Comply or say bye to your franchise!

In brief

With the new Franchising Code of Conduct and civil pecuniary penalties set to commence on 1 January 2015, a recent Full Federal Court decision is a timely warning to franchising parties to ensure their practices comply with the Code. Partner Tim Golder and Associate Nadia Guadagno report on this decision and its significant implications for franchising parties.

Background

In about mid-2010, SPAR and MIS commenced negotiations regarding MIS entering a franchise agreement under which it would operate a SPAR-branded supermarket and purchase groceries exclusively from SPAR.

In July 2010, SPAR gave MIS a disclosure document (as required by the Code). The disclosure document contained financial reports and a solvency statement for the financial year ending 30 June 2009. It did not contain financial reports or a solvency statement for the financial year ending 30 June 2010 – these were not finalised until September 2010. The latter painted a very different picture of SPAR's financial position and showed that the company was in serious financial trouble. MIS gave evidence, which the court accepted, that if it had known of the information contained in the financial reports for the financial year ending 30 June 2010, it would not have entered into the franchise agreement.

In September 2010, during negotiations, a SPAR senior executive made representations to the MIS directors that MIS could be released from the franchise agreement before the end of the five-year term if it paid certain break fees. MIS contended that it would not have entered into the agreement if it knew it would be locked in for five years.

On 1 February 2011, the parties entered into the franchise agreement, which did not provide that MIS could terminate during the term. It only permitted SPAR to terminate the agreement if MIS were in breach, and if SPAR did so, MIS would be required to pay certain break fees set out in clause 20.6 of the franchise agreement. No new disclosure document was provided at that time.

In August 2011, MIS sent a letter to SPAR, withdrawing from the franchise agreement. SPAR commenced proceedings seeking specific performance and obtained an interlocutory injunction restraining MIS from purchasing groceries from any other supplier. MIS cross-claimed, alleging that SPAR had breached the Code, by not providing a current disclosure document, and had engaged in misleading and deceptive conduct.²

The trial

At trial, the judge found that, prima facie, MIS had breached the franchise agreement by purporting to terminate it; however, his Honour did not make any orders in that respect, as his Honour found in favour of MIS for both limbs of its cross-claim. The court made orders varying the franchise agreement, to permit MIS to withdraw from it upon payment of the break fees set out in clause 20.6. It also awarded damages for the misrepresentation.

SPAR appealed the decision.

The appeal

Franchising Code of Conduct

SPAR argued that it had complied with the Code, as the disclosure document was current at the time it was created and the Code did not oblige SPAR to give a subsequent document to the same prospective franchisee before the signing of the franchise agreement. Indeed, the Code does only require a current disclosure document to be provided at least 14 days before the prospective franchisee enters into a franchise agreement or makes a non-refundable payment to the franchisor.³ It does not prescribe a maximum amount of time before entering into a franchise agreement as to when a franchisor can provide a disclosure document.

However, Justice Buchanan (with whom Justice Foster agreed) held that SPAR had not complied with clause 6B at the time the franchise agreement was made, because as at this date the disclosure document was not 'current'.⁴ (Note, however, 'current' is not defined in the Code.) Further, providing a document that, at the time of signing the franchise agreement, was out of date because it did not contain information reflecting the company's current financial status clearly does not support the purpose of the disclosure document – to give a prospective franchisee information 'to help it make a reasonably informed decision about the franchise'.⁵

Justice Farrell disagreed with Justice Buchanan's reasoning. Her Honour stated that the franchisor's duty to give a current disclosure document is discharged once it has been provided to a prospective franchisee at least 14 days before the prospective franchisee enters into the agreement.⁶  If there is a material change in the circumstances between the time the franchisor gives the franchisee a disclosure document and the franchise agreement is signed, the Code imposes no requirement to provide a fresh disclosure document.⁷

However, her Honour concluded that the disclosure document did not comply with the Code, which requires that the disclosure document be in accordance with the template document set out in Annexure 1 of the Code. Paragraph 20 of Annexure 1 requires that the disclosure document includes '[a] statement as at the end of the last financial year, signed by at least 1 director of the franchisor, whether in its directors’ opinion there are reasonable grounds to believe that the franchisor will be able to pay its debts as and when they fall due' (emphasis added). SPAR's disclosure document contained such a statement in relation to the 2008-2009 financial year, but the disclosure document was provided in July 2010 – the first month of the 2010-2011 financial year. Therefore, SPAR's disclosure document should have contained a solvency statement in relation to the 2009-2010 financial year.⁸ SPAR argued that this conclusion would have a draconian consequence, as no disclosure document could be provided in a new financial year until the previous financial year’s accounts had been settled. This did not sway her Honour, who stated that the Code's patent purpose is the protection of franchisees and prospective franchisees by the provision of information to them. In the absence of clear words requiring the convenience of the franchisor to be taken into account, there is no basis for qualifying the requirements of clause 6B.⁹

So, for different reasons, all justices found against SPAR.

The court held that the breach of the Code did not render the franchise agreement void.¹⁰ However, it ordered that the franchise agreement be set aside, as it would not have been made if the current financial position had been disclosed before the execution of the franchise agreement.¹¹

The court rejected MIS' submission that the agreement should be set aside from its inception, as MIS did not provide evidence that it had suffered trading losses or financial loss arising from a perceived loss of opportunity.¹² For the same reason, it held that MIS was not entitled to damages for breach of the Code.¹³ The court may have found otherwise, however, if MIS had provided sufficient evidence that it had suffered financial losses as a result of remaining a franchisee, or would have made a greater profit if it had been allowed to leave and operate under another franchise system. The court also disagreed with the trial judge's finding that MIS should be required to pay break fees – under the franchise agreement, those were only payable if SPAR terminated the agreement due to a breach by MIS.¹⁴ 

Misleading and deceptive conduct

The court found that a SPAR senior representative did make a representation that MIS could be released from the franchise agreement before the end of the five-year term if it paid break fees. However, the mere fact that representations as to future conduct or events do not eventuate does not make the representations misleading –  it is also necessary to establish that at the time of making the representation the representor did not have reasonable grounds for making it.¹⁵

At the time SPAR made that representation, it was based on SPAR's then current policy and practice. As such, SPAR had reasonable grounds for making the representation at the time and so it was not misleading, even if SPAR's position later changed and it sought to hold MIS to the agreement.¹⁶ The trial judge's judgment on this aspect was, accordingly, set aside.

One issue canvassed on appeal, but not at trial, was promissory estoppel. MIS gave evidence that it had requested the agreement be modified to reflect the representation SPAR had made that MIS could terminate the agreement, upon payment of the break fees, before the end of the term, but was told that it was a standard document and SPAR's practice was not to amend standard documents. We consider that a claim for estoppel could have been made even though the contract was entered into subsequent to the representations being made. Of course, MIS would have needed to adduce evidence that it had relied on the representation to its detriment, that SPAR knew MIS was relying on the representation and that it would be unconscionable for SPAR to resile from that representation. These matters certainly appeared open on the facts. However, for whatever reason, MIS did not raise that cause of action at trial and it was too late to raise it on appeal.

If estoppel had been established, MIS would have been permitted to withdraw from the agreement in August 2011, upon the payment of the break fees. Whether or not MIS was worse off as a result of its failure to raise estoppel depends on whether it did suffer loss or a lost opportunity by having to remain a franchisee from August 2011 to May 2014 and, if so, whether this loss was greater than the value of the break fees.

Implications for franchising parties

The first key takeaway point is that the financial reports and solvency statement required by the disclosure document must be for the immediately preceding financial year. As with the appellants in this case, it is certainly foreseeable that this will create logistical issues for a number of franchisors, whose financial reports will often not be finalised until some months after the end of the financial year. Ultimately, this may mean that if a franchisor intends to enter into a franchise agreement and provide a disclosure document early in a new financial year, it may need to delay doing so until current financial reports have been prepared, so that a 'current' disclosure document may be provided.

This decision also has implications for the renewal of franchise agreements, as the franchisor must also provide a 'current' disclosure document at least 14 days before the agreement is renewed, as well as during the life of a franchise agreement, as the franchisor must give a franchisee a 'current' disclosure document within 14 days after a written request by a franchisee. Certainly regarding the latter, franchisors may find themselves applying significant pressure on their accountants to prepare the relevant financial reports if the request is made early in the financial year!

Franchisors should also be mindful of clause 18 of the Code, which applies both to current and prospective franchisees. If a disclosure document does not mention certain matters, the franchisor must tell the franchisee, or prospective franchisee, about that matter no more than 14 days after becoming aware of it.

The stakes become even higher under the new Code, which will apply to all agreements entered into, or renewed, on or after 1 January 2015. The corresponding disclosure provisions under the draft new Code attract civil pecuniary penalties of up to 300 penalty units (currently $51,000) for contraventions thereof. 

The second key takeaway point is that if you are relying on a representation made by another party during negotiations, the safest course of action is to ensure that the representation is included in the written franchise agreement. If a party makes a representation as to a future matter, which is based on reasonable grounds when the representation is made, the party relying on the representation will not succeed in a claim for breach of the Australian Consumer Law if the representor later changes its position  – but query if an estoppel may be available.

Conclusion

As the new Code will introduce greater penalties for breaches, there is now even more reason for franchisors to ensure their practices are compliant with the Code. As SPAR learned the hard way, disclosure documents should contain up-to-date information and be based on financial reports from the immediately preceding financial year. This case also demonstrates that if a representation is important enough to induce one to enter into an agreement, one should make sure that it is in the agreement!