Terminating Franchisees for Fraud or Abandonment: Practical Considerations

Terminating Franchisees for Fraud or Abandonment: Practical Considerations

Terminating Franchisees for Fraud or Abandonment: Practical Considerations Nigel Jones Partner, Norton Rose Fulbright Australia Overview A practical step-by-step approach to considering termination for franchisee fraud and abandonment. Summary of Fraud Step-by-Step Approach

Establish that the conduct is fraudulent. Consider the standard of proof required. Is there an express contractual entitlement to terminate for fraud consistent with the Code? Consider the identity and role of the offending individuals and whether their conduct can be imputed to the corporate franchisee. Assess whether termination for fraud would be unreasonable, unconscionable or in bad faith. Conduct appropriate investigations and collect evidence. Consider the full range of options for dealing with the fraud including a negotiated exit by the franchisee.

Fraud Step-by-Step Approach Step 1 Defining and Categorising Fraud 1) Commonly considered in the context of monetary gain. 2) Commonly defined in one of the following forms: a) An act of deception that is intended to result in personal gain, or to cause a loss to another person or organisation. b) A deception deliberately practiced in order to secure an unfair or unlawful gain. c) A deceitful practice or wilful device, resorted to with intent to deprive another of his/her/its right, or in some manner to do him/her/it an injury. d) The intentional use of deceit, a trick or some dishonest means to deprive another of his/her/its money, property or a legal right. e) Dishonesty calculated for advantage.

3) However, fraud can occur in a wide variety of non-monetary contexts. Note the following: a) Fraud can involve conduct where the wrongdoer has gone beyond that which merely amounts to a civil wrong, he has indulged in sharp practice, something of an underhand nature where the circumstances required good faith, something which commercial men would say was a fraud or which the law treats as entirely contrary to public policy. (London Borough of Kent v Kane [2014] EWGC 4564) b)

Fraud can take the form of a false representation if the franchisee made the representation knowing it to be false, or recklessly, neither knowing nor caring whether it was false or true. (DArling One Pty Ltd v Eagle Boys Dial-A-Pizza Australia Pty Ltd [2011] NSWSC 296) c) Fraudulent false representations could occur in a wide variety of circumstances examples could include: i. The provision of false information about the operation of the franchised business or its performance. ii.

The provision of false information about the status of commercial arrangements that the franchisee has in place with 3rd parties such as the tenure under a lease, the payment of monies owed to creditors or compliance with obligations owed to employees. iii. The franchisees conduct vis--vis 3rd parties for example: A. Falsification of employment records and underpayment of staff in breach of workplace laws and attendant underpayment of group tax.

B. Under-reporting of income to the ATO and thus underpayment of tax. C. Dishonesty in dealing with suppliers. d) Two examples of atypical circumstances in which conduct has been determined to be fraudulent in a franchising context: i.

Two brothers who pretended to be each other when introduced to the franchisor and in their subsequent dealings with the franchisor including by falsely using each others names. (Cafe2U Pty Ltd v Bishambu Pty Ltd [2013] FCA 191) The Court noted that: Why the brothers engaged in this pretence is not clear. It may have started out as a game. But it was not accidental. These representations were fraudulent within the meaning of cl 23(f) of the Code because they were made in connection with the operation of the franchise business and they were knowingly false. ii. Employees of a master franchisee caused it to enter into fraudulent

arrangements whereby its sub-franchisees would receive government training subsidy payments. Since the sub-franchisees were neither apprentices nor trainees (they were not employees of the master franchisee), the scheme was inapplicable and the conduct was fraudulent. (AMC Commercial Cleaning v Coade [2011] NSWSC 932) 4) In summary: take a wide view of fraudulent conduct dont just focus on monetary fraud. Step 2 Standard of Proof Required 1) The party alleging fraud bears the onus. 2) Given the seriousness of an allegation of fraud and the serious consequences of a determination that it has occurred, the Courts require strict proof of it. The evidence

of fraud must be compelling before a Court will make a determination that it has occurred. (Briginshaw v Briginshaw (1938) 60 CLR 336 and Neat Holdings Pty Ltd v Karajan Holdings Pty Ltd (1992) 67 ALJR 170) Step 3 Is There is an Express Contractual Entitlement to Terminate for Fraud in the Franchise Agreement? 1) Most franchise agreements will contain an express right to terminate for fraud which mirrors the Special Circumstances set out in cl 29(1)(g) of the Code. 2) Clause 29 of the Code expressly notes that it does not of itself give rise to a right of termination; such a right must be in the franchise agreement itself. 3) Accordingly, in terminating for fraud a franchisor needs to rely upon a contractual right to do so. 4) In the absence of an express contractual right to terminate for fraud, a useful

basis upon which a franchisor might proceed is to consider whether the fraudulent conduct could be characterised as a repudiation of the franchise agreement. (Hoy Mobile Pty Ltd v Allphones Retail Pty Ltd (No. 2) [2008] FCA 810) Step 4 Consider the Role and Identity of Relevant Individuals. 1) If the franchisee is a corporate entity and a director of the franchisee is personally involved in the fraudulent conduct then typically the directors conduct will be imputed to the franchisee given the directors level of responsibility and role as the directing mind and will of the company. (Caf 2U Pty Ltd) 2) However, further analysis needs to be undertaken where the conduct is engaged in by non-directors such as employees or partners. 3) In relation to employees, imputing fraud might be difficult. The following ought to be

noted: a)A franchisor would typically seek to argue that the employees who are responsible for management tasks that give rise to fraudulent conduct have acted as the franchisors agent in implementing the will of the franchisor. b)The more senior the employee and the greater the scope of that employees authority, the greater traction such an argument is likely to gain with a Court. c)The franchisee might argue that the employees were not authorised to perform their duties in a fraudulent manner or were not the directing mind and will of the franchisee. d) AMC contains a brief but useful analysis of the issue: i.

The two employees were authorised to arrange for both training of subfranchisees and for the method of payment for that training. ii. The employees implemented the fraudulent scheme to obtain payment of government subsidies for the training provided. iii. The managing director of the master franchisee sought to distance himself from the fraudulent activities and to suggest that the employees were acting beyond their authority. However, the responsibility to organise training and arrange for payment did fall within the responsibility of the employees. iv. The Court noted that, even if it was accepted that the managing director was personally innocent of the fraud, nonetheless actionable fraudulent conduct was enabled to occur because he left those aspects of the master franchisees business entirely in the hands of the two employees and seemingly made no effort to oversee or check what they were doing.

e) Provided that it can be established that the employees fraudulent conduct was generally within the scope of authority of the employee and the employee is a senior employee within the franchise, it is more likely than not that the employees conduct and knowledge will be imputed to the franchisee for the purpose of determining whether the franchisee was engaged in fraudulent conduct. 4) In relation to partners, the following ought to be noted: a) The partner is the agent of the other partners for the purpose of the partnership business. (See Partnership Act 1958 (Vic) section 9) b) Accordingly, fraudulent conduct of a partner in the usual course of carrying on the business of the partnership will typically bind the other partners and give rise for termination of a franchise agreement into which the partnership has

entered. Step 5 Assess Whether Termination for Fraud would be Unreasonable, Unconscionable or in Bad Faith 1) Prior to terminating, assess the risk of the termination being determined to be unlawful or liable to be set aside based on the existence of legal remedies based in unfairness: relief against forfeiture, unconscionable conduct and breach of the duty of good faith. 2) If a Court considers that a franchisor may be acting completely unreasonably, unconscionably or in bad faith in the exercise of strict contractual rights, the Court may intervene to provide relief to the franchisee. 3) However, where a determination has been made by the Court that the franchisee has

engaged in fraudulent conduct which ordinarily would entitle the franchisor to terminate the franchise agreement, the Court is very unlikely to intervene to provide relief to the franchisee unless the Court is satisfied that: a) The franchisor is exercising its rights for a capricious (unaccountable or unpredictable) or ulterior motive in the case of bad faith and unconscionable conduct (see AMC); or b) Some conduct on the part of the franchisor caused or in some significant respect contributed to the events that gave rise to the fraudulent conduct and the forfeiture of the franchise agreement in the context of relief against forfeiture and unconscionable conduct. (see AMC and Allphones Retail Pty Ltd v Hoy Mobile Pty Ltd [2009] FCAFC 85) 4) What if the fraudulent conduct is minor in all the circumstances and yet the

franchisor will nevertheless obtain a windfall (the value of the franchised business) as a result of the termination? 5) The magnitude of loss versus gain is typically considered to be a relevant consideration in relief against forfeiture authorities. (See Legione v Hateley (1983) 152 CLR 406) 6) However, , if the Court has determined that franchisee has engaged in fraudulent conduct (even if modest in nature or monetary terms), the franchisee will have great difficulty in successfully resisting termination unless the circumstances in 3) above can be established. (See Tanwar Enterprises Pty Ltd v Cauchi (2003) 217 CLR 315) Typically, these circumstances will very rarely exist. Step 6 - Conduct Appropriate Investigations and Collect Evidence 1) Given the importance of compelling evidence of fraud being put to the Court, it is

fundamental that appropriate steps be implemented to obtain that evidence. 2) The type of evidence to be collected will turn upon the nature of the fraudulent conduct. 3) Evidence is typically obtained/sought from the following sources: a) Data analysis especially Electronic Point of Sale Systems in the context of under-reporting of sales. Excessive voided transactions and patterns in their occurrence are often indicative of under-reporting. b) Surveillance of the operation of the franchised business (by CCTV or private

investigator). For example, in circumstances where under-reporting of sales has occurred, video surveillance might record transactions being undertaken with customers despite the transactions subsequently being voided by the franchisee. c) Supplier information. For example, in circumstances where under-reporting of sales has occurred, suppliers records may disclose that the quantity of stock typically provided to the franchised business greatly exceeds the number of transactions being reported to the franchisor. d) Staff members (current or former - usually disgruntled) can act as whistle-blowers or otherwise provide relevant information under questioning from the franchisor. e) Admissions from the officers/employees of the franchisee often obtained at the time that the franchisors awareness of the fraudulent conduct is first raised with

them during an open meeting. f) Audit or inspection powers most franchise agreements contain broad powers for the franchisor to require the franchisee to produce business records for inspection. These records can contain evidence of suspected fraudulent conduct. g) Customers including Mystery Shoppers. 4) Care needs to be taken to ensure that the manner in which the evidence is obtained is fair and reasonable in order to minimise the risk that the evidence will be determined by the Court to be inadmissible. Step 7 - Consider a Range of Legal and Practical Options 1) The strict exercise of a contractual right of termination ought not be the only option considered by a franchisor for dealing with a franchisee which is suspected of

behaving fraudulently. 2) A franchisor should always consider adopting the following approach prior to exercising any rights of termination: a) Meeting first with the franchisees officers on an open basis to put the allegation/evidence of fraud to them. This assists in: i. Obtaining evidence of admissions; ii. Obtaining evidence of any legitimate or purported explanation by the franchisee for the conduct; and iii. Demonstrating procedural fairness and reasonableness on the part of the franchisor. b) Following the meeting, writing to the franchisee (or its solicitors) detailing the evidence of fraud, noting (where possible) that it discloses fraudulent conduct upon

which the franchisor is entitled to terminate and seeking an urgent written response from the franchisee prior to the franchisor exercising its rights. c) Considering the merits of a negotiated exit by the franchisee whether by meetings between the parties or a formal mediation. Such an exit may, for example, involve the franchisee agreeing to a short timeframe within which to sell the franchised business to a 3rd party failing which the franchise agreement is terminated by agreement. d) Involving innocent business partners of the offending individual in the meetings and negotiations referred to above can sometimes assist in obtaining relevant admissions and a satisfactory negotiated exit. This occurs because the franchisees decision-making process is informed by the involvement of personnel who have a degree of objectivity about (and exposure as a result of) the offenders conduct.

Summary of Abandonment Step-byStep Approach Typically, abandonment under a franchise agreement and the Code occurs in circumstances where the franchisee: 1) Ceases operating the franchised business and vacates its premises (if any); and/or 2) Evinces an intention no longer to be bound by the terms of the franchise agreement that is, engages in repudiatory conduct and thus abandons the franchise relationship. Step 1 - Establish that the relevant conduct constitutes physical abandonment of the franchised business/premises or repudiatory conduct. 1) Evidence of physical abandonment is self-explanatory the franchisee has ceased to operate the franchised business and may have vacated the premises (if any). Photographic and any documentary evidence of this ought to be collected.

2) Repudiatory conduct is established if it is such as to convey to a reasonable person, in the situation of the other party, renunciation either of the contract as a whole or of a fundamental obligation under it. (See Mr Rental Australia Pty Ltd v IRD Services Pty Ltd [2016] NSWSC 700 at [111] citing Koompahtoo v Sanpine) 3) It is likely that documentary evidence will exist which evidences the franchisees repudiatory conduct it ought to be collected. 4) Two examples of circumstances in which Courts have considered the issue of abandonment in a franchising context: a) Where a franchisee ceased paying fees due under the franchise agreement and, in breach of a restraint against competition, used the products of the franchised business to advance the interests of a competing business in flagrant disregard of the terms of the franchise agreement. The Court determined that these circumstances were sufficient

to demonstrate a voluntary abandonment of the franchised relationship. (See Caf 2U) b) Where a franchisee asserted that the wrongful conduct of the franchisor (disconnection of the franchisee from an electronic management system and the failure to pay commissions) had forced the franchisee to abandon the franchised business with the effect that the franchisees abandonment could not be described as voluntary under the language of the Code. However, the Court determined that the franchisee had not made good its complaints in relation to the franchisors conduct and therefore the Court concluded that the franchisee had voluntarily abandoned the franchised business. (See Alpha Centauri Enterprises Pty Ltd (in liq) v Mortgage House of Australia Pty Ltd [2010] NSWCA 188) Step 2 - Consider whether there is an express contractual entitlement to terminate for abandonment in the franchise agreement which is consistent

with the Code. 1) Most franchise agreements will contain an express right to terminate for abandonment which mirrors the Special Circumstances set out on cl 29(1)(d) of the Code. 2) In the absence of (and in addition to) an express contractual right to terminate for abandonment, the common law principles set out above will be applied. Step 3 Notice and Election 1) In the case of physical abandonment: a) Serve a notice on the franchisee confirming the apparent abandonment of the business/premises and relationship and requiring urgent recommencement of operations (say within 1 to 2 days). b) Failing recommencement of operations, take steps to terminate the franchise

agreement. 2) In the case of repudiatory conduct, having confirmed that the conduct is sufficient to constitute repudiation, determine whether to affirm the franchise agreement or accept the repudiation and proceed to termination of the franchise agreement. Step 4 - Consider the merits of a negotiated exit by the franchisee 1) Typically, if the franchisee has physically abandoned the business/premises, the ability to negotiate an orderly exit is unlikely and termination is the more likely short-term step. 2) However, there nevertheless remains an opportunity for the franchisor and franchisee to negotiate a resolution of any dispute arising from the abandonment. If practical, such a resolution should be explored by the franchisor. 3) In the case of repudiatory conduct, there also remains an opportunity for a

negotiated outcome to be reached. A franchisor should at least give consideration to whether such an outcome is possible in the short-term prior to accepting any repudiation and bringing the franchise agreement to an end.

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