Franchising Focus

June 2010

Contacts

Due diligence – not just a legal concept

by Marshall Bromwich

A recent New Zealand case has highlighted the need for prospective purchasers of a business to have an understanding of the industry in which a potential target operates before making an acquisition. While the majority of purchasers will undertake financial and legal due diligence in relation to a target, such enquiries are usually limited in scope and focused exclusively on the operations of the relevant entities rather than general industry issues. For due diligence to be truly effective, it is important to be aware of any practical issues that may not be evident from a review of the written documents and financial reports provided as part of a formal due diligence process.

In the New Zealand Court of Appeal case, a purchaser had no recourse against the seller of a wholesale liquor distribution business where a significant component of the target business effectively disappeared shortly after settlement. The target business supplied liquor, including beer, directly to a range of bars. A number of these bars had exclusive arrangements with a major beer manufacturer which prevented them from acquiring beer from other suppliers. The beer manufacturer had granted a number of these bars waivers to permit them to acquire products from the target business.

Shortly after completion of the transaction, the beer manufacturer withdrew these waivers and sought to enforce the exclusivity of their arrangements with the bars. As a consequence, the bars were unable to acquire further products from the target business which instantaneously and significantly reduced the value of the target business. The purchaser was unsuccessful in its claims against the seller for breach of warranties on the basis that these arrangements were not disclosed during due diligence. The issue for the purchaser was that the target business was not a party to the contracts in question and the court accepted the seller’s evidence that it had no knowledge of the exclusive arrangements.

While the seller may not have been aware of the arrangements, the court noted that these arrangements were relatively common in the industry. If the purchaser had a greater understanding of the industry, the risk that customers of the target business were tied to exclusive arrangements with third parties could have been identified earlier and dealt with during the transaction process.

Due diligence is the process of investigating a business so that a prospective purchaser can make informed decisions as to:

  • whether to proceed with the purchase
  • the price to be paid, and
  • the structure of the transaction.

The example in the above case is the type of issue that can be easily overlooked during a due diligence process as it would be generally beyond the scope of inquiries that a purchaser would instruct its advisers to undertake. It demonstrates the importance of understanding the industry in which a target business operates to enable the identification of the key risks to the ongoing success of the business.

Effective due diligence is an important step in any acquisition but it can be a very expensive and time consuming task if it is not properly scoped before the process commences. From a legal perspective, it is important to focus on issues that are material to the operation of the particular business to ensure that the due diligence conducted is cost effective and the results are relevant and useful.

Engaging advisers (both financial and legal) that have an understanding of the industry in which a business operates will ensure that the process is as efficient and cost-effective as possible. However, any such due diligence needs to be supplemented with a degree of commercial/industry due diligence to be truly effective and to ensure the results can be seen in context.

Employment contracts - validity of set-off clauses upheld

by Diana Diaz and Stuart Kollmorgen

Provided that an “all-inclusive wage rate” is higher than the amounts the employee would have received under an award for hours worked, employers can use set-off clauses to pay their employees an all-inclusive rate.

The Fair Work Ombudsman (the Federal watchdog for employees’ minimum entitlements) has confirmed that it considers set-off clauses as a valid means of making payments to satisfy minimum monetary award entitlements.

Guidance Note 7 (issued 31 May 2010) confirms that over-award payments can only satisfy monetary award entitlements to which an above-award wages payment is directed. It explains:

“Paying a higher wage rate than the award minimum does not offset penalties or loadings in the award unless it is clear that the parties intended to do so (and in fact, the amount satisfies the entitlements that would otherwise be payable to the employee). If an employer has properly entered into an offsetting arrangement that makes it clear that over-award payments are in satisfaction of all penalties, wages etc due under the award, that arrangement can continue to be relied upon to satisfy increases that arise as a result of the commencement of modern awards. In addition, employers can agree with their employees to enter into such an arrangement with respect to future payments.”

While awards such as the Hospitality Industry (General) Award 2010 and the Restaurant Industry Award 2010 include clauses which expressly allow an employer pay an annualised salary in satisfaction of certain monetary entitlements (provided that certain conditions are met), the General Retail Industry Award 2010, Fast Food Industry Award 2010 do not have such clauses.

Provided that an all inclusive rate is higher than the amounts the employee would have received under an award for the hours worked, employers covered by awards without annualised salary clauses can use set-off clauses to pay their employees an all-inclusive hourly wage or annual salary in satisfaction of minimum award entitlements such as minimum wages, allowances, leave loading, penalty rates, overtime, and weekend and public holiday rates.

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Franchisee Under Reporting - Termination for Fraud?

by Nigel Jones

It is an unfortunate fact of running a franchise network based on a royalty income stream, that from time to time a Franchisor will uncover evidence of franchisees under reporting the gross income of their businesses. In these circumstances, Franchisor's wish to understand their rights to terminate the Franchise Agreement for fraud. Although, each matter will need to be considered on a case-by-case basis, a broad overview of the key principles in terminating for fraud is as follows:

  • Fraud is a very serious allegation and there is a high onus to establish it. Prior to termination, the Franchisor must be completely satisfied that it is in a position to prove fraud in Court.
  • Assuming that evidence of fraud exists, the entitlement to terminate will typically be based upon:
    • Contractual rights:
      • typically by reliance upon an express right to do so in the Franchise Agreement; and
      • also based upon the existence of implied terms requiring the parties to deal honestly with each other.
    • Repudiation - Fraudulent conduct is also likely to amount to the franchisee indicating an intention no longer to be bound by the terms of the Franchise Agreement. Such conduct could be characterised as repudiatory which the Franchisor could then use as a basis to bring the Franchise Agreement to an end.
  • There are a number of potential constraints on the right to terminate for fraud. These include:
    • Where it would be unconscionable for the Franchisor to do so. Relevant factors may include:
      • the materiality of the fraud considered in the context of the breakdown in trust and confidence in the relationship which may result from the fraud;
      • whether the Franchisor has an ulterior motive in bringing the relationship to an end;
      • whether the Franchisor itself has engaged in questionable conduct of a fraudulent nature; and
      • the manner in which the Franchisor has treated other Franchisees for similar conduct.
    • Whether it would be in breach of the implied duty of good faith and fair dealing for the Franchisor to do so. Similar considerations as those which apply to unconscionable conduct will need to be considered.
    • Whether the Franchisee is entitled to relief against forfeiture on the basis that a great and disproportionate loss will be suffered by the Franchisee as a result of a "minor" incident of underreporting.

In summary, where clear evidence of fraud is established, a Franchisor will typically be entitled to terminate a Franchise Agreement.

However, great care needs to be exercised in considering the evidence and determining that it is sufficiently compelling to persuade a Court that the conduct is fraudulent. Termination for fraud can be a high stakes strategy and Franchisors should always at least consider the merits of a negotiated exit from the network by the Franchisee. Additionally, caution always needs to be exercised where:

  1. The termination consequences are arguably very disproportionate to the fraudulent conduct. This issue is most likely to arise where the amount of the fraud is modest;
  2. The Franchisor's conduct in dealing with its franchisees may have been dishonest in some respects;
  3. The Franchisor has an ulterior motive in bringing the relationship to an end; or
  4. Termination for fraud would be inconsistent with the manner in which other franchisees have been treated.
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Mediation Update

by Nigel Jones

The ACCC has recently publicised the results of a study which it co-funded in relation to franchising relationships. The study was undertaken by Griffith University on issues arising in franchise conflict.

The study raised a concern that many franchisees were not using mediation services to resolve issues in the franchise relationship. This was despite the fact that the Franchising Code of Conduct provides a clear mechanism in clause 29 for mediation to be used to endeavour to resolve disputes.

In its press release issued on 10 May 2010, the ACCC said:

"The ACCC will look to address some of the issues raised in this study through further education of the franchising sector, with a particular focus on prospective franchisees. Ideally, all franchise systems should develop effective in-house compliance systems to prevent conflict escalating to the point where a complaint is lodged with the ACCC."

As part of Norton Rose's Franchise Workshop Series, we recently held a seminar dealing with the mediation process and strategies for obtaining most effectively utilising mediation. You can access the notes from our Workshop Series here.

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