In the United States, the issue of competition between “bricks and mortar” business franchises and the franchisor-led online channel has emerged as the new form of “encroachment” claim raised by franchisees in recent years. . In Australia, our mandatory disclosure document under the Franchising Code of Conduct requires prior disclosure to a franchisee of information relating to the “territory” of the franchise, but it only refers to a physical geographic territory and does not address encroachment by other distribution channels, such as e-commerce. This has been resolved with the proposed new form of disclosure document to come into effect on January 1, 2015. (Note that the new form is not yet law).
New online sales disclosure
The new disclosure document will contain a new section 12 which requires a franchisor to disclose whether it intends to sell the same goods or services online or whether franchisees may do so. Additionally, if goods or services are to be sold online by the franchisor or other franchisees, details of the extent to which they can be provided to customers in the potential franchisee’s territory (assuming there is has one) and whether there will be any sharing of the revenue generated from these sales should be disclosed. The inclusion of this new information reflects the increased importance of the Internet as a distribution channel in general.
A new form of encroachment claim
The results of recent “online encroachment” cases in the United States have hinged on the wording of particular franchise agreements and whether the franchisee had exclusive territory that the franchisor violated. Most franchise agreements drafted in the United States and Australia since the rise of the Internet and online shopping detail the precise distribution channel granted to the franchisee and what the franchisor can do online, albeit in systems established, this continues to be a sensitive subject. problem, especially with long-time franchisees.
Many franchisors have faced the dilemma of having a franchise system with exclusive distribution or marketing territories as well as increased competition from online sellers. Unless the franchise system also develops an online presence, sales to Internet customers will simply be lost to competitors.
In addition to selling directly to customers over the Internet, franchisors seek to sell their products or services through alternative distribution channels, including supermarkets, non-franchised outlets, mobile vendors, and food trucks.
The old “encroachment” cases, in which the franchisor opened an outlet too close (in the franchisee’s opinion) to the franchisee’s store and “cannabalized” the franchisee’s sales, applied the critical legal concepts that generally apply to the franchisor and franchisee relationships in Australia, namely:
- The implicit duty of good faith (which will soon be the express obligation to act in good faith).
- Unacceptable conduct, and
- Misleading and deceptive conduct.
A recent case from NSW, Video Ezy International Pty Ltd v Sedema Pty Ltd (2014) showed the application of these well-known legal concepts to the contemporary issue of online sales by a franchisor in competition with its franchisee.
Ezy Case video – Territorial exclusivity is violated by online sales
Video Ezy International (VEI) as franchisor has granted franchises for the operation of Video Ezy outlets in defined territories in Australia. A related company, Blockbuster, was responsible for the “TiVo” movie service, a set-top box service that provides access to on-demand videos through a television, and another company, EzyDVD was responsible for the website”ezydvd.com.au” which allows customers to order DVDs online. As the three companies were centrally owned and controlled, the court effectively treated them as a single entity.
On April 1, 2003, Sedema Pty Ltd purchased the Video Ezy business in Hazelbrook in the Blue Mountains from franchisor VEI on the condition that VEI grant Sedema an exclusive 10-year franchise in Hazelbrook.
The Hazelbrook sale agreement contained a restrictive clause which granted Sedema exclusivity in the sense that VEI agreed not to continue “trade or business involving the rental and/or sale of video products or any other business of a similar nature in the Franchise Territory for “Video Ezy Hazelbrook” for the term of the Franchise Agreement (other than as a video franchisor Ezy Franchise System)”.
VEI argued that this did not apply to the business operated by EzyDVD and Blockbuster because the clause refers to the sale or rental of video products “in the territory” and not the sale or rental of video products “on” the territory. VEI said the business itself must be “in the territory of the franchisee” to constitute a breach of exclusivity.
The Court disagreed and held that by selling the video products by ezydvd.com.au or ‘TiVo’ to customers located in the franchisee’s territory, the Franchisor had breached the Hazelbrook Agreement. The Court of Appeal agreed with the magistrate in the case who declared:
The suggested distinction between operating a “physical” business and online commerce is illusory… It would not have been otherwise if VEI, VEA, Blockbuster or EzyDVD had started operating a sales or video rental. products by mail order, at a market stall or in the back of a truck in the territories. It would be an affront to the reasonable person on board the ‘Bondi bus’ to suggest that it was the common understanding of the parties that VEI and VEA could sell or rent video products by mail order, at a market stall or at the back of a truck in the territories. So that would be to suggest that the movie service TiVo and the online companies ezydvd.com.au were different.
Implied duty of good faith also breached
The Court applied the principles in older cases dealing with “traditional” encroachment and found that VEI had a duty to act in good faith with respect to Sedema, “with respect to its contractual obligations to remain faithful, to conform to honest standards of conduct and to act reasonably in relation to the promise of exclusivity in the territories by not competing with Sedema for rental activities or sale to detail.
Regarding the implied duty of good faith, the Court said:
In my opinion, the law on this subject is clear. There must be implicit in franchise agreements a term of good faith and fair use that requires each party to exercise the powers conferred upon it by the agreements in good faith and reasonably, and not capriciously or for extraneous purposes.
It must be said that whether or not there is an implied general duty of good faith in franchise agreements has been a polarizing debate in the Australian franchise industry in recent years. This debate led to the overhaul of the Franchise Code of Conduct to include an express obligation for both parties in franchise agreements to act in good faith, although the final wording has yet to be finalized.
Driving also unacceptable.
In addition to a breach of good faith, the court found that VEI was also guilty of unreasonable conduct in business dealings (Section 21 of the Australian Consumer Law)
Previous cases had stated that impermissible conduct required a high level of “moral defamation” and VEI argued that this had not been shown. The Court said that it was not necessary for there to be “Motive, intent, bad faith and intent to harm for the purpose of driving franchisees out of franchises. It was sufficient to establish inadmissible conduct where VEI’s conduct “was inconsistent with a proper franchisor-franchisee relationshipand demonstrated a lack of good faith.
Inadmissible conduct has been notoriously difficult to establish, but the Sedema decision may represent a new willingness to find such behavior in relation to these encroaching situations.
Franchisees should be aware that the new Code disclosure recognizes the importance of e-commerce to Australian businesses, but in line with previous policy and the principles of ‘caveat emptor’ and economic freedom, the approach is to disclose information rather than imposing conditions or proscribing certain behaviours. After disclosing that it intends to provide the goods or services online and details of any profit-sharing arrangements it may have with its franchisees (or the fact that it does not intend to share online revenue), a franchisor is entirely free to conduct its online business in competition with franchisees as it has disclosed. A potential franchisee is free to enter into the franchise relationship or not.
A franchisor should be aware, however, that any changes it makes to the way online sales (or other competing sales) are conducted (from the manner disclosed) to which the franchisees have not consented may to be impermissible conduct, a breach of the express duty of good faith (to become part of the Code as of January 1, 2015) and/or misleading or deceptive conduct.
This article includes material from the article “Internet Issues in International Franchising” presented at the 30th Joint IBA/IFA Annual Conference on May 7, 2014 in Chicago, USA (Authors: Corinne Attard -Partner Holman Webb Lawyers (Aust) with John Pratt Partner, Hamilton Pratt (UK), Michael Lindsey, Counsel at Steinbrecher & Span LLP (US) and Karsten Metzlaff, Noerr LLP (Germany).