Legal Insights

The long wait for franchising inquiry findings is over

• 15 March 2019 • 25 min read

The Fairness in Franchising report was released by the Parliamentary Joint Committee on Corporations and Financial Services.

The current regulatory environment has manifestly failed to deter systemic poor conduct and exploitative behaviour and has entrenched the power imbalance [of franchisor’s over franchisees]

This statement of the Committee sets the tone of the Parliamentary Joint Committee on Corporations and Financial Services – Fairness in Franchising report (Report) released yesterday. Whilst this is not unexpected, given approximately 80 percent of the submissions in respect of the inquiry were from franchisees, many have been surprised by the severity of the Committee’s negative findings regarding the industry. Whist this may set the scene for reform, it will also have a negative impact on the value of businesses of some franchisors and their network of franchisees at least in the short term.

With the terms of reference released almost 12 months ago on 22 March 2018, the Report has been long awaited. Making 71 recommendations of varying significance, the Report contains extensive content for the franchising sector to digest.

The Report proposes far-reaching changes to the Franchising Code of Conduct (Code) and some would say proposes to encroach on principles of freedom of contracting in an unheralded way. Whether or not this is necessary will continue to be debated by many. There have certainly been examples of poor behaviour in franchise systems, and hot on the heels of the Final Report from the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, the Report certainly picks up similar themes of power exploitation and the like. Conversely, franchising continues to see far higher success rates than traditional small businesses and, most parties would agree, is overwhelmingly comprised of a population of good corporate citizen franchisors.

There is some good news for franchisors. Many of the recommendations are innocuous and reflect practices that many of them will have had in place for years, such as providing documents electronically and in hard copy.

Additionally, over approximately 40 percent of all recommendations are for a dedicated (and yet to be established) taskforce comprising members of Government Departments and the Australian Competition and Consumer Commission (ACCC) to consider the proposals further before any legislative action is taken, or that other regulatory bodies consider issues. With a Federal election highly likely to be just around the corner and the Government dealing with the findings from the Banking Royal Commission, it is logical to question whether government focus on franchising will continue to ebb and flow. In the current environment, decisive action based on the Report may occur by the end of 2019 at the very earliest. Indeed unless there are proposed to be multiple rounds of changes to the Code, it may be prudent for legislative change to be stayed until such time as the taskforce has reconsidered the issues (assuming that process is adopted), other relevant reports are handed down^[2], and the Government has had an opportunity to pull together the various inquiry threads and recommendations. It is also relevant to note that some of the issues canvassed in the Report have been previously recommended and rejected by government, such as a public register of franchise documents.

Why does this Inquiry matter?

Australia’s franchising landscape is one of the most highly regulated in the world. It is also one of the most highly scrutinised. Since the Code was established, there have been significant revisions made to its terms in 2008, 2010 and 2015, following multiple federal and state based inquiries. With that track record, coupled with recent press coverage and the ACCC’s push for multiple changes, participants in the industry should brace for more change. Any such changes will likely emanate from the Report and its recommendations – it has set the benchmark from which policymakers and various advocacy and industry groups will consider their positions.

What did the Inquiry consider?

The terms of reference for the Senate Inquiry included:

the operation and effectiveness of the Code, particularly the disclosure statements required under the Code
the effectiveness of dispute resolution, termination provisions and enforcement under the Code
the impact of the Australian consumer law unfair contract provisions on new, renewed and terminated franchise agreements entered into since 12 November 2016
the imposition of restraints of trade on former franchisees following the termination of a franchise agreement.

The Inquiry received over 400 submissions.

What did the Inquiry recommend? A quick reference guide

It will take time for franchising participants to properly consider and assess the Committee’s recommendations. We have set out below some of the most noteworthy recommendations. In the following weeks we will publish some more targeted articles with further commentary.

	Recommendation	Recommendations
1.	Franchising Taskforce	The Committee recommended that an inter-agency taskforce be established (Franchising Taskforce) to examine the feasibility of some of the Committee’s recommendations, with representatives from the Department of Treasury, Department of Jobs and Small Business and, where appropriate, the ACCC.
2.	Whistleblower protections	The Committee noted that evidence to the inquiry revealed a substantial amount of intimidatory behaviour by franchisors and bullying, threats and intimidation by franchisors was one of the top 10 issues raised in confidential submissions. Following the 2017 inquiry in relation to whistleblower protection, Parliament passed legislation in February 2019 implementing some of the Committee’s recommendations in relation to whistleblowing in the corporate sector more generally. However, in this Report, the Committee recommended that: all of the protections in the Committee’s 2017 Whistleblower Protections report should apply to franchisees and their employees breaches of the Code and Oil Code by franchisors should be included in the definition of disclosable conduct for whistleblower protection. This would result in whistleblower protections in the franchising sector being broader than those which apply to the corporate sector more generally following the 2019 legislative changes.
3.	Intervention power and investigations	The Committee raised concerns in the Report about churning and burning of franchise outlets. Churning refers to repeated sales of a single site and burning refers to continually opening new outlets which may not be viable to profit from upfront fees. However, the majority of the sections in the Report relating to this issue focused on conduct of Retail Food Group and not the franchise sector more generally. The Committee recommended that the ACCC be given powers to intervene and prevent marketing and sales of franchises where a franchisor shows a ‘churning and or burning’ track record. The Committee likened this recommendation to the proposed product intervention powers of Australian Securities and Investments Commission (ASIC) to intervene to prevent financial products from being marketed and sold to unsophisticated investors which are currently being considered by Parliament. The Committee also took the step of recommending the ACCC, ASIC and the Australian Taxation Office (ATO) conduct investigations into Retail Food Group and its directors.
4.	Industry associations	The Committee was of the view that the Franchise Council of Australia (FCA) does not provide a balanced representation of franchisor and franchisee views, favouring those of franchisors due to its membership composition. The Committee considers that this has contributed to historical legislative outcomes favouring franchisors, and a more balanced representation of views would benefit the entire franchise industry. To address this, it recommended the Franchising Taskforce examine issues such as: how to increase franchisee input into franchising policy and regulation whether it is appropriate for a franchisee representative to be a voting member of a franchisor’s board ongoing reporting to the government on the effectiveness of regulatory settings and compliance with regulation.
5.	Disclosure and registration	The Committee acknowledged that a well-functioning and effective franchise sector requires franchisees to be well informed, but that disclosure requirements are already extensive. The Report noted that during the inquiry, many participants raised concerns about the asymmetry of information between franchisors and franchisees, notwithstanding the disclosure regime under the Code. The Committee sought to focus on making practical changes to improve the accuracy and availability of information for franchisees both up front and during the term of a franchise agreement rather than re-model the existing disclosure regime. Some recommendations made included: provision of additional financial information: for existing businesses, the vendor franchisee or franchisor to provide the prior two years' Business Activity Statements, a profit and loss statement and balance sheets, as well as an assessment of labour costs for that particular franchise business. This is either provided to the prospective franchisee or, if the vendor franchisee is closing or selling back to the franchisor, as part of the disclosure document where the franchise is a greenfield franchise, the franchisor must provide the prospective franchisee the Business Activity Statements, profit and loss statements and balance sheets for the two year period of a comparable franchise to the prospective franchise in the disclosure document or attached to the disclosure document including all financial information in the disclosure document, or attached to it requiring a statement to be provided by franchisors that the earnings and financial information is accurate, correct and compliant with the Code and accounting standards except as otherwise stated some procedural/administrative recommendations, such as an obligation to provide both hard copy and electronic versions of the disclosure document. section 51ADD of the Competition and Consumer Act 2010 (obligation to provide the ACCC with information required to be kept by a franchisor under the Code) be amended to provide civil pecuniary penalties for non-compliance with a notice to produce and provide certain documents mandatory disclosure on employment matters (especially Awards, minimum wages and overseas workforce issues to be developed by the Fair Work Ombudsman). Further, it was recommend that the Franchise Taskforce examine: use of third party brokers in selling franchises and the use of clauses to the effect that a broker is not an agent of the franchisor and also that the written agreement represents the entire agreement between the parties. Consideration to be given as to whether additional disclosure on the meaning and effect of such clauses should be mandated a public franchise register with franchisors providing updated disclosure documents and template franchise agreements annually.
6.	Marketing funds	The Committee noted that the primary concerns raised during the injury in relation to marketing and advertising funds consisted of lack of clarity around these items in the Code, misuse of funds and lack of accountability, insufficient reporting requirements and lack of understanding about these reporting requirements by franchisors and auditors. To address these concerns, the Committee recommended: amending clauses 15 (obligation to provide financial statements for marketing fund) and 31 (obligations relating to marketing and advertising fees) of the Code to make the language consistent and address loopholes identified by the ACCC requiring civil pecuniary penalties (monetary fines) for breach of clause 31 of the Code (relating to marketing and advertising fees) requiring actual financial statements for the marketing fund to be provided to franchisees within 30 days of the end of each quarter with specific details to be included (as would be specified in the Code) and prepared in accordance with the relevant Australian Accounting Standards (in addition to the annual audited statement obligation in the Code) clarification that ‘master franchisors’ must comply with clauses 15 and 31 where subfranchisees contribute to funds controlled to administered by the master franchisor auditing and Assurance Standards Board preparing standards and audit guidance for marketing fund audits legislating the procedure for the distribution of unused marketing funds in the event of the franchisor winding up.
7.	Third line forcing	The Committee was critical of franchisors promoting third line forcing where it results in diminishing profit margins for the franchisee. Third line forcing is common in franchise systems (for very valid reasons) and occurs where the franchisor only agrees to enter into a franchise agreement if the franchisee agrees to acquire goods or services from a particular supplier. Third line forcing allows franchisors to ensure there is consistency in products and services sold across the network, as well as a number of other reasons benefitting the network and consumers. In 2017 there were changes to competition laws so that notification to the ACCC is now only required where this conduct may result in a substantial lessening of competition. The Committee was of the view that the current third line forcing provisions do not appropriately take into account the reliance of franchisees on franchisors and may incentivise opportunistic behaviour by franchisors (in the form of volume based rebates paid by suppliers to franchisors) without consideration of the profit margins of franchisees. The Committee recommended that the Franchising Taskforce examine: whether franchisors should be required to include in their disclose documents for the prior 2 year period: where the maximum resale price of items has been below the cost of the price of the product purchased by the franchisee the margin between the purchase price paid by the franchisee and the maximum resale price or recommended resale price whether the ACCC should conduct an inquiry into all terms in franchise agreements relating to the discretion of the franchisor to decide volume and frequency of orders to prevent exploitative behaviour and over ordering.
8.	Supplier rebates	The Committee highlighted that the practice of franchisors receiving rebates from suppliers was of concern, particularly where a conflict of interest arises due to the third line forcing aspects set out above. The Committee noted that rebates provide a temptation for franchisors to price squeeze the franchisee by maintaining or raising the cost of goods while keeping the maximum resale price low. The Committee recommended better disclosure of supplier rebates under the Code, including commissions and other payments to be disclosed as a percentage of the full purchase price on each transaction. Further, the Committee recommended that the Franchising Taskforce consider this issue by: looking at requiring disclosure of this percentage of the supplier rebate, and what proportion of the supplier rebate will be retained by the franchisor or directed to franchisees, through a direct payment, subsidised training, advertising or marketing, subsidised goods and services or administration expenses conducting an investigation to examine conflicts of interest associated with supplier rebates and third line forcing looking at disclosures required by master franchisors in relation to rebates.
9.	Unfair contract terms	The unfair contract terms (UCT) regime means that a term may be declared to be void by a court if it causes significant power imbalance between the parties, is not reasonably necessary to protect a party’s interests, and causes detriment if it were to be relied upon. In 2016, the UCT laws were extended to ‘business to business’ contracts as well as consumer contracts. The Committee was concerned that the UCT provisions had limited impact on the franchising sector and franchisors had little incentive to remove unfair contract terms as there were currently no penalties for the inclusion of such terms (the only consequence being that the relevant term is deemed void). We note that the ACCC has been campaigning more broadly for penalties to be imposed in relation to the UCT regime, so this issue is topical across the corporate sector more generally. To address the Committee’s concerns, it recommended that: the Code be amended to require the consent of a majority of franchisees within the same franchise system to any unilateral variation to the terms of a franchise agreement the ACCC be appropriately resourced to investigate illegal unfair contract terms. The Committee also recommended that certain terms be banned in franchise agreements, such as unilateral variations to terms and conditions and charging wastage and shrinkage payments. The Committee recommended that the Franchising Taskforce consider: amending the existing UCT laws to: expressly refer to franchise agreements (rather than having to determine whether a franchise agreement falls into the category of a ‘small business contract’) – there are currently some franchise agreements that the UCT laws do not apply to including civil pecuniary penalties and allow the ACCC to issue infringement notices for use of unfair contract terms authorising the ACCC to use section 155 notices to request certain evidence about whether a contract contains an unfair contract term amending the Code to require compliance with UCT laws options to address unfair contract terms in perpetual franchise agreements. whether the Code should restrict the ability for unilateral variations to subsidiary requirements to franchise agreements, such as franchise operations manuals or policies.
10.	Cooling off period	The Code entitles a franchisee to a seven day cooling off period after signing the franchise agreement, during which they may terminate the franchise agreement. Prior to this, the franchisee is required to respect a 14 day disclosure period before they can execute a franchise agreement. The Committee wanted to address what it considered to be uncertainty in the timing of these periods and how they are to apply by amending the Code to: extend the cooling off period to 14 days, not 7 days, and be able to be exercised 14 days after *last of*: the franchise agreement having been signed; payment to the franchisor having been made; the required disclosure documents having been received with a copy of the lease apply the cooling off provisions under the Code to transfers, renewals and extensions, together with longer notice periods for renewals and extensions make it clear that the cooling off and disclosure periods in the Code are measured in calendar days.
11.	Exit arrangements	The Committee noted that the evidence during the inquiry indicated that the exit arrangements in franchising are heavily weighted in the franchisor’s favour. The Committee recommended that the Code be amended to: include provisions for franchisee triggered exits in cases of: franchisee over gearing or suffering personal hardship; franchisor exploitation or business failure require franchisors to provide seven days’ notice for termination for the ‘special circumstances’ set out in the Code (e.g. abandonment) and termination be suspended if franchisee lodges a notice of dispute during that time clarify a franchisor can only terminate for fraud if a franchisee is convicted of fraud in connection with the operation of the franchise, and termination for public health and safety can only occur if a franchisee is served with a ‘permanent closure direction’ by a government body or fails to remedy Work Health and Safety (WHS) notices. The Committee also recommended the Franchising Taskforce consider the ability of franchisees to terminate the franchise agreement in special circumstances (such as if a liquidator is appointed to the franchisor). We note the relevant ipso factor reforms are relevant to this recommendation.
12.	Goodwill	The Committee noted that there are only two ways in which a franchisee can obtain a financial reward for goodwill in the franchised business, either through its sale to a third party or if the franchisor is willing to buy back the business. The Committee noted that a franchisor can sometimes receive a windfall if the franchise agreement is terminated/expired with no goodwill payment to the franchisee, and then later on-sold again by the franchisor to another franchisee. The Committee noted that the attribution of goodwill to a franchisee will depend on the franchise agreement and what is specified in the transfer contract. As the extent to which goodwill entitlements are set out in franchise agreements, the Committee recommended that further analysis be done and the Franchising Taskforce examine: whether the Code should be amended to include that franchise agreements and transfer contracts set out the end-of-term arrangements for franchisee goodwill how common it is for franchisee goodwill to be included in transfer contracts and whether franchise agreements attribute goodwill to franchisees if policy and regulatory change is appropriate.
13.	Restraint of trade	Restraint of trade clauses restrict the ways in which franchisees can engage in business activities and may apply during and after the term of a franchise agreement. There already are limits on the enforceability of restraints under common law, and also laws specific to franchising in section 23 the Code. However, the relevant provisions in the Code are only recent and the Committee thought it was difficult to determine if these provisions were fit for purpose. The Committee noted that some franchisees appeared to be under the impression that restraints could not be contested and would benefit from legal advice in some circumstances. The Committee recommended that: the ACCC (or other agency) review clause 23 of the Code to determine whether it is fit for purpose the Code be amended to: require franchisors disclose which clauses of the franchise agreements are not in compliance with clause 23 of the Code and are not enforceable provide further clarity on when restraints may be unenforceable under the existing regime.
14.	Collective action	The Committee attempted to address the tension between the Competition and Consumer Act’s prohibitions and the perceived benefits of allowing parties with less commercial bargaining power to band together to negotiate with more powerful counterparts, in this case franchisors. The Committee supported the ACCC’s proposal for a class exemption to the relevant prohibitions, which is currently under consideration. They recommended it be extended to cover a range of other subject matters, such as disputes and the sharing of information. The Committee also recommended the ACCC investigate whether franchisors have impeded franchisees who have attempted to pursue issues collectively. We note that these recommendations raise a number of complex competition law issues that would need to be considered more fully.
15.	Dispute resolution	The Committee was concerned that franchisors, in particular, were not participating in mediations ‘in good faith’ as required by the Code, and that franchisees were not in a position to pursue their grievances via court action (due to cost or other reasons). The Committee recommended that the Franchising Taskforce to consider the appropriateness of: a new dispute resolution body being funded by franchisors based on number of complaints allowing that body to refer and direct parties to binding arbitrations the appointment of a franchising and small business ombudsman as an independent assessor. In addition, it was recommended that the Code be amended to allow: parties to pursue binding arbitration in addition to mediation (to be generally compulsory before court action) 'multi-franchisee resolutions' by a mediator or arbitrator where disputes relating to similar issues arise (though, what may amount to a similar dispute was not defined with certainty).
16.	Increased penalties	There is a general theme running through the Report that franchisors are not complying with the Code partially because they are calculating and “taking the risk” and the penalties under the Code are not currently a significant enough deterrent. While this may be unlikely to be true for most franchisors, the Committee nevertheless recommends that the Franchising Taskforce consider amending the Competition and Consumer Act and the Code to implement a tougher penalty regime, including: civil pecuniary penalties for all breaches of the Code, irrespective of their triviality increasing the quantum of penalties available for breaches of the Code to be consistent with those available for a breach of The Australian Consumer Law (which have just been increased to various benchmarks depending on the circumstances, including minimum caps of $10 million).
17.	Pre-entry education and access to advice	The Committee noted that many prospective franchisees lacked the skills and experience to understand the risks and responsibilities inherent in being a franchisee, and did not undertake significant due diligence or seek appropriate advice. The Committee recommended that the Code be amended to require the franchisor provide a prospective franchisee with the ACCC’s franchisee manual when it provides them with the disclosure document, and that the ACCC develop further education materials. A recommendation was also made that as part of disclosure, franchisors be required to estimate the personal workload to be undertaken by the franchisee in running the franchised business.
18.	Capital expenditure	Consistent with previous reports and amendments to the Code, requirements for franchisees to undertake capital expenditure remains a key concern of the Committee. The Committee recommended the Franchising Taskforce consider: defining what is meant by ‘capital expenditure’ restricting a franchisor’s ability to require a franchisee to undertake capital expenditure, including where there is not an opportunity to make an appropriate return on the investment.
19.	Other	Various other recommendations were made in the Report, including: alignment of the Oil Code and the Franchising Code an obligation for franchisors to provide franchisees with training in relation to the Code prohibitions on franchisors recovering documentation preparation and other fees and costs from franchisees (including wastage and shrinkage costs) further consideration of how the Code applies to the motor vehicle sector and the need for provisions specific to those businesses in relation to retail leasing and the need for further examination of relationships with landlords and where the franchisor is a head lessor. These included giving franchisees a right to terminate all agreements if the franchisor fails to comply with a head lease whether franchise systems and their agreements involve sufficient co-investment and risk sharing such that they should be regulated in a similar nature to financial products under the Corporations Act 2000.

Where to from here?

Overall franchisors should be alert but not alarmed. The Report definitely takes up a variety of concerns raised by franchising participants, and overwhelmingly those of franchisees. However, there is some way to go before there is regulatory change.

Nevertheless, franchisors should definitely take on board some of the concerns raised by both the Committee and the submissions referred to in the Report. This can be done as part of all good franchisors’ efforts to continually reassess their practices to ensure they reflect best practice. For example:

All franchise agreements should definitely have been reviewed to ensure compliance with unfair contract term laws. There is no excuse for this not having been done.
Marketing funds should also be being operated and reported on with vigilance. Significant guidance on what Courts consider the standards are in this respect and the ACCC’s requirements have been provided, which can easily be incorporated into franchisor’s practices.^[3] As noted by the Report, which there may have previously been some uncertainty as to what was required regarding marketing fund disclosures, franchisors now have detailed guidance which is extremely useful.
Franchisors should consider providing earnings information with their disclosure document, and ensuring that all cost estimates are as meaningful and accurate as possible. As the Report notes, the provision of accurate and specific information benefits all parties, and reduces the risk of surprises down the road.