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FOLLOW THE RULES AND STAY OUT OF TROUBLE

by Stewart Germann and Harshad Shiba,
last updated 28/05/2015

March 2015 - Stewart Germann and Harshad Shiba review three recent cases with lessons for franchisees and franchisors

Franchisors spend a great deal of time building up their brand and when a franchisee acts in such a way as to damage the brand, they’re bound to take action to protect not just their own investment but that of their other franchisees. Here’s a brief review of three cases which show franchisors doing just that and emphasise the importance of using dispute resolution processes when appropriate.

When It’s Over, It’s Over

In our first case, Dream Doors (NZ) Limited v Mike Fatches Designs Limited, a permanent injunction was granted against a franchisee who carried on using the name, trademarks and Intellectual Property (IP) of the franchisor after his franchise agreement had been terminated.

Brief Background

Michael Fatches Designs Ltd was granted a franchise to operate a Dream Doors franchise in Taranaki, with Michael Fatches personally guaranteeing the obligations of the company. The IP provided for under the agreement included the system, the brand names, trademarks, telephone numbers, know-how and other items. The franchise agreement was terminated by consent on 31 May 2012, but Mr Fatches was granted an agency for a further year from 1 June 2012 to carry on a Dream Doors business under an agreement containing similar provisions concerning the protected IP.

The franchisor took steps to terminate the agency agreement on 6 June 2013. It alleged that the defendants had committed breaches of their contractual and trade mark obligations by incorporating a company called Dream Doors Kitchens Limited, continuing to promote the business as ‘Dream Doors’, using the franchisor's trade mark and colour scheme and refusing to return the IP, including transferring telephone numbers and uniforms used under the agency agreement. In addition, the franchisor alleged breaches of section 89 of the Trade Marks Act and section 9 of the Fair Trading Act, and passing off.

The Issue & The Law

Justice Toogood in the New Plymouth High Court ordered that an injunction would issue ‘pending further order of the Court to restrain the defendants from using the name Dream Doors or the Dream Doors trade mark or any similar name in the operation and marketing of the defendants’ business, including the operation of any website in connection with the phone numbers …’

Mr Fatches was without counsel and acted for himself. There were a number of procedural issues and Mr Fatches tried ‘to muddy the waters’ with his submissions, but failed.

Following the injunction, the matter came before Justice Thomas for formal proof on 15 December 2014. Mr Fatches did not reveal any defence other than a simple denial and did not answer the allegations. The Court was told that Mr Fatches was adjudicated bankrupt on 19 November 2014 and as a result his shares in the first defendant (Michael Fatches Designs Ltd) vested in the Official Assignee, and as a bankrupt he could not hold the office of director. The Official Assignee had been advised of the legal proceedings and he confirmed that the plaintiffs were entitled to proceed with the formal proof hearing without requiring leave.

The Relief

The Judge concluded that Mr Fatches and his company had breached the franchise agreement, the deed of termination and the agency agreement, that they had infringed section 89 of the Trade Marks Act and that they had ‘engaged in misleading and deceptive conduct in breach of section 9 of the Fair Trading Act 1986.’ The Judge was satisfied ‘that it is in the interests of justice that the interim orders are made permanent’ and the Judge granted a permanent injunction.

Conclusion

This case is tragic because if Mr Fatches had engaged his own independent counsel, the litigation would have concluded much earlier. By his conduct Mr Fatches was always going to lose and the franchisor had no choice but to pursue the matter in order to protect its intellectual property.

Since Dream Doors is a member of the Franchise Association of New Zealand it must comply with the Association’s Code of Practice. The Code requires any dispute to go to mediation before Court proceedings are issued except in the case where a party must seek injunctive relief from the Court ‘where failure to obtain such relief would cause irreparable damage to the party concerned or the franchise system.’ In this case, the franchisor had every right to pursue an injunction because of the circumstances and urgent need to protect its IP.

The judgment does not comment upon whether any mediation was pursued but, in our opinion, if it had been pursued in tandem with the legal proceedings then Mr Fatches would have soon realised that he should surrender as he would lose the litigation in the long run.

Follow The Process

A 2012 case [Waterco (NZ) Limited v Simpson] had previously reinforced the importance of the dispute resolution process when the franchisor of Swimart, a network of pool and spa retail outlets, put a franchisee which had defaulted on its payments into receivership without prior mediation process. This was despite the fact that the Swimart franchise deeds included a Clause 13 setting out the dispute resolution provisions taken from the FANZ Code of Practice.

The Judge concluded that because the dispute resolution had not been complied with and because there was doubt as to the defendants having received the demand from the franchisor to pay the amount claimed, then the summary judgment proceedings would be stayed (or frozen) until clause 13 (Dispute Resolution) had been exhausted. The facts clearly disclose that there had been no compliance with Clause 13 and the parties were given ‘80 days to make the process work and if it does not work within that time frame, then there would appear to be no bar to the plaintiff continuing with the current proceeding, if the plaintiff elected to do so.’

As franchise lawyers we particularly like the judgment as we believe that the dispute resolution process should be complied with and exhausted before the parties go down the litigation track.

You Can’t Opt Out

Our third case concerns the sale of an existing franchised outlet to a purchaser who wanted to operate the business under a competing brand. The franchisor of the existing outlet, not surprisingly, had a problem with that and set out to halt the sale.

Brief Background

In July 2014, the long-time franchisee of the Super Value convenience store in Pauanui entered into an agreement to sell the business. The purchasers were the current operators of the Four Square convenience store in Whitianga. Super Value is managed by Wholesale Distributors Ltd (WDL), while Four Square is part of Foodstuffs.

Under the franchise agreement, if the franchisee ever wished to transfer its interest in the premises from which the business operated, the franchisor (WDL) had first right of refusal to take up the interest. Failing exercise of that right, the franchisee was entitled to assign its rights in the premises to a third party, but only if the franchisor approved of the transferee.

The Sale & Purchase agreement between the franchisee and purchasers contained a clause which essentially said: this agreement is conditional on the Franchisor giving its consent to the Purchaser buying the business and the transfer of the Franchise from the vendor to the Purchaser. However, the clause was noted as being for the purchaser’s benefit only. When the purchaser declared the agreement unconditional, they purported to waive the clause requiring the franchisor’s consent.

When WDL as franchisor discovered this and realised that it was about to lose its Pauanui store to a competing brand, it sought an interim injunction from the High Court to prevent the sale from proceeding.

It is important to note that an interim injunction hearing does not determine who is right or wrong on the substantive issues (that is for a Court after a proper trial to determine), but rather it is an urgent hearing which is determined based on three factors. Furthermore, an interim injunction will only be granted where the Court agrees that the payment of damages in and of itself would not be enough to remedy any losses to the parties.

The Issue & The Law

The franchisor claimed that the franchisee had breached the terms of the franchise agreement by attempting to assign its rights without the franchisor’s consent.  It also claimed that the purchaser had knowingly induced the franchisee to breach its franchise agreement by entering into the sale and proceeding without the franchisor’s approval.

The High Court declined to grant the injunction for several reasons. It found that: the loss to the franchisor would be minor and quantifiable, so damages would be sufficient; that loss to the purchaser was not quantifiable and that if the sale were prevented the family, having sold their Four Square, would have no source of income; that the purchaser was entitled to waive the condition in the agreement; and that the franchisor had had a copy of the Sale & Purchase agreement for some time but did nothing to have the conditional clause fixed. The High Court suggested that ‘it is an inherent risk in franchising that your franchisees may cause you a loss.’

The franchisor appealed this decision and the Court of Appeal agreed, putting a freeze on the sale. It found that: if the business were sold, the franchisor would lose the rights to buy back the assets of the business together with future franchise fees and goodwill ­–­ this was not minor; while the purchaser would suffer a financial loss if the injunction were granted, that loss would be quantifiable and the franchisor would be able to meet a damages claim if it lost at trial; that the purchaser knew the franchisee needed the consent of the franchisor to sell; and that the purchaser had made up its mind to convert the store to a Four Square well before meeting the franchisor to discuss becoming a SuperValue franchisee. The Court of Appeal found that ‘A franchisor is entitled to expect that its franchisee will comply with the terms of the franchise agreement and to seek injunctive relief if it does not.’

The Relief

The injunction was granted and the sale was prevented from proceeding pending a full hearing. This left the purchasers in a situation where they had agreed to sell their Four Square store and had moved to Pauanui but had no business to run.

Conclusion

This case affirms that the Court will look to protect a franchisor’s interest in its goodwill and brand recognition where a franchisee breaches the terms of its franchise agreement. Given the lower Court’s comments to the effect that a franchisor should expect that its franchisees may cause it loss and that a loss of a store to the network would be quantifiable, this Order is arguably a significant one for franchisors in demonstrating that the loss of brand recognition suffered by a franchisor is a serious loss that cannot necessarily be quantified into an ascertainable amount.

This article was first published in Franchise New Zealand magazine Volume 24 Issue 1

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