Introduction

The last NZLS Seminar on franchising was in 2000. That seminar focussed primarily on New Zealand case and statutory law. I propose to refer to developments since then in a broader context than is usual at seminars such as this, as I believe that the laws relating to franchising in New Zealand are better assessed by viewing them from an international perspective.

The origin of franchising

In the mid-twentieth century there was an employment paradigm of a lifetime job, followed by a blend of private and state pensions. The paradigm changed as the second half of the century drew to a close. In its place there was a steady trend away from permanent employment, and from both private and predictable State pensions. The trend has continued to the point that the number of permanent jobs within the community is now much reduced. Futurologists like Charles Handy had spoken of the way in which people would typically have a number of quite different jobs during the course of their lifetime, and that prediction has been fulfilled.

These changes have led to the creation of new business models, one of which is franchising.

Franchising emerged in the USA after the Second World War but its expansion is attributed to the post-1973 economic crisis. In the changed economic environment it had, and continues to have, three major attractions:

• Franchisees provide most of the capital for the franchised business, making it much easier to amass the capital which is necessary for the creation of a substantial business.
• The existence of an established business model reduces the risk of business failure for the individuals who provide the capital – who at the time they join the franchise are typically unskilled in the particular business and who are often unsophisticated in business generally.
• In an age when lifetime jobs have become increasingly scarce, the new participants (the franchisees) can acquire employment and a measure of self-control over their financial and employment destinies.

The success of franchising

The attraction of the franchise concept has been remarkable. In countries like the USA, Canada, Australia and New Zealand there has been a massive growth in franchising, and the increase in growth continues each year. In 1999 the National Bank Survey of Franchising in this country revealed that there were approximately 35,000 New Zealanders working in franchise operations.

The last Survey of Franchising in this country, which was published in 2001, showed a 20% increase in the number of systems, outlets and those employed in them in the previous twelve months with more than 300 systems operating in franchised areas. More than 70,000 people worked in franchises and 77% of the franchises originated in New Zealand.

The typical franchisee

Most franchisees have relatively modest wealth. To buy into a franchise a franchisee will typically have to raise money against the security of his/her home.

With their modest financial resources and – in many cases – their lack of commercial experience, they are particularly vulnerable to exploitation. Where this arises, it is especially harmful for them and their families since the failure of the franchised business will often lead to the loss of equity in their homes.

Legislative protection for franchisees

Many Western countries have established some form of specific legislation which is intended to protect franchisees from franchisors who may be unscrupulous, and/or less competent than is appropriate for the proper functioning of a successful franchise.

Legislative regimes overseas

In the USA the offer and sale of franchises is regulated by federal law. Many States regard the federal law as inadequate and they have enacted additional statutes or regimes which range in the degree of protection which is given to franchisees. Iowa has the greatest level of protection. Statutes prescribe the form and nature of the disclosure that must be made to prospective franchisees; the timing of delivery; and the individuals who must receive disclosure. The offer of franchises is regulated with requirements for the registration of disclosure documents. A franchisor is required to provide a prospective franchisee with any agreement to be executed (with all blanks filled in) at least five business days prior to execution. Franchisors are often recommended to arrange for the video-taping of sessions at which prospective franchisees agree to enter into franchise contracts.
The federal legislation is supervised by the Federal Trade Commission (the FTC), a Body which has both the capital and human resources to police the legislation.

Europe

In Europe franchising is governed by general laws relating to contracts and so forth, and by Article 81(1) of the EC Treaty which contains some hardcore restrictions which apply to all franchise agreements. The current rules in the Block Exemption Regulation on Vertical Restraints contain various hard core restrictions which apply to all contracts. These outlaw re-sale price maintenance and restrictions that limit the territory into which a franchisee may sell or provide services but they do not ban the solicitation of sales. The Block Exemption Regulations have some safe harbour provisions which are commonly called “grey clauses”. These must be analysed under Article 81(1) principles to see if they conflict with EU competition rules. The grey provisions include post-termination restrictive covenants which are not necessary to protect know-how and relate only to the premises from which the franchisee operated. They are for a period not longer than one year after termination.

Australia

In Australia the Franchising Code of Conduct was enacted in 1998 via section 51AE of the Trade Practices Act. This makes compliance with the Code mandatory for all companies that fall under its jurisdiction. Franchisors must produce a disclosure document that complies strictly in form and content with the terms of the annexures to the Code.

The Australian Franchising Code of Conduct under Part IVB of the Trade Practices Act 1974 includes remedies of injunctions, corrective advertising, damages and the possibility of other orders. An adviser or associate of the franchisor who is found to be involved in a contravention of the Code may be subject to the remedies under the Act. Where earnings information based on a projection or forecast is given, the disclosure document is to specify underlying facts and assumptions; the extent of enquiries and research carried out by the franchisor; the period covered; the reasons for choosing the particular period; whether depreciation, the cost of servicing loans, and franchisees’ salaries have been included; and assumptions on interest and tax. The Australian Competition and Consumer Commission (“ACCC”) is empowered to enforce the Statute.

A Commonwealth-State Joint Task Force had been appointed to enquire into franchising in Australia. It identified numerous problems. The Federal Government decided against specialist legislation and opted for self-regulation in the form of the Franchising Code which was developed by the Franchise Association of Australia (FAA). This became effective on 1 February 1993.

The Task Force had found that prospective franchisees routinely did not read franchise agreements because they are standard form contracts which the franchisee knows will not be altered. It did not take long before the voluntary regime gave way to the compulsory regime which was enacted in 1998.

New Zealand has no franchising laws

By contrast, New Zealand has no specific laws relating to franchising. The major participants in the industry have formed the Franchise Association of New Zealand (“FANZ”) which has its own Code of Practice. Franchisors who choose not to join the Association, or who are unable to meet its criteria for eligibility, have no constraints on their conduct beyond those which are proscribed by general statutes and the common law.

Franchisors are inevitably apprehensive about the prospect of State regulation because of the additional cost and inconvenience which the laws will inevitably create. It is notable, however, that the imposition of statutory regimes for the more satisfactory regulation of franchising does not appear to have harmed franchising. In countries like the USA and Australia the intrinsic attraction of the franchising business model is such that it continues to grow in popularity despite the regulatory regimes there.

In this paper, I propose to consider recent New Zealand cases in the context of these broader international developments. I also propose to do it by reference to the name of the franchise concerned, rather than the case name, to illustrate the range and diversity of franchised businesses in the country.

It is my thesis that New Zealand would benefit from specific legislation but that no changes should be considered until there has been more empirical research into the overall state of franchising, to better assess the extent of undesirable practices and the need for remedial change.

The nature of the franchise relationship

It has been commonly accepted that the franchise relationship is not a fiduciary one with the high burdens which the laws relating to fiduciary obligations would impose upon franchisors. There is, however, a realisation that franchise agreements are not like agreements for the sale and purchase of a commodity.

They are a species of contract which require ongoing co-operation between the parties for the success of the combined venture. One of the benefits of the Dymocks litigation is that it has led to an acceptance by the Courts that franchise contracts are “relational contracts”, ie contracts which should be interpreted by the Courts as requiring a degree of mutual co-operation on the part of each of the contracting parties.

The duty of good faith and co-operation

In the USA, despite the existence of a great deal of regulation at the Federal State level, the general acceptance of a duty of good faith and fair dealing in the performance of contracts (the Restatement Second s.205) has governed the resolution of most relationship disputes between franchisors and franchisees.

Although the New Zealand Court of Appeal suggested in the Dymocks case that “there is no room” for the superimposition of a general duty of good faith in franchise agreements, the Privy Council’s response in the same litigation was that there was no intrinsic reason why the implication of an obligation of good faith “would be an undesirable development”.

As the Privy Council chose to decide the Dymocks’ appeal by reference to the franchisor’s claim that the franchisee had repudiated the agreement, it was not necessary to express any concluded opinions on the arguments about the existence of a duty of good faith. It was understandable, therefore, that the Privy Council should have been cautious in the way that it approached this topic. It can, however, be discerned from its hint that it would not be an undesirable development to import an obligation of good faith into franchise agreements that it was the tentative opinion of the Judges that such a term should be incorporated into franchise contracts. This can be seen from paragraphs 57 and 63 of the decision. In paragraph 57 the Board said that the obligation of good faith is implicit “in the case of partnership and other joint venture agreements”. In paragraph 63 they said that the franchise agreements under consideration “were not ordinary commercial contracts but contracts giving rise to long-term mutual obligations in pursuance of what amounted in substance to a joint venture and therefore dependent upon co-ordinated action and co-operation”. Although joint venture agreements differ between themselves in the obligations which the contracting parties agree to fulfil, the underlying concept remains the same – a venture which is dependent upon co-ordinated action and co-operation. It therefore seems likely that the Privy Council would be willing to hold that such terms may be implied by law into franchise agreements.

In the USA, Courts have defined the implied covenant of good faith and fair dealing to require that each contracting party substantially performs under the contract to accomplish its purposes, and not to act in such a way as to undermine the other party’s right to enjoy the contract benefits.

There are a number of non-franchise cases in which New Zealand Courts have indicated that a duty of good faith will be implied into a contract, notably Elias J’s decision in J J Stanley Ltd v Fuji Xerox NZ Ltd (1997).

It also appears that the Burger King decision in Australia has established the existence of an implied obligation of good faith and confidentiality in franchise agreements in that country, and the trend to trans-Tasman co-operation in legal regimes involving similar business models is likely to influence New Zealand courts to adopt a similar approach here.

A common law duty of “utmost good faith”

The most interesting development in this area of the law has been in Canada. In Country Style Food Services Inc v 1304271 Ontario Ltd (11 February 2003) the Ontario Superior Court of Justice re-asserted the existence of a common law duty on a franchisor to act with the “utmost good faith” towards a franchisee. This is, in essence, the level of responsibility (although not necessarily accountability) which is required of a fiduciary but in a non-fiduciary framework. In that case a franchisor had entered into a head lease of premises in a shopping centre which were in the course of construction. The configuration of the building was shown on a plan which was attached to the lease. A prospective franchisee was shown the plan and, in reliance on it, entered into a franchise agreement and took an assignment of the lease. The developer subsequently modified the configuration of the building in a way which made it far less successful in attracting custom with the consequence that the franchisee’s business failed. Although the franchisor was held not to have been “unaware of the inaccurate and misleading nature of the site plan attached . . . to the sublease” the franchisor was held not to have done enough to prevent the landlord from modifying the premises. The franchisor had made representations to the developer when it discovered the changes that were being made, but its actions were held to be quite inadequate. The Judge described the franchisor’s conduct with maritime imagery:

“When the ship began to sink, the franchisor left its charge afloat in turbulent waters, without a lifejacket. In response to the franchisee’s initial desperation, and with a spasm of energy, Country Style did extend a helping hand, but it failed to pull the floundering swimmer to safety.”

For its failures, the franchisor was ordered to pay the former franchisee C$400,000. The decision is being appealed.

What is the ambit of a common law duty to act with utmost good faith? The Judge said that “the franchisor’s duty of care, the duty to act in good faith, while not elevated to the status of a fiduciary, speaks to concepts of loyalty, respect and fair dealing”.

The underlying concept had been described by Fleury J in this way:

“A franchise agreement creates a different type of relationship than the usual purchase and sale transactions. In some ways, the parties become partners in one venture. In some ways the franchisee has to continue to rely on the integrity of the franchisor with respect to information privy only to the franchisor . A duty of utmost good faith can be implied in any purchase such as the one described in this case.”

The facts of this case pre-dated the application of the statutory duty of fair dealing which is contained in Ontario’s Arthur Wishart Act (Franchise Disclosure) 2000. It may be noted that the doctrine of “utmost good faith” had branched off from the mainstream law in Ontario in 1995.

Although the elements of a franchise agreement do not necessarily give rise to fiduciary obligations, such obligations may nevertheless arise as part of the franchise relationship. In the Burger King litigation in Australia both the New South Wales Supreme Court and the New South Wales Court of Appeal held that Burger King owed fiduciary duties to its master franchisee in Australia; that it had breached those duties; and that it was liable for damages in equity. Burger King had felt frustrated by what it saw as the reluctance of its Australian master franchisee to assist its business in the country and had entered into secret negotiations with Shell to establish Burger King outlets in Shell service stations. It was assisted in this initiative by a “mole” within its Australian master franchisee’s management. Burger King was held to have acted dishonestly and with a lack of probity in doing this, and to have breached the implied contractual terms of having to act reasonably and in good faith.

The decision is, incidentally, one of the most salutary revelations of the serious consequences which can befall a franchisor who acts with an arrogant disregard of its contractual and equitable obligations. Following a trial which lasted 66 days Burger King was ordered to pay A$70m in damages, a sum which was reduced a little on appeal.

Breach by franchisee

Perhaps the most important aspect of the Dymocks litigation was the Privy Council’s incisive and refreshing analysis of the significance of the franchisee’s conduct. Whereas the New Zealand High Court had held that a franchisee’s refusal to pay franchise fees to the franchisor or to participate in franchise activities (without formally cancelling the Agreement) was “ambiguous” conduct, and whereas the Court of Appeal had not even referred to this conduct, the Privy Council regarded it as a straightforward repudiation of the franchisee’s contractual obligations which entitled the franchisor to cancel the agreement. There ought not to be any doubt now about the likely consequences of such actions if a franchisee does not have grounds for termination or does not terminate. In relational contracts it is incumbent upon both parties to work towards the successful implementation of the agreements.

A number of States in the USA contain laws which commonly provide for a minimum advance notice requirement during which a franchisee is granted an opportunity to cure defects and avoid terminations. Such statutory overlays on the contractual obligations of the parties have much to commend them.

Mass defections from franchises

There have been several recent instances of the virtual “collapse” of franchises in New Zealand. In the last few years there have been mass defections from such franchises as Payless Plastics, Kwik Kopy, Nationwide, Warehouse Building Supplies and Mr Electric.

Most of the Payless Plastics franchisees re-badged as franchisees under a new franchise, “Plastic Box”, a development which it is understood may have been possible under the wording of their original agreements. In the case of the other franchises, many of the franchisees alleged that they had been induced to enter into their franchise agreements as a result of misrepresentations by the respective franchisors. I acted in several of these cases and have two observations about this.

The first observation arises from some evidence which was given by a franchisor in a case which was tried in the Auckland High Court last year. It was suggested that a franchise will reach a point of “maturity” from which it can be inferred that it is difficult to achieve further growth. Franchisees who find themselves in a “mature” franchise face particular difficulties. They have leasing obligations and restrictive covenants which make it very difficult to leave the franchise and establish a viable new business; the continuing obligation to pay franchise fees places them at a competitive disadvantage in their businesses; and with the stagnation of the franchise, they have great difficulty in selling their franchised business for a sum which justifies their investment. The net effect is the likelihood of business contraction and increased unprofitability. The present laws do nothing to assist franchisees in this predicament.

The second observation concerns the great difficulties which franchisees face in circumstances where they contend that a franchisor has engaged in serial misrepresentations. The following comments are not meant to reflect on any of the franchises to which I have referred. My comments are intended to be of a much more general nature. Franchisees, even when they act collectively, may well find the burden of the legal costs of opposing a well financed franchisor to be too great. In such contests the local franchisor will often be supported financially by its off-shore parent which is willing to commit substantial resources to the litigation to ensure that franchisees in other countries are not inspired by a successful revolt of franchisees in this country to do likewise in their respective countries.

The situation can be contrasted with the legislation in the USA and in Australia. In these countries the FTC and the ACCC may think it appropriate to initiate litigation against the franchisor. An example of this occurred with the Speedy Sign*A*Rama franchise in the USA. The FTC brought proceedings against the US franchisor in 1993. Two years of intensive discovery followed. The trial on liability ran for six months in 1995. Approximately 70 witnesses, including 40 franchisees and several undercover investigators, testified at the liability trial. The US District Court found the franchisor to be liable on all counts. This involved findings that the franchisor had made false and unsubstantiated claims to prospective franchisees about the gross earnings and profits which they could expect to receive by buying and operating sign shops, the non-disclosure of significant training/transfer fees imposed on franchisees who later sold their franchises, and knowledge by the franchisor’s chairman of these illegal activities. Permanent injunctions were granted against the franchisor and its chairman. In 1999 the company had judgment entered against it for US$3.47m for consumer redress. A group of New Zealand franchisees would be most unlikely to have the resources to achieve such an outcome, but in circumstances where a franchisor has behaved in such a way, it is very much in the public interest that its activities should be investigated, publicised and punished. In this type of situation the status quo in New Zealand compares poorly with a regulatory regime which empowers a well-funded agency like the FTC to ensure that dishonourable conduct of a systemic nature is revealed and stopped - for the protection of both existing and potential franchisees.

Withdrawal by franchisor from franchising

Another risk which franchisees face is the withdrawal of the franchisor from a franchise. A few years ago the Uncle’s franchisor sought to extract a fee from a franchisee to enable it to quit a franchise which the franchisor was itself abandoning! A franchisor who decides to withdraw from franchising will usually be more subtle. The Swinton Insurance Broking business was a large insurance franchise in England. At its peak, the franchisor had 465 branches and 142 franchisees who had 285 outlets serving 1.5m customers. The franchisor announced at an annual conference a few years ago that it was withdrawing from franchising and that franchisees would not be able to renew their agreements on the expiration of their current terms. The franchise promotional materials had said that one of the attractions of joining the franchisee was the ability to build up a business and sell it for a retirement fund.

It was common ground that a term should be implied into each contract that the franchisor would give the franchisee reasonable notice of its decision to withdraw from franchising and a five year term was fixed by the Court.

In a decision which was delivered a few weeks ago in the USA, the California Appeals Court held that a franchisor had breached the implied covenant of good faith and fair dealing by the way it phased out its franchise programme in favour of an employee-based service operation. The phase-out plan provided that the franchisor would cease to sell new franchises. The franchisee claimed that the phase-out programme violated the implied contractual covenants of good faith and fair dealing. The Court agreed and stated that a breach of a specific contract provision is not necessary to create a breach of good faith and fair dealing. Rather, the question was whether the conduct, even though not expressly prohibited, was nevertheless contrary to the contract’s purposes and the parties’ legitimate expectations. It was found that the franchisor had breached these covenants when it had surreptitiously implemented its decision not to renew the franchises and to implement an employee-based service operation. By doing so it had rendered the franchises unsaleable and it awarded the franchisee damages representing the full amount of the probable sales value of the franchises as if the franchisor had not implemented the phase-out programme.

How such a circumstance would be treated by the New Zealand Courts is not clear. With the implied terms of good faith and fair dealing in such an ill-formed state here it cannot be predicted that a New Zealand Court would act in this way.

It is interesting to note that one of the proposed laws in Italy is a requirement that the duration of a franchising contract must take into account the time which is necessary for the franchisee to recoup his/her investment and that it must be for at least three years. A mechanism such as this gives some protection to a franchisee where the franchisor decides to withdraw from franchising.

New York State legislation, which has been copied in several States, contains provisions which prevent franchisors from terminating or refusing to renew a franchise agreement.

The inherent vulnerability of franchised businesses

The Canterbury activewear franchise illustrates another form of problem which can befall a franchisee. The business of the franchisor was critically dependent upon the existence of a contract with the NZRFU. This was spelt out in the franchise agreement in which the franchisee accepted that if the contract was lost, it would have no recourse against the franchisor. When the contract was lost to Adidas, the franchisee’s business collapsed and the franchisee was held to have no recourse against the franchisor. For a franchisee with leasing obligations (it had two shops in Queen Street) this had its own risks. The franchisee proceeded to lease the premises to a competitor of Canterbury which led to the summary cancellation of the franchise agreement – an action which was upheld by the Court.

There is a reasonable argument for contending that a business concept which is critically dependent on a single contract ought not to be the subject of a franchise that purports to grant rights beyond the term of that contract.

Recovering damages based upon the represented level of profit

In two franchise cases which were decided in 2001 the High Court awarded damages to disappointed franchisees based upon the level of profit which the franchisor had represented would be earned during the course of the franchise. In both cases the Judges discounted the recoverable profit to take account of the possibility that it might not have been achieved. In the first case the discount was 30% of the represented profit and in the second the discount was 20%.

Professor McLauchlan has criticised these decisions saying that, as both of the franchises concerned were new, and as there was no established record of earnings, there was no factual basis for establishing a claim for lost profits. He said that instead, disappointed franchisees who have been misled by such representations “would ordinarily be far better advised to pursue, as an additional head of consequential loss, a claim in respect of their lost opportunity for gain elsewhere”.
It should be noted that in the first case (Imagine It) the franchisor was neither present at Court nor represented by counsel, and in the second case (Valda Video) counsel for both the franchisee and the franchisor agreed that it was appropriate to assess the claim for loss of profits based upon the level of profit which the franchisor had represented would be earned.
I was counsel for the plaintiff franchisees in the Valda Video case and the following comments are based in part upon my knowledge of the particular facts of that case.
I accept that, in general terms, the awarding of damages based upon the level of profit which a new and untested business will earn may appear to offend the principle that a plaintiff cannot recover more from an award of damages than it has actually lost.
That is not, however, the situation in a case such as the Valda Video case. There are the following distinguishing features:

• The plaintiff franchisees in the Valda Video case (Mr and Mrs Kirby) were given a single page of calculations which recorded the level of profit which they would make if they signed the franchise agreement which was offered to them by United Video. United Video was a well established franchisor with many franchised Centres and its sales representative had said in defence of the profit calculations that it was possible to predict with certainty that a store of a particular size would make profits of the sum which he represented would be made. This evidence was accepted by the Court. In general terms, all franchisors benchmark the performance of their franchisees and the franchisors are able to make a reasonable assessment of the likely level of profit of a particular franchised outlet, in a particular location. There are, of course, variables which will affect the level of profit and these include the capabilities of the incoming franchisees and unpredictable economic factors beyond the franchisee’s control. But in general, the Court will be likely to take comfort from the franchisor’s own records of comparative profitability of its other shops/centres and consider that it is not unreasonable for the franchisor to be held accountable for the level of represented profit. In the Valda Video case, there was also evidence of another Auckland franchise which was entered into at a similar time as the Kirbys signed their agreement, in which the level of profit that the franchisee actually achieved was substantially greater than the profits which the same salesman from United Video had represented to Valda Video would be earned if they acquired the franchise for that location. Such cases can be distinguished from a start-up franchise where there is no other method of assessing the likely level of profit.
• Neither Glazebrook J (in Imagine it) nor Randerson J (in Valda Video) awarded damages based upon the level of represented profit. Both made substantial discounts in recognition of the contingencies which will inevitably affect profitability. In his article, McLauchlan concedes that the damages for lost profits were “appropriately discounted to reflect the various uncertainties . . .”. (My italics.)
• McLauchlan concedes that the Courts could have awarded the damages based upon the loss of a chance methodology for assessing damages. In practice, the existence of benchmarking statistics in established franchises will often give a Court sufficient information to be able to make reasonable assessments based upon this methodology.
• A significant New Zealand authority in this area of the law is New Zealand Motor Bodies Ltd v Emslie . That case involved representations concerning the profit forecast given to a purchaser of shares. McLauchlan concedes that Barker J held that the plaintiffs were entitled to recover the difference between the value of the shares as represented and their true value, and that the Emslie decision cannot therefore be taken as a reliable base for the thesis that damages ought not to be awarded based upon the represented value of the asset being acquired.
• McLauchlan’s claim that counsel would be “far better advised” to seek the recovery of the monies which the franchisees would have made from the activities which they would have undertaken if they had not signed the franchise agreement reflects the gulf which often exists between academic lawyers and practising lawyers. The burden of proof of establishing what, for example, the Kirbys would have earned if they had not signed the franchise with United Video is, in practice, insurmountable. Few people can say for certain what they would have done let alone what they would have earned, if they had not embarked upon a particular business initiative. In most cases, the person will only have a few vague ideas about possible initiatives which he/she might have explored. The vagueness of such evidence, combined with the costs of litigation and litigation risk, make it practically impossible to advance claims of loss formulated on that basis.

Liability of director of franchisor

In the Gourmet Burger case (2000) McGechan J held that a director of the franchisor company was personally liable to a franchisee for the damages resulting from various misrepresentations. This liability was founded on sections 43(1)(d) and 43(2)(d) of the Fair Trading Act. It appears to assume that the director was “in trade” for the purposes of section 9 of that Act. Those provisions allow the Court to order a person to pay damages if he or she has engaged in conduct which would constitute “being in any way directly or indirectly knowingly concerned in, or party to” a contravention of the Act. In that case, the director was the franchisor company’s alter ego. This decision can be contrasted with a decision of the House of Lords which was reported in 1991 – Williams v Natural Life Ltd - where a director of a health food franchise was held not to be personally accountable to a franchisee for misrepresentations of projected revenues and profits. It was held that to establish the personal liability of a director or employee of a franchisor, there had to be such an assumption of personal responsibility by the person as to create a special relationship between him/her and the franchisee. In determining this, the primary focus is on things done or said by the person concerned, and the question whether it was reasonable for the prospective franchisee to rely on the words.

In Bixby’s Food Systems Inc v McKay the Illinois Federal Court found that the president of a franchisor company was personally liable for misrepresentations which he had made to a prospective franchisee. This liability was determined pursuant to section 6 of the Illinois Franchise Disclosure Act.

In this situation, at least, it appears that New Zealand has (via the Fair Trading Act) enacted legislation which improves upon the deficiencies of the common law and helps achieve what other statutory regimes have achieved.

Liability of salesman for misrepresentations

Although the House of Lords indicated in the Williams v Natural Life case that claims against a salesman would require proof of an assumption of personal responsibility by him such as to create a special relationship between him and the franchisee, the standard is almost certainly lower under the Fair Trading Act. In the Valda Video case the plaintiffs sued both United Video and its salesman and obtained judgment against both. The claim against the salesman was made under the Fair Trading Act.

The franchising of unproven concepts

The proposed legislation in Italy will require that a franchisor must have tested its own formula for at least two years through a minimum of two pilot units located in one or more EU member states before it can enter into franchise agreements. This is a sensible proposal. If it had been enacted in New Zealand, it would have saved numerous franchisees from the loss and hardship which they have suffered. Recent illustrations of franchises which have not been proven in New Zealand to an appropriate degree and which have ended up in litigation include Imagine It (a commercial property internet advertising business); a roof coating franchise; a children’s clothing franchise (Zambiino); Rapid 98 (a real estate listing service) which is presently before the Courts; and Mr Electric (an electrical services business which had been proven in the United States but not in New Zealand.)

A requirement for a franchisee to obtain independent advice

The FANZ Code of Practice requires a franchisor to ensure that a prospective franchisee obtains independent professional advice on the wisdom of entering into a franchise agreement. This is a general requirement of statutory regimes. I am aware of instances where members of FANZ have not complied with this requirement or have only partially complied with it. The situation is much worse with franchisors who are not members of FANZ. For some of these people, the notion of suggesting that a franchisee should get independent advice is abhorrent as it is likely to imperil a sale. A very bad instance of this was revealed in Jackson v Lehmann where it was held that the franchisor had acted fraudulently. If New Zealand had a statutory regime which required a franchisor to ensure that a franchisee was independently advised (as is required in the USA and Australia) there would presumably be far fewer of these cases. This is, of course, one of the main failings of the Code of Practice regime in New Zealand. It only applies to those people who belong to FANZ. Some franchisors deliberately don’t belong to the organisation and others are unable to join it. There ought to be better protection for prospective franchisees in New Zealand than this.

Covenants in restraint of trade

The Para franchise has had its difficulties. When the premises occupied by the Hastings franchisee burnt down and neither the franchisee nor the franchisor could reach agreement on re-establishing a franchise in the same territory, the franchisee surreptitiously established a competing business a short distance away. It was held that this constituted a breach of the covenant in restraint of trade.

This situation can be contrasted with the dispute relating to the Placemakers franchise at 45 Hillside Road, on the North Shore. The McNallys entered into an agreement to operate a Placemakers’ store there, with a contractual restraint from competing for three years within 50 km of the business premises (which were defined as 45 Hillside Road, North Shore). The franchisor (Fletchers) opened a new store at Albany. The franchisee operated both stores. Fletchers later closed the store at Hillside Road. The Albany store did not trade well and the McNallys wanted to go back to the premises in Hillside Road. Morris J held that it was not a breach of the restrictive covenant provisions for them to go back to the same premises:

“To try and use a restraint provision simply to protect the business of other Placemakers’ branches is contrary to public policy and illegal.

Construing clause 11.3 in context here, it is clear that clause only protects the Hillside business and its wording does not extend to prevent competition against other Placemakers’ branches. It does not extend to protect Fletchers’ goodwill in the Placemakers’ concept. The whole of clause 11 talks about efforts to preserve the business at Hillside Road. There is absolutely nothing in the clause which protects any other Placemakers’ branch . . . if such was the object of the clause, one would have thought Wairau Park (only 1 km from Hillside) would be the branch complaining, not Albany . . . The definitions set the parameters and are fatal to Fletchers’ claim for protection.”

The particular clause which is referred to in that passage – clause 11.3 – referred to an obligation not to compete in “any business the same as or similar to the business [ie the business at Hillside Road] . . .”.

Fletchers did not allocate territorial franchises and the suggestion that it had to continue a franchised business from the precise address at which the franchised business operated – during the full length of the term of the agreement (and any renewals) to get the benefit of a restrictive covenant – seems odd, and contrary to principle. While the wording of this contract was capable of being interpreted to achieve that end, it is clearly desirable that contracts should be worded in ways which provide a more meaningful contractual restraint.

Restrictive covenants were in dispute in the Safety Step litigation. The franchisor of the Safety Step franchise (a business which provided anti-slip products) terminated the agreements of its franchisees. They subsequently re-badged and continued to operate similar businesses. In response to the franchisor’s claim that this was a breach of their restrictive covenants, the franchisees contended that as the franchise agreements had been cancelled, they were no longer bound by the covenants. Randerson J held that they were, and based his decision on the wording of their contracts and the provisions of section 8(3) and 9 of the Contractual Remedies Act.

In a slightly different context, the vendor of two pizza businesses which were subsequently incorporated into the Eagle Boys franchise, and who had entered into a three year nationwide restraint as part of the terms of sale, was held to be bound to that restraint which Anderson J said “are presumptively not unreasonable”.

Liability of master franchisor for representations

The Dwyer Group was the US owner of the Mr Electric franchise (a franchise which was concerned with the right to sell, service and repair electrical equipment etc). It entered into a master franchise agreement with the Contractor Success Group in New Zealand to sell the franchises here. Six of the seven businesses collapsed and five of the former franchisees sued CSG, its director, and the Dwyer Group. The Dwyer Group objected to the jurisdiction of the New Zealand Courts and there was a contest as to whether there was a “good arguable case” against the US master franchisor. The promotional materials which were given in New Zealand to the franchisees contained such statements as this:

“As a Mr Electric franchisee, you are part of a worldwide network of businesses backed by the corporate strength of The Dwyer Group, the world’s premier service business franchisor.”

Dwyer was described as the franchisor in the disclosure document and the franchisees were told that they would be getting its support and expertise. Despite the existence of these, and other relevant representations, it was held that there was not a “good arguable case” against the Dwyer Group. In reaching this decision, Goddard J distinguished Donut King Australia P/L v Barter [1999] SASC 241, where the Supreme Court of South Australia had held that a master franchisee’s role inherently involved making binding representations on behalf of the franchisor as to the profitability and success of the franchise and the Federal Court of Australia’s decision in Aims Computer Systems Pty Ltd v IPC Corporation [1996] 847 FCA1 where a Singaporean master franchisor was held liable for representations. Two directors of the Singaporean company had expressly authorised the managing director of the master franchisee in Australia to make various representations and these were found to come within the section of the Trade Practices Act which corresponds to s.45(2)(b) of the Fair Trading Act. The Dwyer Group fared well from this decision which some will think gave an unduly favourable degree of assistance to the US master franchisor.

The Burger King case illustrates alternative ways by which a franchisor may be liable to a franchisee. One of the franchisee’s employees co-operated covertly with Burger King and for this Burger King was held to be liable as an accessory for the breach of confidence by the employee.

Breach by franchisee – significance of acceptance of royalties

When disputes arise between franchisors and franchisees the franchisor commonly wants to continue to receive royalties but there are perils in doing so. It was held in the Burger King case that the franchisor’s acceptance of royalties constituted a waiver of its right to complain about breaches of agreement by its master franchisee.

Misrepresentations concerning turnover etc

Franchisors who provide projections to prospective franchisees not only have to be careful about what they say but also about what they don’t say. In the Gourmet Burger case McGechan J held that the franchisor’s conduct towards a prospective franchisee’s accountant was misleading more in the way in which information was withheld, and in what was not said, than in what was said. Half truths and silence can also constitute misleading conduct.

Agreements

If the terms of an agreement do not define a franchised territory with sufficient precision the “agreements” may be avoided on the grounds of uncertainty. This is what occurred in the Jackson case concerning the franchisee’s use of a roof painting compound.

An unusual decision relating to franchise agreements concerned a franchisee who re-typed the text of a franchise agreement and made some surreptitious changes which were not identified to the franchisor (Caltex). It was held by Nicholson J that the modification of a lengthy document by a franchisee without informing the franchisor of the changes was capable of constituting misleading conduct.

Disclaimers

Virtually all franchise agreements contain disclaimers by which franchisors try to exonerate themselves from liability for misrepresentations. In the Kinsman case it was held that the franchisor was liable for misrepresentations, notwithstanding the existence of a clause which contained a disclaimer and a statement that interested parties should rely on their own enquiries. Rodney Hansen J said of the disclaiming clause that “it was overwhelmed by subsequent oral assurances”. In a similar way William Young J held in the Stirling Sports decision that where a standard form agreement contained a clause in which a franchisee purported to acknowledge that in the negotiations which had preceded the signing of the agreement he had read the provisions of it, had understood them, and had not relied on any statements, representations, inducements etc.

“It is not unreasonable . . . for franchisors such as SSFL to set out to protect themselves from such allegations. In this context, I would have difficulty generally with the franchisor such as SSFL excluding liability in relation to the sort of claims which it now faces.”

It was said that the clause which stipulated that the franchisee had “carefully read the provisions of the agreement” had “understood them” and “not relied on any representation” etc was in effect a lie. It was “simply part of the boiler plate in what is quite a lengthy agreement” and that “potential franchisees might be expected to read it with glazed eyes”.

“If clause 33 had been drafted differently and had been brought specifically to the attention of the [franchisee] earlier, I would have had no difficulty in upholding its validity . . . Where a franchisor . . . wishes to exclude liability it will be well advised to do so in a way which involved a genuine interaction with the potential franchisor and after a process which identifies what, if any, representations have been made and are regarded as being important by the potential franchisee. Such process should serve, in most cases, to identify the extent to which the franchisor is in fact warranting the accuracy of information provided . . .”.

“Franchisors will, I think, have to recognise the reality that if they do not tailor their agreements to the facts as they actually are then they will later struggle to uphold exclusion of liability provisions.”

Trial procedures – exclusion of parties from the courtroom

In the Snap-On litigation the plaintiffs were a number of former franchisees, each of whom had separate claims against the franchisor. The franchisor sought to exclude from the courtroom those plaintiffs who had not yet given evidence. Heath J held that, while the Court had jurisdiction to exclude witnesses who were parties, it was not necessary to exclude the plaintiffs since the current practice of providing evidence by written briefs in advance of a trial had the consequence that they were pre-committed to their evidence. In the Kwik Kopy litigation Laurenson J made it clear to the franchisee plaintiffs that notwithstanding the Snap-On decision, and the fact that they had already provided their briefs of evidence to the franchisor, it would be in their interests if they left the Court until they were called upon to give evidence. In the light of the indications which were given concerning the weight which the Court would attach to their evidence if they did not do so, this suggestion was adopted.

Relief – return of customer details

In the Safety Step litigation the franchisee was required to return material supplied by the franchisor. To the extent that the franchisee had generated customers through its own efforts, the Court held that it was entitled to keep those details.

Relief – injunction to vacate premises

In the Zambiino litigation the franchisee had re-branded and the franchisor failed in its application to stop the former franchisee from continuing to operate from the same premises, with the same type of business but under the new name. One factor which appears to have influenced the Court in deciding not to order the franchisee to leave the site was the existence of its leasing commitments. Another was a concern that the franchisee had not obtained access to commercially sensitive information.

Relief – arbitration clauses

A standard technique to deter disputes with the weaker party to a contract is to have a dispute resolution clause requiring arbitration or litigation in a foreign jurisdiction. In the Denny’s litigation the franchisor had stipulated for disputes to be resolved by arbitration in Hawaii. The arbitration clause was held to be enforceable.

Relief – general damages

General damages are sometimes overlooked in the formulation of claims for damages. It was pleaded in the Gourmet Burger case and each plaintiff received an award of $7,500 for general damages for stress.

Relief - damages

The Burger King case was the most instructive of the recent cases for the diversity of claims of loss which could be claimed. Compensation was awarded to the master franchisee for damages for loss of opportunity to open new franchises over a period of forty years (on the assumption that a 20 year franchise term would ordinarily have been renewed); for an inability to introduce third party franchisees; for loss of service royalties at restaurants opened by the franchisor; damages were recovered for stores opened by the franchisor in three states contrary to an agreement with the master franchisee; but exemplary damages/additional damages in equity were denied on the basis that the awards which were made in favour of the master franchisee were adequate.

Incompetent franchisees

I am aware of recent instances where franchisors have had their business taken from beneath them by their franchisees. In two cases this occurred where the franchisor was less skilled than some of its franchisees and the human dynamic in such situations leads to an inevitable outcome that the latter will prevail. In another case, the franchisor was unlucky to have attracted as a franchisee a person who would stop at nothing to intercept the franchise for himself. These instances heighten the importance of franchisee selection and the need for prospective franchisors to have a sufficient degree of competence to be able to manage their franchised systems well. Too often the establishment of franchises is perceived as an easy pathway to wealth but franchising is not like that and those who embark upon it with that perception are likely to be disappointed.

Conclusions

In my assessment, the most significant development during the last two to three years has been the judicial recognition that franchise agreements are relational contracts with obligations on the part of both parties to act in such a way as to work towards the success of the franchised business.

This, in combination with the adoption of the “good faith” doctrine, is likely to prompt the Courts to interpret obligations in franchise agreements in a somewhat different light, and particularly from the perspective of two parties who have agreed to work together for their collective good.

Next in importance is the Privy Council decision in Dymocks that franchisees cannot go on “strike” as Hammond J described it. They are either in the franchise or out of it and tactical posturing to suggest they are in, when in substance they are out, is unlikely to deceive the Courts.

So far as statutory intervention is concerned, I suspect it is only a matter of time before it occurs. The most significant statistics are these:

• The last survey of franchising in New Zealand revealed that 77% of franchises sold here originated within the country. Many of these are small, unsophisticated operations.
• Approximately two-thirds of New Zealand franchisors do not belong to FANZ.

The world’s most famous franchisor, McDonald’s, does not belong because it disagrees with FANZ’s dispute resolution policies. Some other highly reputable franchisors do not belong for the same and other reasons. But there is an unsettlingly large body of franchisors who are either ignorant of the protocols which have been developed to rid franchising of bad practices, or who are unwilling to comply with them. This presents a reasonably strong case for reform – even if that reform consists only of the implementation of a statutory Code of Practice of the type which has been developed by FANZ, or of the type which has been required in Australia by the amendments to the Trade Practices Act.

I suspect that in the absence of that type of change, there will continue to be a steady stream of franchising disputes which responsible journalists will want to report, and whose reports will harm the interests of all franchisors; and that many people who sign up for franchises without having the benefit of the kind of safeguards which members of FANZ all agree to be essential, will suffer unnecessary worry, stress and financial loss.