The recent Federal Court decision of Rafferty v Madgwicks highlights the need to take care when drafting heads of agreement and agreements relating to the licence of trademarks or distribution of goods or services and consider whether the agreement could be construed as a franchise agreement. Getting it wrong can be very expensive.
This case involved a business venture between companies associated with two parties, Stephen Donovan (Donovan Parties) and Patrick Rafferty (Rafferty Parties).
The Donovan Parties were the owners of certain intellectual property in relation to Modular Accommodation Units (MAUs). The Rafferty Parties paid moneys to the Donovan Parties for certain rights to manufacture and distribute the MAUs. The agreement between the parties was governed by various agreements prepared by Madgwicks on behalf of the Donovan Parties including a Heads of Agreement (HOA) and Rights Agreement (RA). The rights related only to a single territory, being most of Western Australia and all of the Northern Territory. The Rafferty Parties had the opportunity to but chose not to seek legal advice.
Madgwicks provided advice to the Donovan Parties that there was a risk that the arrangements constituted a franchise agreement and the Franchising Code of Conduct (Code) would need to be adhered to. The Donovan Parties elected to ignore the advice and accept the risk. Madgwicks was instructed to prepare the documents in a manner which did not recognise the operation of the Code.
A central issue for the Court became whether or not he arrangement constituted a franchise agreement and whether the Donovan Parties has contravened the Trade Practices Act (now Competition and Consumer Act) in failing to comply with the Code, specifically, by failing to provide a disclosure document. The Rafferty Parties also alleged misrepresentation by the Donovan Parties and claimed that Madgwicks had engaged in misleading or deceptive conduct by silence in failing to advise them that the agreements would constitute a franchise agreement.
The Rafferty Parties succeeded against the Donovan Parties but failed against Madgwicks. The Court held that the Rafferty Parties would not have invested but for the misrepresentations and the non-compliance with the Code.
The Court found that the HOA and RA were both franchise agreements for the purpose of the Code. In doing so the Court looked past the wording of the agreements and preferred a substance over form approach, focusing on the likely effect of the agreements in practical terms.
In particular, the Court looked at whether there was a 'system or marketing plan' for the purpose of clause 4(1)(b) of the Code and found the following factors to be relevant:
- specific requirements for accounting and record keeping;
- reservation by the franchisor of a right to audit books of account and other records;
- inability of franchisee to supply goods or services without approval of franchisor;
- requirement for signage, mechanising, promotional or advertising material to be approved by franchisor;
- a right of the franchisor to approve sales staff, bonus structures, reporting procedures and training for staff; and
- stipulation of retail prices and sales quotas.
The Court also identified criteria for ascertaining whether a system is 'substantially determined, controlled or suggested by the franchisor':
- the extent to which the franchisee's business involved selling the franchisor's goods or services;
- the degree to which the franchisor assumes responsibility for centralised management or standards of quality;
- whether the franchisor dictates any mandatory obligations with respect to advertising or marketing; and
- the degree to which the franchisor controls the franchisee's business having regard to advertising and financial support, auditing books and financial reporting requirements, staff and sales quota, training and the like.
The Court also held as follows:
- the definition of "franchisee" may include the shareholders of the franchisee and any others who could be construed to have an interest in the franchisee;
- the definition of "franchisor" may include a sole director of the franchisor, so that persons standing behind the franchisor have personal obligations under the Code;
- a HOA may be an agreement to enter into a franchise agreement. If so, the obligations under the Code will apply, even if the proposed franchisee had not yet been incorporated and there is no franchise system yet in place.
This case shows that it is important to consider whether the oversight and quality controls provided in an agreement, particularly in relation to a trade mark licence, distribution agreement or similar (including heads of agreement), could go so far as to make the agreement a franchise agreement and require compliance with the Code.
This issue must be considered at the earliest possible opportunity in the agreement development process as the Code applies to parties before they enter into formal agreements in relation to the franchise.
Failure to properly identify a franchise arrangement may result in a breach of the Code (and Competition and Consumer Act) which may lead to court orders including payment of damages and/or injunctions.