Important legislative proposals affecting franchising

Two proposed legislative changes, having consequences for franchising, are currently winging their way through the legislative channels.

They are:

1. Proposed changes to Part 6A of the Employment Relations Act 2000; and

2. Commerce (Cartels and Other Matters) Amendment Bill.

Both pieces of legislation have gained considerable traction and will affect the franchising industry if enacted, which seems very likely.

The purpose of this short note is to briefly explain each of the above two proposed legislative changes, and comment on where they will raise challenges in the franchising world (for franchisees and franchisors).

The franchise sector needs to ensure it understands these proposed changes and any business that does not agree with the changes should make their own independent submissions. It is my view that the changes will, if enacted, be bad for franchising and will slow down commercial growth. They are a good example of franchising being caught in the tangle of wider commercial and social problems that affect society. As an industry, franchising has to be strong in declaring itself to be very different from other business models, and with protections already in place to ensure weaker contractual parties, and the end consumer, are not disadvantaged.

Changes to part 6A of the Employment Relations Act.

Part 6A of the Employment Relations Act was enacted to provide protections for certain groups of employees in the cleaning, orderly, catering and laundry industries. The protections kick in when the employer’s business undergoes restructuring and the employee’s work is assigned to a new employer (because, for eg, the contract has been awarded to another party). Under Part 6A, those employees have a right to transfer to the new employer on the same terms and conditions of employment.

Part 6A was designed to manage possible disadvantage to vulnerable employees as a result of repeated renewal of their employment contracts following a restructuring, sale of the business or the awarding of contracts from their employer to another party.

The provisions were designed to ensure that when a business was sold, or a contract changed hands, the terms and conditions of an employee’s contract were not then ratcheted down and tinkered with, thus disadvantaging the “vulnerable” employee.

Prior to Part 6A being enacted, vulnerable employees were constantly exposed to changes in their wages and hours every time there was a restructure.

Without a doubt, there were plenty of good moral and policy reasons for the enactment of Part 6A and, as a whole, Part 6A is here to stay.

Part 6A has however proved troublesome for many SME's, in particular, the fact that it is the employees who have the right to choose whether their employment is transferred.

In franchising, especially in the area of cleaning franchises, it has meant that a franchisor who wins a contract can be forced to take on employees from an outgoing contractor, despite the fact that the reason the new contract was awarded to someone else was the useless job being done by the outgoing contractors’ employees.

A key aspect of the Part 6A change proposed, and very much welcomed by businesses and employers, is that businesses with fewer than 20 employees will be exempt from Part 6A, when they take over a new contract.

As was recently reported by FANZ, the trouble for franchising is that the Government is proposing to create a class of "associated persons" to be taken into account, as well as those of the employer, in tallying up the numbers of employed persons in order to attract the exemption. The consequence is that both a franchisee AND the franchisor must employ fewer than 19 persons between them, in order to be exempt from Part A. This is, as was explained recently by FANZ in a letter from the Minister of Labour, Hon Simon Bridges, is to "help ensure that only genuine small-to-medium businesses are exempt".

The purpose of the “associated persons” limitation is to prevent large employers from setting up SME’s to take advantage of the exemption.

“Associated persons” will include the incoming employer, the parent company of the incoming employer, other subsidiaries of the parent company, other subsidiaries of the incoming employer, subcontractors engaged by the incoming employer and the immediate franchisor of the incoming employer.

Under this very wide definition, a cleaning franchisor who secures a contract for work will not be exempt where the total numbers of persons employed by the franchisor and the franchisee exceeds 19.

That the exemption could potentially not apply in franchising seems to completely misunderstand the true contractual and commercial nature of franchising.

The respective businesses of franchisor and franchisee are legally and commercially separate. They are not joint ventures, they are not related entities, and they are not partnerships. They rely on each other for commercial success, as do any contracting parties, but therein ends the commonality.

The purpose of the “association persons” definition, as currently proposed, is to avoid the multiple setting up by one company of subsidiaries or other entities as a means of avoiding compliance, thereby using the company structure as nothing more than a device. In franchising, this could not be farther from the commercial realty of what goes on. There is nothing about the franchising model which suggests the sort of commercial contrivance or device sought to be caught by the purpose of the associated person definition.

These are important distinctions, which have been completely misunderstood, by whoever has deemed it necessary to bring franchising under the umbrella of the associated persons definition.

If this legislation affects your business, I urge you to make submissions on this legislation, which, in its current form, will continue to be a bind for franchisors (to say nothing of the affected employees), if enacted in its current form.

Cartels Bill

Introduced in 2010, the Commerce (Cartels and Other Matters) Amendment Bill represents the largest amendment to the Commerce Act since it was enacted in 1986.

In May this year the Bill was reported back from Select Committee and is now one certain steps closer to enactment.

There are essentially two underlying drivers behind the proposed enactment:

a) To bring New Zealand's competition laws in line with those of Australia, as part of the Single Economic Market.

b) To enhance the identification of, and enforcement against, global cartels by facilitating the Commerce Commission's ability to co-operate with overseas regulators.

In relation to cartels, the Bill intends to:

a) clarify the scope of prohibited behaviour;

b) introduce new exemptions, including exemptions for collaborative activities and vertical supply arrangements

c) introduce criminal sanctions for hard-core cartel behaviour.

A key feature of the Bill is a prohibition on agreements containing “cartel provisions”. The bill provides that no person may enter into a contract which contains a cartel provision, unless they can rely on one of the statutory exemptions.

A “cartel provision” is defined as a provision, contained in a contract, arrangement, or understanding, that has the purpose, effect, or likely effect of 1 or more of the following in relation to the supply or acquisition of goods or services in New Zealand:

(a) price fixing:

(b) restricting output:

(c) market allocating.

In the draft Bill, Market allocating means allocating between any 2 or more parties to a contract, arrangement, or understanding, or providing for such an allocation of, either or both of the following:

(a) the persons or classes of persons to or from whom the parties supply or acquire goods or services in competition with each other;

(b) the geographic areas in which the parties supply or acquire goods or services in competition with each other.

When I read this definition I was immediately alarmed to see how readily it could apply to franchises. Franchises are a form of market allocation, under this definition.

The bill provides for certain categories of exemptions. If the activity falls within an exemption, there will be no breach of the Act.

Relative to franchising, there is arguably an exemption for “collaborative activity”, as follows:

“(1) Nothing in section 30 applies to a person who enters into a contract or arrangement, or arrives at an understanding, that contains a cartel provision, or who gives effect to a cartel provision in a contract, arrangement, or understanding, if, at the time of entering into the contract, arrangement, or understanding or giving effect to the cartel provision,—

“(a) the person and 1 or more parties to the contract, arrangement, or understanding are involved in a collaborative activity; and

“(b) the cartel provision is reasonably necessary for the purpose of the collaborative activity.

(2) In this Act, collaborative activity means an enterprise, venture, or other activity, in trade, that—

(a) is carried on in co-operation by 2 or more persons; and

(b) is not carried on for the dominant purpose of lessening competition between any 2 or more of the parties.

(3) The purpose referred to in subsection (2)(b) may be inferred from the conduct of any relevant person or from any other relevant circumstance.”

The exemption for collaborative activity does not make it clear that franchising will qualify for an exemption.

Sensibly (and in line with FANZ recommendation), the report back from Select Committee has stated:

“We encourage the Commerce Commission to develop specific guidelines for its application of the provisions of the bill to various franchise systems. This would provide more certainty as to whether the collaborative activity exemption might be applied to particular franchise arrangements.”

It remains to be seen what form these guidelines will take and all franchise businesses should be urged to keep a close eye on developments. I would hope the guidelines provide for a wide definition of franchising so that there is no room for doubt that businesses of a genuine franchising nature are exempt.

Criminalisation of cartels is a significant development in competition law, and when making this change, as has been pointed out in the NZ Law Society’s submissions to the Select Committee, it is important that there remains certainty for bona fide business people. It would be absurd if a genuine, bona fide, franchise business became entangled in the coverage of this legislation.

Without a full exemption for genuine franchise agreements, the bill, if enacted will, through seeking to achieve its pro–competitive purpose by driving out Cartel behavior, unwittingly serve to criminalise arrangements like franchising, which are legitimate and indeed promote competition because they encourage competitive behaviour in the market.

CONCLUSION

Any franchise business worried about these legislation changes should address this by lodging their own submissions.

The franchising sector, having escaped the noose of its own purpose built legislation several years ago, will continue to come under the legislative spotlight. It is shortsighted not to expect that trend to continue, and, as a sector, the franchise industry needs to be ready to continue to address these changes as they come.

As an aside, one can’t help but wonder if a single, overarching, piece of legislation, dealing specifically with the franchise industry, might not, after all, have served some beneficial overall purpose, not the least of which is it would have enabled the sector to be able to point to that legislation as a reason why further legislation was unnecessary. Also, it might have cleaned out the dodgy operators from the industry and, with the Australian experience to learn from, we could have cut back significantly on some of the more draconian and cumbersome features of their legislation which have been well complained about elsewhere.

However, hindsight is a great thing and my point is that these types of challenges will continue to be faced over the upcoming years.

Case note on Club Physical

The recent High Court case involving the Club Physical franchise system will be of interest to franchisors and franchisees alike, not only in regard to the enforceability of restraint of trade clauses but also in relation to the dangers of termination of franchise agreements by a franchisee.

The case has attracted a great deal of public attention, largely because of the way in which the media have chosen to publicise the dispute. A close analysis of the decision however reveals there is little new to franchising in the dispute itself. From a legal perspective, it does not set ground-breaking law but, rather, is an example of the way in which the Court applies basic contract and restraint of trade principles to a franchise agreement.

The franchisee in the Club Physical case had three franchises, having purchased each franchise from previous franchisees in November 2009, December 2010 and June 2011 respectively.

On 8 February 2013, the franchisee issued notices terminating each of the franchise agreements. Franchise agreements do not normally provide for termination by a franchisee, but any party to a contract may of course terminate, in reliance on the grounds provided in the Contractual Remedies Act 1979 (a little understood statute, in my experience, in regard to franchising).

The franchisee alleged that the grounds it was entitled to rely on were:

a) Misrepresentation by the franchisor that it intended to honour its obligations under the agreements; and

b) Breach by the franchisor of its on-going assistance obligations set out in the agreements.

Following termination, the gyms were rebranded “Jolt Fitness” and proceeded to trade under that name.

Under the Contractual Remedies Act, it is not just any misrepresentation or breach which gives rise to the right to terminate. The Act contains the express requirement that the misrepresentation and/or breach have an element of “substantiality”. It must, for example, be demonstrated that the misrepresentation has substantially increased the burden of the cancelling party under the agreement or, similarly, reduced the benefit. Minor breaches, or breaches of a less than substantial effect, will not justify termination.

Importantly (or perhaps, dangerously), where a cancelling party gets it wrong, ie, they terminate a contract where sufficient grounds are not made out, that cancellation can, in and of itself, give rise to a right for the other party to cancel.

That is exactly what happened in the Club Physical case. The franchisor claimed that the franchisee’s action in terminating and rebranding amounted to a repudiation of the franchise agreements. The franchisor relied on that repudiation as grounds for cancellation and therefore cancelled the three agreements.

The case came before the Court as an application for an interim injunction to stop the franchisee from conducting or being interested in any health and fitness business within a distance of 5km from the premises being operated as a Club Physical gym. A cross application filed by the franchisee sought to restrain Club Physical from accessing its membership lists and from contacting members. The franchisee argued, with the agreements being at an end, it owned the membership details of the clients.

In relation to the restraint of trade injunction, the franchisee responded by alleging:

a) because crucial elements of the restraint of trade clauses were not fully completed by the parties on the agreements themselves, there was effectively an incomplete restraint of trade clause;

b) to the extent that the restraints did impose obligations, they were in any event unreasonable; and

c) the franchisor should not be able to rely on the restraint of trade clauses because it was in breach of the franchise agreements.

It is important to remember that the case came before the court as an interim injunction only. This means that whilst interim orders are made (pending a trial), the case will eventually be set down for trial and the issues determined on the substantive basis. As far as the merits of a restraint are concerned, at an interim injunction hearing, the court is only concerning itself with whether there is “a serious question to be tried” that the restraint of trade clause is enforceable.

In the Club Physical case, the restraint of trade clauses were drafted in a way which commonly appears in franchise agreements, particularly agreements drafted in Australia, in that they provided several alternate options for the duration and distance of the restraint. This is a well-known drafting technique designed to facilitate severability of an unreasonable restraint so that a narrower restraint can be enforced.

In the Club Physical case, however, there was somewhat of a glitch or drafting error in that the clauses had not been correctly (or completely) filled in. No geographical distance had been stated for the restraint in relation to two of the franchises. In the other franchise there was a hand written notation regarding the geographical distance, but the duration had not been circled.

Notwithstanding these possible drafting issues, Her Honour Winkelmann J found, that for the purposes of establishing the serious question to be tried, for the two premises where there was no mention of distance, the restraint applied, at the very least, to the premises themselves. In relation to the franchise where the distance only had been mentioned, the court found that the restraint would still relate to 5km from those premises for the duration.

The next issue Her Honour dealt with was whether the restraints were reasonable. On the question of “protectable interest”, which is a matter for the franchisor to prove, she observed, apparently with little challenge, that a franchisor may have a legitimate interest in protecting its goodwill developed through the use of its business model by means of a restraint of trade. The judgment does not record whether there was any real debate or challenge on this topic by the franchisee, in relation to the Club Physical system.

Her Honour then went on to accept the argument of the franchisor that if the franchisee was allowed to continue trading in competition with Club Physical, it would be impossible for a Club Physical franchisee to re-establish itself in the area due to the limited demand for health and fitness gyms. On that basis, she found there was a serious question to be tried that the restraints were reasonable.

Having dealt with that issue she then considered whether the franchisee was released from its obligation to comply with the restraints by virtue of the franchisor’s alleged breach of contract.

She agreed that it was certainly arguable that if a franchisee was able to establish breach of contract by a franchisor which justified cancellation under the Contractual Remedies Act they would not be bound to further perform the provisions of a restraint of trade clause. She then, however, went on to examine the issue of whether or not the franchisor in this case had breached its obligations in the franchise agreement to the extent required to give grounds to cancel.

The franchisee relied on the obligation on the franchisor :

“to provide on-going business development and assistance and advice in relation to the operation of the Club Physical franchise including a site visit to the premises at least four times in each financial year”.

The franchisee’s complaints were:

a) The franchisor’s own Club Physical gyms were undercutting prices across the rest of the group, which created confusion in the market place about the Club Physical offering and undermined the franchisee’s attempts to attract members,

b) The marketing systems were poor. The franchisor refused to review the approach to marketing and instigated marketing campaigns which tended to lose rather than build market share,

c) Attendance at fitness classes provided by the franchisor and charged separately to the franchise fee was very low because the franchisor did not refresh the nature of the classes, meaning that the franchisee’s gyms lost customers to their low cost competitors,

d) Mr Richards did not carry out the required number of site visits.

To corroborate his accounts of events the franchisee produced three letters from other previous Club Physical franchises.

It is clear from the judgment that Her Honour took a robust view of the franchisee’s evidence, finding that the breaches of contracts relied on as justifying cancellation where “poorly supported”. She stated that the franchisee’s evidence was “in significant part, confused and contradictory”, pointing out that the franchisee had complained that, despite promises of assistance and support being made, Mr Richards did not visit the clubs or provide them with any direct assistance or training and he offered a “total lack of support”, but in the affidavit filed by the franchisee, he had admitted there were in fact monthly marketing meetings and that that he had had numerous meeting with Mr Richards in which he raised pricing issues with him.

She also considered it of relevance the franchisee faced the difficulty that the three franchises were brought over a period of almost two years, making the rather common sense point that if the franchise had been dysfunctional throughout, the franchisee’s decision to go and buy two further franchises appeared inconsistent with his allegations of breach of contract.

In granting the injunctions, Her Honour, found that:

a) The franchisor had a strongly arguable claim that it had enforceable contractual provisions which restrained the franchisee from operating a gym at each of the three business premises;

b) The franchisee’s claim that breaches by the franchisor entitling it to cancel must be assessed as weak. Even on the franchisee’s own evidence there was little to support its argument that the franchisor did not provide on-going assistance;

c) There was no evidence that the franchisee had an ability to meet a substantial damages award in the event an injunction was not granted and, at a trial, damages were ordered in favour of the franchisor;

d) By contrast the undertaking the franchisor had given as to damages had substantial value;

e) Other franchisees would be damaged by the actions of the franchisee because the value of the business model they pay fees for will be reduced by the reduction and the overall number of gyms.

She declined to grant the cross injunction that the franchisor stopped contacting the franchisee’s gym members, finding that the franchisee had not established that there was a serious question to be tried that the use by the franchisor of those details was a misuse of the franchisee’s property or confidential information. That was because there was a specific obligation in the agreement which provided that on termination, the franchisee would co-operate to ensure a smooth transition so as not to disrupt the customers of the business. She was of the view that was a clause that plainly contemplated the franchisor would simply step into the shoes of the franchisee on termination and carry on the business of the existing customers.

Lessons from the case

As discussed at the outset, the case does not involve ground breaking law but the following lessons can, in my view, be learned from it:

a) Franchisees, or any contracting party for that matter, who choose to terminate an agreement under the Contractual Remedies Act need to be very clear that there are strong legal grounds which will justify cancellation under that Act. A purported cancellation is an irretrievable act, particularly where the other party, as in the Club Physical case, treats the cancellation as a repudiation and cancels themselves.

There is no going back from a cancellation that is wrongful.

b) It is unknown whether the franchisee in Club Physical had explored mediation. There is always a place for Court action, but franchise agreements contain dispute resolution procedures for good commercial reason. It is a (cheaper) way of airing and resolving disputes without incurring the risks brought about precipitous legal action.