Introduction
Why are we looking at franchising?
1 At the end of 2007 and the beginning of 2008 there were high profile cases of franchise deals going wrong and a number of people being left without the business they thought they had purchased. The Serious Fraud Office is now investigating some of these cases. However, these events raised questions about whether franchisees are sufficiently protected by our current laws and structures. This is why we are carrying out this review.
2 The purpose of this review is to:
- explore whether there is some form of franchise-specific regulation that could enhance the contractual process;
- ensure those entering into franchise agreements have adequate information to make good business decisions; and
- minimise compliance costs which could affect the growth of the sector if any form of regulation is introduced.
What are we interested in?
3 We are interested in hearing your views on the following:
- Is there a problem? If so, how big is it and who is affected?
- Do the current laws and structures (such as the Fair Trading Act 1986 and the Serious Fraud Office) work for franchisors and franchisees?
- What else could be done?
4 This review should not be viewed as a response to the alleged scams involving franchises. While these events have brought franchise issues into the spotlight, the purpose of this review is not to find ways to reduce the incidence of cases of fraud. Rather, it is to explore whether there are gaps in the current law as it relates to franchising, and whether there are steps the government can take to effectively address this.
5 Unconscionable conduct – unreasonable, or harsh and oppressive conduct – has been raised as an issue to be considered in relation to franchising. However, unconscionability is currently being reviewed by the Ministry of Consumer Affairs as a part of its review of the Fair Trading Act and is being considered in a wider context than just franchising. This issue is therefore outside the scope of this review.
Background
What is franchising?
6 "Franchising" can be viewed as a form of licensing distribution arrangement, but the term is often used loosely to refer to one or more types of these arrangements. For example, ‘product franchising' is where a distributor supplies the product of a manufacturer, often with exclusive right to sell within a specific market (e.g. motor vehicles or petrol). Another type is a ‘manufacturing franchise' where an essential ingredient or technical information is all that is supplied, like in the manufacturing of soft drinks.
7 Unless otherwise specified, this discussion document is primarily focused on a third category of franchising, being business format franchising. This is an internationally popular business method, providing both a growth strategy for small businesses and a competitive advantage to franchisors and franchisees. The franchise relationship can be complex as it is both interdependent and unequal.
8 This mode of doing business is based on a long-term contract and licence, where a business (the franchisor) grants a person or company (the franchisee) the right to operate a copy of its business system for a specified period. A franchisor usually then concentrates on brand building, systems development and support, purchasing and strategic issues, while the franchisee focuses on its own business operations, customer service, staffing and day-to-day matters.
9 The relationship between franchisors and franchisees is thus one of mutual interdependence. Franchisees pay to set up the business, often in a particular area, and are the owners of their own business. They will usually obtain the ability to use the intellectual property (IP), such as a name, symbol, logo or design, the business system and the know-how of the franchisor. Franchisees may also rely on the franchisor to obtain other benefits, such as those associated with national advertising campaigns and having an established support system. They receive their income from successfully marketing a product or service under a promotable brand name.
10 The franchisor is also dependent on the franchisee. The franchisor can gain its income from initial and on-going fees paid by the franchisee, or through supply and distribution agreements. It also has the goodwill associated with its IP at stake and so relies on all franchisees behaving in ways that are fully consistent with the brand. Because reputation is so important for everyone involved, franchise contracts can give broad powers to the franchisor to allow them to exert significant control over many aspects of the franchisee's business.
11 Another aspect to franchising is master, or sub-franchising. This can take several forms, but usually a franchisor grants a master franchisee the right to grant its franchises, rather than dealing directly with the franchisees. This allows the franchisor to concentrate on system development and strategic issues while the master franchisee focuses on regional expansion, recruitment of franchisees and support. These multi-tiered systems can exist not only within New Zealand, but across international boundaries as well.
The franchising agreement
12 A written franchise agreement is central to the franchise relationship. It will set out the obligations of each party, the fees to be paid by the franchisee and should ensure that all likely issues related to the business efforts of the franchisor and the franchisee are addressed. This agreement is accompanied by an operations manual which sets out further details of the relationship and usually allows the franchisor to have significant control over key aspects of the business. The manual will be linked to a clause in the agreement which gives the franchisor the right to make unilateral changes to the manual, allowing them to introduce new mandatory systems requirements, for example.
13 In a recent submission to the Commerce Select Committee,1 FANZ outlined and commented on some of the typical clauses one would see in a franchise agreement. The table below is a summary of those clauses.
Table One: Summary of Typical Clauses in Franchising Agreement
| Clause |
Clause Description |
| Parties |
Identifies the parties to the contract. If the franchisee is a company, personal guarantees of directors may be required. |
| Grant of franchise |
Identifies what intellectual property rights are granted, to whom, on what conditions and for how long? These rights are collectively described as the franchisor's system. |
| Limitations on the grant |
Specifies any limitations on the use of the intellectual property or reservation of rights to the franchisor or other parties. The franchise may be limited to a specific location or territory. The territory may be exclusive or reserve the right for the franchisor to sell further franchises or distribute the goods or services through other channels (e.g. the internet). |
| Term and renewal |
Specifies the term of the agreement and any rights for renewal. The term will ordinarily be long enough for the franchisee to generate an adequate return on the initial investment. Renewal may be at the franchisee's option provided preconditions are met (which may include a fee, refurbishment, refresher training, etc). |
| Payment and fees |
Outlines who pays what, when and what happens if payment is not made. If ongoing fees are payable, they may be set as a fixed fee or as a percentage of gross sales. Non-payment may attract sanctions. |
| Franchisor's responsibilities |
The franchisor's core responsibility is to provide the intellectual property. The agreement may provide further responsibilities, such as support, services, training, conduct of marketing activities, provision of system improvements, etc. |
| Franchisee's responsibilities |
The franchisee's responsibilities may be extensively detailed. Key obligations may include complying with the system, only using the intellectual property in the manner authorised, meeting any performance standards, attending training, and cooperating with the franchisor and others in the network. |
| System compliance |
The franchisee must comply with the system as described in the agreement and the operations manual. The agreement normally provides the franchisor with the unilateral right to vary the operations manual so long as the variation is consistent with the agreement. |
| Transfer |
Specifies the circumstances when the franchisor or franchisee may transfer the franchise. Usually the franchisee must obtain the franchisor's consent to transfer. In such cases, the agreement may also specify the grounds for withholding consent or that such consent should not be withheld unreasonably. |
| Termination |
Specifies the circumstances when either party may terminate the agreement. Usually only the franchisor will have an express right to terminate the agreement early. The grounds for termination may include franchisee insolvency, serious breach of the agreement, or breach and failure to remedy the breach within some specified period. |
| Consequences of termination or expiry |
Outlines what happens on termination or expiry of the agreement. This may include returning all intellectual property and stock to the franchisor, transferring of any leased premises, and taking down all signs, etc. The ex-franchisee may also be bound not to compete in a similar business for some period. |
| Dispute resolution |
Provides for how disputes to be resolved. The clause may outline a process for mediation as a prerequisite to arbitration and/or litigation. |
Franchising in New Zealand
14 In its submission to the Commerce Select Committee, FANZ reported that:
- the estimated turnover of the franchising sector is around $16 billion;
- there are approximately just over 400 franchise systems, an estimated 350 of which are considered ‘active'; and
- the sector supports around 16,000 units and employs an estimated 70,000 people.
15 Franchising is a popular business model in industries such as: motor vehicle distribution, automotive retail, servicing and repair, bulky goods retail, specialty retail, quick service restaurants, convenience stores, real estate, travel, finance and mortgage lending, petrol retail, hairdressing, fitness, health and beauty, pharmacy, and home services. Franchising is usually associated with small businesses, but it is a business format that is used by large business as well.
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