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Friction at the end may be the beginning of a dispute

It is not unusual that one of the most difficult times in the ‘life-cycle’ of a business relationship between the franchisor and franchisee is at the end of the term of the franchise whether or not there is an option to renew and whether or not the end of the term is by expiry of the franchise on the end date or by termination by one party for breach of the franchise agreement.

 

Even if there is no option to renew or the franchisor disputes the franchisee’s exercise of the option because of breaches of the franchise agreement, a franchisee may find it difficult to understand or accept that the franchisee’s right to operate the franchise business is at an end. 

 

Emotionally the franchisee may feel that even if the franchise term has ended that it is the franchisee who owns the business and that the franchisee’s customers and the franchisee’s trained and skillful staff are assets of the franchisee to be used in the continuation of the business.

 

Even if the parties accept that there is a difference between the specific business operated by the franchisee and the franchisor’s franchise system, brand and intellectual property, there may be other terms of the franchise agreement that make problematic any intention by the franchisee to continue to operate the business after the expiry of the franchise term independently of the franchisor’s franchise system, intellectual property and brand-name.

 

Our experience as franchise dispute lawyers has shown that many franchise disputes that are resolved by mediation conducted under the Franchising Code of Conduct (Code) are on terms that include the franchisor allowing the franchisee to de-brand the franchise business and be permitted to operate the business as an independent business outside the franchise system. Such a resolution of the franchise dispute in this manner may involve the payment of compensation by one party to the other party depending on the nature of the dispute.

 

This outcome when it is achieved often involves the franchisor giving up certain rights such as a right to enforce restraints of trade and rights to the business’ customer list. Franchisors are not always willing to permit this post termination arrangement without the franchisee paying compensation to the franchisor.

 

The outcome in our experience is more likely to occur when the business is marginally profitable but viable once franchise fees are removed as a cost of operating the business, but not so profitable that the franchisor has an incentive to take over and operate the business or sell it to a prospective new franchisee.

 

The resolution of end of term disputes may be complicated if, during the franchise term, the franchisee has made a substantial capital expenditure in order to operate or continue to operate the franchise business.

 

The fact that the franchisee has made substantial capital expenditure during the term of the franchise can be a substantial point of friction on the termination of the franchise agreement, especially if:

  1. The franchise agreement gives the franchisor a right to acquire the franchisee’s fit out, or equipment purchased by the franchisee at considerable costs during the term of the franchise; and
  2. The franchisor intends to operate the franchise business or to sell it to prospective new franchisees.

This point of friction has led, in our experience, to several serious disputes. It is likely to continue to be a source of disputes in the future.

 

The Code anticipates the potential problems including financial stress caused by franchisors making unreasonable demands for large scale expenditure by franchisees on point-of-sale systems, fitout, signage, equipment upgrades, refurbishments not only at the commencement but during the term of a franchise agreement. 

 

The Code prohibits a franchisor from requiring a franchisee from undertaking significant capital expenditure not disclosed to the franchisee before a franchise agreement is signed or extended but there are important exclusions which means that franchisees may ultimately need to meet significant capital expenditure items.

 

If a franchisee has been required to make Code compliant significant capital expenditure then it is likely to be a source of friction if there is a dispute in respect of end of franchise term arrangements about the franchise business.

 

Recent case

The decision in Zhang & Liu Investment Pty Ltd v Nando’s Australia Pty Ltd [2023] VSC 199 is an example of a dispute between franchisor and franchisee on the expiry of a franchise agreement in which the franchisor sought to acquire equipment purchased by the franchisee during the term of the franchise. This case was an appeal from a summary judgment decision against the franchisee.

 

The Facts

The facts of the case were as follows:

  1. The franchisor (Nando) and franchisee (Zhang) entered into a franchise agreement in 2011; 
  2. The franchise term was 5 years and was renewed once in 2016 for a further term of 5 years;
  3. Nando did not wish to renew the franchise agreement again when it expired on 6 May 2021, and instead wish to exercise a contractual right under clause 18 of the franchise agreement to operate the restaurant business and acquire certain fixtures, fittings and equipment (Assets) of the franchisee at a price to be agreed by the parties or at fair market value to be determined by a valuer appointed by Nando;
  4. Nando offered Zhang $50,000.00 plus GST for the Assets;
  5. Nando proposed three independent valuers to Zhang, and when Zhang failed to respond, Nando appointed one of those valuers to value the Assets;
  6. The Assets were valued at $134,610.00;
  7. Nando’s took possession of the business in May 2021 on expiry of the franchise term.

 

Issues

There was a primary issue between the parties as to whether the obligation in clause 18 of the franchise agreement on which the franchisor relied to acquire Zhang’s business assets applied only if the franchisor terminated the franchise agreement for breach or also applied to expiry of the term of the franchise agreement if not renewed. This was an issue of interpretation about the meaning of an ambiguous clause in the franchise agreement.

There was a further issue about whether the valuation should have attributed any value to alleged capital improvements undertaken by the franchisee at the direction of the franchisor. Zhang alleged that the value of the Assets was $372,035.00. Success on this issue for Zhang was contingent on Zhang succeeding on the primary issue.

 

Court’s decision

The Court in dealing with the primary issue considered several clauses in the franchise agreement which used either or both of the words ‘expire’ and ‘termination’ or their derivatives and which although they overlapped were not synonymous. 

The court noted there was ambiguity in clause 18 due to the clause not using the word expiry or expiration but found that ‘termination’ in clause 18 meant termination by actions of a party (e.g., for breach) or by effluxion of time. 

Specifically, the Court found the purpose and object behind clause 18 was to ensure a mechanism at the conclusion of the franchise agreement for Nando to continue to exploit the benefit of the franchise business that was then operating after the incumbent franchisee has ceased operating the business and to acquire the Assets at a price to be agreed or at market value to be determined by an independent valuer to enable the business to be operated by Nando.

Despite finding against Zhang and indicating it would have otherwise dismissed the Appeal in the ordinary course, the court did not dismiss the Appeal as the summary judgment part of the orders made by the Associate Judge may have worked an injustice to Zhang by preventing him from bringing a claim for recovery of the amount of the valuation payable to Zhang pursuant to clause 18, or to challenge the valuer’s expert valuation.  

In effect the Court’s orders permitted Zhang to amend the statement of claim to seek to recover the amount of $134,610.00 pursuant to the clause 18 valuation but its claim to recover $372,035.00 could not be maintained.

Although this case was a dispute about what Nando should have paid Zhang for taking back and operating the franchise business the subject matter of similar disputes is often whether the franchisee should keep the business as an independent business outside the franchise terms.

 

Take aways

The case shows that friction at the point at which a franchise agreement expires by effluxion of time or is terminated by action of one of the parties can lead to a dispute and the commencement of costly legal proceedings.

The lesson for franchisees to draw from this case is the importance of making sure that the due diligence done before signing the franchise agreement covers any foreseeable significant capital expenditure during the term of the franchise agreement. Compensation for capital expenses may be restricted or prevented by the terms of a franchise agreement.

It is also important that franchisees obtain legal advice that covers all risks of obligations under the franchise agreement including those obligations that arise at the end of franchise agreement, including whether the franchisor has the right to step in and continue to operate the franchise business and acquire the franchisee’s business assets used in the operation of the franchised business.

There is also a lesson for franchise lawyers from this case. 

The case reinforces the importance of careful drafting and the consistent use of terms in franchise agreements to avoid ambiguity, which may be a source of expensive legal disputes. There is really no excuse for a lack of precision in drafting legal agreements.

Specifically, when franchise agreements provide a regime for what happens to the franchise business after termination or expiry of the franchise agreement, it is important that terms such as terminate or expire, or their derivatives, are used in a careful and consistent manner.

The last thing parties to a franchise agreement need is for the end of the franchise to be the beginning of a long costly legal dispute.

 

 

Bill Morgan has over 25 years of experience in Commercial Litigation and Dispute Resolution with a focus
on the franchise sector. He is a nationally accredited mediator and is a panel member of the Australian Small Business and Family Enterprise Ombudsman.

 

Morgan Mac Lawyers
T: (07) 3221 2221 | E: info@morganmac.com.au | www.morganmac.com.au