by Gehan Gunasekara

last updated 29/07/2009

Gehan Gunasekara is a senior lecturer in commercial law at the University of Auckland's School of Business where he researches and teaches the law surrounding franchising. He has contributed to several legal books and journals in both New Zealand and overseas.

Strengthening Franchising Through Regulation

by Gehan Gunasekara

last updated 29/07/2009

Gehan Gunasekara is a senior lecturer in commercial law at the University of Auckland's School of Business where he researches and teaches the law surrounding franchising. He has contributed to several legal books and journals in both New Zealand and overseas.
December 2007 - Gehan Gunasekara adds his thoughts to the debate on franchise legislation. He argues that New Zealand should follow its own path in developing the content of regulation and that it should enhance the relationship between franchisors and franchisees and their customers.

There has been an increased trend overseas in recent years for legislation designed to protect those who buy franchises. The regulatory tide reached Australia a decade ago but has not, as yet, come to our shores. I believe legislation of some type is inevitable here and that the discussion in New Zealand ought to move towards its content and extent. Failure to grasp the nettle will merely ensure that change when it does occur will be driven by Australian bureaucrats pursuing an agenda of trans-Tasman harmonisation of business law. This would be a pity for a number of reasons: first, legislation here should maintain a distinctive local flavour whilst at the same time addressing the concerns of overseas investors; second, adopting regulations which have been designed for overseas conditions may impose an unnecessary level of costs or constraints upon local franchisors.

Business format franchising is often compared to a marriage. The parties agree to live happily together for the term of the franchise and to be committed to each other. Of course, as with marriage in general neither party can fully predict the course of the relationship and the risks to it, which explains why disputes occur. Any legislation governing franchising should therefore be appropriate for New Zealand, aimed towards strengthening this relationship and providing mechanisms for resolving disputes where it has broken down.

In this article I make some suggestions as to the content of these rules and what their proper function ought to be. I begin, though, by questioning the public perception of what a franchised business is and whether this needs to be changed.

The Public Facade Of Franchising

One of the great advantages of business format franchising is its ability to mimic monolithic vertically-integrated corporate organisations while operating via independently-owned and operated businesses. Uniformity is of course a critical aspect in building a franchise brand image and is also the basis for the franchisor's claim to ownership over goodwill. A customer walking into a franchised outlet generally has no way of telling whether it is company-owned or operated under licence by a franchisee.

Although often encouraged by franchisors, this deliberate facade can also be a double-edged sword for them. This is because a single ‘bad' franchisee can tarnish the entire brand and affect all franchisees alike. If the public has no way of differentiating independent operators from company stores, all are likely to suffer the same fate - as was shown by the recent story of the Dunedin Subway franchisee which reported one of its employees to the police for sharing a drink with a friend. Although the charge laid by the police was subsequently dropped, the negative publicity associated with the case impacted adversely on the franchisor's brand and raised questions as to the adequacy of its training programme for franchisees. Another reported instance this year concerned Hell Pizza where some franchisees failed to honour the tear-off coupons entitling the customer to a free pizza (some franchisees asked for receipts as well as the tokens).

A far more serious aspect that has scarcely arisen in New Zealand yet is the thorny issue of a franchisor's legal liability for the actions of its franchisees. Fortunately for franchisors, New Zealand is not a litigious society when compared to some other countries. In the United States and elsewhere, by contrast, franchisors have faced substantial liability claims.

There have, for instance, been a great many cases brought against McDonalds Corporation. One such case was brought by a woman in Oregon in the 1990s. The Big Mac she had purchased contained a sharp diamond-shaped stone which caused her severe dental injury. Her lawsuit, of course, was brought not against the local franchisee but against the McDonald's Corporation on the basis that all McDonald's restaurants looked alike and she believed they were all owned by the Corporation. A jury agreed awarding her a very large amount of compensation which was upheld on appeal: the court reasoned that McDonald's had not differentiated its stores as being franchisee-operated in its advertising and it was reasonable for a customer to believe the restaurants were operating as agents of the Corporation.

Another example concerns the Holiday Inns hotel franchise. In the 1980s, "motel bandits" in the United States discovered that when one franchised hotel had lax security this was likely to be replicated across the entire chain. A couple who checked into a Holiday Inn hotel were assaulted and imprisoned by bandits in their room. As a consequence, the wife subsequently developed heart complications requiring surgery. They recovered substantial damages against the Holiday Inns Corporation on the basis that the franchisor had required all its franchisees to associate themselves with its brand and image.

These examples provide a salutary lesson for franchisors. Although litigation for personal injury is not possible in New Zealand, there have been instances where customers have sought recovery of financial losses from franchisors where a franchisee has absconded with their funds or is otherwise impecunious. Can the risk be mitigated? Some may argue, of course, that franchisors should in principle stand behind their brand accepting liability as a natural consequence of using the franchise method.
Public education is an important factor in this regard. There have been several instances in the United States where litigation against franchisors was unsuccessful when it was established that the customer knew they were dealing with an independent operator. Might legislation be useful in this context?

Serious consideration should be given in any future legislation governing franchising to introducing a requirement that franchisees' independent status be identified. Many franchises do currently identify franchisees by devices such as a plate on the wall announcing ‘Proudly operated by John and Mary Smith' or, as in the case of couriers and the like a sign on the vehicle stating ‘independent owner-operator' (as is already required under Section 10 of the Franchising Code of Practice that is mandatory for members of the Franchise Association of New Zealand). Another option may be to develop a shorthand method for this: companies, for example, use the ‘Ltd' label to denote their separate legal identity. Perhaps in time a label such as ‘Fee' or ‘Lee' might be employed to characterise a franchisee or licensee respectively. Franchisors may baulk at any mandatory requirement which could lead over time to differentiation between company-owned and franchised businesses but, as I have observed, franchisors cannot otherwise expect to enjoy the fruits of their public facade without the rind of potential liability.

It should also be noted, in passing, that some types of liability for the acts of franchisees are prescribed by legislation and usually not possible to avoid. For example, franchisors are potentially liable under health and safety, consumer guarantees and human rights legislation. It is unlikely that liability under these codes can be avoided by the expedient of labelling suggested above.

Disclosure And The Case For Certainty

At present there is no disclosure requirement on franchisors, other than for members of the Franchise Association of New Zealand. Membership in the Association is voluntary, hence a level playing field does not exist as far as franchises go. Professor Andrew Terry, at the University of New South Wales, has suggested that franchisees are at an inherent informational disadvantage when buying a franchise. It was in responding to this deficit that federal legislation in Australia introduced a comprehensive disclosure document for franchisees and prospective franchisees as part of the Franchising Code of Conduct adopted in 1998.

Although some may argue that this response was heavy-handed and disproportionate, there is something to be said for the manner in which the Code was adopted - as regulations under the Trade Practices Act. This means that industry groups can consult closely in developing Code provisions and, unlike legislation, alterations can be made relatively easily. Several revisions to the Code have already been made, one of them being to adopt a two-tier set of rules with differential obligations depending on the expected annual turnover of the business thus reducing the burden on smaller-scale operators. In a 2006 survey of franchising in Australia, franchisors listed the lack of suitable franchisee candidates as the biggest hindrance to growth (68%) whereas impediments arising from the Franchising Code of Conduct were at the bottom of the list at 4%. This suggests that compliance with a disclosure regime is unlikely to be ruinous for franchisors.

It is often argued that existing legal provisions in New Zealand, such as the prohibition against misleading and deceptive conduct contained in the Fair Trading Act, provide sufficient protection to those considering buying a franchise. Although the Fair Trading Act does currently provide a remedy it should be kept in mind that in the end this amounts to an ambulance at the bottom rather than a fence on top: by the time the remedy is invoked the loss has already occurred and the franchisee is often unable to recoup his or her investment.

Another aspect which is often ignored is that considerable uncertainty exists at present as to the extent of disclosure needed under the Fair Trading Act to avoid a finding of liability. Franchisors are to some extent subject to the whims of judges in this regard: for example, in 2001 United Video was ordered to pay over $500,000 for misrepresentations as to the estimates of likely earnings in a virgin territory. Rulings such as these mean that over-cautious franchisors will tend to disclose more information than is necessary.

A mandatory disclosure regime would on the other hand provide a standard template for disclosure to franchisees and reduce the likelihood for litigation as well as legal costs. It could, for example, be a requirement that all estimates to potential franchisees in new territories be qualified by the statement that they are based on a typical territory and may not apply to the territory in question (another FANZ requirement). A standard template could also force attention to be paid to important aspects of the agreement (eg. exclusivity of territory, right to sell the franchise etc). Anecdotal experience suggests that drafting franchise agreements in Australia has become less costly and more straightforward due to the standardisation brought about by the Code.

Disclosure should not, however, be required for its own sake but rather be designed to assist franchisees where they are unlikely to be able to otherwise gain the information needed (for example, risk factors within the franchisor's knowledge). Other areas of disclosure where ‘mischief' could be seen to occur if not declared up-front include:

  • Whether the franchisor has any interest in suppliers from whom franchisees are required to obtain goods or services (franchisees can then decide if quality control or self-interest is the motivation behind duties imposed on them)
  • Whether the franchisor receives refunds from suppliers and whether these are shared with franchisees
  • Requiring the supply to franchisees of audited financial statements for all advertising and other co-operative funds (to ensure franchisors have spent the money on what it was given for and not siphoned it off for other uses).

The last point suggests that the need for disclosure is ongoing, not a once-off event.
Requirements such as these take the sting out of potential claims by franchisees they have been exploited. Openness and transparency in the relationship between franchisors and franchisees actually strengthens the relationship between them and enhances trust and confidence. It is not something to be feared.

Rules for Managing the Relationship

Openness and transparency go a long way but are not sufficient to prevent all relationship disputes. Franchise agreements are perhaps unique in that they are of a standard form but, due to their longevity, the need arises for the flexibility to adapt the obligations of franchisees to circumstances as they arise. The mechanism used, of course, is the Operating Manual which is the centrepiece of a franchise agreement. The difficulty arises in that amendment of the manual is within the purview of the franchisor whereas the burden of compliance with it rests with the franchisees. This allows the franchisor to essentially alter the terms of the agreement at will. This is precisely what occasioned the recent dispute between the Super Shuttle franchisor and several of its franchisees (even resulting in a wildcat strike as well as litigation). How then should the law address relationship conflicts between franchisors and franchisees?

Broadly, two options are available: the first is to introduce mechanisms into law safeguarding the interests of all small businesses in their relations with larger enterprises: this is the approach in Australia where there is a duty not to act unconscionably (this incorporates a duty to act in good faith when dealing with franchisees). The second approach is to enact franchise-specific protection which has been followed in Malaysia and several other countries.

I prefer the latter for several reasons, one being that the Australian Code must be read with the amendments to the Trade Practices legislation introducing a new definition of ‘unconscionable' conduct. New Zealand would have to adopt a similar definition and grapple with the issue of whom to extend it to (a ‘small business' in New Zealand might mean something very different to one in Australia). A franchise-specific statute would by contrast introduce specific rules governing the relations between franchisor and franchisee, whatever their respective sizes. These are preferable to vague and widely-drawn obligations such as the duty to refrain from ‘unconscionable' behaviour or the duty to act ethically or in good faith; concepts such as these are a recipe for litigation whereas clearly articulated rules can reduce the risk of conflict between the parties.

Rules have many functions: they include setting societal standards (no-one would suggest that repealing the prohibition against homicide will lead to a frenzied rush of murder) as well as preventing conflict and reducing friction in relationships. Many rules of commercial law (for instance, those contained in the Companies Act) exist specifically for the purpose of reducing friction and to facilitate rather than hinder business relationships. The same rationale applies to franchising.

If I buy or set up a stand alone business I decide where it runs, how long it is to be run and any goodwill I generate is mine. With a franchise, all of these things are decided by the franchisor. Risks are part of all business. Professor Terry has said that legislation should be aimed only at protecting franchisees from the types of risks not faced by other small businesses. What are some of these and how might rules be designed to address them?

Disputes frequently arise concerning territory. These include cannibalising of territory that can occur by franchisors: if it is a non-exclusive one, a franchise can be granted to another person in the area or the franchisor can set up operations itself in the vicinity. Legislation might stipulate that, provided it has met the standards expected of it, an existing franchisee ought to have the right of first refusal within a territory.

There is at present no automatic right for a franchisee to sell the business prior to the expiration of the term of the franchise. This is entirely subject to the franchise agreement which frequently bans sale outright or gives the franchisor a veto. Obviously the franchisor must be satisfied as to the suitability of the new franchisee but if this is not an issue can consent be withheld for any other reason? New Zealand cases have been inconsistent and the law in this area is not clear. Any future franchise law needs to clarify the grounds under which the franchisor can withhold consent.

Sale back to the franchisor by franchisees is often problematic: although this often occurs on termination, no standard mechanisms exist for establishing a fair valuation: for example, in one 2005 case, the franchisor was reportedly able to buy back a business for $1 excluding stock and fixtures. This nominal price didn't include the franchisee's liabilities, however. There were other factors that made this much more reasonable than it might seem at first glance, but the news stories at the time did not cover these and the result was a poor advertisement for franchising. A franchise law should contain some procedure for independent arbitration in instances such as these.

There need to be safeguards against arbitrary termination of a franchise. Although existing law does not allow agreements to be terminated unless franchisees are in serious breach of their obligations the standard form nature of the agreement and their detailed nature mean that it can be easy for franchisors to use these as a lever against a franchisee. Franchisees ought to be allowed to remedy any defects within a reasonable period of time - alternatively, this could be part of the requirement to act in good faith.
There should also be a stand-alone requirement for franchisors and franchisees to act in good faith towards one another in the course of discharging their duties under the agreement. Good faith is a fickle concept: it does not exist in the abstract - it can only take form when linked to obligations in the contract, some of which I have outlined above (for example, when withholding consent to a sale of a franchise by the franchisee).

A mandatory dispute resolution procedure should be an essential feature of any franchise law: it is at present a central aspect in the Code of Practice of the Franchise Association but similar provision should be made for all franchises including non-members.

It is also arguable that safeguards should exist for franchisees when either the ownership of the franchisor undergoes significant change or where the franchisor seeks to make major changes to the obligations of franchisees through, for example, changes to the operating manual: in this event franchisors should have a duty to consult franchisees or perhaps obtain the consent of the majority of them. In addition, disaffected franchisees should have the right to sell their business back to the franchisor. Although this last suggestion is likely to be somewhat controversial it at least merits serious consideration in the context of franchise law reform.

Finally, on the other side of the coin, any future franchise law should expressly preserve the right of franchisors to obtain an injunction to restrain franchisees in extreme circumstances: there have been cases where franchisees have committed serious crimes, become mad or otherwise acted in a deliberate manner such as to destroy or damage the franchisor's goodwill. All the countries with franchise laws expressly preserve the rights of franchisors to act in a decisive manner against franchisees in these types of circumstances. Franchisors need not fear that their ability to discipline errant franchisees will in any way be impaired.

Inevitability of Regulation and the Role for Industry Groups

I believe the Franchise Association has a vital role to play in lobbying for and securing legislation aimed at the needs of its members. It should take the lead in lobbying for a franchise protection law as well as in developing the content of such a law. I have suggested a tentative wish-list of topics that may be included but, of course, this is only a starting point for serious debate. Legislation should primarily address the areas where ‘mischief' has been known to occur in franchise relationships. I have indicated a preference for well-drafted ‘rules' in lieu of broad obligations such as the duty to refrain from ‘unconscionable' conduct which would have to be defined through expensive test cases.

Trans-Tasman harmonisation of business law does not have to be ‘Australia's way or no way.' If one looks to the United States, there is considerable variation in the way franchising is regulated across the different states. It is perfectly feasible to develop a regulatory package for New Zealand which caters to its unique requirements. New Zealand should enact a ‘Franchise Protection Act' that contains both a tight definition of a business format franchise (a good one exists in the Association's Code of Practice) and provision for regulations to adopt a mandatory code of practice. The advantage of such a regulation-making power is to preserve flexibility as well as to allow the input of interested groups such as the Franchise Association.

Lastly, I believe regulation of franchising will in the end strengthen it. It will reduce the need for litigation, introduce certainty and streamline drafting for lawyers (thereby reducing costs). Most important of all, by giving people confidence that those buying a franchise get a fair deal, it will encourage more people into the sector and help good franchises to grow.

Gehan Gunasekara is a senior lecturer in commercial law at the University of Auckland's School of Business where he researches and teaches the law surrounding franchising. He has contributed to several legal books and journals in both New Zealand and overseas.
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