Legislation: Help Or Hindrance?

At the Franchise Association’s national conference in June 2005, the closing debate on the desirability or otherwise of franchise-specific legislation was given added piquancy by breaking news of the call for just such legislation by a new group called the Fair Trading Coalition.

In New Zealand, there is currently no legislation that deals specifically with franchising. Instead, franchisors and franchisees are governed by the same laws that apply to all other commercial enterprises. This is the situation in about half the countries which are members of the World Franchise Council; in the others, the type of legislation varies from that which sets out the way in which franchises can be sold to a more proscriptive form governing many aspects of the ownership and ongoing management of a franchised business.

In Australia, an amendment to the Trade Practices Act saw a compulsory Franchising Code of Conduct introduced in 1998 which has been described as ‘the most stringent national regulations for franchising introduced anywhere in the world’. Given the number of franchises now operating both ways across the Tasman and the increasing impact of CER, there is an obvious possibility of franchising legislation being enacted here.

Interestingly, as was evident at the Conference debate, it is an issue on which franchisors and advisors are themselves divided. On the one hand, franchisors recognise that the small number of ‘cowboys’ purporting to offer franchises (the ones who usually turn up on Fair Go) do damage to the reputation of the franchise sector and to franchisors and franchisees as a whole. If legislation were to rid franchising of such hangers-on, it would be well worth it, they say. On the other hand, franchisors are wary of the impact of legislation that Australian experience suggests would slow growth dramatically in the sector for several years while it is tried and tested. More legislation would mean more compliance costs, they say – and, unlike Australia, most of our franchises here are relatively small, meaning that the additional costs would be spread over a much smaller number of franchisees.

There is also the question of whether legislation would really achieve anything practical. While the Franchise Council of Australia has embraced legislation and government involvement in franchising enthusiastically, it has really had little choice, say critics. They note that the last Australian survey suggested that the level of franchise disputes in Australia, after seven years of legislation, is running at an impressively low 2%. However, surveys in New Zealand carried out regularly since 1997 have consistently found that the level here is at or around 1%. ‘We have never had the same level of problems that Australia had,’ comments one lawyer. ‘Apart from anything else, New Zealand is too small for a cowboy to get very far before word gets out and you see his face on Fair Go,’ says one lawyer. ‘But it still does damage to the sector as a whole.’

The Franchising Code of Practice

The Fair Trading Coalition has called for the introduction of franchise-specific legislation similar to that included in the Australian Code. Interestingly, many of the provisions of the Australian Code are mirrored in the Franchise Association of New Zealand’s own Franchising Code of Practice, by which all the members of the Association have agreed to operate. These provisions include disclosure of material information by the franchisor prior to a franchisee signing a franchise agreement; a seven day cooling-off period; an opportunity for franchisees to seek independent advice; and an alternative dispute resolution procedure. Additional concerns raised by the FTC include termination of the agreement without good reason; the franchisor’s right to veto the on-sale of the franchisee’s business; misleading representations and the imposition of mandatory promotions on franchisees without discussion.

The full text of the Franchising Code of Practice (as updated in July 2011) can be found here. Although the Code is compulsory for all Association members, it has been pointed out – not least by the Fair Trading Coalition, which has its roots and its funding in the motor trade - that the membership currently accounts for just over one third of all systems operating in New Zealand and is not currently supported by any legislation.

Mike Henderson, chairman of the Franchise Association, responds, ‘While that is true, our membership has grown strongly over the past couple of years and we are seeing continued growth particularly among reputable franchise systems. We are, of course, aware that the Code only applies to our members, which is why we have promoted the message ‘Don’t Sign Without This Sign’ to new franchise buyers to encourage them to deal with members only. We are also investigating ways of giving the Code greater force. However, the issue of possible legislation is one which needs to be handled very carefully to ensure that it has a beneficial effect upon the many good operators, both franchisors and franchisees, in the sector, rather than a negative one.’

This is something that David Munn is very aware of. A barrister and solicitor, David has over 20 years’ experience in franchising, having worked with some of the biggest names and the smallest. He has represented franchisors and franchisees and seen all sides of the franchisor/franchisee relationship. In the rest of this article, David considers the purpose, value and implications of franchise legislation.

Do We Need More Oil?

Law is a tool that, used wisely, can regulate and balance the varied rights and interests of parties so that they can smoothly inter-relate with one another. It is also one of the instruments used by governments to enable economies to attain optimum performance.
Introducing law into the commercial world can be like adding oil to a high-performance engine. You need first to fully understand the engine and what is required for optimum performance. You then need to add just the right quantity of oil, of just the right grade in just the right place to reduce friction. Get that right and you increase performance. Get it wrong and you can expect less than optimum performance, damage or even seizure.

Anyone proposing law to regulate franchising needs first thoroughly to understand the unique concept of full business format franchising. It is a method of doing business, not an industry. Governments around the world are increasingly recognising the importance of this method and the significant growth it brings to economies. We should therefore be careful to protect and enhance franchising, not stifle it.

I say that franchising is not an industry because, as a business model, it transcends particular industries – a lesson some recent advocates for change are neglecting to understand. A problem in one industry which involves franchising is not necessarily a problem in another industry. It does not necessarily denote a problem with the franchising method itself. In many cases, then, the introduction of law to address such problems should be focused on that industry, rather than on the whole of franchising.

Help Small Business Flourish

While franchising can achieve ‘big business’ proportions by harnessing and nurturing the entrepreneurial heart of small independent business, it is a big mistake to presume to treat it in law as being of the same nature and power as big business corporate conglomerates. It may look like that, but as a marketing concept it is intended to. However, in the traditional economic and corporate sense, franchising often competes with the traditional big business world by releasing the energy of small business. Good franchising dramatically enhances competition and growth.

The all-important relationship structure of business format franchising, combined with the need for franchisors to manage a network of independent businesses, can make it vulnerable, though. To seek to neutralise the balance of power in business format franchising is to seriously risk damaging some of the very fundamentals that need to exist for the protection of a brand and franchise system. If law is required to address detrimental power imbalance factors in franchise contracts, then great care and definitional precision is required of the law-makers. We need to ensure that we do not introduce ‘broad brush’ law that, far from promoting franchising and growth, actually makes it more difficult for business format franchising to flourish.

Do We Need More Law?

We should ask if the majority of problems encountered are adequately dealt with by present law? No-one should lightly interfere with the fundamental principle of freedom of contract and certainty in the law that business strives to retain. The existing general commercial law functions very well in New Zealand. It includes law as it applies to contract, restrictive trade practices, intellectual property and the law of misleading or deceptive conduct. The latter is particularly relevant to pre-contractual negotiation in franchising, although it can be used just as effectively during the period of the contract relationship. It includes the power of courts to consider and remedy particular conduct which is found to be unreasonable. Various remedies are available under the Contractual Remedies Act and there are very broad discretionary powers to make numerous orders or grant relief under the Fair Trading Act and the Illegal Contracts Act. More extensive powers can also be found in the inherent equitable jurisdiction of the Courts and case law.

Concerns have been expressed by some regarding some of the relational aspects of franchise agreements such as termination without cause or withholding consent to franchise sales. Case law has established, however, that you generally cannot terminate a contract of the nature of a franchise agreement during the term without just cause, and that the power to terminate should be exercised reasonably. It is acknowledged that New Zealand courts have not yet fully embraced a generally implied obligation of good faith such as now exists in Australia. However it is accepted that in a relational contract of the nature of a business format franchise agreement with continuing obligations requiring the parties to co-operate and work together, a duty of good faith may be implied regarding the exercise of specific powers and obligations. The existing law can adequately deal with these areas of franchise relationships.

Having regard to existing law, I would suggest that there is no clear justification in New Zealand to introduce into the general commercial law the additional statutory law of “unconscionable conduct” as the Australians have done. First, it is not franchise-specific law and can have wide uncertain ramifications for business generally. Secondly, if there is a problem in a particular industry then, for the reasons stated above, it is better to deal with that industry alone. A measured power imbalance or disproportionate bargaining strength is often to be found in business format franchise agreements and for good reason. That factor along with the need to future adjust manuals and preserve uniformity of contracts should not place a franchisor under threat of ‘unconscionable conduct’ and the uncertainty and consequences that might follow from that.
Given the above, then, I would suggest that if one were to consider any franchise-specific law, it should be aimed only at redressing possible detrimental power imbalance. It should be confined to this object and only operate when unfairness or detriment is found.

What Could Law Do?

If we accept that carefully-targeted law might enhance the overall value of franchising as a method of doing business, let us now consider the distinctive elements of business format franchising that could arguably justify further attention. These may include:

a) business format franchising involves the overall business of the franchisee being dependent upon the franchisor’s trademark and marketing system and being determined or controlled by the franchisor. Franchise-specific law may be considered therefore not to reduce power imbalance in such circumstances but rather to ensure that information is clearly made available and understood in advance of the commitment to enter the relationship. Law could ensure the franchisor discloses who they are, their track record, what the franchisee can expect from the relationship and what each party's responsibilities will be. This can assist rational decision-making by franchisees prior to investment rather than give rise to perhaps futile legal action once the franchise system has collapsed and the investment is lost. It leads to better-informed franchisees which should add value to the franchise system. Disclosure law combined with independent advice can also assist to expose (if not eliminate) in advance any potential for sharp practices or fraud and may provide a comparative basis for evaluating poorly-designed or operated franchise systems.

b) franchising involves being indelibly and publicly linked with the identity of the franchisor. Accordingly, law that provides an opportunity for second thoughts after commitments are made and to exit the arrangement during an initial ‘cooling off’ stage is worthy of serious consideration.

c) franchising is an ongoing relationship. It is therefore important that there is a method of resolving disputes without destroying the relationship between the parties. Litigation tends to destroy relationships and is very expensive. It is of little consolation to advise a person that they have legal rights when they are washed up financially (if not emotionally) and cannot afford to pursue those rights. Mandatory alternative dispute resolution procedures such as mediation can in many instances preserve relationships despite conflict.

Little of the above would be contested by good franchisors, many of whom have already signed up to it voluntarily as members of the Franchise Association. However, that still leaves unregulated franchise systems in the marketplace. If such law were introduced, compliance and enforcement issues would mean a statutory established and funded regulator would need to be considered in order to ensure protection for all players. Just who that regulator should be is a question for further debate. Clearly, however, various options are available as evidenced by recent law changes in the areas of retirement villages (through its own industry) and consumer credit and finance (through the Commerce Commission).

There are a number of further considerations that must also be debated as part of any new law. These include whether law changes should be introduced by specific statute law that can only be changed by the formal law-making process of parliament or by a code established under statute which may be more easily fine-tuned by executive fiat. The application of law changes to master licences and international franchising raise further issues, including international uniformity of law. The degree of prescriptive disclosure required will have a direct effect on compliance costs and this must be carefully determined and balanced.

International Impact

This raises another question. Franchising is part of the international village in which franchise-specific legislation is rapidly developing. We should seize the opportunity to learn from the vast knowledge and experience of those that have already travelled down this path. We must also be mindful of the declared desire to further harmonise the laws between Australia and New Zealand as recommended in the recent research report of the Australian Productivity Commission.

It is interesting to observe that while some argue that the Australian law model for regulating franchising should be introduced into New Zealand, some of the greatest and experienced franchising minds in the world have been critical of Australian law makers.

The International Institute for the Unification of Private Law (UNIDROIT) being part of the United Nations was so concerned with the legislation introduced by Australia and some other countries that it initiated its own model franchise disclosure law for domestic franchising to better assist governments considering franchise-specific law. Professor Warren Pengilley, a leading authority on competition law in this part of the world, has also been critical of Australia’s ‘overkill’ and imprecise legislative approach to franchising.

The challenge to New Zealanders, therefore, is to enhance the performance of franchising as a method of business for the benefit of all. It means developing better understanding of business format franchising and the manner in which it helps small businesses compete. If further law is introduced, it must be like oil in machinery - of the right grade, provided in the right quantity and applied in the right place.

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