Franchisors and Unfair Contract Terms

If a contract is deemed to be a standard form Small Trade Contract and it contains an unfair contract term ("UCT") the Commerce Commission may apply to the court to get a declaration that the term is a UCT and then the party who has the benefit of the UCT may not include the term in their Small Trade Contracts nor will they be able to apply, enforce or rely on UCT. If they do there are penalties of up to $200,000 for individuals and up to $600,000 for corporates.

Many of my Franchisor clients have or are now reviewing their franchise documentation to ascertain whether their agreements contain terms which are at risk of being a UCT and are amending their documentation.

There are a number of requirements which must be met for a term to be considered an UCT. In this article I will step through each of these requirements to help Franchisors make decisions about their franchise documentation in light of the UCT provisions of the Fair Trading Act 1986.

Is your franchise documentation a standard form Small Trade Contract?

The first question is whether or not the agreement in question is a standard form contract. If it is not then the Unfair Contract Terms in the Act will not apply. It is for the court to determine whether a contract is a standard form contract of not and in doing so will take into account:

• If one party has all or most of the bargaining power;
• Whether or not the contract was prepared before discussions between the parties started;
• If a party was required to either accept or reject the terms of the contract;
• What opportunity did the parties have to negotiate the terms of the contract;
• Making sure that your requirements for the sale or purchase of a franchise business are met;
• Whether the contract took into account specific characteristics of a party or not.

I believe it is clear that most franchise agreements would be considered standard from contracts. While there can be some negotiations around some of the terms largely Franchisees are required to accept the term of a franchise agreement. It is usually considered vital by Franchisors and for the benefit of the system and franchise network that each of their Franchisees is bound by the same terms and conditions.

Assuming therefore the next question to be answer is whether the franchise agreement meets the requirements for a Small Trade Contract which are:

• Each party must be engaged in trade;
• It is not a Consumer Contract; and
• It does not comprise part of a trading relationship that exceeds the Annual Value Threshold when the relationship first arises

"in Trade" "Consumer Contract"

A Franchisor and Franchisee are both in business therefore will be considered to be "engaged in trade". Franchise documentation will not be a consumer contracts because neither party is a consumer (i.e., the goods and services supplied under the contract are not of a kind "ordinarily acquired for personal, domestic or household use or consumption" and the Franchisee is acquiring the goods and services for the purpose of resupplying them in trade").

"Part of a trading relationship"

It is the third requirement that requires careful consideration. When considering whether a franchise agreement is in fact a Small Trade Contract the whole trading relationship must be assessed. In the Act the term "Trading Relationship" means a relationship consisting of the actual contract (i.e., the franchise agreement) and any other contract between the Franchisor and the Franchisee on the same or substantially the same terms. The requirement that the contracts must be on the same or substantial terms means that a sublease or premises licence entered into between a Franchisor and a Franchisee will not form part of the "trading relationship" as they are not on the "same or substantially the same terms".

However, if a Franchisor and a Franchisee have entered into more than one franchise agreement (for example; relating to difference sites or territories) then these contracts will fall within the definition of a "trading relationship".

It is common for Franchisors to supply products and services to Franchisees and that the terms and supply of those products and services from part of the Franchise Agreement (usually in the form of an annexure to the franchise agreement). So these terms will subject to scrutiny as well.

Does the Trading Relationship exceed the Annual Value Threshold?

The next consideration is whether the trading relationship exceeds the Annual Value Threshold when the relationship first arose. If it does the UCT provisions do not apply. A trading relationship first arises when the first (or only) contract is entered into. The trading relationship will exceed the annual value threshold when the relationship first arises if at that time:

• If it includes a transparent term or terms which provide for consideration (including GST) of $250,000 (or more) to be paid under it relation to any annual period for the goods, services or interest in land; or
• Consideration (including GST) worth $250,000 or more is more likely than not to be payable under the relationship in relation to any annual period for the goods, services or interest in land involved.

An annual period starts on when the relationship began and ends 12 months later.

So, whether a Franchise Agreement is deemed to Small Trade Contract regard must be had to:

• Other franchise agreements entered into between the Franchisor and the Franchisee (e.g., where the Franchisee holds multiple sites or territories);
• The total amount payable by the Franchisee to the Franchisor under the franchise agreement – this could include not just royalties but the cost of goods and services supplied to the Franchisee under the franchise agreement.

When is a term considered to be an Unfair Contract Term?

Once it decided that an agreement is a Small Trade Contract, the next step is to determine whether it contains any term or condition which could be considered to be a UCT.

A term is not automatically an UCT. A term is only a UCT when a court can declares it to UCT and only the Commerce Commission can apply to the court to declare a term a UCT.

For a term or condition to be considered a UCT it must meet the following criteria:

• It would cause a significant imbalance in the parties' rights and obligations arising under the contract; and
• It is not reasonably necessary in order to protect the legitimate interest of the party would be advantaged by the term; and
• It would cause a detriment financial or otherwise) to a party if it was relied on, enforced or applied.

A court will also consider how transparent the term is and the contract as a whole and other matters it considers relevant.

What is a significant imbalance?

It is likely that a court will consider the following in determining if the UCT would cause a significant imbalance in the parties' rights and obligations arising under the contract:

• If a party's obligations and rights are not equivalent;
• Whether or not the term is weighted so heavily in favour of one party as to tilt the parties' rights and obligations in that party's favour;
• The transparency of the term;
• What is the effect of the contract with and without the term?
• A comparison of the rights and liabilities of each party as a result of the term;
• Is there a meaningful relationship between the term and the protection of one party and is that relationship is reasonably foreseeable at the time of entering into the agreement?

Not reasonably necessary in order to protect the legitimate interests

This will largely be dependent on the facts of the particular situation and what interests the term in question is seeking to protect. A legitimate interest is not necessarily a monetary interest. For a franchise agreement a legitimate interest may be the protection of the brand as a whole for the benefit of not only the Franchisor but all Franchisees within the franchise system.

A court may consider what other options a Franchisor has available to it to protect its interests.

It would cause a detriment

There must be more than a mere possibility of a detriment.

Transparency

Under the Act, "Transparency" is defined to mean that the term is:

• Expressed in reasonably plain language
• Legible
• Presented clearly; and
• Readily available to any party affected by that term.

It is not enough that the term is "visible". Factors such as the size of the font and whether a term was drawn to a party's attention and whether or not plain language is used and the unfairness (or not) of the contract as a whole are likely to be taken into account in order to determine whether a term is transparent or not.

What happens if a term is declared to be a UCT?

Once a term is declared to be an UCT, a Franchisor cannot:

• Include it in a Small Trade Contract in the future
• Apply, enforce or rely on the UCT in a Small Trade Contract

What terms could be considered UCT's?

The Act specifies some examples of terms which could be UCT's:

• Terms that allow one party to avoid or limit performance of the contract;
• Unilateral termination clauses; unilateral penalties for breach or termination of the contract;
• Unilateral variation clauses; unilateral renewal clauses; unilateral variation of the upfront price, without the ability of the other party to terminate the contract without penalty;
• A term that permits, or has the effect of permitting, one party unilaterally to vary the characteristics of the goods or services to be supplied, or the interest in land to be sold or granted, under the contract;
• A term that permits, or has the effect of permitting, one party to unilaterally determine whether a contract has been breached or to interpret its meaning;
• A term that limits one party's vicarious liability for its agents;
• A term that permits, or has the effect of permitting, one party to assign the contract to the detriment of another party without that other party's consent; a term that limits, or has the effect of limiting, one party's right to sue another party;
• A term that limits, or has the effect of limiting, the evidence one party can present in proceedings relating to the contract; or
• A term that imposes, or has the effect of imposing, the evidential burden on one party in proceedings relating to the contract

What are some examples of possible UCT's in a franchise agreement?

Set out below some examples of clauses which could be considered UCT's.

• Indemnity clauses that are just for the benefit of the Franchisor (and no equivalent clause for the benefit of a Franchisee).
• Clauses which allow a Franchisor to unilaterally vary the agreement – I have seen clauses in franchise agreements which allow a Franchisor to increase fees etc.
• Limitation of Liability clauses – it is very common to see clauses which limit or totally exclude a Franchisor's liability but the same privilege is not afforded to a Franchisee.
• Penalty charges and liquidated damages – in some agreements Franchisors have the require a Franchisee to pay a "fine" if they default (these clauses are also common in leases) – these amounts must bear some resemblance to the costs which a Franchisor expects to incur as a result of the default;
• One sided termination clauses - it is very uncommon for a franchise agreement to contain a right for a Franchisee to terminate an agreement due to the default of a Franchisor but this might be something which is included in certain situations.
• Clauses which contract out of certain provisions of the Fair Trading Act 1986.

However, a clause cannot be taken in isolation – as referred to above, there are other factors which may apply e.g., is the clause reasonably necessary in order to protect the legitimate interests of the Franchisor, does it cause a detriment, is it transparent?

My suggestions for Franchisors

I suggest that Franchisors review their franchise agreements to ascertain if there are any clauses which could possibly be considered UCT's. For each of those terms consider the following:

• Does this clause serve any useful purpose and would you or have you ever enforced it? If not, remove it.
• If the clause is of use, then consider if it can be changed so that it is no longer a UCT.
• If you don't want to remove or change the clause – consider documenting your argument as to why this clause should not be considered an UCT.
• Also consider the whole of your franchise agreement – is it in plain English, is it longer than necessary – do sentences last for the length of a paragraph?

All Franchisors should now consider making it a non-negotiable requirement that their Franchisees get their own legal advice prior to entering into a franchise agreement (or a renewal of a franchise agreement). This may be a factor a court will consider in determining whether or not a clause is a UCT but is also valuable in assisting a Franchisee to understand his or her obligations under the agreement.

Lastly do not forget about your other agreements – e.g., terms of supply and subleases/ premises to licence – consider whether they come within the definition of a Small Trade Contract and need to be reviewed in light of the UCT provisions of the Fair Trading Act 1986.