According to Mason Sier Turnbull, the Federal Court has ruled that although franchisors and their managers are entitled to audit and inspect their franchisees’ operations, franchise agreements contain an implied term which requires them to act in good faith when doing so.
In the cases of Luce Optical Pty Ltd v Budget Specs (Franchising) Pty Ltd and Visionmax Pty Ltd v Budget Specs (Franchising) Pty Ltd, the franchisor had issued valid Notices of Termination after
an audit and impromptu inspections had found that the franchisee had committed breaches of the franchise agreement. Justice Greenwood ordered that the franchisor be restrained from "acting upon or implementing a Notice of Termination" because it had failed to act in good faith when exercising its right to inspect and audit the franchisee's books.
His Honour also found that there was a serious question to be tried in relation to how the franchisor had exercised its power.
Although the matter has not yet gone to trial, the court’s preliminary finding illustrates the importance of franchisors and their managers exercising caution when conducting the inspections and audits their franchise agreements permit.
Surprise inspection
The impromptu inspection was carried out when the franchisor’s national operations manager and an accountant entered a franchised store without notice or warning. The franchisee had been expecting the national operations manager that day but only to discuss marketing issues. Instead, the franchisee was handed a Notice of Inspection and Audit which stated that the franchisor was exercising its right under the franchise agreement.
The notice required the franchisee to produce books of account and other records relating to the conduct of the franchise. Fearing that the business might be shut down if they refused to comply with the notice, the franchisee allowed the inspection to proceed.
Audit report
The court heard evidence that the Ferrier Hodgson accountant had effectively been wearing two hats. He had conducted the inspection as an agent of the franchisor but had acted as an independent accountant when auditing the books of account. Concerned by some "serious issues" which the audit raised, the franchisor convened a meeting with the franchisee and their respective lawyers.
Grounds of termination
The auditor’s report identified several breaches which provided grounds for terminating the franchise agreement. In particular, the franchisor claimed that the franchisee had failed to record all of their sales, understated their income, underpaid royalties and falsified records. The franchisor subsequently issued a Notice of Breach and Intention to Terminate Franchise Agreement identifying seven grounds of termination derived from the auditor’s report. When the breaches were not remedied, the franchisor issued a Notice of Termination.
Franchisee's contentions
The franchisee argued that the franchisor could not rely on any of the grounds of termination because its power to exercise its right of inspection and audit could be exercised only after giving reasonable notice and no notice had been given. They also argued that the franchisor's failure to exercise its power of inspection and audit in good faith had rendered the resulting process of inspection and audit unlawful and therefore of no effect. They further contended that the franchisor's conduct contravened Section 51AD of the Trade Practices Act 1974 (i.e. Contravention of Industry Codes).
The franchise agreement
The franchise agreement empowered the
franchisor with the right of inspection and
audit by requiring the franchisee to, among other things: permit the franchisor and its agents to inspect and take copies of the books of account as well as all other records relating to the conduct of the franchise at all times; and make the relevant books and records 'available for inspection at a location' stipulated by the franchisor. It also permitted the franchisor to, at any time, nominate an independent auditor to examine the books and records and calculating or other equipment used by the franchisee.
Serious question
The Notice of Inspection and Audit described Ferrier Hodgson as agents of the franchisor for the purposes of inspection and the taking of copies of books of account and other records. Considering this, Justice Greenwood held that the difficulty in this case was that a serious question arose as to whether Ferrier Hodgson could act as an agent of the franchisor, and at the same time, as an independent auditor to exercise the examination power.
His Honour reasoned that the firm “could not be both an agent of the franchisor and at the same time an independent auditor.”
Reasonable notice
As to whether there was reasonable notice, his Honour reasoned that "if an implied duty of good faith and fairness subsists and an obligation to exercise rights and powers reasonably, there is a serious question as to whether the implied obligations have been contravened". Consequently, if a power of inspection was exercised in breach of an implied duty, there is a serious question as to whether the franchisor can rely upon the report arising out of the exercise of that power.
His Honour therefore held that, for interlocutory purposes, the franchisor had an implied duty to exercise its powers under the franchise agreement in good faith, fairly and reasonably. Further, the franchisor was not entitled to exercise its legal rights in such a way that constitutes unconscionable conduct.
As a result of these findings, the franchisor was restrained from acting upon the Notice of Termination.
Lessons for franchisors
This case adds to the list of cases which place greater obligations on franchisors and requires them to act, not only in good faith, but also within the powers conferred on them by the franchise agreements into which they enter. Justice Greenwood’s findings highlight the importance of franchisors (and their managers) taking care when conducting inspections and audits, even though they have a legal right to conduct such activities. The case also underscores the importance of franchisors giving their franchisees 'reasonable notice' at all relevant times. The courts will determine what constitutes reasonable notice by examining the literal construction of the franchise agreement and taking all other relevant circumstances into account.
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16-May-2006