Franchising Code – compliance and operational next steps

Most franchise systems will see the changes to the Franchising Code of Conduct announced on 1 June 2021 as a sensible conclusion to a 3 year regulatory review process. For most, the changes can be summarised as being manageable, but not ideal. Importantly, the Code changes do not include some of the unworkable recommendations that arose from the report of the Parliamentary Inquiry into franchising.

However the Code changes are not easy to follow in some areas, add compliance costs and, for some franchise systems, will create risks that will need to be immediately recognised, and carefully managed. Increased supply chain disclosure, and changes to termination rights, are likely to be the most problematic areas for franchise systems. To mitigate the impact of additional disclosure requirements, some franchise systems will want to make changes to their supply chain prior to 1 July, 2021.

We recommend that franchisors immediately undertake the following:

1. Review the Code changes and assess the general implications for their business;
2. Urgently assess their supply chain, and whether the additional disclosure requirements concerning third party rebates and financial incentives will cause problems with suppliers, make confidential information available to competitors, impact relationships with existing franchisees or unfairly impact their business. If so, action can be taken to ameliorate the impact, provided it is taken quickly and carefully;
3. Revise existing processes dealing with disclosure, franchisee to franchisee sales, cost recovery and marketing funds to meet the new requirements; and
4. Review dispute handling processes, including how breaches and potential terminations are handled. Although some Code changes only apply to franchise agreements entered into, renewed or extended from 1 July 2021, others apply to all franchise agreements.

Automotive brands need to pay attention not just to the new requirements that apply to motor vehicle dealerships, but be aware of the additional changes to the automotive provisions that are in the legislative pipeline. Dealer Agreements are likely to require significant amendment.

Time is of the essence, as the changes apply:

• From 2 June 2021 for disputes, including disputes in relation to an existing agreement;
• From 1 July 2021 for disclosure, capital expenditure, restraints, cost recovery and termination;
• To disclosure documents given after 1 November 2021.

The Government is still considering how to best introduce a public registry for franchise systems, but it appears current thinking may mean a registry would provide full public access to franchise agreements and disclosure documents. Industry consultation is continuing on this issue.

Franchise documents and disclosure document

The pre-entry disclosure requirements have been revised, including:

• a new form of Information Statement now needs to be provided, with the form published on the ACCC website;
• introducing a new concept of a Key Fact Sheet, which must be provided with disclosure and updated annually, also to be published on the ACCC website;
• a franchisee may require that the disclosure document is provided in printed form, electronic form, or both.

These changes take effect 1 July 2021. However the provisions attempt to allow the changes to apply to a disclosure document given from 1 November 2021, which is consistent with the 4 month updating period for a franchisor with a 30 June financial year. For franchise systems with a different financial year, the intended benefit of the transitional arrangements will not be available and an ‘out of cycle’ update is likely to be necessary.

There are also changes to some of the disclosure obligations in the following areas:

• Leasing information, including whether a franchisor has an interest in a lease;
• Enhanced disclosure of significant capital expenditure;
• A new obligation to disclose the percentage of franchisees that were a party to a mediation, conciliation or arbitration conducted or pending in the previous financial year (whether initiated by franchisees or franchisor)
• A new obligation to disclose the rights of franchisor and franchisee to early termination of the franchise agreement
• The franchisee’s rights to goodwill generated by the franchisee
• Whether the Franchise Agreement includes a restraint of trade
• Rebates and financial benefits from supply chain arrangements.

Earnings information, if provided, must be part of the disclosure document and, if provided separately, can potentially invalidate disclosure. In addition, earnings information must include a statement as to the accuracy and appropriateness of financial information as follows:

“To the best of the franchisor’s knowledge, the earnings information given is accurate (other than particular earnings information specified in the document as earnings information that the franchisor knows is not accurate)”

The requirements for disclosure of rebates and financial benefits are complex. It may be possible to adjust or restructure arrangements to mitigate the impact of these provisions. In summary, franchisors must disclose whether the franchisor will receive a rebate or other financial benefit from a supplier of goods or services to a franchisee. If so, on a supplier by supplier basis, it must disclose:

1. the nature of the rebate or financial incentive
2. the name of each business providing the rebate; and
3. the total amount of rebates/benefits in the previous financial year from each supplier, expressed as a percentage of total group purchases from the supplier (not including purchases by corporate units).

There are some exclusions, including if the franchisee is permitted to buy from sources other than the franchisor, without approval, or the whole of the rebate received is to be returned to the marketing fund. There is also an exclusion that is intended to exempt wholesale supply arrangements from the disclosure obligation. The exclusions are narrow and careful attention needs to be paid to satisfying the precise wording if franchisors seek to rely on an exclusion. Bespoke expert assistance is recommended.

Leases

From 1 July 2021 additional disclosure of leasing arrangements must now be made in the disclosure document, including specific disclosure of franchisor’s interest in the lease, which includes any incentive or financial benefit it is entitled to receive.

The amendments complicate the leasing and franchising disclosure process. To start the 14 day disclosure period, if the franchisor holds the head lease, the franchisor must provide:

• the lease or an agreement for lease; and
• the landlord’s disclosure statement, or a franchisor version containing information of that kind.

There is an ongoing obligation to supply a landlord’s disclosure statement upon written request – as soon as reasonably practical and within 7 days. This covers information disclosed to the franchisor prior to the 1 July 2021 effective date of these changes, and penalties apply for breaches.

The franchisee’s 7 day cooling off period does not commence until accurate lease terms have been supplied to the franchisee. Further, the prohibition against legal cost recovery applies to “documents relating to the franchise agreement”, so includes costs for the outlet licence (and potentially lease) unless such costs are for a fixed amount and payable up-front.

Cooling off

The franchisee’s cooling off period has been extended to 14 days (from 7 days).

If the lease is not in force when entering the franchise agreement, the franchisee can terminate within 14 days after any of the following:

• receiving the first document setting out the terms of the proposed lease;
• receiving any later document setting out the terms of the proposed lease, if those terms are not substantially identical to the first document; or
• entering into the lease or occupancy right, if the franchisor did not first give the franchisee a term sheet which contained substantially identical terms as the actual lease or occupancy right.

The change applies to agreements entered into, extended or renewed on or after 1 July 2021. Although franchisees exercising a right to terminate during the cooling off period is rare, these changes need to be carefully considered by franchisors that control the leasing arrangements. In particular, the process of having franchisees sign franchise agreements before there is an agreed lease should be reconsidered.

Transfers

Transfers are now also subject to cooling off period. This adds unnecessary complexity and cost to the transfer process, although the impact of the changes can be mitigated through changes to franchisor operating processes.

Where the franchisee enters into a new franchise agreement, as is common practice, the Code’s normal 14 day cooling off process applies and the provisions below do not apply.

If the incoming franchisee novates or takes a transfer of the franchise agreement, the buyer may cool off within the earlier of:

• 14 days after “the new franchisee becomes the franchisee for the purposes of the franchise agreement”; or
• “the day the new franchisee takes possession or control of the business”.

If the buyer cools off, the buyer may cease to be the franchisee. If the seller can become the franchisee again, the buyer can cause the seller to do so, cancel the sale contract and novation agreement, recoup the purchase price from the seller (less reasonable, pre-defined expenses) and obtain a refund of any amounts paid to the franchisor (less reasonable, pre-defined expenses).

The change applies to transfers occurring on or after 1 July 2021.

Capital expenditure

The changes to CAPEX obligations in essence amend the Code to adopt the changes made in 2020 to the Code provisions governing the automotive sector. They narrow the circumstances in which a franchisor can impose an obligation to undertake significant capex during the term, and impose a higher threshold of the detail required in order to rely on pre-disclosure. There must now be a statement setting out: “as much information as practicable” including: the rationale; the amount, timing and nature of the expenditure; the anticipated outcomes and benefits; and the expected risks associated.

Where CAPEX is likely to be required during the term there is an obligation to discuss expenditure prior to entering an agreement, addressing the “circumstances under which the franchisee considers” it is “likely to recoup the expenditure, having regard to the geographical area of operations”.

These enhanced disclosure requirements create significant timing challenges for franchisors that wish to implement material changes to the franchise business model.

The change applies to agreements entered into, extended or renewed on or after 1 July 2021.

Marketing funds

There have been various drafting changes to the requirements governing marketing funds, and penalties now apply for failing to comply with all of the key compliance requirements. The changes are largely refinements and clarifications to the existing obligations, and take effect on 1 July 2021.

Legal costs

From 1 July 2021 a franchisor must not enter into a franchise agreement that allows the franchisor to recover its legal costs relating to the preparation, negotiation or execution of the agreement or documents relating to the agreement. This would appear to include not just fees for initial franchise documentation, but the charging of legal fees for breach notices, renewal notices and termination notices. The explanatory statement issued with the changes to the Franchising Code support a very broad interpretation of this restriction on recovery of legal costs.

Cost recovery is permitted where it is a fixed amount and specified in the agreement, stated as being for recovery of legal costs and not inclusive of any costs of legal services provided after the documents are executed. The exception also limits the recovery of legal costs to where the costs are payable before the franchise business commences.

Dispute resolution

Various changes have been made to the dispute resolution framework with effect from 2 June 2021, including describing the role of the Australian Small Business and Family Enterprises Ombudsman and broadening the alternative dispute resolution options to conciliation and arbitration, including binding voluntary arbitration. Most franchise systems will choose not to adopt these new options.

The new framework for multi-party dispute resolution is likely to cause practical problems, in that it allows franchisees with similar disputes to require a single ADR process. Where the multi-party dispute resolution process is initiated, the appointed mediator or conciliator may require the franchisor to participate. In our experience multi-party dispute resolution is rarely successful in resolving disputes, as whilst it may provide franchisees with a greater sense of comfort, it invariably leads to a more adversarial process, and impacts on the ability for franchisors and franchisees to negotiate acceptable separate settlements.

Multi-party dispute resolution is likely to be particularly problematic for franchisors in the context of the new franchisee right of termination described below.

Termination

For franchise agreements entered into, extended or renewed from 1 July 2021 there are important changes to the previous right to immediately terminate those agreements:-

A 7 day notice period is now required for termination in special circumstances, and the right of termination must be in the franchise agreement. Importantly, a franchisee can issue a notice of dispute prior to termination. If a notice of dispute is issued, the franchisor must not terminate for 28 days from the date the original notice was issued (effectively a 21 day extension). The dispute may be referred to an ADR practitioner for an ADR process. Arguably the franchisor is now in a worse position for the serious circumstances that justify immediate termination than for those where a notice of breach is required.

The changes to the immediate termination provisions do offer some relief from franchisors, with the Code expressly allowing for the suspension of a franchisee in special circumstances, provided that the right is included in the franchise agreement.

Additional options will need to be considered for franchise agreements, as immediate termination is much less likely to be used given the risks of substantial delay. Suspension, or the ability to appoint a manager, and other rights may need to be considered.

Franchisee termination

From 1 July 2021 a franchisee may provide a written proposal to terminate at any time. Although this does not give the franchisee a specific right to terminate, it does create a framework that requires careful navigation by a franchisor.

A franchisor must provide a substantive written response to any proposal within 28 days, including reasons if the franchisor refuses to terminate on the grounds proposed. Both the franchisor and franchisee must act in good faith, and a refusal to terminate on the grounds proposed may give rise to a dispute to which the ADR process applies.

Automotive

The changes made to the Code in 2020 to insert specific provisions only relevant to franchisors in the automotive sector have been further augmented by provisions which are likely to cause significant challenges for brand owners.

Some provisions appear more designed for political appeasement than legal effect, and to some degree do not even make sense. For example there is a new requirement for an agreement entered into from 1 July 2021 to provide for compensation for early termination if a franchisor decides to undertake early withdrawal from the Australian market, rationalisation of a network or changes to distribution model in Australia. The compensation must take into account lost profit, unamortised capital expenditure, loss of opportunity to sell established goodwill and the costs of winding up the franchised business. The amendments appear to ignore the fact that so called “early termination” would in fact be a breach of the franchise agreement that would entitle the franchisee / dealer to compensation on the same basis as provided in the amendments.

Amendments to the good faith obligation now provide that a court must have regard to whether the terms of the Agreement are fair and reasonable. This amendment confuses conduct, which is the essence of good faith, and contract law, which is already regulated at a Federal level and in New South Wales under legislation specifically focused on unfair contract terms.

The Code now requires that the terms of a franchise agreements should provide franchisees a reasonable opportunity to make a return, during the term of the agreement, on any investment required by the franchisor as part of entering into, or under, the agreement.

Great care will need to be taken before entering any agreement after 1 July 2021, particularly as further changes have been flagged that are likely to contain additional restrictions on automotive franchisors.

Future changes

The Government has flagged future changes to the Code to require the mandatory registration of franchise systems via a public registry of franchise systems. The timing is uncertain, but it is likely to be Government run and the Government has committed to funding of $4.3 million over a four-year period, starting in 2021-22

Penalties under the Code are also flagged to increase from 300 to 600 Penalty Units, and for penalties to applying to a broader range of breaches of the Code.

Additional changes have also been flagged to the automotive provisions.

Next steps

To learn more about the Franchising Code of Conduct, visit our 'Marketplace' hub page, or watch our webinar on the amendments to the Code.

We have been working with our franchisor clients to deliver training to head office teams and have also updated the franchising module in our online training program, Compliance Manager . Please contact a member of our team if you are interested in discussing either of these training and compliance measures.