In the United States, the issue of the competition between ‘bricks and mortar’ retail franchises and the online channel conducted by the franchisor has taken front place as the new form of “encroachment” claim made by franchisees in recent years.  In Australia our mandatory franchise disclosure document under the Franchising Code of Conduct requires prior disclosure to a franchisee of information relating to the franchise “territory”, but it refers to a physical geographic territory only and does not address encroachment through alternative channels of distribution, such as e-commerce.  This has been remedied with the proposed new form of disclosure document due for commencement from 1 January 2015.  (Note the new form is not law yet).

New disclosure about online sales

The new disclosure document will contain a new Item 12 which requires a franchisor to give details of whether it intends to sell the same goods or services online or whether the franchisees may do so.  Also if goods or services are to be sold online by the franchisor or by other franchisees, the details of the extent to which they may be supplied to customers in the prospective franchisee’s territory (assuming there is one) and whether there will be any sharing of the revenue generated by those sales must be disclosed.   The inclusion of this new information reflects the increased importance of the internet as a distribution channel generally.

A new form of encroachment claim

The outcomes in the recent US “online encroachment” cases have depended on the wording of the particular franchise agreements and whether the franchisee had an exclusive territory which the franchisor had breached.  Most franchise agreements in the US and Australia drafted since the rise of the internet and online shopping go into detail about which precise channel of distribution is granted to the franchisee and what the franchisor may do online, although in established systems this continues to be a sensitive issue, particularly with long-term franchisees.

Many franchisors have had to deal with the dilemma of having a system of franchisees with exclusive distribution or marketing territories along with increased competition from online sellers.  Unless the franchise system also develops an online presence the sales to internet customers will simply be lost to competitors.  

In addition to selling directly to customers over the internet, franchisors are seeking to sell their products or services through alternative distribution channels including supermarkets, non-franchised outlets, mobile vendors and food trucks.

The old cases of “encroachment” in which the franchisor opened a retail outlet too close (in the view of the franchisee) to the franchisee’s store and “cannabalising” the franchisee’s sales, applied the critical legal concepts which apply generally with respect to franchisor and franchisee relationships in Australia, namely:

  • The implied duty of good faith (soon to be the express obligation to act in good faith).
  • Unconscionable conduct, and
  • Misleading and deceptive conduct.

A recent NSW case, Video Ezy International Pty Ltd v Sedema Pty Ltd[1] (2014) has shown the application of these well known legal concepts to the contemporary issue of online selling by a franchisor in competition with its franchisee.

Video Ezy case– the territorial exclusivity is breached by online sales

Video Ezy International (VEI) as franchisor granted franchises for the operation of Video Ezy outlets in defined territories in Australia.  A related company, Blockbuster, was responsible for the ‘TiVo’ movie service, a set top box service that allows access to on-demand videos via a television and another company, EzyDVD was responsible for the website “ezydvd.com.au” that allows customers to order DVDs online.  As the three companies were centrally owned and controlled, the court treated them effectively as a single entity.

On 1 April 2003, Sedema Pty Ltd purchased the Video Ezy business in Hazelbrook in the Blue Mountains from the franchisor VEI with the condition that VEI would grant Sedema a 10 year exclusive franchise in Hazelbrook.

The Hazelbrook sale agreement contained a restrictive covenant which granted Sedema exclusivity in that VEI undertook that it would not carry on “the trade or business involving the rental and/or sale of video products or any other business of a similar nature within the territory of the franchise for “Video Ezy Hazelbrook” for the term of the Franchise Agreement (other than as Franchisor of the Video Ezy franchise system)”.

VEI submitted that this did not apply to the business operated by EzyDVD and Blockbuster, as the clause refers to the sale or rental of video products “within the territory” and not the sale or rental of video products “into” the territory.  VEI said that the business itself must be “within the territory of the franchisee” to be a breach of the exclusivity.  

The Court disagreed and found that in selling the video products through ezydvd.com.au or ‘TiVo’ to customers located in the territory of the franchisee, the Franchisor had breached the Hazelbrook agreement. The appeal court agreed with the Magistrate in the case who said:

The distinction suggested between the operation of a “bricks and mortar” business and on-line trading is illusory.... It would have been no different had VEI, VEA, Blockbuster or EzyDVD commenced operating a business of the sale or hire of video products by mail order, at a market stall or out of the back of a truck in the territories. It would be an affront to the reasonable person on the “Bondi bus” to suggest that it was the common understanding of the parties that VEI and VEA could sell or hire video products by mail order, at a market stall or out the back of a truck in the territories. So to would it be to suggest that the TiVo movie service and ezydvd.com.au on-line businesses were any different.

Implied good faith obligation also breached

The Court applied the principles in older cases dealing with “traditional” encroachment and found that VEI had an obligation to act in good faith in relation to Sedema, “in relation to its contractual obligations to remain loyal to, comply with honest standards of conduct, and act reasonably in relation to the promise of exclusivity in the territories by not competing against Sedema for rental or retail business.

In terms of the implied obligation of good faith, the Court stated:

In my view the law on this topic is clear. There is to be implied in the franchise agreements a term of good faith and fair dealing which obliges each party to exercise the powers conferred upon it by the agreements in good faith and reasonably, and not capriciously or for some extraneous purpose.

It should be said that the existence or otherwise of a general implied duty of good faith in franchise agreements has been a polarising debate in the franchising sector in Australia over the last few years.  This debate has led to the redraft of the Franchising Code of Conduct to include an express obligation on both parties in franchise agreements to act in good faith although the final wording is not yet settled.

Unconscionable conduct too

In addition to a breach of good faith the court found that VEI was also guilty of unconscionable conduct in business transactions, (s 21 of the Australian Consumer Law)

Previous cases had said that unconscionable conduct required a high level of “moral obloquy” and VEI argued this had not been demonstrated. The Court said it was not necessary that there be “motive, intent, bad faith and intent to injure with some purpose to drive the franchisees out of the franchises. It was enough to establish unconscionable conduct where VEI’s conduct was inconsistent with a proper relationship between franchisor and franchisee, and demonstrated a lack of good faith.”

Unconscionable conduct has been notoriously difficult to establish however the Sedema decision may represent a new willingness to find such conduct in relation to these encroachment situations.

Conclusion

Franchisees should be aware that the new Code disclosure recognises the importance of e-commerce to Australian business, however in accordance with previous policy and in line with principles of ‘caveat emptor’ and economic freedom, the approach is to provide disclosure of the information rather than to mandate terms or proscribe certain behaviours.  Having disclosed that it intends to provide the goods or services online and the details of any profit sharing arrangement it may have with its franchisees (or the fact that it does not intend to share the online revenue), a franchisor is completely free to conduct its business online in competition with the franchisees as it has disclosed.  A potential franchisee is free to enter into the franchise relationship or not.

A franchisor should be aware however that any changes it makes to the way online (or other competing) sales are conducted (from the way disclosed) to which the franchisees have not agreed is likely to be unconscionable conduct, a breach of the express obligation of good faith (to be part of the Code from 1 January 2015) and/or misleading or deceptive conduct. 

This article includes material from the paper “Internet Issues in International Franchising” presented at the 30th Annual IBA/IFA Joint Conference on May 7, 2014 in Chicago USA (Authors: Corinne Attard –Partner Holman Webb Lawyers (Aust) with John Pratt Partner, Hamilton Pratt (UK),  Michael Lindsey, Counsel at Steinbrecher & Span LLP (USA) and Karsten Metzlaff, Noerr LLP (Germany).