“Aspects of damages in franchise disputes” which was delivered at a LexisNexis conference on commercial litigation in June 2005.

Misrepresentations concerning profitability
1. One of the most popular areas of dispute in franchising relates to representations concerning future profitability. Franchisors, being keen to attract franchisees, attempt to over-sell their product and franchisees, being keen to secure a profitable business, can be gullible recipients of such information.

In the traditional Common Law world there are broadly two methodologies for assessing loss in such a situation: the tort measure of loss and the contract measure of loss . The latter permits the recovery of anticipated profits while the former does not.

New Zealand

2. Although there is some uncertainty in saying this, the current position in New Zealand appears to be that a franchisee can recover loss on the contractual methodology, and is entitled to recover not only his or her capital investment and out-of-pocket expenses, but also a significant percentage of the profits which have been represented by the franchisor.

The New Zealand approach can be illustrated by a brief summary of three cases.

(a) New Zealand Motor Bodies v Emslie [1985] 2 NZLR 569

The plaintiff bought shares in a Company in reliance on the defendant’s budget forecasts which predicted that the Company would make a particular level of net profit during the course of a 6 month period. The plaintiff was awarded compensation for its out-of-pocket expenses, but did not make a claim for loss of profits. Barker J thought this was “rightly so” as the representation was not a warranty that the business would achieve the specific levels of profitability but was instead a representation that there was a reasonable factual basis upon which the projections could be made.

(b) Imagine IT No 1 Ltd v Nexus Waikato Ltd

The plaintiff franchisee Company and its directors alleged that they had been induced to enter into a franchise agreement by pre-contractual misrepresentations concerning the level of profit which would be earned in the first and second years of the business. In a claim under the Fair Trading Act, the plaintiff recovered the costs which it had incurred with its initial investment in the franchise, the set-up costs, trading losses, and interest on those sums.

A percentage of the represented profit was recovered in a claim which was made under the Contractual Remedies Act. Glazebrook J commented that “the misrepresentation is that the current state of affairs indicates that a profit in the region of the sum given may reasonably be expected.” This representation was treated as a contractual term for the purposes of the Contractual Remedies Act and the plaintiff succeeded in a claim for lost profits, trading losses and interest.

(c) Valda Video Ltd & Others v United Video Franchising Ltd

The plaintiff franchisee was induced to enter into a franchise agreement by a representation that the franchised business would have a weekly turnover of $10,000. The business struggled to realise half of this projection. The plaintiff made a successful claim under the Contractual Remedies Act for trading losses, loss of profits, capital losses, and interest.

It was held that the representations concerning profitability had induced the plaintiff to enter into the contract and that the plaintiff was entitled to expect that there was a proper factual foundation for the representation that the business would achieve the represented weekly turnover of $10,000.

Pursuant to s 6(a) of the Contractual Remedies Act the plaintiff was entitled to be put into the position which it would have been in if the contract had been performed. It was accordingly entitled to recover its lost profits and trading losses - but not both the lost profits and the loss of capital value of the business. The latter restriction was based on the decision in Herbison v Papakura Video [1987] 2 NZLR 720, and was supported by similar cases in Australia which are discussed later in this paper. The Court reduced the level of recoverable profits by 20% to take account of the risks to which the franchised business would have been subjected.

In a separate claim the proprietors of the plaintiff Company were held to be entitled to recover a monetary sum for the value of their time and labour that had been spent on the business and for which they had not been remunerated.

3. As noted in my seminar, CLE Franchising Update 2003, Professor D W McLauchlan has criticised the recovery of the represented profits in both Valda and Imagine It. The crux of his critique is based on the English authority of Esso Petroleum v Mardon. It was said in that case that the representing party does not warrant a particular level of profit but merely warrants that there is a reasonable factual basis for the making of the predicted level of profits.

4. McLauchlan proposed that plaintiff franchisees 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. They might be able to establish that, but for the misrepresentation, they would at least have maintained the status quo (for example, continued their existing employment or business) or even that they would have entered into a different transaction which would have yielded the equivalent of the profits expected from the wrongfully induced contract.

5. Since Valda and Imagine It, New Zealand has seen only one case dealing with this issue: Coburn & Leeming v Newport & Ors, (“Coburn”). Coburn concerned two separate proceedings against the same franchisor. They were heard together. The franchisor’s agent had, among other things, represented to potential franchisees that one of the directors of the franchisor had operated as a sole trader in Christchurch and the agent provided them with fictitious sales figures for a period when the business was said to have been in operation. The franchisor made a false representation that he had established an exclusive network of nationwide contracts when such arrangements were either non-existent or, at best, they had not been the subject of any formal agreement.

6. The franchisees recovered damages for loss of profits in a claim under the Contractual Remedies Act. The profits were assessed as being the difference between the net income which would have been derived from the contracts if the representations had been true, less the income which the franchisees had in fact obtained by from those sources. The sum was discounted to recognise the difficulties which any new business encounters in its first few weeks of trading.

7. Trading losses, which were described as the cost of the franchisee’s labour in soliciting new contracts, were also awarded for a time.

8. The plaintiffs were held not to be entitled to recover the loss of their capital investment when, with full knowledge of the misrepresentations, they had declined to sell their businesses back to the franchisor, albeit at a price which would have produced a significant loss.

9. Durie J referred to the difficulty of recovering lost profits in a claim under the Fair Trading Act. The two plaintiff franchisees had acquired their franchises after being led to believe that the businesses which they would operate would obtain work from contracts which had been entered into with all major motor companies and nationwide suppliers. The loss in terms of labour, as identified by Durie J, was not that the clientele did not exist but the fact that the plaintiffs had been led to believe that the work did exist. This loss was materialised in the labour which the plaintiffs were required to spend to generate sufficient business to keep the Company afloat:

The fact that the business was not there, contrary to the representations made, caused only the lower return. The claim to a higher return can depend only on the promise of a higher return, enforceable only by a claim in contract, if such a claim was or could be made. I therefore hold that the claim for loss of profits is not recoverable under the Fair Trading Act in this case.

10. The Judge then referred to the circumstances when lost profits may be recoverable under the Fair Trading Act:

It does not follow that a claim for loss of profits cannot be recovered under the Fair Trading Act under any circumstances. For example, if in this case, it were established that the business had been there but the defendants had taken it away, or the defendants had prevented the plaintiffs from accessing it, for example by failing to make the necessary introductions, then the profit loss would have been caused by that conduct and a loss of profits would have been recoverable.

Proving the value of lost opportunities

11. Professor McLaughlin’s suggestion that franchisees should not obtain damages for loss of profits but should seek recovery of the sums which they would have earned or received if the franchise had not been entered into will in all but exceptional circumstances be a wasteful exercise which will not only result in failure but will incur a liability to pay costs to the franchisor. As practitioners in this area of the law will know, it is usually impossible to prove what a plaintiff would have earned but for the fact that he/she/it had entered into an unsuccessful franchise.

12. These difficulties are recognised by judicial statements and dicta from abroad.

(a) The Canadian Supreme Court dealt with this issue in Rainbow Industrial Caterers Ltd v Canadian National Railway. The case concerned a tender contract for the preparation and delivery of meals for CNR staff. CNR represented that a much greater number of meals would be required than was actually required. As a consequence Rainbow made a loss on the contract. The Supreme Court upheld the trial Judge’s award of $1,000,000 for loss of profits. However, the profit that could have been made on alternative contracts had Rainbow not entered into the CNR contract were held to be too remote a loss to be attributed to the misrepresentation.

While the authority is not specifically related to franchise contracts, this principle has been applied in numerous Canadian cases brought by franchisees claiming loss of profits.

(b) In Anema E Core Pty Ltd v Aromas Pty Ltd, the Federal Court of Australia held that because the plaintiffs were unable to specify the precise opportunity which had been lost, it would not make an award of damages for the loss of a chance to invest elsewhere.

(d) In More than Meats (Forest City) Inc v 1058335 Ontario Inc and David Frey, the loss of income which the franchisee would have earned if she had not resigned from her job to enter the franchise was held to be “too remote” a head of damage for her to recover.

(e) In Haynes v Top Slice Deli Pty Ltd, the plaintiffs sold a sheep shearing business and entered into a franchise for a delicatessen business. A claim for damages for the profits which would have been earned from the sheep shearing business was rejected by the Federal Court of Australia which said:

Such damages are frequently impossible to calculate in a manner which tends to a realistic practical result.

The Court was not convinced that the plaintiffs had been induced to leave their business by the representation and it conjectured that the plaintiffs had been intent on leaving the shearing industry and buying a new business in any event.

Thus, even in a situation where a plaintiff had foregone a concrete income earning opportunity, as opposed to a hypothetical one, the loss of opportunity to earn the calculable profits was regarded as too difficult to predict.

Recovery of lost profits – an international perspective

England

13. The Courts in England tend to assess damages in such circumstances by the tort measure of recoverability. The leading case of Esso Petroleum v Mardon still holds sway and is the basis for more recent decisions on this subject. Esso had misrepresented the volume of petrol which was likely to be sold from a petrol station which would be leased to Mr Mardon. The Court of Appeal declined to assess damages by reference to the forecast volume of sales. It said that the representations concerning the volume of petrol which would be sold at the site had been made with due care, on reasonable grounds, and Esso had not warranted that a specific level of profit would in fact be achieved. Mr Mardon was accordingly entitled to recover the costs which he had incurred in entering into the tenancy agreement, together with the set-up costs of the business.

14. Mardon was applied in Clark Goldring & Page v ANC Limited . In that case a franchisee had been induced to expand its franchise territory after representations from the franchisor and in particular, a representation of a ‘pro-forma profit and loss account’ which the franchisor had prepared. Following Mardon it was held that the representation warranted only that the document had been created with due care and skill and was based on accurate information. It was held that there was no entitlement to recover for lost profits.

Canada

15. The Ontario Superior Court of Justice purported to follow Mardon in Murray v TDL Group . In this case it was said:

In essence then, the plaintiffs would be entitled to be put in the position they would have been had they not entered into the contract. … The measure of loss is therefore the plaintiffs’ loss rather than the contractual expectations measure.

The Court proceeded to qualify this principle by stating:

However, that loss is interpreted broadly to include loss of the opportunity to earn from other sources.

16. In the same year, the Ontario Supreme Court in Machias v Mr Submarine Limited stated that the ‘starting point’ for assessing damages in such a claim is to consider the represented profit and return on the plaintiff’s investment.

17. The British Columbia Supreme Court granted expectation damages for misrepresentation in a franchise contract in Miller v Edelweiss International Franchise Group. The franchisee had entered into a contract on the strength of representations that there was no competition in the surrounding Mall; that the store from which the franchise would operate had been well-run and would do better under an owner-operator; that the franchisee would realise a certain level of turnover and profit; and that the lease of the premises was for 10 years with a right of renewal. The franchisor did not disclose that it was aware that a local supermarket was setting up in direct competition with the franchise; that the lease for the premises from which the franchise would be operated had only 20 months to run; that entitlement to renew the lease was dependent upon the level of the previous year’s sales; and that the business had not maintained a sufficient level of sales to ensure the renewal of the lease.

18. The Court found that the franchisor’s behaviour constituted both contractual and negligent misrepresentation. Owen-Flood J when discussing the different approaches to contractual and tortious damages cited the Supreme Court of Canada:

Contract is normally concerned with ‘expectation’ damages while tort is concerned with ‘reliance’ damages. The denial of ‘expectation’ or ‘loss of bargain’ damages in a misrepresentation case … will occur when it is concluded, for example, that but for the misrepresentation, no contract would have been entered at all; this was the situation that the Court found in Rainbow Industrial Caterers Ltd v Canadian National Railway Company… The Rainbow assessment of damages can obviously lead to a different quantum of damages because this method frees the parties from the burden or benefit of the rest of their bargain. The assessment of damages in a Rainbow situation could be lower or higher than the contract damages depending on whether the contract was a good or bad bargain.

19. Owen-Flood J distinguished the facts of the case from Edelweiss. The misrepresentations which had been made in Edelweiss were made for the purpose of inducing the plaintiff to enter into the contract, but they also had the effect of materially misleading the plaintiffs as to what it was due to receive under the terms of the contract. Because of the misrepresentation, the franchisee did not get what was bargained for and it was permitted to recover expectation damages for loss of profits, over and above the recovery of wasted capital expenditure.

Australia

20. The measure of recoverable damages in Australia in claims made under the Trade Practices Act is governed by section 82 of that Act. This section permits the recovery of the loss or damage which has been sustained by the conduct of another person in contravention of the Act. There is no stated limitation on the kinds of loss which are recoverable under the Act. By s 87 the Court can make any order which it thinks appropriate to compensate the person who has been wronged.

21. The prima facie measure of damages for a franchisee who has been the subject of misrepresentations is the difference between the purchase price which it has paid for the franchise and the fair value of the business at the time of purchase. If additional loss can be proved to exist, and to have been caused by the misrepresentation, that loss will also be recoverable. For example, in Thompson & Anor v Ice Creameries of Australia, the franchisees were able to surmount the huge practical difficulties or proving what alternative money they would have earned if they had not entered into the franchise and obtained recovery for this loss. It is worth noting that it was said in this case that the Courts must not provide compensation for damages which do not arise directly from the misrepresentation, but are more attributable to some intervening cause such as the folly, error or misfortune of the franchisee since the franchisor is not an underwriter of the franchisee’s commercial performance.

22. The Australian Courts have developed their own approach to the assessment of compensation where representations have been made about levels of profitability. The prima facie measure of damages is the difference between the contractual purchase price and the actual worth of the business at the date of purchase. In the view of the Australian Federal Court, this measure of damages recognises the misrepresentation about the level of profits.

23. This point was illustrated in the case of Carlton v Pix Print Pty Ltd. The plaintiff had been induced to (a) enter into a master franchise agreement and (b) buy a franchise by a series of representations regarding the demand for franchises, in a particular geographic area; the alleged reliability of royalty payments which would be paid to the master franchisee; and the likely profitability of the franchise business. The Court stated:

The difference between the price paid and the value of the business at acquisition date … is to be assessed ‘according to what price freely contracting, fully informed parties would have offered and accepted for it’ . . . [T]he value of a business at acquisition date will ordinarily be a reflection of its future profitability.

And further:

Once it is realised that that value of the business reflects future profitability, it is difficult to see any justification for allowing a further sum calculated by reference to the anticipated profitability of another, unidentified business.

In Carlton, it was held that the value of the business with no chance of future profitability was nil. As such, it was said that the return of the purchase price would adequately cater for the misrepresentation as to profitability and the trading losses.

24. A similar calculation was applied in Neilson Investments (Qld) Pty Ltd v Spud Mulligan’s. In that case it was also held that recovery for the loss of a chance to earn an income elsewhere was ‘inappropriate.’

25. As to compensation for unrewarded labour, the Court in Carlton granted the plaintiff franchisee a small sum to recognise the hours which had been worked in excess of what a reasonable business owner would expect to work - the excess being ‘caused’ by the misrepresentation.

26. The awarding of interest on the level of capital loss was considered to be adequate recovery for the loss of a chance in Jaques v Cut Price Deli Franchising Pty Ltd. The award of interest recognised that the franchisee could have applied its capital investment elsewhere for gain. This decision was upheld on appeal. .

Exemplary Damages

27. The Coburn case raised the question of entitlement to exemplary damages. In that case the franchisor had, among other things, provided financial projections which had been deliberately falsified. Durie J articulated what appears at first sight at least, to be an unusual methodology for dealing with claims for exemplary damages in such cases. He stated that one must look first at the appropriate level of exemplary damages for the conduct concerned. The next inquiry is to consider the level of compensatory damages which the representor will be liable to pay. The former should be weighed against the latter to consider whether it is appropriate to require the payment of exemplary damages.

28. Durie J assessed the appropriate level of exemplary damages at $50,000. Since this figure exceeded the compensatory damages which the franchisor would be liable to pay he declined to make an award of exemplary damages, on the basis that to do so would exceed the appropriate level of punishment. In fairness to the Judge it should be added that it appears from the judgment that this topic was not the subject of detailed submissions.

Exclusion Clauses

29. In Miller v Edelweiss International Franchise Corp, the British Columbia Supreme Court discussed the effect of an exclusion clause or an entire agreement clause which purported to exclude liability for any representations which had been made during the negotiation of a franchise agreement. Quoting from the British Columbia Court of Appeal, Owen Flood J stated:

If the exclusion clause is part of a standard form contract of adhesion it will not operate to exclude liability in contract in the face of an explicit representation which induced the making of the contract. In those circumstances the more specific term, namely the explicit representation will prevail.

30. And further:

If the misrepresentation … concerned a point of substance, such that if it had been known the representation was false at the time it was made, then it might reasonably be supposed that the party to whom the representation was made would not have entered into the contract, then the exclusion clause is no defence for the person making the misrepresentation.

31. In another Canadian Case the existence of an exclusion clause was held not to exclude liability for a franchisor’s misrepresentations because, so it was said: “a franchise agreement is not your usual agreement of purchase and sale.” The Ontario Supreme Court of Justice implied that a duty of upmost good faith was incorporated into purchase agreements of this kind, and that this duty required the full disclosure to prospective purchasers of potential difficulties which might arise during the course of a franchise agreement.

33. The New Zealand Courts have not yet had the opportunity to consider whether exclusion clauses in franchise contracts should be defeated on this rationale.