The Supreme Court of NSW yesterday handed down judgment in the first case dealing with the validity of a termination of a franchise agreement for alleged underpayment of franchisee employees.
The judgment provides valuable lessons and warnings for franchisors and franchisees that may be on the brink of similar litigation. Ultimately, the key take-away point from this judgment is that in the absence of objective evidence, these cases are likely to be decided on whether the court is prepared to accept the evidence of the employees or the evidence of the franchisee. In this regard, the credibility of their respective evidence is key.
A 7-Eleven franchisee was alleged to have underpaid two of its employees through a cash-back scheme. The scheme involved the franchisee paying wages based on the correct award rate to the employees but then requiring them to return a portion of their wages back to the franchisee.
The net effect of this cash-back scheme was that:
- the first employee was allegedly paid $12 per hour during a 1-month period; and
- the second employee was allegedly paid $15 per hour during a 6-month period.
After investigating the claim, 7-Eleven terminated the franchisee's franchise agreement on the grounds that:
- the franchisee had acted fraudulently in running the 7-Eleven store; and
- the franchisee was likely, by the continued operation of the 7-Eleven store, to cause substantial damage to 7-Eleven's reputation.
The franchisee denied the cash-back scheme and argued that its franchise agreement had been unlawfully terminated.
The Court observed that, given the absence of objective evidence, its finding would be based on the credibility of the franchisee's evidence as against the credibility of the employees' evidence. Ultimately, it found against the franchisee for the following reasons:
Motive: Whilst the employees had no clear motive in deliberately lying about their evidence, the franchisee had a clear motive. The franchisee not only faced the loss of a convenience store in which he had invested a large sum of money by way of a franchise fee, but also faced personal damage of being found to be fraudulent. As the franchisee had a great deal at stake, he had a clear motive in lying about his evidence.
Employees' background: The Court noted that there were numerous imperfections in the employees' evidence, however it was sympathetic to the difficulty faced by the employees in explaining their evidence due to language difficulties, their age (21 and 24 years old respectively), their limited familiarity with the court system and their genuine intimidation/fear of the franchisee.
Hostile and dishonest witness: The Court found the franchisee's sole director to be a "volatile and hostile" witness who provided answers in cross-examination which were "clearly evasive and deliberately so". When coupled with the franchisee's motive in lying about his evidence, the Court found that the employees' evidence was to be preferred.
Lawful termination of the franchise agreement
Based on the finding that the franchisee underpaid its employees through the cash-back scheme, the Court found that the franchisee had engaged in fraudulent conduct and that this would cause damage to 7-Eleven's reputation. Therefore, the Court found that the franchise agreement had been lawfully terminated.
What if the franchise agreement had been unlawfully terminated?
It is interesting to look at what the franchisee's likely position would have been if the Court had found that the franchise agreement had been unlawfully terminated. The Court considered this question and found that in relation to:
- Specific Performance (which would involve the franchisee regaining possession of the franchise store): the litigation itself and the manner in which both sides had conducted themselves in the litigation would have led to the conclusion that there had been "an entire breakdown of whatever trust and confidence the parties may once have reposed in each other". In light of this, the Court found that an order for specific performance would have been inappropriate. Therefore the franchisee would not have regained possession of the franchise store.
- Damages: although the Court would have given an indication of the damages that it may have awarded in this instance, it found that the franchisee's expert report (prepared during the hearing) provided no assistance in assessing damages. In particular, the Court found that the expert's report was based on incorrect financial information (namely, the financial reports provided by 7-Eleven rather than the franchisee's financial reports) and had applied an incorrect and "arbitrary" discount rate in applying the discounted cash flow valuation approach.
The key lesson from this judgment is that cases dealing with alleged underpayment of franchisee employees are likely to turn on the credibility of the franchisee, as against the credibility of the employees. In this type of situation, the franchisee would likely be disadvantaged in a battle of credibility because a court is likely to find that the franchisee has a clear motive in lying about their evidence. In other words, given what is at stake for a franchisee (i.e. losing their investment in the franchise store and the reputational damage of being found to be fraudulent) a court may well make a similar finding to what happened this particular case ie that the franchisee has a clear motive in lying about their evidence. This could potentially be countered in circumstances where the employees' underpayment claim is substantial and where they would stand to gain a significant sum of money if their evidence was accepted.
Regardless, franchisors and franchisees will need to accept the inherent risks of running a court case which hinges on the credibility of their witnesses. This risk is heightened, given that the prospects of achieving an early settlement will be substantially reduced where both parties appreciate that the strengths (or weaknesses) of their case will only be readily apparent after their witnesses have been cross-examined.
So the next question for franchisors and franchisees on the brink of similar litigation is whether they are prepared to roll the dice…