Franchising in Australia: An Introduction

Australia is arguably the most highly regulated environment in the world in which to conduct a franchised business.

This article outlines an Australian trend whereby businesses that would traditionally have utilised a franchise model to grow and develop their business are looking to alternative models that give them greater control over their network, and align them better to all stakeholders.

History of franchising in Australia

In Australia 20 years ago, a franchise agreement could largely contain any terms that the franchisor considered appropriate, provided an explanatory disclosure document was given explaining the relationship and the terms of the agreement.

A common theme of the franchisor-franchisee relationship was that the franchisor wanted to make sure that the franchisee was obliged to comply with the franchise system and represent the brand in a manner consistent with the franchisor’s brand positioning.

Over the past 20 years, successive governments in Australia have heavily regulated the franchising sector on the premise of providing adequate protections for potentially vulnerable franchisees, leading to Australia becoming perhaps the most regulated environment for franchising in the world.

Good faith

Pursuant to the Franchising Code, each party to a franchise agreement must act towards another party with good faith, within the meaning of the unwritten law from time to time, in respect of any matter arising under or in relation to:

• the franchise agreement; and
• the Code.

The obligation to act in good faith contained within the Code extends to negotiations and discussions before the parties enter into a franchise agreement.

“Good faith” is not defined in the Franchising Code, which provides that “each party to a franchise agreement must act towards each other with good faith, within the meaning of the unwritten law”. The “unwritten law” means the law developed in the Australian courts through case law or common law.

The High Court of Australia has held that good faith involves “fairness in dealings between contracting parties” (Commonwealth Bank of Australia v Barker [2014] HCA 32).

Similarly, the Federal Court of Australia has held that the obligation to act in good faith means to:

“act honestly and with a fidelity to the bargain; an obligation not to act dishonestly and not to act to undermine the bargain entered or the substance of the contractual benefit bargained for; and an obligation to act reasonably and with fair dealing having regard to the interests of the parties (which will, inevitably, at time conflict) and to the provisions, aims and purposes of the contract, objectively ascertained” (Paciocco v Australia and New Zealand Banking Group Limited [2015] FCAFC 50).

The obligation to act in good faith includes the following elements:

• honesty;
• fairness;
• not acting arbitrarily;
• co-operating to achieve the purpose of the franchise agreement;
• reasonableness; and
• having regard to the interests of the other party.

While the Franchising Code does not define “good faith”, it provides that a court may consider whether a party acted honestly and not arbitrarily, and whether it co-operated to achieve the purpose of the franchise agreement when assessing whether that party acted in good faith.

The development of the law of good faith means that franchisors cannot simply look to their own interests in consistency within the franchise system to justify actions and decisions. While a party must take the interests of the other party into account, the obligation to act in good faith does not prevent a party from acting in its own legitimate commercial interests. Consequently, a party is not required to act in the interests of the other party at the expense of its own interests.

The view of the Australian Competition and Consumer Commission (ACCC) is that conduct is prohibited where it harms the franchisee but is not necessary for the protection of the franchisor’s interests. The Federal Court of Australia has accepted that view, and held that the duty to act in good faith does not enable a party to make a general claim that there has been a failure to act in good faith. Where a franchisee complains that a franchisor has not acted in good faith, the Court has held that “the focus of an obligation of good faith should ordinarily be on a franchisor’s use of powers and opportunities available by reason of the franchise relationship” (Australian Competition and Consumer Commission v Ultra Tune Australia Pty Ltd [2019] FCA 12).

Unfair contract terms

Under the Australian Consumer Law, contract terms in a standard form small business or consumer contract (including franchise agreements) are deemed unfair if they:

• cause a significant imbalance in the rights and obligations of the parties under the contract;
• are not reasonably necessary to protect the legitimate interests of the party advantaged by the term; and
• would cause detriment to the other party if applied or relied upon.

Prior to 9 November 2023, if a court or tribunal found that a standard form small business franchise agreement contained a term that was “unfair”, the term would be void, meaning it would not be binding on the parties.

Since 9 November 2023, businesses are prohibited from entering into standard form contracts with small businesses or consumers that include unfair contract terms. They are also prohibited from applying or relying on (or purporting to apply or rely upon) unfair contract terms in contracts entered into or renewed, or any unfair contract terms that are varied, on or after 9 November 2023.

The ACCC can now seek significant financial penalties from businesses that breach these prohibitions. Subject to the transitional arrangements for standard form contracts entered into before 9 November 2023, entering into contracts with, or relying or purporting to rely upon, unfair contract terms may now be subject to significant penalties. This means that many provisions that would typically have previously been seen in franchise agreements are now unlikely to be permitted, such as:

• entire agreement provisions;
• set off for the franchisor only; and
• unilateral variation provisions.

Perhaps most troubling, the ACCC has expressed a view that restraint of trade and non-competition clauses may infringe the unfair contract laws.

Unconscionable conduct

Good faith (discussed above) and unconscionable conduct are different legal concepts, both of which must be complied with by franchisors in Australia.

Pursuant to Section 20 of the Australian Consumer Law, a person in trade or commerce must not engage in conduct this is unconscionable, within the meaning of the unwritten law from time to time.

This is referencing the fact that there is no codification of what will amount to unconscionable conduct; what amounts to unconscionable conduct will be determined by the courts in Australia on the merits and circumstances of each occasion in which are asked to make an assessment.

However, Sections 21 and 22 of the Australian Consumer Law provide the following.

• First, that the court must not have regard to any circumstances that were not reasonably foreseeable at the time of the alleged contravention of the duty not to engage in unconscionable conduct.
• Second (without limiting the matters that the court may have regard to), the court may have regard to the following (this list relates to suppliers, and similar provisions apply in respect of acquirers):
1. the relative strengths of the bargaining positions of the supplier and the customer;
2. whether, as a result of conduct engaged in by the supplier, the customer was required to comply with conditions that were not reasonably necessary for the protection of the legitimate interests of the supplier;
3. whether the customer was able to understand any documents relating to the supply or possible supply of the goods or services;
4. whether any undue influence or pressure was exerted on, or any unfair tactics were used against, the customer or a person acting on behalf of the customer by the supplier or a person acting on behalf of the supplier in relation to the supply or possible supply of the goods or services;
5. the amount for which, and the circumstances under which, the customer could have acquired identical or equivalent goods or services from a person other than the supplier;
6. the extent to which the supplier’s conduct towards the customer was consistent with the supplier’s conduct in similar transactions between the supplier and other like customers;
7. the requirements of any applicable industry code;
8. the requirements of any other industry code, if the customer acted on the reasonable belief that the supplier would comply with that code;
9. the extent to which the supplier unreasonably failed to disclose to the customer any intended conduct of the supplier that might affect the interests of the customer, or any risks to the customer arising from the supplier’s intended conduct (ie, risks that the supplier should have foreseen would not be apparent to the customer);
10. if there is a contract between the supplier and the customer for the supply of the goods or services: the extent to which the supplier was willing to negotiate the terms and conditions of the contract with the customer; the terms and conditions of the contract; the conduct of the supplier and the customer in complying with the terms and conditions of the contract; and any conduct that the supplier or the customer engaged in, in connection with their commercial relationship, after they entered into the contract;
11. without limiting the above, whether the supplier has a contractual right to vary unilaterally a term or condition of a contract between the supplier and the customer for the supply of the goods or services; and
12. the extent to which the supplier and the customer acted in good faith.

In the matter of ACCC v Productivity Partners Pty Ltd (trading as Captain Cook College), the High Court of Australia has confirmed that the Act does not require a court to evaluate the impugned conduct by reference to the presence or absence of the circumstances the Act specifies, irrespective of the relevance of those circumstances to the impugned conduct or to the cases as put by the parties to the court. However, the Court has made clear that, insofar as a factor in the Act is applicable, “that matter must be considered. If not applicable, the matter need not be considered”. The judgment goes on to say that the Act does not “codify the values of Australian statute and common law” nor “resolve such difficulties in its application”. The provision articulates “a list of wide-ranging matters to consider when applying these values”.

It is the totality of the circumstances relevant to the conduct being considered which dictates if any matter set out in the Act applies.

This case confirms that a matter will not be characterised as unconscionable unless it is “outside societal norms of acceptable commercial behaviour [so] as to warrant condemnation as conduct that is offensive to conscience. Some form of moral turpitude remains an important measure of unconscionable conduct”.

Vicarious liability

Historically, the view was that employees of the franchisee were the responsibility of the franchisee alone.

In Australia, there has been growing recognition in recent years that franchisors may bear vicarious liability for the conduct of their franchisees, particularly in relation to obligations owed to franchisee employees. Franchisors should be conducting audit-like activities to monitor what franchisees are doing to comply with employment laws; failing to do so could have significant brand and financial consequences for franchisors.

Manuals and unilateral variation

Historically, manuals were heavily referenced in a franchise agreement and were said to be incorporated in the franchise agreement; therefore, adding to or amending the manual would change the terms of the contract.

After recent changes to the Franchising Code, the ability of franchisors to make unilateral variations to a franchise agreement is now limited, including restricting the ability to amend the manual that forms part of a franchise agreement.

Furthermore, the Franchising Code obliges franchisors to disclose unilateral changes that might occur during the term of the franchise agreement. If a particular unilateral change is not disclosed, it will impact the franchisor’s ability to make such a change.

Considering alternatives to franchising

As Australia has arguably become the most regulated franchising environment in the world, some businesses are starting to consider alternative strategies to implementing a franchising strategy in Australia.

Many people consider that the environment in Australia no longer enables a franchisor to have sufficient control over their franchisees due to the regulatory environment restricting contractual protections and prohibiting certain conduct that would historically have occurred to enforce brand standards and systems.

Current and prospective franchisors are starting to assess whether franchising is the best option for them, considering:

• if they will have obligations to the franchisee’s employees;
• if they cannot confidently enforce standards; and
• if franchisees can walk away from restraints because they are unfair contract terms or because there has been a decision to move away from a franchise model to a different model and simply take the system knowledge with them.

The two key approaches in Australia are as follows.

• First, the use of a corporate structure with employees being incentivised through bonuses and employee share plans using both short-term and long-term incentives. The Franchising Code does not apply to this arrangement.
• Second, the use of a corporate structure with a number of different classes of shares enabling equity participation for persons who would otherwise be franchisees.

The different classes of shares can divide participation in revenues and profits from a company-wide share down to a share of profit from a single shop or business unit.

Adopting this structure (subject to it being properly implemented) means that the business moves out of an environment where the regulator is the ACCC and instead becomes regulated by the Australian Securities & Investments Commission (ASIC).

If correctly structured, the Franchising Code no longer applies, with regulation under the Corporations Act and related legislation instead taking over.

The level of control improves substantially for the business if it elects not to franchise and instead adopts a corporate structure. It can direct employees to do exactly what they want them to do. Furthermore, this corporate structure provides a higher value business for both the entity that would have been the franchisor and the person who would have been the franchisee.

The following case study is intended to demonstrate this concept.

Case study – Back in Motion

Back in Motion was a physiotherapy franchised business with 64 clinics across Australia and New Zealand. As an aside, it was quite a unique franchise in Australia (and perhaps globally) because it is a health and professional services franchise; many people have considered that medical and health professionals could not successfully be obliged to comply with a franchise system.

Franchises in the Back in Motion network were traditional franchises, with an upfront fee and ongoing royalties and marketing fees paid by franchisees on their revenue.

Once up and running, a single Back in Motion business operating under a franchise agreement might be capable of being sold at up to approximately three x Earnings Before Interest and Tax (EBIT).

The franchisor was considering a sale of its business as the franchisor of the network, and was able to negotiate a sale of not just the franchisor company, but of 100% of the franchisee businesses as well, at the same time to the same purchaser, which was an Australian Stock Exchange-listed company that did not itself operate a franchise system but operated similar businesses.

In this transaction, the value obtained by each franchisee was substantially above three x EBIT, which was a fantastic outcome for the franchisees involved, who could never have individually achieved a financial outcome at that level by selling their individual franchises. The franchisor also benefitted by a share in the upside that was recognised in the former franchisee businesses.

In the transaction, Back in Motion became “unfranchised”. Upon the sale date, each franchise agreement was cancelled and instead each former franchisee was granted a unique class of share that related to the physiotherapy clinic from which they operated their former franchise.

The unique share meant that each former franchisee could choose what percentage of their business they wanted to sell and what percentage they wanted to effectively retain to continue to work in a relationship akin to a joint venture with the purchaser company. The unique share also enabled each former franchisee to share in a corresponding percentage of profits related to the business they were working in and managing, now as an employee of the company.

In this model, there is a true symbiotic relationship between the company and the employee, whereby they are both focused on profitability rather than revenue (noting that most franchises take their royalties from the top line whether or not a franchisee business makes any profit).

Choosing a structure or restructuring

An entity that already operates a franchise network does not need to wait for a sale of its entire network to restructure away from franchising to a corporate model. This can be done at any time.

If a business is considering franchising as a business model to grow the business, it should consider all business models before determining if franchising is in fact the best model.

Models other than franchises can include:

• a company with a single class of shares (listed or unlisted);
• a company with multiple classes of shares (listed or unlisted);
• a joint venture (incorporated or unincorporated);
• a partnership (of individuals, companies or trusts); or
• a unit trust, among others.

Conclusion

Franchisors and potential franchisors do not need a franchise-specific lawyer to advise them alone – they require advice about a range of structural options, of which franchising is only one.

Even if franchising is chosen as the relevant business structure, a range of laws apply to operating a franchise structure in Australia.

As Australia is home to many domestic and international franchises, the arrangements that should exist between Australia and other international operations also require consideration, such that globally connected advisers can often add additional value through their experience and networks.