Second Opinion on Court of Appeal's Due Diligence Decision

The recent Court of Appeal case involving the franchisor James Home Services
(David and UAR Ltd v TFAC Ltd and others [2009] NZCA 44) is an important decision for anyone selling a franchise or considering challenging a franchisor for misrepresentation. Its conclusion regarding the importance of franchisees taking independent advice from experienced professionals is to be valued. Quite apart from the benefit to franchisees of such due diligence, it should definitely be heeded by franchisors if they want to manage their pre-contractual liability risk. However I would caution franchisors from becoming too complacent based on this decision, as I perceive there are some troubling features to it.

In a recent story in Franchise New Zealand , the comment is made by Peter Woods of Anthony Harper & Co that ‘there should be a collective sigh of relief within the franchise industry as this judgement has redressed the balance between franchisor and franchisee.' This is based on the fact that the documents involved required the franchisee to obtain independent legal, accounting and business advice before signing the franchise agreement and that, the franchisee having obtained legal and accounting advice ( the franchisee did not obtain business advice), the franchisor could then rely on the disclaimer clauses and certificates supplied by the professionals.

The decision has certainly added some weight in favour of franchisors. However, simply relying on independent professional advice to franchisees and disclaimer clauses based on this decision is, in my view, not wise. The decision certainly should not diminish the need for franchisors to have rigorous and comprehensive risk management strategies and procedures in place when selling franchises. I do not consider this decision provides a great deal of protection or comfort as its conclusions are vulnerable to being distinguished (confined to the facts of that particular case) by another Court. My reasons are briefly as follows:

1) The comments made by the Court with regard to the effect of disclaimer clauses were firstly what lawyers call ‘obiter'. That means that they were not fundamental to the Court's decision, as the Court had already decided the case on other grounds. Obiter comments are influential but do not establish binding precedent. In this case, the Court of Appeal had already found, unlike the Judge in the High Court, that on the particular facts of this case there had been no misleading or deceptive conduct on the part of the franchisor. It therefore did not have to deal with the disclaimer clauses but elected to comment on them.

2)  The franchisor had expressed the opinion that the Australian experience with this franchise (which had been successful) was transferable to New Zealand, so that the franchisee could rely on it as indicating a sound investment. The Court found that opinion was honestly held and soundly based at the time. That merely restates the current law and nothing has changed by virtue of this case. Each case in such matters of alleged misleading or deceptive conduct will always be decided upon its particular facts. Disclaimer clauses were not relevant to that part of the decision.

3) In its obiter comments much was made by the Court of Appeal of the franchisee needing to obtain independent professional advice and in fact obtaining it. However it did not consider in any significant way what that advice was particularly focused on. It was narrowly focused professional advice and was not on the franchise business opportunity generally. Indeed that seems to have been more within the domain of the franchisor.

4) The documents only required the lawyer to focus on explaining ‘the regional Master Franchise Agreement', the disclosure document and some ancillary trade restraint and trade mark documents. That is what the lawyer did and that is all he certified to. In this case it could hardly be said he was advising on the business or negotiating the terms of the franchise agreement as one might do with a business acquisition contract.

5) The accountant appears to have only focused on the information supplied by the franchisor in its documents. He reviewed the methodology and calculations but not the inputs to the cash flow. That review, together with explaining its ramifications, appears to be all he certified to. However the Court seems to have attributed a much broader role to the accountant in terms of assessing the business prospects of the franchise.

6) With regard to the requirement to consult an independent business adviser, the franchisee did not consult with such a person and no certificate was ever supplied. It is noted that the franchisee prepared several business plans in conjunction with the franchisor but the franchisor initially considered them too conservative. It was the franchisor who finally determined the number of expected sales which then formed the basis for the cash flow projections that were considered by the accountant. It is interesting to also note that the franchisor knew that the prior regional franchisee had made no sales at all over a seven-month period, claiming ‘he didn't cut it.'

7) I submit the most disturbing feature of this case relates to the Court of Appeal commenting on the limited justification for the Fair Trading Act to apply to the transaction. The Court states that ‘while it has force in the context of consumer transactions, it has less force in the context of commercial transactions involving substantial independently advised parties negotiating from positions of equality. In the latter case, any resulting contract can be expected to reflect the parties' wishes as to allocation of risk...'

This was not an existing business acquisition agreement where parties may well negotiate terms and warranties from positions of equality etc. This was a typical non negotiable contract to purchase a franchise opportunity and the franchisee then had to establish the business. The parties are hardly equal. The vendor franchisor already knew the system and indeed the market and the franchisee's independent advice was much more narrowly focused than the Court would suggest.

With respect, the Court appears to have failed to properly appreciate the nature of what is involved in buying a ‘green fields' franchise. While it obviously is a commercial transaction it is very difficult not to see prospective franchisees as (to some extent) vulnerable consumers needing protection under consumer protection law like the Fair Trading Act in such circumstances. Despite disclaimer clauses and independent advisers there is still a substantial dependence upon the franchisor as the ultimate "guru" for its franchise which it is selling. For this reason it seems to me that the reasoning in this case is vulnerable to being re-considered by a later Court case. Franchisees and their advisers will no doubt continue to have significant expectations of franchisors and therefore there should only be cautious comfort from this case. It is too soon for franchisors to celebrate or breathe a sigh of relief.

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