ACCORD Infobrief: The Franchising Code of Conduct

Franchising and Co-operatives – The Franchising Code of Conduct

© 2002 Stephen Giles, Fiona Wallwork. This publication is copyright. Except as permitted under the Copyright Act 1968 (Cth) no part of this publication may be reproduced by any process, electronic or otherwise, without the specific permission of the copyright owners.

The Authors

Stephen Giles is a partner with Deacons, practising in the Sydney and Melbourne offices and specialising in franchising, trade practices and commercial law. He is co-author of Giles Redfern & Terry - Franchising Law & Practice, co-editor of Franchising Law & Policy Review and author of the franchising section of The Australian Encyclopaedia of Forms and Precedents.

Stephen is National Chairman of the peak industry body, the Franchise Council of Australia, and handled all negotiations with Government concerning the introduction of the Franchising Code of Conduct and the 1998 changes to the Trade Practices Act.

Stephen has a long history of dealings with cooperatives, including 7 years as a director of a large community credit union in Victoria. He has provided advice to many cooperatives on intellectual property, commercial structure, distribution, licensing, constitutional issues and franchising.

Fiona Wallwork is a Senior Associate in Deacons' Sydney office. Fiona's main areas of practice include franchising and distribution, and trade practices and competition law. Fiona has extensive experience in the franchise sector specialising in commercial and compliance issues for a wide range of Australian and international franchisors. Fiona is an Accredited Franchise Executive (through the Franchise Council of Australia).

INTRODUCTION

1. WHAT IS FRANCHISING?

“We are not a franchise. We are a cooperative!!”

I have heard this comment a thousand times, usually spoken with a considerable degree of passion.

However the fact is that since the introduction of the Franchising Code of Conduct the term “franchise” now has a much more broad meaning. Despite the protestations many cooperatives are clearly franchises for the purposes of the Code.

This is not just an extension of the law. The fact is that many cooperatives are now more sophisticated than they once were, with a significant involvement in trade and commerce. Members of groups seek more than just the bare right to use a trade mark or name, and have awoken to the power of branding in a network. Cooperatives are commercially closer to franchise networks than once may have been the case.

When people think of franchising they think of McDonalds or Jim’s Mowing. However today the term “franchising” describes a wide range of different practices of varying degrees of sophistication. In general terms franchising is an ongoing business relationship where one party (the franchisor) grants to another (the franchisee) the right to distribute goods or services in accordance with the franchisor’s system or marketing plan and using the franchisor’s trade mark or brand name in exchange for a fee.

In practice these features of franchising are often supplemented by other activities such as group purchasing, some form of market segmentation and a range of services provided by the franchisor, including training. The more sophisticated franchise arrangements specify a precise business format under which the franchisee is expected to carry on business, ensuring a common customer experience throughout the network.

Common features of a franchise are a term for a limited duration (5-10 years is the industry average), a territory or region within which the franchisee is authorised to trade and various group purchasing and marketing activities. The fee structure varies depending on the value of the brand and the nature of services provided by the franchisor. Typically, the franchisor will collect an initial fee (which is usually used in part for the cost of training and inducting the franchisee) and a continuing franchise fee (which is usually a % royalty of turnover but may be a flat fee, or fee incorporated in the price paid for products).

I appreciate that cooperatives come at the field of trade and commerce from a different angle, and that profit is not the sole or even the dominant motivator in many cases. The culture of cooperatives is much more egalitarian and different to a pure franchise network, and there is usually much more focus on member benefit. However the dividing line between a cooperative and a franchise network is becoming more blurred, and the Federal Government found the distinction too difficult to draw in drafting the Franchising Code of Conduct.

I also invite delegates to consider that there is no longer a stigma that attaches to franchising. Franchising in Australia has developed into a dynamic business activity. It is a proven business method, which has penetrated most industry sectors.

The Franchising Australia 1999 survey found that there are a total of 747 franchise systems in Australia, and the total turnover of all franchise systems in Australia in 1998/99 was $76.5 billion. There are 49,400 franchised outlets in Australia, and approximately 652,000 people are employed in the franchise sector.

2. THE FRANCHISING CODE OF CONDUCT

The Franchising Code of Conduct (the Code) was introduced on 1 July 1998 and became fully operational on 1 October 1998. It is a mandatory industry code prescribed under section 51AE of the Trade Practices Act 1974 (TPA). Section 51AD of the TPA gives legislative effect to the Code, by providing that a corporation must not, in trade or commerce, contravene an applicable industry code. The Code is administered by the ACCC.

The Code regulates those franchise arrangements that fall within the Code’s definition of a “franchise agreement”. The Code’s definition of “franchise agreement” is the principal definition that should be considered when considering the sort of distribution or supply arrangement that is required or is to be achieved.

The definition of “franchise agreement” is contained in section 4 of the Code and is defined as an agreement:

(a) that takes the form, in whole or part, of any of the following:

(i) a written agreement;

(ii) an oral agreement;

(iii) an implied agreement; and

(b) in which a person (the franchisor) grants to another person (the franchisee) the right to carry on the business of offering, supplying or distributing goods or services in Australia under a system or marketing plan substantially determined, controlled or suggested by the franchisor or an associate of the franchisor; and

(c) under which the operation of the business will be substantially or materially associated with a trade mark, advertising or a commercial symbol:

(i) owned, used or licensed by the franchisor or an associate of the franchisor; or

(ii) specified by the franchisor or an associate or the franchisor; and

(d) under which, before starting business or continuing the business, the franchisee must pay or agree to pay to the franchisor or an associate of the franchisor an amount including, for example:

(i) an initial capital investment fee; or

(ii) a payment for goods or services; or

(iii) a fee based on a percentage of gross or net income whether or not called a royalty or franchise service fee; or

(iv) a training fee or training school fee;

but excluding:

(v) payment for goods and services at or below their usual wholesale price; or

(vi) repayment by the franchisee of a loan from the franchisor; or

(vii) payment of the usual wholesale price for goods taken on consignment; or

(viii) payment of market value for purchase or lease of real property, fixtures, equipment or supplies needed to start business or to continue business under the franchise agreement.

Section 4 expressly includes a motor vehicle dealership agreement as a franchise agreement but excludes:

an employer and employee relationship;
a partnership relationship;
a landlord and tenant relationship;
a mortgagor and mortgagee relationship;
a lender and borrower relationship; and
the relationship between the members of a co-operative that is formed under the Corporations Law or any of the state Co-operatives acts.

There are further exceptions under section 5, specifically where the franchisor is resident outside Australia and only grants one franchise or master franchise to be operated in Australia, or where the franchise agreement is for goods or services substantially the same as those previously supplied by the franchisee and the sales under the franchise are likely to provide no more than 20% of the franchisee’s gross turnover. These arrangements will not fall within the ambit of the Code.

3. THE COOPERATIVES EXEMPTION

At first glance the exemption for a cooperative appears to provide the perfect out. However this is not correct, and for most practical purposes the exemption is irrelevant.

It is important to study the precise wording of section 4(3)(f), which says:-

“However any of the following does not in itself constitute a franchise agreement:

(f) the relationship between the members of a cooperative that is registered, incorporated or formed under….(the various State and Federal laws).”

All the exemption says, in lay terms, is that the mere act of setting up or operating a cooperative will not establish a franchise agreement. However it is in my view clear that any cooperative that goes beyond this step will immediately fall to be considered under the definition. In short, a cooperative that charges fees to members, has a name or trade mark used by members and some sort of system or marketing plan needs to carefully consider whether they will be caught by the Code.

Those cooperatives that rely on their Constitution or Articles of Association, or perhaps even long standing practice, to grant rights of use are in no better position, as the Code extends to verbal and implied arrangements.

4. INTERPRETATION OF THE DEFINITION OF FRANCHISE AGREEMENT

Overview

The Code’s definition of “franchise agreement” is extremely broad and captures a wide range of distribution and supply arrangements not traditionally considered to be franchises. As a consequence, there has been some judicial consideration of the definition in circumstances where companies have sought to avoid the mandatory operation of the Code.

Agro Holdings Ltd v Flex-coil (Australia) Pty Ltd

Although the Agro Holdings Ltd v Flexi-coil (Australia) Pty Ltd case was interlocutory in nature, it is useful as an indication of the view that a court may take when interpreting the definition.

The case arose out of an application for an interim injunction restraining the Respondent from terminating or acting on notices of termination of a dealer agreement. The dealership was in respect of non-motorised agricultural equipment. As such, Nicholson J considered whether or not the dealer agreement satisfied the criteria in clauses 4(1)(b), (c) and (d). In doing so, Nicholson J took into account that the requirements of clause 4(1) are cumulative.

In relation to clause 4(1)(b), His Honour found that there was no proof that a marketing plan was provided to the applicant at the outset of the relationship. The provision of marketing material, sales manuals, service operator manuals, price books and spare parts by the Respondent suggested little more than that the parties were partners in promotion. Further, there was no express reference to a system or marketing plan in the dealer agreement.

In relation to clause 4(1)(c), the Respondent submitted that there was no right or licence granted to the Applicant to use the Respondent’s trade marks, advertising or commercial symbols. Further, there was no obligation on the Applicant to display any signs, hats or flags and nor were the Applicant’s staff required to wear any special uniform or endorsed clothing. However, the Applicant did in fact purchase and display at the business premises neon signs and other promotional material bearing the Respondent’s name and was supplied with the Respondent’s corporate clothing for its staff.

In relation to clause 4(1)(d), there was no evidence of any fee or payments being made under the Dealer Agreement despite the Respondent providing training to the applicant.

His Honour found that it was unlikely, on the evidence, that the dealer agreement would satisfy the cumulative requirements under clause 4(1) and therefore would not be characterised as a franchise agreement for the purposes of the Code.

Subway Systems Australia P/L v Thorpe

In Subway Systems Australia P/L v Thorpe the applicant sought an order to strike out those paragraphs of the respondent’s amended defence and counterclaim that relied on allegations that the Subway Development Agency Agreement was a “franchise agreement” under the Code.

Under the Development Agency Agreement the respondent was appointed for a particular territory to set up Subway sandwich shops and to secure franchisees for those shops.

In that case His Honour took the view that the Development Agency Agreement did not confer “the right to carry on the business of offering, supplying or distributing goods or services under the Subway name” within the meaning of sub-clause (b) of the definition. Rather, the agreement granted the right to provide services to the applicant or its franchisees on behalf of the applicant. When considering sub-clause (c), His Honour took the view that various policies set out in the Development Agent Manual, the Operations Manual and weekly newsletters constituted a “system or marketing plan”.

Enviro Systems Renewable Resources v ASIC

In Enviro Systems Renewable Resources v ASIC the court considered both the definition of franchise agreement under the Corporations Law and the definition of franchise agreement under the Code. The case arose out of an application by Enviro for a declaration that a scheme in which it invited investors to participate in the growing, harvesting and sale of timber was a franchise for the purposes of Chapter 5C of the Corporations Law. ASIC opposed the application and asserted the scheme was operated as a managed investment scheme.

In that case the Court concluded that the arrangement in question was not a franchise agreement (and hence the provisions of Chapter 5C applied) as Enviro had the day to day control of the operations of the scheme, it did not intend that the participants would run their own businesses, the documentation did not identify a “system” for marketing or selling timber for which intellectual property could be claimed, nor was any income earned through the exploitation of a particular right to use Enviro’s intellectual property.

The case is also interesting because it refers to policy statements of the National Companies and Securities Commission, the Australian Law Reform Commission and the Security Advisory Committee as to when they would allow an exemption under the relentat legislation. The policy statements appear to consider business format franchising when considering whether an arrangement is a franchise agreement.

Conclusion

The case law to date appears to indicate that the courts will take a strict view of the definition, requiring some element of support / control. However ultimately consideration must be given in each case as to whether there is a “system” or “marketing plan” and whether it is “substantially determined or controlled by the franchisor”.

5. KEY PROVISIONS OF THE CODE

The focus of the Code is on creating an environment where a prospective franchisee can make an informed business decision whether to enter into a franchise agreement.

The key provisions under the Code include:

Disclosure - There are comprehensive disclosure obligations on the part of a franchisor who intends to enter into, extend or renew a franchise agreement covered by the Code.

A franchisor must provide to a prospective franchisee at least 14 days prior to signing a franchise agreement a detailed disclosure document. It must also provide a copy of the Code and a copy of the franchise agreement.

The disclosure document requires the franchisor to provide approximately 250 items of information listed under 23 categories. The information required to be disclosed includes details of the franchisor, the business experience of those involved, litigation history, existing franchisee contact particulars, and information concerning intellectual property ownership, any territorial or supply restrictions, marketing or other cooperative funds, range of costs and payments relevant to the franchise and the franchisor’s financial position.

The obligation to disclose is a continuing obligation.

Cooling-off period - The Code provides a 7day cooling off period for franchisees.
Advice before entering into a franchise agreement – Franchisees are strongly encouraged to seek independent legal, business and accounting advice. Indeed before a franchise agreement is signed, the Code requires the franchisor to obtain from the prospective franchisee signed statements that the franchisee has been given advice, or has been told to seek advice but has decided not to seek it.
Required provisions in franchise agreement – The Code requires all franchise agreements to contain provisions concerning assignment, termination and dispute resolution. In broad terms a franchisor cannot unreasonably withhold consent to assignment, termination can only occur on the grounds set out in the Code and mediation must be used to attempt to resolve disputes if one party so desires.
Marketing and other cooperative funds – The Code requires the franchisor to provide financial statements for any marketing or other cooperative funds to which franchisees have made financial contributions.

Although the cost and complexity of Code compliance for franchisors has been rightly criticised and could be easily reduced without prejudicing the protections provided, the Code provides an excellent regulatory framework for the franchising sector.

6. RECENT AMENDMENTS TO THE FRANCHISING CODE

Overview

The Federal Government amended the Franchising Code of Conduct by introducing the Trade Practices (Industry Code – Franchising Amendment Regulations 2001). The regulations were made by the Governor General on the 28 June 2001 and took effect on 1October 2001.

The most significant amendment to the Franchising Code of Conduct was the introduction of a short form disclosure document where a franchised business has an expected annual turnover of less than $50,000. The short form of disclosure document must follow the format of Annexure 2, which requires a franchisor to disclose only 11 of the 23 categories of information required under Annexure 1 of the Code.

However, the benefit may prove somewhat illusory. If a franchisee or a prospective franchisee who is given a Disclosure Document in accordance with Annexure 2 asks the franchisor for information referred to in Sections 3, 5, 6, 9, 10, 11, 14, 17, 18, 19, 21 and 22 of Annexure 1, the Code requires that the franchisor must give that information unless, in the circumstances, it is reasonable to withhold the information.

Franchisors will need to take great caution if they seek to utilise the $50,000 limit on turnover as justification for producing a short form disclosure document. Projected turnover is rarely capable of being forecast with any great certainty. In addition, they will probably have to have a full length version available anyway, as the cost of providing piecemeal additional information would be prohibitive.

The Code also clarifies the position of master franchisees, although some uncertainty still exists. Where a subfranchisor/master franchisee proposes to grant a subfranchise, both the franchisor and the subfranchisor/master franchisee must provide disclosure, either via separate disclosure documents or a joint disclosure document.

From a franchisee’s perspective, the key change is to abolish the requirement for a franchisee to provide a disclosure document where the business is being sold to another franchisee.

Industry representatives expressed disappointment that the amendments did nothing to address industry concerns in relation to the unnecessarily prescriptive nature of the disclosure requirements in the Code. A number of other industry recommendations to improve the Code without impacting on the protection it provides were ignored.

A detailed analysis of the amendments made to the Code is set out below

The Purpose of the Disclosure Document

The Code has been amended to extend the purpose of a disclosure document. The purpose is not only to give a prospective franchisee information from the franchisor to help the franchisee to make a reasonably informed decision about the franchise, but to also give a franchisee current information that is material to running the franchised business.

The reason for this change is presumably the new requirement for franchisors to continue to maintain a current disclosure document for a year after they have ceased entering into franchise agreements.

Emphasis on Current Disclosure Documents

The regulations extended the requirement on providing a disclosure document to maintaining a current disclosure document.

The Code now provides that a franchisor must, before entering into a franchise agreement, and within three months after the end of each financial year after entering into a franchise agreement, create a document in accordance with Division 2.1. This amendment requires a franchisor to prepare and, on request, issue a disclosure document even if it has ceased franchising.

This amendment is most unusual, and appears ill conceived. The relevance of a disclosure document to an existing franchisee is questionable, and the policy is inconsistent with other Federal legislation. For example under the Corporations Law companies do not have to issue a prospectus in the year after they raise funds!

Relationship Between the Code and the Petroleum Retail Marketing Franchise Act 1980

The regulations clarified the relationship between the Code and the Petroleum Retail Marketing Franchise Act 1980 ("PRMF Act") by providing that the Code will apply concurrently with the PRMF Act. Affected franchisors will have to comply with both.

ACN/ABN

All references to ACNs were amended to refer to an entity's ABN, Australian Business Number.

Short Form Disclosure Document

However, the benefit may prove somewhat illusory. If a franchisee or a prospective franchisee who is given a disclosure document in accordance with Annexure 2 asks the franchisor for information referred to in Sections 3, 5, 6, 9, 10, 11, 14, 17, 18, 19, 21 and 22 of Annexure 1, the Code requires that the franchisor must give that information unless, in the circumstances, it is reasonable to withhold the information.

The amendment raises as many problems as it solves. For example is the $50,000 annual turnover for the first year, or at any time during the franchise agreement? Is the turnover expectation to be based on an "average" franchisee, or does it apply if there is anyone earning that amount? Can additional information requested by a prospective franchisee be provided verbally? Is the compliance cost of producing information a "reasonable" basis for withholding information? (One would assume not, which demonstrates that the exemption serves little purpose.)

The amendment is unlikely to reduce Code compliance costs. Australia remains the only jurisdiction in the world with such highly prescriptive requirements on form and content of disclosure documents. It is disappointing that industry requests for simplification of disclosure form and content for all franchisors were ignored.

Master Franchisees and Sub-franchisors

It is now clearer how the Code applies in a master franchising situation. A number of provisions of the Code were amended to ensure that the Code applies to sub-franchisors and master franchisees. The term “master franchise” has been defined, and a reference to a sub-franchisor has the same meaning as a reference to a master franchisee.

The amended Code provides that if a subfranchisor/master franchisee wishes to grant a subfranchise to a prospective subfranchisee, both the franchisor and the subfranchisor/master franchisee must provide disclosure, either via separate disclosure documents or a joint disclosure document.

The amendments will need to be carefully considered by those involved in any multi-level arrangement, as considerable uncertainty still remains. The intent appears to be to require disclosure from both franchisor and master franchisee, either via separate disclosure documents or a joint disclosure document. However uncertainty remains as to:-

The obligations where the franchisor grants the subfranchise, and the subfranchisor/master franchisee provides services or support. Arguably the subfranchisor/master franchisee has no disclosure obligation at all;
The term "participates in a franchise";
The extent of the master franchisee's obligations under the other parts of the Code.

These issues are compounded because the definition of "franchise agreement" includes oral and implied agreements.

A number of organisations that previously only provided disclosure by the franchisor may now need to produce an additional disclosure document.

The Definition of a Franchise Agreement

The definition of a franchise agreement was amended to specifically ensure that a reference to a "wholesale price" clauses 4(1)(d)(v) and 4(1)(d)(viii), is a reference to the franchisor's "usual" wholesale price. This amendment was intended to clarify that the price referred to in paragraphs 4(1)(d)(v) and (vii) is a genuine wholesale price.

As a result, it is now clear that franchisors are not able to avoid the application of the Code by simply charging an increased margin on product as opposed to other royalties and fees.

It is interesting to note that the amendments failed to address an apparent failing of the Code to cover arrangements where the payment of "an amount" is from franchisor to franchisee.

Non-refundable Money

All references to "non-refundable money" were replaced with "non-refundable payment" to cover both money and other valuable consideration.

Electronic Documents

A special note was inserted at the end of clause 10 of the Code to recognise that under subsection 9(1) of the Electronic Transactions Act 1999 a requirement under a law of the Commonwealth to give information in writing is satisfied by giving the information electronically if it is reasonable to expect that the information will be readily accessible and useable for subsequent reference, and the person receiving the information consents to the information being provided electronically.

However, franchisors seeking to take advantage of this process should exercise caution, as electronic access is not always a simple process. Security measures to protect confidential information, track access and prevent hacking need to be considered. Franchisors wishing to use this process will need to amend their acknowledgment and receipt forms and recruitment procedures, as the burden to prove compliance with the Code will remain.

Franchisee Disclosure Documents

The requirement for a franchisee to provide a franchisee disclosure document upon the transfer of its franchised business has been removed. This sensible change has been requested by industry since the introduction of the Code.

Materially Relevant Facts

The provisions in relation to disclosure of relevant facts were amended to include a requirement that the franchisor disclose:

Any judgments against the franchisor under the new Industrial Relations Act 1999 (Queensland);
Any civil proceedings by "at least" 10% or 10 (whichever is lower) of the franchisees in Australia of the franchisor;
Matters referred to in paragraphs 4.2(a), (b) and (c) of Annexure 1; and
Any changes relating to intellectual property including ownership and control of intellectual property that is material to the franchise system.

Termination by Reasonable Notice

Clause 22(1) of the Code was amended to make it clear (if clarity was in fact required) that a franchisor may only terminate a franchise agreement by giving reasonable notice to the franchisee where the franchise agreement specifically makes provision for such termination by the franchisor.

Mediation

A number of amendments were made to the clauses in relation to mediation. These amendments are as follows:

Mediation must be conducted in Australia to avoid parties nominating an overseas jurisdiction; (Interestingly other forms of dispute resolution, such as arbitration and negotiations, may be conducted in other jurisdictions. This issue is particularly relevant to foreign-based franchisors. A clause confirming this position has been recently upheld in Australian courts provided proper disclosure is made.)
Mediation must be attended by a person who has authority to enter into an agreement to settle the dispute on behalf of the party to ensure that mediation is effective; and
In the event that a dispute is not resolved within 30 days after the commencement of mediation, the mediator may terminate the mediation if satisfied the resolution of the dispute is not imminent. This allows the parties to pursue other dispute resolution mechanisms specified in the agreement or otherwise available.

Amendments to the Disclosure Document

Various minor or consequential amendments were also made to the prescribed form of the disclosure document set out in Annexure 1. The most notable amendments are:

An amendment which requires a franchisor to disclose any requirement for the franchisee to provide a minimum amount of unborrowed working capital and any requirement that the franchisee maintain a particular debt to equity ratio;
A requirement for the franchisor to also summarise or cross reference those provisions of the franchise agreement that deal with the obligations of the franchisor that continue after the franchised business ceases to operate. (The rationale for this change is unclear.)
Amendments to paragraph 16 which recognise the fact that not all franchised business are conducted from a premises;
Changes to item 18 that require a summary of any agreement whereby the franchisee gains use or ownership of any intellectual property, or is obliged to enter into a loan agreement or provide a bank guarantee to a third party;
An amendment to item 20.3 which provides that the statement under Item 20.1 must be supported by an independent audit provided by a registered company auditor within 12 months after the end of the financial year to which the statement relates if the financial reports of the franchisor are not provided. This would appear to make it extremely difficult for franchisors to use this process, as auditors are unlikely to be comfortable with a copy of their audit report being provided to a third party such as a franchisee.
An amendment to item 23, which provides that the proposed franchisee may keep the disclosure document. Although this is normal practice for franchisees that proceed with a franchise, franchisors may need to be more selective in giving disclosure documentation only to those who are genuine prospects. It is also unclear how this amendment sits with the provision of information electronically. Arguably the franchisee should be entitled to print off a copy or even save it electronically. Franchisors will often prefer to provide information on a "read only" basis.