Franchising and directors’ duties

an Article by Deva Saraswati, Associate, Watkins Tapsell Solicitors that also appeared in Governance Directions, October 2015.

Part of selling any business is to highlight its good points, how much income it makes and the benefits that buying it can offer to any potential purchaser. Problems can arise, however, when those benefits are oversold.

In a franchise this area results in additional risk, as the franchisor must ensure that they are complying with the Franchising Code of Conduct and the Competition and Consumer Act 2010, in addition to the usual warranties regarding disclosure that arise with selling a business.

While it may be tempting to ‘talk up’ the good aspects of a business being sold, recent decisions by the Federal Court of Australia makes it clear that a franchisor, and the directors of that franchisor, must ensure that they do not misrepresent the value of the business to get a sale.

The cases: Coverall

  • Australian Competition and Consumer Commission v South East Melbourne Cleaning Pty Ltd (in liq) (formerly known as Coverall Cleaning Concepts South East Melbourne Pty Ltd) 1
  • ACCC v South East Melbourne Cleaning Pty Ltd (in liq) (formerly known as Coverall Cleaning Concepts South East Melbourne Pty Ltd) (No 2)2

Facts of Coverall

Coverall operated a franchised system in Victoria for cleaning services provided by franchisees. Coverall entered into franchise agreements with two franchisees, Mr Eliaser and Mr Patel.

As part of the Agreements, Coverall maintained relationships with businesses to provide them with cleaning services. Coverall negotiated all services and prices for those services with these businesses. Coverall’s franchisees then provided the cleaning services to the customers. The franchisees had no direct contractual or financial relationship with the customers. Coverall also collected all payments from the customers for the cleaning services provided by the franchisees and passed the payments on to the franchisees, after deducting its franchisor franchise fees.3

Coverall promised that, in exchange for the franchise fees, Coverall would provide business and cash flow support, which included billing the customer and collecting all payments from the customer, as well as enough cleaning work to meet a guaranteed monthly amount. The amount of work provided was determined by the particular ‘franchise plan’ that the franchisee purchased.

Mr Eliaser for example, purchased the ‘P4’ franchise plan in which Coverall guaranteed that it would deliver him, Mr Eliaser, a minimum of $4,000.00 gross billings per month.4 These promises were made by both Mr Jones, Coverall’s sole director, and Ms Haley, Coverall’s sales manager.

Both Mr Eliaser and Mr Patel purchased franchises based on the above promises, in part through up front payments, and in part by a ‘loan’ from Coverall for the balance of the franchise fee.

Mr Eliaser was 23 years old and had never been a franchisee before. He also had no previous business experience and was limited in his ability to understand legal documents. Coverall did not advise him to obtain independent legal advice, but they accepted a statement from him that was contradictory in that it stated that he had been told to obtain advice, and stated both that he had sought independent advice and not sought independent advice.

Mr Patel was also a first time franchisee, and while he signed a certificate saying he had been advised to obtain independent advice, he also stated that he had not chosen to obtain it.

Coverall, Mr Jones and Ms Haley, were all aware of these facts in relation to both franchisees.5

Coverall arranged commercial contracts with customers, to provide cleaning services to those customers. The cleaning services were to be provided by the franchisees. Mr Eliaser and Mr Patel then provided cleaning services to customers of Coverall. Coverall invoiced the customers and collected the fees.

The franchise agreement stated that on the 30th day following the month in which the services were provided, Coverall was to pay the franchisees the amounts collected, less the franchise fees owing to Coverall. Coverall did not pass on the fees to the franchisees, as required under the franchise agreement. Mr Eliaser, for example, undertook $15,301.43 worth of cleaning services for Coverall’s customers between October 2013 to April 2014, which was well under the minimum monthly guarantee. He was only paid $635.19.Mr Patel provided $13,141.19 worth of services between September 2013 and September 2014, also beneath his minimum monthly guarantee, and was paid a total of $2,204.46.6

In the case of Mr Patel, Coverall also engaged a debt collector to recover the ‘loan’ when he did not make the required payments, despite not providing payments to Mr Patel for work he had undertaken.

The Court’s decision

In proceedings brought by the ACCC, the Federal Court of Australia found that South East Melbourne Cleaning Pty Ltd (in liquidation) (formerly Coverall Cleaning Concepts South East Melbourne Pty Ltd) as franchisor had contravened both the Australian Consumer Law, and the Franchising Code of Conduct. The court found that:

  1. The franchisor had engaged in misleading and deceptive conduct, in breach of s 18 and 37(2) of the Competition and Consumer Act 2010 Schedule 2 — Australian Consumer Law (ACL), including:

1.1 overstating what potential income two potential franchisees might earn if they bought a franchise from the company;

1.2 misrepresenting the systems the franchisor had in place under the franchise to both collect payments from customers and to pay franchisees on time; and

1.3 misrepresenting that Coverall would pay the franchisees a minimum figure, whether or not that amount of work had been undertaken.7

  1. The franchisor acted unconscionably, in breach of Section 21 of the ACL, by:

2.1 failing to pay money owed to the franchisees

2.2 demanding repayment of the loans, and engaging debt collectors to recover the loans, despite not providing payments to the franchisees

2.3 taking advantage of their stronger bargaining power, noting the inexperienced nature of the franchisees.8

  1. The franchisor had breached the Franchising Code of Conduct by:

3.1 providing the prospective franchisees with earnings information that was not based on reasonable grounds

3.2 failing to disclose information required under the Code

3.3 entering into an agreement with Mr Eliaser without the required statement that Mr Eliaser had either obtained legal and financial advice, or had been told to obtain advice and decided not to do so.9

Penalties

The court ordered a penalty of $500,000 against the franchisor, Coverall in relation to the Company’s breaches of the Australian Consumer Law in its actions towards Mr Patel and Mr Eliaser. This was made up of:

  • $300,000 in relation to two breaches of s 21 of the ACL for unconscionable conduct (one against each franchisee)
  • $200,000 in relation to four contraventions of s 37(2) of the ACL for misleading and deceptive conduct (two against each franchisee).

The court also made orders against the sole director, Mr Jones, personally. He was:

  • ordered to pay compensation to each of the franchisees directly, which totalled $23,604.44 ($17,713.79 to Mr Eliaser and $5,604.65 to Mr Patel) being the amount of their loss as assessed by the court
  • required to pay a $30,000 penalty for his ‘deliberate, unfair, and exploitative’ conduct.10
  • required to pay $5,000 towards the ACCC’s costs
  • disqualified from managing a corporation for two years
  • required to give an undertaking that he would not be ‘directly involved in the marketing and/or management of a franchise business.’11

The sales manager, Ms Haley, also gave an undertaking that she would not be ‘directly involved in the marketing and/or management of a franchise business’.12

Franchising and Directors Duties

The new Franchising Code of Conduct

The case above was brought under the previous Franchising Code of Conduct. An updated Code was introduced on 1 January 2015.13

The new Code:

  • includes the obligation for parties to act in good faith in their dealings with one another • introduces financial penalties for serious breaches of the Code
  • requires that franchisors provide an information sheet to prospective franchisees which sets out the risks of franchising
  • requires increased transparency on the part of franchisors in their use of marketing and advertising funds
  • requires new disclosures in relation to on line commerce, for example if the franchisee may make goods or services available for sale on line, or if there are restrictions on selling goods and services on line
  • places increased restrictions on franchisors requiring significant capital expenditure by franchisees during the term of their franchise.

If the Coverall fact scenario had occurred under the new Code, it is probable that additional penalties would have been imposed against the franchisor for the breaches of the Code. The ACCC can now seek penalties of up to $54,000 for breaches of the penalty provisions of the Code by franchisors, for example the obligation to act in good faith14 or provide disclosure documents.15

In March 2015, the ACCC stated that ‘compliance with the Franchising Code of Conduct is a Priority for the ACCC’.16

Obligations of franchisors

The Coverall cases serve as a warning both to franchisors, their directors, and to potential franchisees.

For franchisors, it is essential that you comply with the Australian Consumer Law and the Franchising Code of Conduct in all dealings with your franchisees and Potential franchisees. There are significant penalties that can be imposed by the courts of it is found that a franchisor has breached their obligations under the legislation.

For directors, it is evident that the court is quite happy to order penalties against a director individually, even where there is a company structure in place, if the director is aware of, or is engaging in conduct that is in breach of the Franchising Code or the Australian Consumer Law. The company structure does not protect directors if they are engaging in conduct that is, for example, misleading, deceptive or unconscionable.

For potential franchisees, the warning is to carefully research any potential franchise purchase, including obtaining independent legal and financial advice, as sometimes, what is being sold really is too good to be true.

Deva Saraswati can be contacted on (02) 9521 6000 or by email at devanand.saraswati@watkinstapsell.com.au

Notes

1 [2015] FCA 25.

2 [2015] FCA 257.

3 Above at n1, para 13.

4 Above at n1, para 13.

5 Above at n2, para 3-4.

6 Above at n1 para 23-24 and 37-38.

7 Above at n2 at para 4.

8 Above at n2 at para 3.

9 Above at n2 at para 2.