Earlier last year, as summarised in our previous article, the Federal Court dismissed the class action brought against Yum! Restaurants Australia Pty Ltd (Yum!) by a number of its franchisees trading under the Pizza Hut brand (Franchisees). In doing so, the Court held that the franchisees failed to establish that commercial decisions by Yum!, relating to the range and price of pizzas (Value Strategy), amounted to a breach of the obligation of good faith or were unconscionable.
Unhappy with this outcome, a number of Pizza Hut franchisees appealed the decision arguing that the trial Judge erred in not finding that Yum! was liable to them when the Value Strategy failed. Last month, the Full Federal Court dismissed the appeal ruling in favour of Yum!, holding that, although there is a requirement for franchisors to take reasonable care (and act in good faith) in implementing a particular commercial strategy, the failure of that strategy, or its inability to realise a profit for franchisees, will not necessarily render the franchisor liable. In doing so, the Court also provided some much needed guidance on the interplay between good faith and reasonableness, and unconscionability generally, within the franchise relationship.
Grounds of Appeal
In the appeal, the franchisees challenged the trial Judge’s conclusions as to whether Yum! breached the contractual duties it owed to them. The Franchisees also contended that the primary Judge erred in not concluding that Yum! was liable in negligence and for unconscionable conduct.
Reasonableness and Good Faith
In the earlier judgement, the Judge held that Yum!’s exercise of discretionary power under the franchise agreement (to set prices for its products) was subject to an implied term of ‘good faith and reasonableness’. In doing so, the franchisees contended that the element of reasonableness was a separate obligation and one that was to be applied objectively and not subjectively as had occurred. In essence, the franchisees agreed that Yum! implemented the Value Strategy in good faith, but argued that the prices set by Yum! and its pricing methodology were each unreasonable.
The Full Court rejected the franchisee’s argument that good faith and reasonableness were two separate obligations, instead finding that:
- good faith and reasonableness are to be considered in a ‘composite and interrelated sense’, that is, where there is a finding of good faith, there must necessarily also have been reasonableness
- in this context, reasonableness is not to be approached as in producing a reasonable outcome. Rather, reasonableness concerns the quality of conduct in the sense that conduct that was ‘capricious, dishonest, unconscionable, arbitrary or product of a motive which was antithetical to the object of the contractual power’ would be unreasonable and in bad faith.
As such, the Full Court was unwilling to set aside this aspect of the trial Judge’s decision.
At trial, the Judge held that the franchisees failed to establish that Yum! had conducted itself in an unconscionable way through the implementation of the Value Strategy. On appeal, the Full Court found that there was no error in the primary Judge’s conclusion due principally to:
- unconscionability being fundamentally concerned with the vulnerability of parties and although Yum! was in a stronger position than the Franchisees, it was not in a ‘bargaining position’
- Yum! had a legitimate interest in adopting the Value Strategy, which it carefully considered
- it was not shown that Yum! unreasonably failed to disclose the risks involved
- Yum! merely exercised the powers conferred to it under the franchise agreement and the use of its price setting power was not, for example, a unilateral variation of a term or condition.
One curious aspect of this decision was the Full Court’s assessment of power between the parties in the context of their bargaining power. Given the changes to the Australian Consumer Law in 2010, it is now clear that unconscionable conduct arises throughout the life of the contract and not just at the time that the ‘bargain’ is struck.
In our view, the better approach (in the sense that it would be more consistent with the Parliament’s intent) would be for the Court to consider the difference in power between the parties and then to assess how that power had been applied. However, even if the approach contended by us had been applied, we don’t believe that it would have changed the outcome given the trial Judge’s other findings, which were not displaced by the Full Court.
What this means for Franchisors
We all know that in running a dynamic network, franchisors often design and implement significant business strategies (such as brand changes, new products and pricing), many of which may pose a financial risk to individual franchisees. As such, the decision of the Full Court is good news for franchisors, as it rejects the franchisee’s attempt to impose a new objective standard of reasonableness when making such decisions.
Of course, franchisors do not have an unencumbered right to take whatever action they wish regarding to the franchise. A franchisor’s powers are still subject to the terms of the franchise agreement and the implied obligation to act in good faith, with reasonable cause and in a manner that is not unconscionable.
To ensure that their actions comply with obligations of good faith and reasonableness, and to reduce the risk of any allegations of unconscionable conduct, franchisors should:
- ensure that any business strategies are in the best interests of the franchise network as a whole and that the decision to implement it has been properly considered
- ensure that the strategy is consistent with the terms and overall objectives of the franchise agreement
- undertake pilot programs of the proposed strategy in an appropriate and representative ‘sub-market’
- undertake comprehensive financial modelling to evaluate a proposed strategy and its impact on different classes of franchises and the network, generally
- ensure that data used to develop a strategy is reasonable (and has not been, for example, unreasonably modified or excluded so that it does not legitimately reflect a franchise’s business)
- implement a robust consultation program with franchisees about the proposed strategy with appropriate feedback channels
- have a clear, unequivocal and properly drafted franchise agreement that clearly establishes the rights of the franchisor to make strategic decisions for the franchise network.
If you would like more information, please contact a member of our Consumer Markets & Franchising team.