Should the Franchisor terminate without notice?

Franchisee Fraud

Should the Franchisor terminate without notice?

Introduction

When acting for franchisors, an issue can arise where a franchisee is found to have engaged in fraudulent behaviour. This can be failing to properly account for cash or sales or manipulating the cash or POS system. Should the franchisor, confront the Franchisee and disclose the information it has and give them a right of reply, or just terminate the franchise without notice? What are the risks to the franchisor?

The Franchising Code of Conduct (“the Code”) requires franchisors to provide notice of an intention to terminate in certain circumstances.
Clause 23(f) of the Code, however, gives the franchisor a right to terminate immediately without notice and without giving a reasonable time for a franchisee to remedy the breach where the franchisee is “fraudulent in connection with the operation of the franchise business”.

The Franchisor might have what they consider to be clear evidence of fraud. There are still however risks to a franchisor in terminating a franchisee without notice, even though the Code gives franchisors that right.

What is fraud?

A franchisor needs to be extremely cautious in relying on this provision of the Code to terminate a franchisee. Each case must be examined on its own facts.

Fraud is not defined in the Code. A common legal definition of fraud is “an intentional dishonest act or omission done with a purpose of deceiving”.

Is it fraudulent for a franchisee to fail to account for cash takings or deliberately doctor the weekly takings and alter its POS system? The answer is clearly yes!

What evidence do you need to support the allegation of fraud? There can be grey areas when dealing with allegations of fraud.

A franchisor risks an allegation by a franchisee that they have acted unconscionably by being terminated without notice. The franchisee may say that it has a reasonable explanation for its conduct or that the conduct arose by reason of a failure on the part of the franchisor or a failure in the franchisor’s own system.

In weighing up the action to take, franchisors and their legal representatives need to be mindful that a franchisor may be ordered to pay damages and individual directors and officers of the franchisor may be made personally liable to a franchisee where they have been terminated without notice.

The Franchising Code of Conduct seeks to protect the party considered to be at a disadvantage, in this case the franchisee. The Code therefore sets out termination procedures and notice requirements where there are allegations of default.

Franchisees make a substantial investment to establish a franchise particularly retail franchise. The upfront capital costs could be in the order of $250,000.00 to $500,000.00.

The franchisee’s ability to obtain a return on that investment will generally only come from running the business over the term of the Franchise. If the franchise is terminated at an early stage, the franchisee has no ability to obtain a return on their investment, and they will undoubtedly crystallise a loss.

The Courts are mindful of protecting the interests of a franchisee, noting the powerful position of a franchisor and that the franchisor will retain any goodwill and will have the ability, after termination, to bring in a new franchisee and/or on sell the franchise.

Most franchise Agreements impose an obligations on a franchisor to agree to acquire on termination the plant and equipment at written down value and stock at invoiced price.

Even where a franchisor may have clear evidence of dishonest conduct, a franchisee can still allege that termination without notice was inappropriate and unconscionable and seek injunctive relief under the Trade Practices Act (section 80 or 87) 1974 (Cth) or, alternatively, rely on the Court’s power to grant injunctive relief.

The decision by a Franchisor to terminate without notice must therefore be considered carefully.

The case of Bingham v 7-Eleven Stores Pty Ltd considered the issue of alleged franchisee fraud and the validity of an immediate termination with notice.

In this case, a termination notice was issued and the franchisee’s lawyers requested particulars of the alleged fraud. The franchisor’s lawyers responded stating as follows:

“We are not able at this stage to provide you with material that evidences fraudulent operation by [the franchisee]”.

The franchisee sought an injunction preventing the franchisor from acting on the termination notice. The Court granted an interlocutory injunction. The matter progressed to trial. The franchisor failed to produce evidence of the alleged fraud, and was restrained from acting on the termination notice. An appeal to the Queensland Court of Appeal by the franchisor was dismissed.

The Test

The cases where this issue has been examined by the Court seems to balance the right of a Franchisor to terminate without notice for certain serious conduct against the irreparable harm to a party (the franchisee) arising from the termination.

The Courts have imposed a greater burden on franchisors to establish fraud, or a risk of further fraud occurring before conceding a Franchisor’s right to terminate without notice.

It is important therefore for a franchisor to objectively analyse the actual evidence upon which they will rely with their legal advisors before terminating as once terminated a franchisee has a right to claim loss and damage.

Risks to a franchisor post termination

A franchisee will undoubtedly allege that the franchisor has acted unconscionably where there has been a termination without notice, particularly if there is some doubt as to the evidence of fraudulent activities. However, allegations by Franchisees of unconscionable conduct are difficult to prove in this context and often franchisees do not have the means to contest the termination.

There are implied terms of good faith and fair dealing which may also impact on a franchisor’s decision to terminate without notice. The case of Priority Management Systems NSW 2007 establishes that the implied term of good faith requires a franchisor to exercise its powers under the Franchise Agreement reasonably and honestly, considered objectively and not rely on information provided by third parties.

Other considerations in assessing whether a Franchisor has acted in good faith are:

• whether the franchisor acted for some “ulterior motive” or was acting legitimately to protect its commercial interests; and
• whether the franchisor stands to benefit from termination after taking control of the business.

The Judge in the Priority case suggested that exercising a termination right would not be unconscionable where the Franchisor had not engineered or contributed to the default and the Franchisor was protecting its legitimate interests by terminating the Contract, for example, by ensuring it can collect its own franchise or other fees to which they were contractually entitled.

Summary

Raising the allegation of fraud with a franchisee and requesting an explanation and justification of any inconsistencies, may be an option in some limited circumstances. This gives the franchisee a right to respond which may assist the franchisor counter any allegation that they have acted unconscionably.

Proceeding to a mediation under the Code may be an option before terminating without notice, however in some circumstances that may be adverse to the franchisor’s interests.

It may well be that there is no option to protect the franchisor’s interests but to terminate a fraudulent franchisee. That would be the case if there is compelling evidence that the franchisee has acted in an intentionally dishonest way and their conduct was likely to continue to cause loss to the franchisor and possibly to the franchise system as a whole.

Ultimately, there are risks for franchisors in terminating a Franchisee without notice despite the right to do so bearing in mind franchisees have equitable rights under the Trade Practices Act and at common law.

Termination without notice should therefore be carefully considered by a franchisor as an action of last resort, and only where there is clear evidence of fraud.

Robert Toth | Partner| Corporate & Commercial
p +61 3 9612 7297| f +61 3 9629 4035
robert.toth@wisemah.com.au | http://www.wisewouldmahony.com.au

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