Franchise Agreements and the obligations to act in good faith and reasonable cause

The typical franchise operates within a business structure that gives the franchisor discretion to implement strategies, introduce new products and set prices for the ‘branded’ goods or services. These commercial decisions however must be exercised in ‘good faith and reasonableness’.

The obligation of good faith is reflected in the Franchising Code of Conduct which sets out mandatory processes for buying and selling a franchise and regulates the conduct of franchisors and franchisees.
The obligation of good faith was considered at length in Virk Pty Ltd (in liquidation) v Yum! Restaurants Australia Pty Ltd [2017] FCAFC 190.

The case concerned an appeal from an earlier decision where Pizza Hut franchisees claimed that, by introducing its ‘Value Strategy’, franchisor Yum! breached terms of its franchise contract, engaged in unconscionable conduct and was liable in negligence. The strategy required franchisees to slash pizza prices and reduced the pizza range from four to two categories, resulting in financial loss for many franchisees.

The original case and appeal were unsuccessful, with both considering the scope of the duty of good faith and whether that duty requires a franchisor to act reasonably.

The duty of good faith and reasonableness

In the original decision, the judge referred to the concept of good faith and reasonableness when finding that the franchisor had not breached this obligation.

On appeal, the franchisees conceded that the franchisor had acted honestly and in good faith, however sought to dissect the element of ‘reasonableness’ from the composite phrase ‘good faith and reasonableness’, to attribute liability to the franchisor. In other words, the reasonableness of the franchisor’s decision to implement the price-reduction strategy should be given separate consideration on an objective basis.

The Court disagreed with this approach preferring that the elements of good faith and reasonableness must be considered collectively. Consequently, if it is found that good faith is exercised, it follows that an element of ‘reasonableness’ is also present.

Further, and favouring a subjective test of the concept of reasonableness the Court considered the focus should be on the alleged conduct rather than the result produced.
The Court stated:

‘The obligation, expressed as one of good faith and reasonableness, is to be considered in a composite and interrelated sense. To the extent that consideration is given to whether a party’s conduct is reasonable or not, it is directed to the primary component of the obligation, namely of good faith. Reasonableness is not to be approached in a case such as this as akin to a tortious duty to exercise due care and skill or to produce a reasonable outcome. Rather it goes to the quality of the conduct…’

Absent behaviour that is ‘capricious, dishonest, unconscionable, arbitrary or the product of a motive which was antithetical to the object of the contractual power’ the franchisor’s commercial decision could not be considered as having been exercised in bad faith.

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Parties to a franchise arrangement must act in good faith within the meaning of the unwritten law as determined in various cases. Essentially, good faith requires parties to act reasonably, honestly and not arbitrarily, with a common goal of achieving the purposes of the agreement.

Franchisees must be aware that franchisors will usually have discretion to change branding, introduce or delete products, or change policies and processes. Whilst this discretion is not unfettered, it may, as in the above case, impact upon the financial viability of the franchisee’s business. In this respect, franchise agreements often contain terms protecting the franchisor from claims if the business or proposed location of the business is unsuitable, or the franchise unprofitable.

Franchisees should give careful consideration to the constraints of a franchise system and the potential need to adapt to changes imposed by the franchisor, before committing to an agreement.

Key points for franchisors

The obligation to act in good faith applies to all aspects of the franchise arrangement – from pre-contractual negotiations, for the duration of the contract and, in some circumstances, after its termination. The obligation is mandatory and cannot be excluded from the relationship.

The franchisor has discretion to introduce change and make key decisions affecting the conduct of the business, in doing so must consider the rights and interests of the franchisee. This obligation will not prevent a party from acting in its own legitimate commercial interests nor must a franchisor act purely in the interests of the franchisee.

In complying with the Code and the obligation of good faith, franchisors should:

• have comprehensive and carefully drafted franchise agreements that clearly set out the respective rights of the parties, taking into consideration their statutory requirements;
• make commercial decisions that are in the overall best interests of the franchise network and that have been well-researched, tested and that comply with the provisions of the franchise agreement;
• ensure that franchisees are appropriately trained and implement sound consultation and review systems that allow reciprocal feedback;
• make a careful assessment of a potential franchisee and its capacity to successfully operate the franchise business before entering into the franchise agreement.

In determining whether conduct constitutes good faith, franchisors should consider;

• the integrity of their dealings with the franchisee;
• whether the franchisee’s interests have been evaluated;
• whether there is an ulterior motive for the proposed conduct;
• attempts to resolve disputes or disagreements with franchisees, where relevant;
• the consultative processes adopted within the franchise system;
• whether adequate assistance is provided to a franchisee, particularly if a franchisee has difficulties using systems specifically designed for use in the franchise system, for example, software for mandatory reporting to the franchisor;
• the potential for a conflict of interest (whether territorial or otherwise) between the franchisee and a related franchisor business entity.

If you or someone you know wants more information, please contact us on (03) 9600 0162 or email info@lordlaw.com.au.