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Friday, April 24, 2015

Representations as to future profit – a fine balancing act

By Nadia Guadagno, Senior Associate, and Catherine Francis, Law Graduate

Franchisors making representations regarding profitability has been flavour of the month in the courts. Recently, a cleaning company franchisor, South East Melbourne Cleaning, was ordered to pay a hefty penalty of $500,000 for unconscionable conduct and making false and misleading representations about earnings to its franchisees. Bank of Queensland (BOQ) franchisees, on the other hand, were unsuccessful in their claims that the bank had made misleading and deceptive statements about future profitability. Let's take a quick look at each case to understand the contrasting results.

ACCC v South East Melbourne Cleaning 

The ACCC went after the Melbourne-based cleaning company, South East Melbourne Cleaning, for breaching the Australian Consumer Law and the Franchising Code of Conduct.

The court found that the company had misled two people into signing up to run franchises, with promises of earnings that never materialised. On top of this, the franchisor also refused to pay monies owed to the franchisees, while at the same time insisting that the franchisees pay significant amounts of money for the right to run the cleaning franchises. The individuals involved had very little business experience, and the court was unimpressed that the franchisor took advantage of this.

These were all factors that went to the decision to impose such a high penalty. The ACCC had asked for a slightly higher penalty of $600,000, but will no doubt be heartened by this result. It shows that the Federal Court is willing to impose substantial penalties if the ACCC can show that franchisors are not doing the right thing by franchisees.  As the cleaning company has gone into liquidation, it won't actually end up paying the penalty. The Federal Court knew this but awarded a substantial penalty anyway, as the court wanted to send a clear message to other franchisors not to flout consumer law.

The total amount of $500,000 was awarded due to multiple breaches of the Australian Consumer Law. However, some of the conduct was also in breach of the Franchising Code of Conduct. The court sounded a warning to franchisors that the Code is there to guard against those who 'may be tempted to exploit their significantly stronger position for their own advantage'. At the time of the conduct in this case, the old 1998 Code applied, which didn't provide for financial penalties for breach. The new Code that applies as of 1 January 2015 has its own direct penalties, so the ACCC can use this to pursue franchisors who don't comply with its strict requirements. Non-compliance with certain provisions of the Code will now attract significant penalties of up to $51,000 for each breach. As an alternative, the ACCC can issue infringement notices of up to $8500 for a body corporate or $1700 for individuals.

Traderight v BOQ

As part of its interstate expansion, BOQ appointed a number of franchisees in New South Wales to operate BOQ branches. Unfortunately, some of the branches were so unsuccessful that their proprietors were forced to cease trading. A deluge of proceedings against BOQ followed.

The main allegation made against BOQ was that it engaged in misleading or deceptive conduct in the course of the negotiation and formation of the franchise agreements. Two types of statements were claimed to have been made by a BOQ employee during introductory meetings with the prospective franchisees.
  • 'Target statements' – Based on BOQ's modelling, a metropolitan franchisee would need to write $4 million, and a regional franchisee $3 million, in new loans on average per month to have a successful business and that a franchisee ought to be able to meet those targets.
  • 'Break-even statements' - Based on BOQ's modelling, if a franchisee wrote new loans to that level each month, there would be a break-even point of 8 to 12 months.
The prospective franchisees were also given Expression of Interest letters and a disclosure document which contained various disclaimers, including that BOQ cannot give any assurances about costs, revenue or future profitability of their branch and that prospective franchisees are responsible for assessing their own financial resources and capabilities. Prospective franchisees were also advised to obtain independent advice, speak to existing franchisees and prepare their own business plan.

BOQ was successful at trial and again on appeal. So why did the court find differently in this case?
  1. The statements made by the BOQ employee were not representations as to the future financial performance of any particular branch – instead they were statements of hypothetical possibility. The opinions were based on modelling which dealt with a hypothetical case which incorporated assumptions which might or might not match the actual circumstances in which a particular branch was to be established and would operate.
  2. While BOQ was undoubtedly expressing an opinion, it was at most an opinion that if actual circumstances in a particular case matched the assumptions in the modelling, there was a statistically objective basis for a conclusion that particular financial consequences would follow.
  3. In reality, many different factors would contribute to the actual results achieved by a branch including location, the competitive environment and the skills and experience of the branch operatives.
  4. While BOQ had the right to insist on adherence to certain standards, the franchisee would operate within those as it chose and BOQ had no control over the effort expended or business development initiatives of any particular franchisee. As such, BOQ could not know what quantity or quality of business a particular franchisee would achieve.
  5. In light of the above, it was not possible for the BOQ employee to be able to speak meaningfully of what a particular branch could or would achieve and the prospective franchisees must have appreciated that his statements were not more that hypotheses.
The court took into account the fact that the prospective franchisee's principals were commercially sophisticated persons with business and, in most cases, banking experience. At trial, the judge also placed considerable weight on the disclaimers given by BOQ.

Earnings information – risky business!

Both cases demonstrate the salient risks associated with franchisors providing representations as to future earnings and profitability to prospective franchisees. The South East Melbourne Cleaning case demonstrates that failure by franchisors to disclose required information to franchisees, such as earnings and risks of the business, will be in breach of the Code. The ACCC evidently won't be shy to pursue franchisors for this type of conduct. While BOQ was found not to have made misleading representations about future profitability, that case highlights the risks associated with employees making such representations. Franchisors need to ensure that when 'recruiting' new franchisees, the statements their staff make orally are consistent with what is written in the formal documentation.

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