FCA and the Franchising Code of Conduct

According to the Franchise Council of Australia , the introduction of the Franchising Code of Conduct in 1998 provided the franchise sector with a regulatory backbone that has assisted Australian franchising to grow and develop. The disclosure regime provides prospective franchisees with considerable information relevant to the franchise, and the requirement for consistent formatting of disclosure documents facilitates comparison between opportunities.

Although there are compliance costs, it is arguable that this creates an appropriate barrier to entry. If franchisors cannot afford the relatively modest cost of preparation of a franchise agreement and disclosure document, they ought not be attempting to franchise.

The broad definition of franchising has ensured that organisations cannot cloak themselves as franchises without being caught by the Code. In overseeing the operation of the Franchising Code of Conduct, the Australian Competition and Consumer Commission (ACCC) has been vigilant and professional. By taking action against organisations that seek to operate at the margins, securing the benefits of franchising without complying with the disclosure and other obligations contained in the Code, the ACCC has helped preserve the reputation and credibility of franchising as a business method.

However, there is one area where the Franchising Code of Conduct requires amendment. At present, section 5(3) of the Code provides that it does not apply to a franchise agreement if the franchisor is resident, domiciled or incorporated outside Australia and grants only one franchise or master franchise to be operated in Australia.

In discussions leading up to the introduction of the Code, it was felt that this exemption was appropriate to cover situations where foreign systems were transacting in Australia with substantial Australian corporations. It was felt that without the exemption, Australia may miss out on international innovation, and the Code may place an unreasonable burden on US systems transacting with their substantial Australian master franchisees. The Code was introduced very quickly, and the merit of this argument went fundamentally untested and uncontradicted. With the benefit of hindsight there seems little logic in the proposition that a foreign franchise system should be exempt from Australian law if selling a franchise or master franchise in Australia. Further, there is now considerable evidence that some foreign franchise systems have abused the privilege provided by the exemption.

Exemption or loophole?

In a recent article in Business Review Weekly, it was noted that a number of US systems appear to be exploiting the loophole in the Franchising Code of Conduct. The writer provided several examples of inappropriate behaviour, and chronicled the disastrous consequences for those master franchisees and franchisees caught up in the failure of several foreign concepts in the Australian market. There would be few that would argue with the accuracy of the article. Indeed those who have been involved in franchising in Australia for some time can provide a litany of failed foreign systems. Although there are no statistics kept, anecdotally most industry experts would agree that foreign franchise systems have a much higher failure rate than local systems.

The concern expressed by the article is that the international companies enter the Australian market with little or no commitment to it. They locate a master franchisee, pocket a significant upfront fee, and largely leave the master franchisee to their own devices. Apart from being a flawed market entry strategy, this situation often leads to hardship not just for the master franchisee, but for any franchisees appointed by the master franchisee in an attempt to exploit the opportunity in Australia. It was noted that we have also seen in recent times a number of consultants establish themselves in the Australian market, frequently working on a success fee basis that has little to do with the ultimate success of the concept.

Rather, success is measured by the sale of the master franchise. The consultant then exits the process and moves on to the sale of the next master franchise.

In the US, foreign franchise systems are really unable to exhibit at trade shows or offer their business opportunities to the local market without overcoming some compliance hurdles. That is not the case in Australia. A foreign system could take trade space at a franchise show or other business opportunities event, and freely sell their master franchise without any registration or disclosure requirements.

Further, they can speak not only to sophisticated investors, but any person who happens to attend the trade show. It is of course no surprise that a person, albeit objectively more suited to being an individual franchisee, can become excited with the prospect of being a master franchisee for the whole of Australia. It may even cost less to purchase the master rights than to purchase a substantial franchise. However the payment of $300,000 as an initial master franchise fee for an unproven concept is obviously a far more risky endeavour.

Should foreign systems face higher standards?

There is in my opinion no economic justification for the continuation of the current foreign franchise exemption given the instances of damage caused to local master franchisees, franchisees, employees, consumers, suppliers and others who have suffered as a result of the demise of a foreign franchise chain.

Indeed, there is some logic to the argument that foreign franchise systems should face more stringent compliance requirements if they seek to offer a franchise or master franchise in a marketplace where they have no physical presence and no prior experience. The Australian market is now quite mature and sophisticated and highly competitive in most sectors. The chances of a foreign system successfully establishing in Australia continue to diminish. There is a clear case for moderating the regulatory requirement to remove the current exemption and to carefully consider the regulatory requirements that should apply to foreign franchise systems seeking to enter the Australian market. Australia is, to my knowledge, the only country in the world that has such an exemption. Indeed, in the US, the home of franchising, it is necessary for all foreign systems to comply with the US regulatory regime before they can begin franchising in any form. Compliance is not a simple process. For example, an Australian system seeking to appoint a master franchisee in California as a beachhead for US expansion will need to produce a uniform franchise offering circular (similar to our disclosure document) including quite detailed financial information, and register under Californian state franchise law.

The Federal Trade Commission has proposed legislative changes to moderate the impact of US franchising laws on all franchise systems. In many US states there are already various exemptions, including a ‘sophisticated investor’ type of exemption where the proposed master franchisee or the transaction is of a certain size or the franchisee has substantial business experience. Although there are currently no exemptions at a federal level, the Federal Trade Commission has published proposed amendments to the federal legislation consistent with the current state exemptions and also focusing on the large investment/sophisticated investor concepts.

Amending Australian law

In my opinion the Franchising Code of Conduct should be amended to remove the current exemption for a foreign franchise system.

In its place there should be an exemption that provides that a franchise agreement is exempt from the operation of the Code if the franchisor is incorporated, registered or domiciled outside Australia and grants a single franchise or master franchise to a ‘sophisticated investor’ or the transaction is a ‘substantial transaction’. The definitions can be the subject of discussion, but as a suggestion I would propose that the sophisticated investor would be a person who:

(1) has net assets in excess of $2 million; or

(2) has five years business experience.

I further suggest that a substantial transaction would be a transaction involving the payment by the prospective franchisee or master franchisee in the first year of the term of more than $500,000.I believe these limits strike a good balance between the respective interests of the parties. The amendments are consistent with the proposed US changes, although it should be noted that the federal rules apply to all franchises. Indeed, the sophisticated investor limit in the US is $5 million in net assets, and a substantial transaction requires an initial payment of $1.5 million. With the federal and state requirements, which indeed vary between states, US law is much more burdensome than Australian law. I do not believe Australian franchise systems require sophisticated investor or substantial transaction exemptions for their domestic franchising transactions. However I believe foreign franchise systems can fairly make the case for these exemptions if the blanket foreign franchise exemption is removed.

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