Many franchisors engage in internet selling, which directly or indirectly competes with franchisees. A recent Court decision holds that such conduct can infringe the  rights of franchisees to an exclusive territory. However, the reasoning of the Court  potentially raises an issue even when there is no exclusive territory.

The recent decision of the Supreme Court of New South Wales in Video Ezy v Sedema highlights that franchisors may be at risk of breaching their franchising agreements if they engage in online businesses that, either directly or indirectly, compete with their franchisees. The decision provides very broad protection for franchisees and, consequently, franchisors should carefully review the exclusivity or other provisions of their franchising agreements to ensure that they have sufficient flexibility to operate on-line. Further, disclosure documents need to fully and clearly disclose to franchisees any actual or proposed online selling by the franchisor.

The decision serves as a timely reminder given changes to the Franchising Code of Conduct (Code), which are to take effect on 1 January 2015. Key new elements of the Code include an express obligation upon the parties to act in good faith during the negotiation and performance of a franchising agreement. Furthermore the new Code contains a marked increase in the disclosure requirements for franchisors, including specific provisions requiring disclosure of information about online trading by the franchisor.

The facts and the primary proceedings

The franchisor granted franchises for the operation of Video Ezy outlets in defined exclusive territories in Australia. A related company of the franchisor, EzyDVD, was responsible for a website (ezydvd.com. au) that allowed customers to order DVDs online. As the franchisor and related companies were owned and controlled by the same entity, they were treated by the court as a single group.

The franchisee brought a claim in the lower Court for breach of the exclusivity provisions, breach of the implied duty to act in good faith and for unconscionable conduct pursuant to the Competition and Consumer Act. These claims were upheld in the lower Court and the franchisor’s appeal to the Supreme Court was dismissed.

Exclusivity

Pursuant to the exclusivity provision of the franchise agreement, Video Ezy 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 the term of the franchise agreement.

Video Ezy contended the exclusivity provision in the agreement was not breached as the business of EzyDVD did not involve “the rental and/or sale of video products… within the territory of the franchise…” Specifically, Video Ezy argued that the word “within” connotes the containment of the business inside the territory, which therefore meant it did not apply to the rental and/or sale of video products over the internet to customers within the franchisee’s territory.

The Supreme Court held that “within the territory” is to be given its natural and ordinary meaning and should not be read narrowly. Through applying the test of what a reasonable person would have understood it to mean, the judge found that internet sales breached exclusivity.

Good faith

The franchisee contended that Video Ezy had an implied obligation of good faith and that it breached this obligation by failing to remain loyal to the promise in relation to exclusivity. Video Ezy submitted that there was no implied term of good faith and, even if there was, it should only be used in relation to matters such as termination, and not to expand the scope of an exclusive licence.

The Supreme Court held that the law implies into franchise agreements an obligation of good faith and fair dealing which obliges each party to exercise the powers… in good faith and reasonably, and not capriciously or for some extraneous purpose. The Court held that the franchisor had an obligation to act in good faith in relation to the franchisee, 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 an exclusive territory by not competing with the franchisee for rental or retail business. It did not matter that the franchisor and the company carrying on internet trading were separate legal entities, because they were related companies in the same group.

Unconscionable conduct

The franchisee claimed that it had purchased an exclusive licence for a substantial sum of money and that companies related to the franchisor had actively competed against the franchisee in that territory, thereby derogating from the goodwill purchased by the franchisee. Video Ezy submitted that there was no evidence of an accumulation of incidents which discloses an overwhelming case of unreasonably, unfair, bullying or thuggish behaviour in relation to the franchise that amounts to unconscionable conduct in contravention of the Competition and Consumer Act.

The lower Court’s finding that the conduct of the franchisor and related companies was inconsistent with a proper relationship between franchisor and franchisee, and demonstrated a lack of good faith, was upheld. The related companies were also liable because, as they were all ultimately controlled by the same entity, they were held to possess the requisite actual knowledge of the unconscionable conduct.

What this means for franchisors

The case indicates a willingness of the courts to adopt a broad view of the meaning and application of implied “good faith” obligations into franchise agreements. The case highlights that franchisors may be at risk of breaching their franchising agreements if they engage in online businesses that, either directly or indirectly, compete with their franchisees. Consequently, franchisors should carefully review the provisions of their franchising agreements  (whether  exclusive  territories are granted or not) and ensure that any actual or proposed online trading by the franchisor is expressly permitted under the franchise agreement and fully and clearly disclosed to franchisees in their disclosure  document.