will be keenly observing how the defendants respond to the Hog’s Breath class action and how the Court deals with the issues that arise under the Australian Consumer Law and the Code.

In light of the allegations against Hog’s Breath, and in order to avoid similar claims by franchisees or the ACCC, it is important that franchisors continue to focus on:

• full and proper disclosure to franchisees, particularly for the use of marketing funds
• clear and unambiguously drafted franchise agreements
• consultation with franchisees regarding any system changes and having a strong business case to justify them.