What is good faith in franchising? Part 2
By Deirdre Watson
In Part 1 (LawTalk 924), I explored the concept of good faith in franchising, including referring to some of the more commonly expressed attempts at a definition of “good faith”. I also discussed some of the Australian law and the Australian Franchising Code of Conduct which has, since 2015, included a compulsory obligation on all parties to a franchise agreement to act in good faith towards each other.
New Zealand doesn’t have any franchise specific legislation and it has very little case law which touches on the topic of good faith in a franchise agreement.
Franchisors who are members of the New Zealand Franchise Association must act in accordance with its codes. Those codes contain a requirement that a franchisor must “act in an honourable and fair manner in all its business dealings” and “adopt the highest standards of competency, practice and integrity in all matters pertaining to franchising”. This is layperson’s wording, but would be broad enough to cover good faith and indeed arguably goes much wider.
Therefore, whilst there is no franchise specific legislation in New Zealand, where there is a contractual requirement on a franchisor under their franchise agreement to abide by the New Zealand Franchise Association codes, then there is a clear contractual requirement on the franchisor, enforceable by the franchisee, to act in a fair and honourable way and with integrity.
The Franchise Association is however a voluntary association, whose members account for only roughly one quarter of all franchise systems in New Zealand. Not all franchisors are therefore subject to their code, and not all lawyers acting for franchisees know about the codes.
Assuming there is an implied obligation of good faith in a franchise agreement, what are the elements of good faith or its counterpart, bad faith?
The Australian Competition and Consumer Commission (the ACCC) has published some explanatory material on its website by way of guidance to the franchise industry in Australia as to what will amount to good faith in the franchise context.
In fleshing out the sort of conduct that would demonstrate a lack of good faith, it asks the following useful questions:
- Have you been honest with the other party?
- Have you considered the other party’s interests?
- Have you made timely decisions?
- Have you consulted with the other party regarding issues/proposed changes?
- Do you have a contractual right to act in that way?
- Are you imposing any conditions on the other party? Are those conditions necessary to protect your interests?
- Where a dispute has arisen, have you attempted to resolve the dispute (either directly with the other party, or through mediation)?
- Are you acting for some ulterior purpose?
The ACCC then goes on to provide a couple of hypothetical examples of good and bad faith. One such example is where a term of the franchise agreement requires the franchisee to follow specific procedures for invoicing and reporting. The franchisee experiences difficulty in accurately processing invoices using the software and hardware that is provided by the franchisor. Meetings fail to resolve the issues, leading to a breakdown in the relationship. Subsequently, the franchisor issues breach notices, relying on non-compliance with the invoicing and reporting requirements. However, there is a lack of clarity around whether or not the franchisee has failed to follow these requirements. It is proven that the franchisor’s breach notices are motivated by desire to simply terminate the franchise agreement.
In this instance, the franchisor has not acted in good faith because it was acting for an ulterior purpose.
In another example provided by the ACCC, the franchisor of a takeaway food franchise gives the franchisee the right to operate a franchise business at a specific location but not within an exclusive territory. There is no limit on the franchisor’s ability to open new stores and the franchisee did not have the right to be considered to own and operate additional stores. However, under the franchisor’s expansion policy, an existing franchisee would be eligible to operate another store if they satisfy certain eligibility criteria, including compliance with the franchisor’s standards of operation. During the agreement, reviews of the franchisee’s store indicate that it is not meeting the necessary standards. This leads to issues between the franchisee and the franchisor and several months later the franchisor decides to open up a new store in the vicinity of the franchisee’s store, due to perceived commercial benefits of expanding its system.
In this situation, the ACCC posits that the franchisor has acted in good faith because all of its actions are motivated by perceived commercial advantage to the franchisor in opening new stores. In other words, the franchisor is merely acting in the pursuit of its own legitimate business interests.
This latter type of situation is not atypical of many franchise disputes where there is controversy about the operation of the franchise following a process of consultation but where franchisees nevertheless allege there has been a lack of good faith simply because the franchisor will not accept their arguments. In reality, while the conduct of the franchisor certainly appears at face value unreasonable and draconian, the franchisor is simply acting in the pursuit of its legitimate business expansion interests.
Strong note of caution: Supatreats
A recent case before the High Court of New Zealand highlights the mess franchisees and franchisors can get into when they don’t see eye to eye about what is best for the business following consultation, and when neither side will back down. It’s another example (such as Health Club Brands Ltd v Colven Botany Ltd  NZHC 428) of franchisees coming off far worse than the franchisor when there is an operational dispute leading to termination of the franchise agreement. It sounds a strong note of caution to practitioners advising franchisees to follow a conservative route when seeking to resolve disputes about operational matters.
The essential facts in Supatreats Asia Pte Ltd v Grace & Glory Ltd  NZHC 1612 were that in 2017 the master franchisor and the New Zealand master franchisee fell out over a proposed change by the master franchisor to the approved supplier of product to franchise stores. The master franchisee argued that the proposed new supplier was too expensive and that its product was inferior to that provided by the existing supplier. It is natural that the master franchisee would want to protect its franchisees from increased costs and exposure to an inferior product. It is also understandable that the master franchisee would have taken issue with these proposed changes.
When neither side would back down, the master franchisor formally requested that the master franchisee and franchisees purchase product from the new approved supplier and, when they failed to do so, a breach notice was issued. Following further breach notices issued for non-payment of marketing and franchise fees, eventually the master franchise agreement was terminated.
Amidst all the strife, lawyers acting for the master franchisee advised the master franchisor that all of the franchisees had surrendered their franchise agreements. A company was incorporated by the cousin of the director of the master franchisee. That company then set up a similar business with new branding. Franchisees began to rebrand their businesses to that new branding. Materials put in evidence by the master franchisor supported the assertion that there was a marked similarity between the master franchisor’s stores and the stores run by the franchisees under the new branding.
With the master franchise agreement having been terminated, the master franchisor sought to enforce the post termination provisions of the franchise agreement, one of which was that all franchise agreements held by the master franchisee would need to be assigned to the master franchisor. The master franchisor sought orders from the court, amongst other things, seeking to restrain any of the defendants from trading as the new branded business.
The defendants made the submission that the master franchisor repudiated the franchise agreements by insisting on its franchisees using a nominated supplier. There is no record of the basis for that submission, but it is assumed this would have been developed on the grounds of a lack of good faith. That said, there is no record in the judgment which highlights or mentions any dishonesty or lack of integrity on the part of the master franchisor or even any evidential matter which might have suggested a lack of consultation, or an improper or arbitrary motive.
By the time the case came before the court, it was clear that the full rollout of the new brand was largely complete. The system involved a large number of franchisees, not all of whom were before the court. In finding that the balance of convenience was in favour of the master franchisor, and in granting the injunctions, Wylie J stated [at 79] that he regarded it as significant that the defendants had rebranded with their eyes open and despite express notice from the master franchisor. One can only imagine that the outcome of the decision would have led to some difficult circumstances for the master franchisee and franchisees.
There is a lot franchisees have to lose when franchisors and franchisees do not have a meeting of minds about operational matters, resulting in termination of the franchise agreement. It is therefore understandable why, increasingly, practitioners are advising franchise clients to use dispute resolution provisions in their agreements to reach a negotiated outcome about the operation of the franchise that at least brings with it contractual certainty regarding the future. When parties are in a relational contract such as a franchise agreement, disputes don’t always have to lead to breach notices and termination. Unless there has been a loss of trust and confidence between the parties, there is no reason why dispute resolution should not ensure the relationship repairs itself and remains on foot.
Deirdre Watson is a barrister and mediator specialising in franchising disputes firstname.lastname@example.org. She is Vice-Chair of the Franchise Association of New Zealand.
Last updated on the 8th February 2019