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The break-up: What happens when franchises go wrong

Monday, 4 February 2013 | By Leon Gettler

feature-heartbreak-hotel-thumbA franchise has often been compared to a marriage. Franchisor and franchisee have a close working relationship built on trust and mutual respect.


But just as some marriages break down in divorce, there are times when franchisees and franchisors get caught up in costly disputes.


All sorts of issues might come up. A franchisee could say the franchisor had given undertakings on how the business would perform when they signed up, and it didn’t.


On the other side, the franchisee might be underperforming for a whole range of reasons. Maybe they have discovered they are not cut out to run a business, maybe they’re getting divorced.


A handful of disputes end up in court but most are resolved outside because franchisees usually can’t afford a lengthy court case and the franchisor needs to keep costs down, with an empty store costing them money.


A slice of the legal pie


The most recent case has seen Pie Face franchisees preparing to sue the company for millions of dollars, with one franchisee alleging that undisclosed costs were a key factor in the underperformance of his stores.


Pie Face, founded in 2003 by former investment banker Wayne Homschek and his wife Betty Fong, sells savoury and sweet gourmet pies along with sausage rolls, sandwiches and drinks.


The franchisees claim they are losing money because the franchisor is opening outlets close to their stores.


Prit Dutta, one of the three Brisbane-based Pie Face franchisees taking legal action, said the marriage didn’t work because Pie Face was not keeping its commitments.


“The problem was they opened too many shops within a three minute walk,’’ Dutta said. “When we purchased the shop, they found the location and they built the shop and they sold it to us with forecast figures of what the shop would do and it’s not matching the forecasts.”


“I paid $450,000 for the store. They have sold bigger shops with more fit outs and more inclusion for $390,000. I keep asking them why did you charge me more?”


He says the franchisor had also left off key expenses like staff entitlements, accounting and IT costs.


As a result of all this, his store was not making the profit figures that had been forecast.


He said he had challenged the franchisor to come in and run the store themselves to see if they could make the profit. When they didn’t, he took legal action.


But Homschek has defended his company, telling SmartCompany “we’re in the business of franchising, and not everyone is going to be a good franchisee”.


“Not all of them are going to make the business what it could be,” he said.


When projections don’t materialise


There have been other cases. Last year, for example, there was the Billy Baxter’s case where a Glenelg franchise suffered losses.


As a result, the franchise owners were unable to pay the fees due under the franchise agreement.


They terminated the franchise agreement and the franchisor accepted their termination as repudiation of the franchise and proceeded to pursue legal action to recoup the outstanding fees.


The franchisees denied the claim. They hit back with a counterclaim that they had been induced to enter into the franchise agreement by the misleading and deceptive conduct.


In the end and in a unanimous decision, a previous decision was reversed by the Victorian Court of Appeal into the franchisee’s favour, with $1.22 million damages awarded.


In the Muffin Break case of 2007, the franchisor granted a franchise to operate a muffin shop at a particular shopping centre and the franchisor's representative allegedly made various representations, orally, with respect to the anticipated performance of the unit.


The projections did not hold true, and the franchisee sued for misrepresentation. The franchisor was ordered by the courts to pay $316,570.31, plus interest on a loan.


Courting costly litigation


The franchise industry claims that the dispute level is low, far lower than the divorce rate, but the Franchise Relationship Institute puts the average level of disagreement at 18%.


Ilya Furman, the principal solicitor at Franchise Legal, says the industry’s claims are misleading.


“The industry can claim that only a very small percentage of relationships give birth to a serious dispute and the vast majority of those disputes are fairly quickly resolved but the statistics don’t truly reflect the reality,’’ Furman says.


“The reality is most franchisees can’t afford to take it to court, in which case the franchisee doesn’t have much choice.”


“They either do nothing about it and live with it, or within a tight budget mount some sort of case and live with a settlement under very much compromised conditions.”


“And there are some problems franchisees will just live with if overall if it’s commercially viable for them to continue.”


He says the disputes just keep coming in. His firm picks up lots of work. “They have been fairly constant certainly in the last 10 years that I’ve been in the business,’’ he says. “In terms of disputes, we have a constant flow of work.”


Where does it all go wrong?


The most common flash points? “The common areas usually are promises made by franchisors to induce the franchisee into entering the agreement and those promises not being fulfilled. Usually it’s: ‘You told me I would make this much and I made nowhere near that much.’


“Another common complaint is the franchisor not delivering support services. Other disputes relate to franchisees that are more advanced and saying, ‘I’m happy running the business but I don’t need the franchisor’.”


He says there is only way to avoid this from happening – do the proper due diligence before entering an agreement and get good legal advice.


Unfortunately, he says, many aspiring franchisees don’t do that.


“Good legal advice and negotiation before entering into the agreement will get rid of a lot of it and then good legal advice at the early stage of a disagreement can also prevent them developing into big disasters,’’ he says.


“Most franchisees don’t get good legal advice before they enter into agreements and often don’t really understand the financial commitments. They think, ‘It’s a business, I’ll give it a go and if it doesn’t work, I’ll just go and do something else’. But usually it’s very difficult to just go and do something else.”


The reality is that in a five to 10 year agreement, the franchisee would have to pay out the franchisor if they decided to terminate before the agreement expires.


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Does the code of conduct help or hinder?


He says franchisees have rights under the franchising code of conduct.


Furman says: “The franchising code of conduct has specific provisions about how to deal with disputes. It has a step-by-step system and provides for mediation, which is an informal way of attempting to resolve a dispute and the franchise agreement itself is a contract.”


“It’s a source of rights and obligations for both parties. You have an overriding code of conduct which is compulsory as also you have a private contract which specifically negotiated rights and obligations.”


The then small business minister Brendan O’Connor last month announced a review into the franchising code, set up by the Howard government in 1998, which ensures prospective franchisees receive key information about a franchise before making a financial commitment and entering into a franchise system and ensures they have certain rights in their ongoing franchise relationship.


Under the code, franchisors have to ensure franchisees are aware of all the company’s particulars, and must follow set procedures when dealing with franchisees.


But Furman says it needs fixing.


“In relation to disclosure, I think it would be good if you had to on the front page of the disclosure document sign a statement of minimum financial agreement,’’ he says.


“I think it would be much more user friendly if it had on the front page of the agreement a simple sentence saying if you’re entering this agreement, the simple financial commitment is X.”


“Also, if you break the provision there should be a fine payable. Today if a franchisor breaches the code, there is no immediate consequence. There may be nothing as a result of the breach.”


“It really is up to the franchisee to go to court and prove they suffered loss as a result of that particular conduct.”


But Stephen Giles, deputy chair of the Franchise Council of Australia, says there is no need to change the code, which has all the legal weight of legislation.


“The bottom line is Australia has the best regulatory framework in the world, the code is very strong on disclosure and all the information has to be provided. The franchisee has protections if there is any misleading conduct or misrepresentations, the Competition and Consumer Act applies,” Giles says.


“And if there is an issue where there has been illegal conduct, they should go to someone like the ACCC and they’ll find if they move quickly, all these problems will tend to sort themselves out.


“The code contains almost a fool-proof process for people to make an informed decision if they follow the system. The problem often derives from when the franchisees don’t get advice.”


Buyer beware and get good advice


The failure to get good advice before entering an agreement is the big problem, he says.


“Once you make the decision, you are entering into a long-term relationship and it is subject to the contract and you can’t change your mind half way through. Often people will get legal advice when they’re buying a house and it’s surprising the number of franchisees who won’t spend a little bit of money to get good legal and business advice.


“Typically if the business is running well and making profits, like a marriage, there is not a problem; but if there are financial stresses involved then the franchisee and the franchisor are both impacted by that, there will be a problem,’’ he says.


“If you have a franchisee who hasn’t been as successful as expected, it’s a fundamental human coping mechanism to say it wasn’t my fault.


“It’s unusual these days with the strong regulatory environment for there to be any systematic inappropriate behaviour by a franchisor who is on to that. There is a strong regulatory framework and a pretty well informed franchisee market place so pretty well most of the disputes are about business issues and expectations and dreams.”


So if the system is so good, why are there still disputes?


“Most of the disputes tend to be mismatched expectations,’’ he says. “A lot of the surveys show people consistently underestimate how difficult it is to run a business, how taxing it is personally, how time consuming it is.


“Also, the franchisor might say the franchisee is not following the system, the franchisee might say the problem is I misunderstood the nature of the relationship, the franchisor is not doing what they are supposed to do.”


Giles says problems are best handled by mediation or by franchise advisory councils that many franchise operations have running. This will allow them to talk to other franchisees. “If they’re having a problem, then others might be having the same problem,’’ he says.


Keeping lines of communication open


He says regular communication is another way to avoid the problems. “The good franchise systems really focus on communicating frequently and effectively with their owners because the people who buy a franchise business want to be part of a team, they want to have a collaborative relationship and they want to have the support they need.


“Sometimes there are disputes which are essentially communication breakdowns.


“It’s a bit like a marriage. If you stopped communicating with each other, then sometimes the relationship breaks down for that reason.”


Peter Buckingham, managing director of Spectrum Analysis, which advises the franchise sector, says one way to avoid disputes is for the franchisor to have good modelling analysis of the market.


“If the answer is based on a wet finger in the air, I say go look for a new franchise system that will do better than that,’’ Buckingham says.


“The Act says you have to do your own due diligence. Different companies have different levels of assistance to do that. Some of the good companies will actually give you a list of the other franchisees and say give any one of these a ring and have a chat.


“If you did take that liberty and you rang five or six franchisees and visited one or two and everyone was rosy, you’d be feeling pretty comfy.


“Also, a lot of the franchisors now do a lot of psychographic testing of people to see if they’re suitable to be a franchisee.”


And as a franchisee, you have to ask a few hard questions and probably ask for analogue modelling.


He says bigger franchises provide that sort of modelling but smaller ones don’t.


“A lot of people go into smaller franchises, small chains and chains getting started and you can only look at what you can look at,” he says.


Buckingham says franchisees tend to take action “when everything turns to crap.”


“Normally these things don’t end up in court,’’ he says. “The code of conduct and the whole franchising documentation is very much about seeking a mediator as soon as possible.


“Most franchise agreements have a dispute resolution tactic that normally brings these things to a head because most people are pretty gun shy about going to court.”