"Direct supervision" provisions in franchise agreement upheld
The interesting issue in Masterclass Enterprises Pty Ltd v Bedshed Franchises (WA) Pty Ltd  WASC 67 is clearly set out at the start of the judgment of Newnes J:
"This case raises a novel question as to the enforceability of a provision in a franchising agreement which requires that the franchise business be at all times under the direct supervision of the franchisee or, in the case of a corporate franchisee, someone having a substantial interest in the corporate franchisee. The plaintiff (Masterclass) contends that such a provision is an unreasonable restraint of trade and is unenforceable."
The Bedshed franchise, comprising about 30 stores around Australia, was a retail system for the sale of bedroom furniture and certain other household products. Clause 6.2 of its franchise agreement provided that:
The [Bedshed Claremont business] and the [premises at which it is carried on] shall at all times be under the direct supervision of the Franchisee or the Guarantor except for short temporary absences and reasonable vacations from time to time (in which case the Business shall always be under the direct, on-premises supervision of a fully trained employee-manager approved by the Franchisor).
The franchisee claimed that:
- this provision was an unenforceable restraint of trade; and
- the franchisor’s refusal to approve the franchisee’s transfer of the business to a company because the transferee company would not at all times be under the direct supervision of a principal of the company was unreasonable and contrary to the Franchising Code of Conduct.
Restraint of trade
In the absence of any direct authority Newnes J considered the restraint under general principles, and held:
(i) that it was not a restraint within the scope of the restraint of trade doctrine; and
(ii) even if it was it was not an unreasonable restraint of trade.
In relation to (i), it was held that although the practical effect of clause 6.2 (as with any full time employment or business activity) may be to limit the capacity of the franchisee or its principals to engage in other types of business, "there is no basis for concluding that clause 6.2 was calculated to have that effect or to limit competition with Bedshed’s business, nor is there any basis to conclude that the requirements of clause 6.2 are contrived for any such purpose":
Any curtailment of ... opportunities to engage in other business activities arises simply because of the obligations necessarily involved in the direct supervision of the operation of the Bedshed Claremont business. That business is a substantial one. The question is not whether it needs full-time supervision but simply by whom that supervision should be provided. By clause 6.2 of the franchise agreement, Bedshed requires that the Bedshed Claremont business (as with its other franchise stores) be supervised by the [principals]. On the evidence, it does so because it considers that such supervision is most likely to ensure the success of the franchise business, to the benefit of both franchisor and franchisee.
In the circumstances, I am quite unable to see that that contractual requirement can be regarded as a restraint of trade.
In relation to (ii) Newnes J held that:
In light of the interests of Bedshed in the continuing successful operation of the franchise business, and of the ‘maintenance of a close working relationship with [Masterclass] in the conduct of the [Bedshed Claremont business]’ as contemplated by the franchise agreement, I do not consider it unreasonable for Bedshed to include in the franchise agreement measures which are intended to ensure that the franchise business is supervised in a manner which enables it to operate as effectively and competitively as reasonably practicable. In particular, I do not consider that the requirement of clause 6.2 in relation to the supervision of the Bedshed Claremont business goes further than is reasonably necessary to protect Bedshed’s legitimate interests.
The judge was not sympathetic to the franchisee’s argument that the requirement was unnecessary and therefore unreasonable; that a store is capable of being conducted as well, if not better, if supervised by an employed manager as compared with a person with a substantial interest in the franchisee:
[The franchisee] sought to support that contention by pointing to the fact that Bedshed owns and operates some stores itself, using managers whom Bedshed employs. I do not consider it gains any assistance from that. I accept ... evidence that those stores fall into a quite different category. They provide a much greater income to Bedshed than would be obtained from franchise fees if they were franchised stores, and at the same time they enable Bedshed to provide training to new franchisees and their staff, and to experiment with such things as new product lines and store layouts before deciding whether to include those in the franchise system. They also enable Bedshed to secure appropriate sites for future Bedshed stores, ahead of any competitor.
Consent to transfer
The agreement, consistent with clause 20 of the Franchising Code of Conduct, provided that "a franchise cannot be transferred by Masterclass without the prior written approval of Bedshed, which approval is not to be unreasonably withheld".
Newnes J confirmed that the specific circumstances set out in clause 20(3) (where refusal to consent is deemed to be reasonable) are inclusive and that the franchisor can withhold consent in other circumstances subject to the overriding requirement that consent to transfer cannot be unreasonably withheld.
The transfer proposed by the franchisee was to a family business whose directors/major shareholders would not work full time in the business which would be operated principally under management. The franchisee argued that the fact that no-one having a substantial interest in the proposed transferee would be supervising the business at all times was not a reasonable ground for withholding consent.
The franchisee further argued that the legitimate interests of both franchisor and transferee would be better served by having the business subject to an experienced and proven manager of the business, rather than by one of the shareholders none of whom had any experiences in conducting a business of this nature.
The judge accepted that the franchise agreement involved a "continuing close commercial arrangement over its term" and held that in these circumstances,
. . . it cannot be regarded as unreasonable for Bedshed to require that the franchise business be supervised by someone with a substantial interest in the franchisee. It is entitled to act, as from the evidence it does, on the basis that provides greater motivation for the continuing success of the business over the lengthy term of the franchise agreement, and that it is also likely to ensure a continuity and consistent quality of supervision that is less likely to be achieved if the business is dependent upon employed managers.
Newnes J was not sympathetic to the argument that, at least in the first six months the employee manager proposed could operate the business more competently than directors. The franchisor provided training and assistance and, given the term of the agreement, there were hazards in leaving the availability of effective management of the business to the vagaries of the labour market.
In the circumstances it was not unreasonable that Bedshed placed such importance on the continuity of supervision of the business likely to be provided by someone with a substantial interest in the franchisee. The judge was also not convinced by the franchisee’s argument that the franchisor did not require disclosure of the extent of the specific financial contributor of each director and shareholder to the franchisee. This was claimed to undermine Bedshed’s contention that it is in the overall interests of its franchise system that each franchise business is supervised by someone with a substantial interest in the franchisee:
It is clearly the case that there may be circumstances where, in fact, a substantive shareholding does not reflect a commensurate financial interest in the franchisee. But there are plainly limits to the extent of the enquiries that Bedshed can reasonably make into the internal financial affairs of a prospective franchisee and, given the often relatively complex nature of even intra-family financial and taxation arrangements, there are equally limits to the conclusions that can reasonably be drawn from such enquiries as to the precise nature of the interest of a specific shareholder. In the circumstances, the assumption underlying Bedshed’s requirement in respect of supervision is not unreasonable.
A "device" constructed in an attempt to satisfy the director supervision requirement – the manager guaranteeing the franchisor’s obligations while being indemnified against any liability thereby incurred – which had been specified by the franchisor was similarly treated by the judge. The franchisor’s rejection of this arrangement was not unreasonable and "it is not surprising that Bedshed viewed the arrangement simply as a device to circumvent their ‘owner/operator’ requirement."
Newnes J did not consider it necessary to consider a further argument of the franchisee – that the franchisor’s selection criteria (which is one of the FCC’s clause 20(3) grounds for reasonable refusal if not met) itself had to be reasonable. His Honour nevertheless noted that:
"There is no requirement under clause 20(3)(c) that the selection criteria themselves be reasonable. In that respect, clause 20(3)(c) differs from other provisions in clause 20(3). That is because the nature of any selection criteria, and any assessment as to whether or not an individual meets the criteria, involves inherently subjective commercial decisions upon which reasonable people may disagree. Counsel for Bedshed argued that while selection criteria could not offend equal opportunity legislation or amount to unconscionable conduct, or be a guise for bad faith or some ulterior reason for refusal, there is no requirement that they be reasonable."
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