The Full Court of the Federal Court of Appeal in Rafferty v Madgwicks [2012] FCAFC 37 delivered a judgement that re-emphasises that:

  • when identifying if an arrangement is a franchise agreement the courts will examine substance over names given to describe arrangements;
  • individuals knowingly concerned in misleading and deceptive conduct will be held personally liable; and
  • advisers to parties engaged knowingly in misleading and deceptive conduct risk also being knowingly concerned and accountable for their client’s conduct.

This article provides a brief summary of aspects of the case and the court’s reasoning for its findings.  

Background

This case arises out of events which occurred between May 2007 and May 2008. After discussions between the parties of an “exciting business opportunity”, Mr. Rafferty was told that prototype Modular Accommodation Units (MAUs) were currently being constructed in China pursuant to a contract with a manufacturer.

The Rafferty parties entered into a business venture with the Donovan parties, incorporating Time 2000 West Pty Ltd (T2W) to manufacture MAUs in China, to be sold in Australia. The business venture was established by a heads of agreement (HOA), a joint venture and shareholders’ agreement (JV) and a rights agreement (RA).  

These agreements were prepared by Madgwicks, solicitors who acted on behalf of the Donovan parties. Madgwicks advised the Donovan parties that there was a real risk that the arrangements would be categorized as a franchise agreement. The Rafferty parties did not obtain legal advice.

Mr. Rafferty advanced $200,000 for the start up of T2W over a period of time.

Both parties sought to secure investors. During the process of setting up T2W and finding investors Mr. Rafferty was not aware there was no present contract for the manufacture of MAUs in China or that construction of the prototypes had not yet commenced. Upon becoming aware of these circumstances Mr. Rafferty accused Mr. Donovan of embezzlement.

At this point the relationship between the parties broke down.

Issues

The court was asked to determine whether:  

  • the Franchising Code of Conduct applied to the HOA and the RA;
  • the Donovan parties were guilty of misleading and deceptive conduct; 
  • section 87 of the Trade Practices Act (TPA) supported an order for the repayment of moneys by the Donovan parties;
  • Madgwicks, who acted as solicitors for the Donovan parties, were liable pursuant to s 75B of the TPA as a person involved in the contravention of s 51AD of the TPA or had engaged in misleading or deceptive conduct in breach of s 9 of the Fair Trading Act 1999 (Vic) by their silence on the characterization of the agreement as a franchise to the Rafferty parties (FTA).  

Reasons for decision

  1. Did the Code apply to the HOA, JV and the RA?

In order to establish whether the Code applied to both the agreement contemplated in clause 8 of the HOA and the RA, the court considered whether:

  • a franchisor and franchisee could be identified;
  • the joint venture demonstrated factors indicative of a system or marketing plan; and 
  • there was an element of control or suggestion by the franchisor over key aspects of the franchisee’s business.

The court established that the Code applied to both the RA and the agreement in the HOA.

As the Donovan’s had not provided the Rafferty parties with a Disclosure Document as required by clause 10 of the Code or written statements pursuant to clause 11 of the Code. The court held that the Donovan parties were in breach of the Code.

  1. Were the Donovan parties guilty of misleading or deceptive conduct?

The Rafferty parties had to establish that:

  • conduct had occurred;
  • that conduct viewed objectively, was misleading or deceptive; and
  • the Rafferty parties relied on the conduct, which induced them to do something that caused damage.

The Rafferty parties pleaded that they “would not have entered into the Agreements and paid the said sums totaling $1.7 million but for the misrepresentations”.

The Court considered the representations made regarding the existence of a contract with a Chinese manufacturer to make the units in China and the prototypes. The court stated that Mr. Donovan was responsible for the actions of the companies T2W.

The court held that the Donovan parties were guilty of misleading and deceptive conduct pursuant to section 52 of the TPA as there was no agreement to produce MAUs and none were being made.

  1. Did section 87 of the TPA support an order for repayment of moneys by the Donovan parties?

It was argued by the Donovan parties that s 87 of the TPA would not support an order for repayments of moneys. Section 87 is engaged where a party to the proceeding has suffered, or is likely to suffer, loss or damage as a result of the conduct of another person who has contravened a provision of the TPA. This section allows the court to make orders to:

  • Compensate the party for loss or damage suffered;or
  • Reduce the loss or damage suffered or likely to be suffered.

The court held that the trial judge did not err when exercising his discretion to make the order and that section 87 of the TPA would support an order for repayment of moneys being made.

  1. Was Madgwicks involved in the contravention of s 51AD of the TPA or misleading or deceptive conduct under the FTA?

Madgwicks was sued by both their clients, the Donovan parties, and the Raffertys.

The Donovan parties argued that Madgwicks did not discharge their professional duty as they did not give adequate warning as to the consequences if the agreements were found to be governed by the Code.

The court rejected this submission finding that: it accepted the evidence of Madgwick’s two witnesses who claimed that the Donovan parties received adequate warning and an explanation of the consequences if the agreements were found to be governed by the Code.

The Court indicated that there was limited evidence presented by the Donovan parties demonstrating their reliance on Madgwick’s advice and that it could therefore be inferred that there was no additional evidence to support their case.

With respect to the Rafferty parties the Court said to determine whether Madgwicks held the requisite intent, Madgwicks must be aware that T2W (in the case of the RA) was entering into a franchise agreement and Embleton (in the case of the HOA) was entering into an agreement to enter into a franchise agreement.

In order for a person to aid, abet, counsel, procure or be knowingly concerned in a relevant contravention under s 75B(1), he or she must have knowledge of the essential elements of the TPA contravention.

The court considered the evidence as a whole and held that Madgwicks did not know and were not willfully blind to the fact to the fact Embleton was entering into an agreement to enter into a franchise agreement and T2W was entering into a franchise agreement.

Madgwicks did not have sufficient knowledge to be involved in the contraventions of s 51AD by T2W and Embleton.

As a further argument the Rafferty parties argued that Madgwicks engaged in misleading or deceptive conduct through a failure to act or silence which can amount to misleading or deceptive conduct in circumstances that give rise to a reasonable expectation that if a fact exists, in this case whether the arrangement constituted a franchise agreement and if the MAUs were being produced or not, it will be disclosed.

The Court said that it was appropriate to consider the relationship of the parties to consider whether conduct is misleading or deceptive. Here, Madgwicks acted for Mr. Donovan, and therefore was not expected to be advising the Rafferty parties as to the nature of the agreement. Any non-disclosure of facts to the Rafferty parties was in the Court’s view irrelevant.

As a result the court held that Madgwicks in the circumstances did not engage in misleading and deceptive conduct.

Lessons to be learned

It is advisable for parties to an agreement to seek independent legal advice throughout all stages of entering an agreement. That way parties are aware of their obligations, potential risks and legal effect of what they are agreeing to do.

For franchisors, advice should be sought to ensure all obligations of disclosure are met and no other liabilities are likely to arise.

The Code provides mandatory steps to be taken by a franchisor when entering or proposing to enter a franchise agreement.  

Compliance with these requirements needs to be adhered to or a party risks a court making orders to remedy breaches, pay compensation or provide other relief.