26 February, 2019
The Australian Federal Court has sent a resounding a message to franchisors that delays or inadequacy in franchise disclosure will not be tolerated.
The decision in Australian Competition and Consumer Commission v Ultra Tune Australia Pty Ltd [2019] FCA 12 was triggered by a complaint to the ACCC regarding non-return of a deposit, which in turn led to an extensive compliance audit. Ultra Tune has paid dearly for its failures as total penalties of AUD2.6 million were awarded, together with the ACCC's legal costs on an indemnity basis.
Importantly, the case serves as a test case for the level of detail required to be included in marketing fund financial statements and suggests that a significant level of detail is be required.
Lessons for franchisors
This is the first case in which the ACCC has seriously tested the Franchising Code penalty regime, which commenced on 1 January 2015. The failure to return the deposit resulted in the maximum penalty for failing to comply with the good faith obligation in the Code, then AUD54,000.
It resulted in high penalties for misleading or deceptive conduct, totalling AUD1.4 million, including in cases where the misleading conduct was relatively minor.
The lessons from the case include:
- the need to strictly follow the Code time requirements for disclosure;
- the importance of franchisor sales staff not under-estimating costs or expenses;
- the importance given by the ACCC and the court to franchisors having a "culture" of compliance;
- the benefits of internally auditing franchise sales processes for Franchising Code compliance;
- how penalties will be awarded;
- the level of detail required in marketing fund financial statements: they must provide an explanation to enable franchisees to assess how the money they have contributed has been spent.
The complaint to the ACCC
The case originated from a complaint by a prospective Ultra Tune franchisee, Mr Ahmed, who had applied to purchase an existing franchise. Ultra Tune made representations to him regarding the longevity of the store and the amount of rent and upfront expenses to be payable, each of which proved to be incorrect. Critically, Ultra Tune insisted on Mr Ahmed paying AUD $33,000 before he signed up or attended training, to cover the cost of purchasing equipment and of the training, not mentioning whether or not it was refundable. As Mr Ahmed was not provided with a franchise agreement or disclosure document until after the training commenced, it was a breach of the Franchising Code for it to receive a non-refundable payment at that time.
When he learned the correct details of the likely expenses, rent and period of trading, Mr Ahmed immediately withdrew his application and sought a refund of the AUD30,000 equipment fee. At the time he withdrew, Ultra Tune had received a quotation from the equipment supplier but had yet to invoice the franchisee, although it denied this through most of the hearing. The Judge found that Ultra Tune had retrospectively created and backdated an invoice to justify retaining the AUD30,000.
A culture of compliance
The court considered Ultra Tune's failure to promptly create, produce and provide the annual disclosure materials required by the Franchising Code to be more than merely careless. It found that it did not consider compliance as a priority, it had no effective internal compliance systems and it could not prove that its delays in disclosure were aberrations.
For that reason, when considering whether maximum penalties would be awarded, the court agreed with the ACCC that high penalties should be awarded, both to "encourage" Ultra Tune to comply in future, but also to deter the franchising sector in general from non-compliance.
The penalties
The penalties awarded illustrate how even relatively small breaches can be penalised and how penalties can multiply across franchise systems, including that:
- penalties can be retrospective: in auditing compliance, the ACCC can look back for up to six years;
- penalties are mostly for each document and each fund: in some cases, such as with Ultra Tune, a franchisor will have multiple franchise agreements or marketing funds. Penalties can be awarded for each disclosure document and also for each marketing fund not updated within four months of the end of the financial year and for each fund not audited within four months at the end of each financial year if an audit is required (then a maximum of AUD54,000, now AUD63,000 for each such disclosure document, fund and audit in each year);
- penalties can in some cases be for each franchisee: there is an offence for each franchisee not provided with a copy of the marketing fund statement and (where required) and for each franchisee not provided with a copy of the audit statement within 30 days of when it is prepared, in each relevant year (then a maximum of AUD54,000, now AUD63,000 per franchisee, per document, per year).
In this case, Ultra Tune had 185 franchisees and its failure to provide them with financial statements and audit reports within 30 days of their preparation was only considered for one financial year. The penalties for this alone could have totalled AUD19,980,000. The court felt that a penalty of that magnitude was not warranted, but chose a penalty to reflect what it considered to be the seriousness of the breach and the number of franchisees involved. Of the 185 franchisees, 182 of them received the statements six months after they were required to be provided. The court found an appropriate penalty for this offence to be AUD370,000.
In relation to the false or misleading statements made to Mr Ahmed, the penalties awarded were:
- for implying that they would refund the deposit when they did not: AUD1 million out of a maximum possible penalty of AUD1.1 million, as Ultra Tune had denied the conduct to the ACCC and to the court until the end of the hearing and had manufactured evidence to avoid its return;
- for the false or misleading representation that the store had been open for "about" six months, when in fact it had been open for many years, although closing for several months about a year earlier : AUD300,000 as it was a pivotal factor in Mr Ahmed deciding to proceed;
- for the false or misleading representation that the rent was AUD45,000, when in fact it was AUD50,000: a penalty of AUD50,000; and
- for the false or misleading representation that the purchase price totalled AUD163,000 but this omitted a charge for AUD12,100 for new signage: a penalty of AUD50,000.
Required detail for marketing fund financial statement
Over the last several years, the ACCC has indicated that some franchisors' marketing fund statements required more detail. However, limited guidance has been provided on this issue.
In September 2018, the ACCC announced that Luxottica had voluntarily changed its marketing fund statement to include more details. The changes it made are not publicly available, however the ACCC said that the concerns it had raised included that details of contributions by corporate stores should be included, together with the marketing services purchased using contributions from corporate stores. It also considered that, due to the multiple brands within the Luxottica network, the marketing funds should be broken down by brand and by geographical location. This provided limited guidance on the specific concerns.
The ACCC had earlier conceded that there was no "one size fits all" for marketing fund statements but had stated that, in order to comply with the requirements in section 15(1)(a) of the Franchising Code, the financial statement should include "sufficient detail" of the fund's receipts and expenses "so as to give meaningful information" about income and expenditure, it would expect that:
- the sources of income be broken down between franchisees, corporate stores and suppliers;
- the nature of the marketing or advertising be described as, for example, "radio advertising" or "print advertising"; and
- geographic scope of the advertising or marketing would be included.
Ironically, Ultra Tune had described its major category of advertising as "promotional advertising – television" which appeared to be consistent with the ACCC's examples of "radio advertising" and "print marketing" and this issue was at the core of the ACCC's allegation that Ultra Tune's marketing fund financial statements were inadequate.
Ultra Tune had five separate marketing funds in five different regions. The television advertising was apparent to its franchisees because it had aired and details of the advertising was included in magazines provided to the franchisees. For these reasons, Ultra Tune argued that it had provided "sufficient" detail and "meaningful" information. The Judge agreed with the ACCC and considered that for information to be "sufficiently" detailed and "meaningful" it needed to be "useful and practical", not "merely minimal accounting information". It needed to be information which would enable the franchisee to know whether the expenditure was in fact appropriate and where the funds had come from. The Judge read the obligation in section 15(1) in light of the obligation in section 31(3) to spend marketing "fees" only on items disclosed in a disclosure document, agreed with the franchisees or which are otherwise "legitimate" marketing and advertising expenses.
Ultra Tune had argued that because section 15(1) requires a "financial statement" this needs to bear in mind what an accountant or auditor might prepare. The Judge did not accept that it should be limited to the level of detail which might normally be included in financial statements prepared for accounting purposes. He considered that the information did not come "even close" to meeting the requirements and imposed a penalty of AUD350,000 in total across the five funds for two years.
He considered that franchisees should be entitled to know:
- to whom amounts have been paid;
- what services were obtained; and
- when the services were obtained,
and that the detail must be included in the marketing fund statements themselves, without recourse to other materials which may have been provided.
It is arguable that this interpretation of section 15(1) goes too far and that it should be interpreted without reference to section 31(3) which has a different history and role. However, the Judge's findings are consistent with the ACCC's policies and, as a result, franchisors will need to review their processes of compiling marketing fund financial statements and, importantly, the details they include within them.
For further information, please contact:
Jonathan L. Flintoft, Partner, Baker McKenzie
jonathan.flintoft@bakermckenzie.com
