Australian Regulatory Changes: The Consequences
May 2008 Franchising World
By Stephen Giles
Legislative amendments to the Australian Franchising Code of Conduct took effect March 1. Among other things, they removed the single foreign franchise exemption used by many U.S. systems to avoid having to comply with the code. However, the changes are much broader than many appreciate, with the legislation applying not only to new franchise agreements, but all existing agreements signed since Oct. 1, 1998. Foreign franchisors also now have annual disclosure document updating obligations, and need to continuously disclose to all franchisees material changes.
The Regulatory Framework
Franchising in Australia is subject to a dedicated regulatory regime. The Franchising Code of Conduct was introduced by the Trade Practices Amendment (Fair Trading) Act 1998, and became operational in October of that year. The code is federal franchise legislation backed by the strong enforcement remedies available under the Trade Practices Act and through the involvement of the Australian Competition and Consumer Commission. A breach of the code is a breach of the TPA, and will entitle a party who has suffered loss or damage to compensation, and enable a court to grant an injunction, require specific performance, declare void ab initio in whole or part any agreement, vary any contract or arrangement or make such other orders as a court thinks appropriate. A breach of Clause 11 of the code can automatically invalidate the franchise agreement. Breach of the code which comes to the attention of the ACCC is likely to prompt an investigation, and may result in the institution of proceedings by the commission, with additional cost and possible adverse publicity.
The application of the code is largely determined by the core definition of a “franchise agreement” in clause 4(1) of the code, although clause 4(2) expressly includes a motor vehicle dealership agreement as a franchise agreement. Section 5 of the code exempts certain franchise agreements. These are, for the most part, fairly limited exceptions, and include a partial franchise exemption where the franchise agreement is for goods or services substantially the same as those previously supplied by the franchisee and the sales under the franchise are likely to provide no more than 20 percent of the franchisee’s gross turnover.
One of the most important exemptions–where the franchisor resides outside Australia and only grants one franchise or master franchise to be operated in Australia–ceased to apply from March 1. As a consequence, not only do foreign franchise systems need to comply with the code from March 1, but all “franchise agreements” executed before that time and previously exempt from the application of the code will now be caught. The consequences of this amendment are significant, and are discussed in greater detail below.
Removal of the Single Foreign Franchise Exemption
The single foreign franchise exemption has been deleted from the code with effect from March 1. Clause 5(1) of the code provides it applies to a franchise agreement entered into on or after Oct. 1, 1998. Accordingly, all franchise agreements executed between Oct. 1, 1998 and March 1, 2008, including those previously exempt from the application of the code, are now caught.
The amendments, therefore, have somewhat of a retrospective effect for foreign franchise systems. In effect, foreign franchisors will have to retrospectively disclose to their existing franchisees or master franchisees, notwithstanding that the franchise agreements are already in place, the commercial terms negotiated and settled and the relationships established. They will have to produce a disclosure document each year if they have any existing franchise agreements or master franchise agreements in Australia, as clause 6(1) of the code provides that a franchisor must create a disclosure document “before entering into a franchise agreement and within four months after the end of each financial year after entering into a franchise agreement.”
One of the biggest potential traps will be for foreign franchisors that have granted a single master franchise or master license agreement for Australia. It is common for the Australian company to act as the local franchisor, and in some cases, to have little or no contact with the U.S. owner of the intellectual property. The U.S. company may well be blissfully ignorant of the new Australian compliance obligations that have been foisted on their existing contractual relationship.
The removal of the single foreign franchise exemption creates disclosure obligations not just vis a vis the master franchisee, but to the unit franchisees in Australia. This is because clause 6B of the code provides additional disclosure obligations in a multi-tiered arrangement. Clause 6B(2) provides that (2) if a subfranchisor proposes to grant a subfranchise to a prospective franchisee (a) the franchisor and subfranchisor must (i) give separate disclosure documents, in relation to the master franchise and the subfranchise respectively, to the prospective franchisee; or (ii) give to the prospective franchisee a joint disclosure document that addresses the respective obligations of the franchisor and the subfranchisor; (3) the subfranchisor must comply with the requirements imposed on a franchisor by this part.
If a U.S. owner of a franchise system grants a master franchise to an Australian company and that company then grants franchises in Australia, clause 6B(2) would appear to apply. This is notwithstanding that the disclosure document prepared by the Australian company must already contain in Section 4 details as to the rights of the Australian company to use the foreign company’s intellectual property.
Relationship and Agreement Issues
A comprehensive consideration of the code’s compliance obligations is beyond the scope of this article. The main consequences for existing franchise agreements and the franchise relationship are:
• The franchise agreements must provide for, and are presumably deemed to now include, a mediation-based complaint handling procedure that complies with the requirements of the code. The code requires parties to give a prescribed form of notice of dispute in the event of a dispute in relation to a franchise agreement. If the matter cannot be resolved between the parties according to the internal complaint handling procedure, then the dispute should proceed to mediation. The mediation must be conducted in Australia and attended by someone with the power to settle the dispute on behalf of each party;
• Franchisors must not induce franchisees or prospective franchisees not to form an association or associate with other franchisees or prospective franchisees for a lawful purpose;
• A franchise agreement entered into after October 1998 must not contain or require franchisees to sign a general release of liability toward the franchisee or the waiver of any verbal representation made by the franchisor;
• If the franchisees contribute to a central-marketing fund, franchisors must prepare an annual financial statement detailing all of the funds receipts and expenses, have the fund audited (unless 75 percent of franchisees vote not to require an audit) and send the statement and audit report if applicable to all franchisees within 30 days of preparation;
• Franchisors must not unreasonably withhold consent to a transfer of a franchise;
• Franchisors must abide by the termination procedures which generally require that reasonable notice and an opportunity to cure be given to a franchisee except in situations such as insolvency, fraud or abandonment;
• Franchisors must provide franchisees with a copy of the lease where the franchisee leases the premises from the franchisor; and,
• Franchisors must tell franchisees to seek professional independent advice and comply with a certification process designed to ensure this occurs.
Disclosure is a core element of the code. Franchisors are required to prepare a comprehensive disclosure document that must be provided to prospective franchisees prior to entering, extending or renewing the scope or term of a franchise agreement. A franchisor must provide the detailed disclosure document to a prospective franchisee at least 14 days prior to signing a franchise agreement. The franchisor must also provide a copy of the code and a copy of the franchise agreement “in the form in which it is to be executed.” As noted previously, in the case of a sub-franchise situation both the sub-franchisor (master franchisee) and the franchisor are required to prepare a disclosure document. This may be done either jointly or individually.
The disclosure document must contain comprehensive information concerning the franchisor and the franchise, including corporate details of the franchisor and related entities, the business experience of those involved, litigation history, existing franchisee contact particulars, and information concerning intellectual property ownership, any territorial or supply restrictions, marketing or other cooperative funds, range of costs and payments relevant to the franchise and the franchisor’s financial position. The code dictates the information that must be included, as well as the form, order and numbering of the document. As the disclosure document must be in the format and using the headings set out in Annexure 1 to the code, a foreign franchisor’s Uniform Franchise Offering Circular or other foreign disclosure document will not suffice. A disclosure document must be updated within four months of the end of each financial year regardless of whether the franchisor is recruiting new franchisees or not.
The code provides for a “cooling off” period for franchisees in which they may terminate the agreement within seven days of entering or paying any money under the agreement. They are then entitled to a refund of all the money paid less the reasonable expenses of the franchisor.
Prospective franchisees are explicitly encouraged by the code to obtain independent legal and business advice. Clause 11 of the code requires that before a franchisor enters into a franchise agreement, the franchisor must obtain from the prospective franchisee signed written statements from the franchisee which confirm that the franchisee has received, read and had a reasonable opportunity to understand the disclosure document and the code, and signed statements that the franchisee has been given legal, business and accounting advice, or has been told to obtain that advice, but has decided not to do so. The requirement to obtain these written statements from the franchisee is a fundamental rather than a procedural obligation. Indeed the New South Wales Court of Appeal in Ketchell v. Master of Education Services held that a franchise agreement signed by a franchisor in breach of Clause 10 or 11 of the code was illegal and therefore unenforceable notwithstanding that the franchisor had provided disclosure and otherwise complied with the code.
Franchisors also need to comply with the obligations contained in Clause 18 to make continuous disclosure to all franchisees within 14 days of materially-relevant facts such as change of majority ownership or control or any relevant court judgements or undertakings. This is quite an onerous requirement for foreign franchisors, and of little relevance to either an Australian-based master franchisee or Australian-unit franchisees.
The code requirements are comprehensive and compliance is subject to a strong enforcement mechanism. All franchise systems in Australia, including foreign-based franchise systems, are subject to higher compliance requirements from March 1. Although compliance should not prove difficult for reputable franchise systems, there are certainly significant additional compliance obligations and costs.
There are compelling arguments to relax some of the ongoing compliance obligations for foreign franchise systems, as it is the author’s view that the removal of the single foreign franchise exemption, designed to put foreign systems on the same footing as Australian systems for pre-contractual disclosure, has had unintended consequences that impose unreasonable costs upon foreign franchisors.
Stephen Giles is a partner with Australian law firm Deacons. He can be reached at firstname.lastname@example.org.
Sources of Information:
Clause 11 prohibits a franchisor from entering into a franchise agreement or receiving any non-refundable payment unless the franchisor receives certain documents from the franchisee. (Ketchell v. Master of Education Services, 2007 NSWCA 161)
“Subfranchise” and “master franchise” are used interchangeably, and rather unhelpfully defined in Clause 2 of the code as “a franchise in which the franchisor grants to a subfranchisor or master franchisee the right to grant a subfranchise or to participate in a subfranchise.” Assuming the master franchisee is granted the right to use the intellectual property in Australia, any grant to a unit franchisee by the master franchisee would appear to be technically a “subfranchise.” This is somewhat of a moot point, as Clause 26 of the code provides that a franchise agreement entered into on or after 1 October 1998 must contain such a procedure. As most will not, the consequences are not totally clear. The above is a commonsense interpretation.
Clause 15 of the code: Waiver clauses are often included in franchise and master franchise agreements. Presumably such a clause would be severed, assuming the franchise agreement contains an appropriately drafted severance clause. However, the specific reference to October 1998 in the legislation is unfortunate.
In the author’s experience, many foreign drafted agreements would not satisfy this requirement. However the code would override the franchise agreement in this situation.