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Complexities and common sense

Feature Articles

Cite as: December 2015 89 (12) LIJ, p.36

Acting for a prospective franchisee is not easy. The negotiating power is tipped in the franchisor's favour and there is often significant time pressure and cost constraints. Part II 

By Stephen Giles and Nick Rimington

snapshot
  • Most commercial practitioners will regularly encounter franchising transactions, and the government has enshrined in the Franchising Code of Conduct an important role for legal advisors.
  • Faced with many complex documents and a modest budget, a legal practitioner needs to focus on the key issues and try to add value without obstructing the process. It is also vital that a client is clear on the advice the practitioner is, and is not, providing.
  • This article aims to provide a guide for practitioners who have a working knowledge of franchising, but are looking to better advise their clients when entering a franchising transaction.
  • With considered use of the Franchising Code of Conduct (the Code),1 the Competition and Consumer Act (CCA)2 and common sense, lawyers have a valuable role to play in helping their clients make an informed decision. Although franchise agreement terms are usually negotiable, franchisors will rightly resist if a franchisee’s lawyer seeks wholesale changes or pedantic or stylistic amendments.

    Starting the conversation

    Acting for a prospective franchisee can be complex. There are legal and business issues and matters where common sense input will be valuable. Often a prospective franchisee will have had little prior experience dealing with a lawyer and no real appreciation of business.

    It is therefore vital that practitioners properly scope their retainer when acting for a prospective franchisee. Otherwise, if things go wrong, the franchisee may look to the lawyer for compensation. It would be prudent to limit the retainer to explaining the legal effect of the documentation and other specifically agreed activities. The retainer should exclude the provision of business advice, or any opinion on the likely prospects of success of the franchised business. It is also prudent to briefly confirm in writing any advice provided, and any caveats or warnings given.

    Practitioners should be mindful that the prospective franchisee will be required, as part of the Code disclosure process, to sign a certificate that she/he has obtained legal and business advice, and may well list the practitioner on the certificate. Although the Code certificate provides that it may be signed by a lawyer to certify they have provided the advice, it is common practice that lawyers take a risk averse approach and decline to sign the certificate.

    It is almost impossible to provide legal advice to a prospective franchisee without providing some commercial input. It may be obvious to you that the franchise opportunity simply does not stack up as a viable business, or the risk may be too high relative to the potential reward. Although practitioners should be wary about providing business advice, there will be situations where it would be negligent to remain silent.

    It is also worth noting that the biggest risk for a prospective franchisee can in fact be whether the person has the skills, capital and work ethic to make a success of the business. If the franchise system is well established and has a lot of franchisees, this factor and the location or operating territory of the business are probably the two biggest variables. It is appropriate to bring this to a client’s attention.

    Practitioners should encourage prospective franchisees to obtain accounting advice and to prepare a budget and cash flow to ensure they will be able to operate the business profitably. Most franchisors will provide additional details of revenue from comparable existing franchised businesses, and existing franchisees are also usually quite forthcoming with information.

    The disclosure document provided under the Code contains a wealth of information, including a list of existing and former franchisees, that should be utilised by the prospective franchisee. Existing and former franchisees are typically a very good source of information. If information in this section of the disclosure document appears incomplete or there are no details of former franchisees, a practitioner should encourage the prospective franchisee to make more detailed enquiries.

    Consistency is crucial in franchising so franchisors are unlikely to agree to wholesale changes to their standard franchise agreement. A practitioner should alert the prospective franchisee to this fact at the outset to ensure the client’s expectations are realistic. Nevertheless, it is often possible to obtain specific amendments or written clarifications either to the agreement or by side letter. Further, the fact that concerns are recorded can be useful should any future dispute arise or if there is a need to provide evidence of representations made to the prospective franchisee in the context of a misleading or deceptive conduct claim.

    The regulatory framework
    The Franchising Code of Conduct

    Franchising is a highly regulated sector. The Code is the legal backbone for franchising in Australia and will greatly assist a practitioner when advising a prospective franchisee.

    Effective from 1 January 2015, a new Code came into force which builds on the existing protections afforded to franchisees with several new requirements and restrictions on franchisors. All practitioners acting for franchisees should familiarise themselves with the new Code.3

    Practitioners should explain the key aspects of the Code to the client and encourage the client to read the copy of the Code annexed to the disclosure document.

    The disclosure period

    A key requirement of the Code is the mandatory 14 day disclosure period.4 Although it is the franchisor’s responsibility to ensure this process is followed, a franchisee’s lawyer should actively protect the franchisee’s right to proper disclosure, particularly if there is pressure from the franchisor for the prospective franchisee to sign the franchise agreement early. In such a case, the practitioner should counsel the prospective franchisee on its rights and, if instructed, contact the franchisor or its legal advisor about the non-compliance.

    If the franchisee decides not to proceed with the franchise before the end of the 14 day period, any money paid to the franchisor is fully refundable.5 It is important for a prospective franchisee’s lawyer to explain this to the client as early as possible. The client may have developed serious doubts about the franchise, but feels locked in and financially committed. If the client is aware of their right to walk away, this could significantly influence the decision making process.

    The cooling off period

    Even after the franchisee has signed the franchise agreement, the “cooling off period” allows the franchisee to terminate the agreement within seven days after the earlier signing or making any payment under the agreement and to receive a full refund of payments made to the franchisor (less the franchisor’s reasonable expenses).6 The practitioner should make the client aware of their rights in this regard in case of a change of mind.

    Reviewing the franchise documentation
    Disclosure document

    The disclosure document is a critical component of a franchise documentation review. A practitioner should of course advise the client to read the disclosure document, but the trained eye of an experienced practitioner can uncover areas of concern.

    Issues a practitioner may wish to raise with the client when reviewing a disclosure document include:

    Is the disclosure document current and compliant? The disclosure document must be updated within four months of the end of the franchisor’s financial year. As of 31 October 2015, all disclosure documents must be in the revised format prescribed under the new Code.7 If the disclosure document is outdated or defective, consider requesting an updated version and restarting the disclosure period.

    Is there any litigation? If the franchisor has been involved in any litigation recently, the practitioner should assess the gravity and likely impact on the franchise network.8 Where the disclosure document reveals current litigation affecting key trademarks or a class action by a significant number of franchisees, consider requesting information on the status of those proceedings.

    Who owns the intellectual property? The key trademarks may be registered to a holding company or the founder and licensed to the franchisor.9 Where this is the case, consider requesting a copy of the licence agreement or a letter of comfort from the intellectual property owner that it will license the intellectual property directly to the franchisee if the licence is terminated for any reason.

    Is there a master franchise relationship? Item 10 of the disclosure document10 will provide details of any master franchise arrangement. Where relevant, the practitioner should ensure that the master franchisee has long term, secure rights to operate the franchise system in the territory in which the proposed franchise is to operate. Consider asking for a copy of the master franchise agreement or a letter of comfort from the head franchisor stating that it will automatically accept an assignment of the franchise agreement in the event of termination of the master franchise agreement.

    Has the franchisor provided earnings information? If a franchisor chooses to provide projections or forecasts, it must provide certain supporting details, such as the facts and assumptions on which the projections are based and the extent of enquiries and research undertaken.11 Consider noting the earnings information as a pre-contractual representation by the franchisor if the franchisee is required to sign a “prior representations statement”.

    What other agreements will the franchisee be required to sign? The practitioner should request copies of all other agreements that the franchisee will be required to sign, such as a supply agreement, software licence agreement, equipment lease agreement and any other ancillary document.12

    What occupancy arrangements are in place? Under the new Code, the franchisor must now provide details of any incentives or financial benefit received by the franchisor as a result of the lease.13 Some franchisors may not be aware of this new requirement. Therefore, requests should be made of the franchisor if this information is not provided at first instance.

    Franchise agreement

    As franchisors are unlikely to agree to wholesale changes, practitioners should focus on carefully explaining the franchisee’s obligations under the franchise agreement. However, a practitioner can improve the franchisee’s position with intelligent use of the Code and knowing what changes to request.

    Prohibited clauses

    Division 3 of the Code sets out certain clauses that are void and unenforceable if included in a franchise agreement. While these clauses will be automatically void and of no effect, they should be deleted or amended so that the contract accurately reflects the legal position of the parties and avoids uncertainty.

    The prohibited clauses specified in Division 3 include:

  • a general release of the franchisor of liability towards the franchisee
  • a waiver of any verbal or written representations made by the franchisor
  • a requirement that a party bring court action in a different state or in a jurisdiction outside Australia
  • a requirement for a franchisee to pay the franchisor’s costs in relation to the settling of a dispute.
  • Synergy with the Code

    The Code also places prescribed procedures and limitations on certain conduct. The practitioner should ensure that the franchise agreement is consistent with the provisions of the Code that deal with cooling off, dispute resolution, transfers, termination and end of term arrangements.

    Examples of amendments

    The key to achieving a positive and efficient outcome for a franchisee client is to focus on a few key issues that will deliver the greatest practical benefit. In many cases, these will appear as commercial bargains rather than legal drafting changes. Possible change requests include:

    Exclusive territory: Depending on the nature of the franchise, consider requesting an exclusive territory. If the franchisor will not agree, a reasonable compromise may be a first right of refusal in respect of any proposed new franchises within a certain area. If any representations or assurances are provided to a prospective franchisee in relation to exclusivity or non-encroachment, they should be confirmed in writing.

    First right over adjoining territories: Where the franchisee has a territory, consider requesting a first right of refusal over any adjoining territory.

    Royalty relief: Especially in the case of a greenfield site, consider requesting a reduction in royalties during the early stages to allow the business to establish itself and gain momentum.

    Term to match lease: Where there is a premises lease, consider matching the length of the term and any further terms to the term of the lease. This will allow the parties to consider the renewal of the lease and franchise agreement concurrently and avoid “holding over” situations.

    Opening promotion contribution: Consider requesting that the franchisor spend a certain amount on promoting the opening of the business in the local area (from the franchisor’s own funds, not the marketing fund).

    Compensation at end of term: The new Code provides that restraints of trade are unenforceable in certain circumstances unless the franchisor pays the franchisee genuine compensation for goodwill.14 Practitioners could use this new provision to persuade a franchisor to include a formula for payment of compensation to the franchisee in the event the agreement is not extended at the end of the term.

    Guarantees: Ideally remove personal guarantees, but if this is not possible, consider amending the guarantee provision to limit the exposure of the guarantors.

    Competition and Consumer Act

    The Code is enacted under the CCA and provides considerable protection for prospective franchisees, including the new obligation to act in good faith. The prohibitions against unconscionable conduct15 and misleading or deceptive conduct16 are often relevant in the franchising relationship, and the new CCA amendments to prohibit unfair contract terms in standard form small business contracts are also likely to be relevant to many franchise agreements from 2017 onwards. So, franchisees have ample remedies if a franchisor has not acted appropriately.

    From a legal perspective, the information in the disclosure document is important, but often other representations made during the recruitment process are more influential, and potentially more misleading. Practitioners should encourage clients to keep all documents provided by the franchisor and keep a record of all verbal representations made during the recruitment process, as this could assist in a claim against the franchisor in the future.

    Practitioners may also wish to consider any third line forcing17 or resale price maintenance18 arrangements when reviewing the franchise documentation, and conduct searches of the ACCC notifications register to ascertain whether such arrangements are lawful, or should be challenged.

    Concluding remarks

    Often the extent of a practitioner’s involvement with a prospective franchisee will be determined by the skills and experience of the client, the client’s budget and the nature of the franchise opportunity. Some compromises will be necessary to meet the client’s expectations, but with careful scoping of the tasks a practitioner can add substantial value. Although there is no substitute for experience, this article suggests some areas where practitioners may wish to focus their attention to help ensure the client’s experience of franchising is a positive one, or ensure a franchisee does not make an unwise investment decision.

    1. Competition and Consumer Act (Industry Codes – Franchising) Regulation 2014 (Cth). 2. Competition and Consumer Act 2010 (Cth). 3. For a more detailed analysis of the new Code, refer to our article “Changes and Consequences”, LIJ, November 2015, 89.11 p28. 4. Note 1 above, Schedule 1, cl 9(1). 5. Note 1 above, Schedule 1, cl 9(1)(e). 6. Note 1 above, Schedule 1, cl 26. 7. Note 1 above, s8(b). 8. Note 1 above, Schedule 1, Annexure 1, Item 4. 9. Note 1 above, Schedule 1, Annexure 1, Item 8. 10. Note 1 above, Schedule 1, Annexure 1, Item 10. 11. Note 1 above, Schedule 1, Annexure 1, Item 20. 12. Note 1 above, Schedule 1, cl 14. 13. Note 1 above, Schedule 1, cl 13. 14. Note 1 above, Schedule 1, cl 23. 15. Note 2 above, Schedule 1, ss20-21. 16. Note 2 above, Schedule 1, s18. 17. Note 2 above, Schedule 1, s47. 18. Note 2 above, Schedule 1, s48.
    Stephen Giles is a partner with Norton Rose Fulbright Australia and has more than 30 years’ experience in franchising and commercial law. He is author of several franchising publications including Franchising Law & Practice and The Annotated Franchising Code of Conduct. Nick Rimington is a senior associate in the franchising group at Norton Rose Fulbright Australia and practises extensively in franchising, competition and consumer law.

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