Alert | Federal Court finds trade mark licence 'heads of agreement' caught by the Franchising Code

25 May 2012

In Rafferty v Madgwicks [2012] FCAFC 37, the Full Federal Court recently held that a trade mark licence 'heads of agreement' was caught by the Franchising Code of Conduct (Code). The decision clarifies:

  • when heads of agreement (or other preliminary or incomplete agreements) constitute 'agreements to enter into franchise agreements' for the purpose of triggering disclosure obligations under the Code.
  • what constitutes a 'system or marketing plan controlled or suggested by the franchisor' for the purpose of the Code.

Businesses need to carefully consider the implications of this decision, particularly in view of the Court's 'substance over form' approach. Equally, the decision provides welcome guidance to those businesses seeking to remain outside the operation of the Code.

Background to case

The franchise in this case concerned the sale of modular accommodation units (MAUs) which were to be manufactured in China. The licensee (the Rafferty Parties) invested significantly in the business in reliance on representations by the licensor (the Donovan Parties) including that a Chinese company had been engaged to build the MAUs, that prototypes were being built in China, and that there had been serious interest in the product (Representations). The parties agreed to establish a new company (Time 2000 West Pty) to distribute the MAUs in Western Australia and the Northern Territory.

The Donovan Parties were keen to avoid the Code as they did not have sufficient time to consummate the deal if Code timing requirements had to be met. Accordingly, the parties entered into various agreements, including a Heads of Agreement (HOA) and a Rights Agreement (RA), with a particular focus on ensuring that the 'system or marketing plan' element of the definition of franchise agreement under the Code was not satisfied.

The Representations turned out to be false and the Rafferty Parties sued the Donovan Parties, alleging misleading and deceptive conduct and breach of the Code.

When is there 'an agreement to enter into a franchise agreement'?

The Donovan Parties argued that the HOA did not constitute an 'agreement to enter into a franchise agreement', since all of the terms of the 'franchise agreement' (in this case, the RA) were not finalised.

The Full Court found instead that it was sufficient there was a 'discernible agreement to enter into a franchise agreement, without any necessity that the precise terms of that franchise agreement be settled'. The HOA was held to be an agreement to enter into a franchise agreement (the RA), triggering the Code's disclosure requirements.

What are the elements of 'a system or marketing plan'

The Donovan Parties argued that the agreements were nothing more than mere licences to use intellectual property and did not fall within the operation of the Code. The central question in deciding whether the HOA and/or the RA fell within the Code was whether they created a 'system or marketing plan substantially determined, controlled or suggested' by the Donovan Parties.

The Full Court accepted 16 elements which are indicative of a system or marketing plan as outlined in Capital Networks Pty Ltd v .au Domain Administration Ltd [2004] FCA 808 and ACCC v Kyloe Pty Ltd [2007] FCA 1522.

Eleven of these elements were found to be present in the terms of the HOA and RA:

  1. Specific requirements for accounting and record keeping: the Rafferty Parties were required to 'prepare and maintain financial records' with a specified firm 'on a management system approved by the Donovan Parties.

  2. Reservation by the franchisor of a right to audit the books of account and other records: although a right to audit was not specifically reserved, the Donovan Parties did have a right to access financial records.

  3. Inability of the franchisee to supply goods or services to customers without the franchisor's approval: the Donovan Parties had 'absolute discretion' to scrutinise, refuse or approve any proposed sales contract.

  4. Reservation by the franchisor of the right to approve promotional and advertising material: both the HOA and the RA required the Rafferty Parties to follow 'all reasonable directions of the [Donovan Parties]' relating to quality control in marketing.

  5. Stipulation of retail pricing structures, sales structures, sales quotas and the like: the Rafferty Parties were obliged to meet specific sales targets and the agreements could be terminated should they fail to achieve these quotas.

  6. Creation of marketing and sales territories: the RA granted an exclusive right to 'promote, market, sell and install' the MAUs in the Northern Territory and Western Australia.

  7. Reservation by the franchisor of the right to approve sales staff: the Full Court held that provisions requiring the Rafferty Parties to 'employ sales persons as reasonably required' by the Donovan Parties satisfied this criterion.

  8. Restriction on the franchisee selling competing products: the RA contained a non-competition clause.

  9. Requirements for signage and merchandising: both agreements required the Rafferty Parties to use 'display units' as reasonably required by the Donovan Parties.

  10. Badging requirements (mandatory use of trading name, uniforms, stationery): there was a ban on using 'Core IP' outside the territory or 'Industry Markets'.

  11. Requirement to comply with the franchisor's policies and procedures: Their Honours held that a provision requiring compliance with any 'policies and procedures' was not merely 'generic' provision of no real effect. The Court looked to the 'overarching purpose' of the agreements as well as the other obligations listed above, and found that this provision would indeed enable the creation of a system or marketing plan if the franchisor so desired.

In the case of 'an agreement to enter into a franchise agreement' (the HOA), the Court confirmed that it does not matter if the exact details of a system or marketing plan have not been fully devised. Rather, it is enough that 'it has been agreed that there be an agreement that will create rights and obligations of this nature, even though the terms of the franchise agreement are yet to be settled'.

The Court also approved a number of further indicators of a 'system or marketing plan', although they were not applicable in this case:

  • provision by the franchisor of bonus structures
  • provision by the franchisor of training for staff
  • management structure
  • controls on the use of brand and trading names
  • reporting systems for profit or turnover.

Criteria for phrase 'substantially determined, controlled or suggested by franchisor'

Their Honours considered that the question of whether a system or plan is 'substantially determined, controlled or suggested by the franchisor' is closely linked to the existence of the system or plan. They suggested four criteria to ascertain the degree of supervision exerted by the franchisor:

  1. 'the extent to which the franchisee's business involves the sale of the franchisor's goods and services,
  2. the degree to which the franchisor assumes responsibility for some centralised management and uniform standards regarding quality,
  3. whether the franchisee is under obligations regarding advertising and promotional campaigns, and
  4. the extent to which the franchisor controls the franchisee's business, having regard to advertising and financial support, auditing of books, inspection of premises, hiring of staff, sales quotas, management training and the like.'

Finding that the business had satisfied these criteria, the Court also noted that the business was solely concerned with the franchisor's product. The franchisor also had a 'critical degree of control' over aspects central to the business, including financial records, sales orders, prospective customers and merchandising.

Conclusion

The Full Federal Court upheld the Judge's findings that the Donovan Parties:

  • were required, but failed, to give the Rafferty Parties a disclosure document before they entered into the HOA/RA and, accordingly:
  • had breached the Code (and section 51AD of the Trade Practices Act), and
  • had engaged in misleading and deceptive conduct.

The damages award of $1.7 million was also upheld.

Implications of the decision

Even a relatively uncertain agreement may constitute an agreement to enter a franchise agreement, and therefore trigger the requirement under the Code to give a disclosure document to licensees.

  • Licensing arrangements, particularly in relation to trade marks, need to be carefully considered in light of the decision.
  • Potential (and existing) franchisors may need to revisit their current arrangements to ensure that they are not acting in breach of the Code.
  • For businesses seeking to remain outside of the operation of the Code, the decision also provides some welcome guidance regarding the 'system or marketing plan' requirement of the Code.

Author(s) Rebecca Bedford