The hotly (no pun intended) anticipated decision of Diab Pty Ltd v YUM! Restaurants Australia Pty Ltd [2016] FCA 43 – a class action brought by a number of Pizza Hut franchisees against the franchisor, YUM! – was recently handed down by the Federal Court of Australia, and represents a massive win for not just this franchisor, but franchisors generally in Australia.

Background

The decision arose in mid-2014 from a strategic move implemented by YUM!, requiring all franchisees to decrease the range of pizzas offered from 4 to 2, and dramatically drop price points. Such a move was enforced by the Franchisor, and based on a model successfully adopted in New Zealand, and following a “testing” of the strategy in the ACT by the franchisee there (who owned all 8 Pizza Hut franchises in the territory). The strategy was implemented even following an unexpected move by Domino’s to launch a similar campaign weeks before the anticipated Pizza Hut launch, meaning Pizza Hut lost its “First to Market” advantage. Such a move by Pizza Hut’s main rival, it seems was accepted by all parties, affected the failure of the system in obtaining an estimated 48% uplift in sales for franchisees, and, in essence, further ate into the potential profit of franchisees.

The decision, by all accounts, resulted in franchisees losing money, with the franchisees claiming the strategy was not and could not result in profit and was doomed to fail. The franchisees further claimed that the presentation of data resulting from the ACT testing before the strategy was implemented was manipulated by YUM!, and that the consultation as between the franchisor and franchisee before determining to implement the strategy was inadequate in all respects.

The claims

A number of causes of action were pursued by the franchisees, as follows:

  1. Breach of implied terms – here, the franchisees argued there was an implied term in the franchise agreement that YUM! would set profitable prices, such that individual franchisees could make, and increase profit;
  2. Good faith – that the introduction of the strategy was contrary to an obligation of good faith owing by the franchisor to the franchisee, incorporating in itself a duty to cooperate to achieve the objectives of the franchise agreement (mutual benefit) and to comply with standards of conduct that are reasonable having regard to both parties’ interests;
  3. Negligence – that the introduction of the strategy amounted to common law negligence, in that YUM! owed a duty of care to individual franchisees in the exercise of power pursuant to the franchise agreement; and
  4. Unconscionable conduct pursuant to the Australian Consumer Law – that the actions of YUM! in implementing the strategy were, in all the circumstances, unconscionable, in circumstances where the franchisor had ‘sacrificed’ the interests of franchisees by implementing a flawed strategy which was doomed to fail.

The Defence

YUM!, in response to the claims, relied predominantly on the precise terms of the franchise documentation itself, in that:

  1. The purpose of the franchise agreement was to enable franchisees to, in effect, license the franchise system;
  2. The agreement itself contained no guarantee that any advertising, promotion or strategy would be profitable;
  3. While the franchisor was generally subject to implied obligations to cooperate to achieve the contractual objectives of the franchise agreements and to act honestly in doing so, (which included compliance with honest standards of conduct and compliance with standards of conduct that are reasonable having regard to the interests of the parties), these obligations must be understood in the context of the parties’ commercial bargain;
  4. The precise wording of the franchise agreement was paramount to determining the parties’ respective obligations, including the ability of the franchisor to implement a strategy with or without the consent of individual franchisees, as was provided for by the contract;
  5. Where the franchise agreement was intended to be a complete statement of the respective parties’ rights and obligations, there could not be said to be a general duty of care owing to the franchisees, and thus there was no basis to advance the claim of negligence.

YUM! submitted that it has fully complied with its good faith obligations in exercising its contractual powers to implement the strategy, noting because:

  1. it exercised its contractual powers for the purposes for which they were granted, namely to change the products, pricing and marketing of the Pizza Hut system in a uniform manner;
  2. one of the franchisor’s primary concerns in developing and, ultimately, deciding to implement the strategy was to increase the profitability of the franchisees;
  3. it genuinely believed that the results of the ACT test, the experience in New Zealand and the results of the modelling suggested that an increase in profitability was likely to occur for most the franchisees upon implementation of the strategy;
  4. it consulted with the franchisees about the proposed strategy, even though it was under no contractual obligation to do so; and
  5. it did not exercise its contractual powers capriciously or dishonestly.

YUM! also contended for the purpose of determining whether any breach had occurred, the relevant time was at the date of the alleged (but not admitted) act, being the decision to launch and/ or the launch date itself, and that the ultimate outcome of the strategy for individual franchisees was not determinative of a breach having occurred.

YUM! led evidence of the process that led up to the implementation of the strategy, including the decision to continue with same even after Domino’s had obtained the “First to Market” advantage.

The Outcome

The Court found in favour of the franchisor on all accounts. In essence, the Court accepted the submissions advanced by YUM! set out above with respect to the contractual obligations, and made findings of fact that the implementation of the strategy was an appropriate commercial course for it to take and this conduct was therefore reasonable. Further, as a matter of law, the Court determined there was no general obligation on the franchisor to ensure that all of its franchisees make a profit following the implementation of a particular strategy.

On the all-important issue of “good faith”, the Court applied the statement of  Edelman J in Mineralogy Pty Ltd v Sino Iron Pty Ltd (No 6) [2015] FCA 825 at [1004]:

“When contracts incorporate an express obligation of good faith then the meaning and content of that obligation must be determined in that particular contract. Where, as in this case, a contract does not expressly incorporate an obligation of good faith then the question becomes one of what is required to be implied, in line with the test for the implication of terms.”

Ultimately, the Court held:

“Yum had an obligation to act honestly and with fidelity to the bargain but that does not mean that Yum was under a strict liability to make decisions that only resulted in success and more profits for the Franchisees. That does not mean that a decision made in good faith and on reasonable grounds that proved to be unsuccessful in realising profits, and in fact realised losses, renders Yum liable for any Franchisee losses. It also does not mean that hindsight is applied to a decision, importing facts known subsequently but not at the time that the decision is made.”

And accepted the position of the franchisor as to the importance of the precise contractual terms, noting:

“It is not for the Court to rewrite those contractual powers, although care should be taken to ensure that the powers are not abused by being exercised unreasonably, particularly where the power was conferred only on one party without a balancing power conferred on the other.” 

The Court also found that the franchisee failed to show that the franchisor had acted dishonestly, in bad faith, or with reckless disregard for the franchisees. Yum had made what it considered to be the best decision from its point of view and for the future profitability of the franchisees.

On the issue of timing, the Court accepted that the breach must be analysed on the day the alleged cause of action arose, and while the benefit of hindsight may have proven the strategy to fail, the knowledge and actions of YUM! as at the all-important decision day/s was what mattered.

What this means for Franchisees

No doubt there are a number of franchisees left with a pretty bitter taste in their mouth following this decision. Facing a costs order in favour of the franchisor and with no recourse from the loss of profit (and loss of business) subject to bringing an appeal, the implications of this decision have wide reaching effects on franchisees generally.

In particular, this decision reinforces the view that the contract is key, and while terms may be and will be implied into the franchise agreement, the contract itself is the primary source of parties’ contractual rights and obligations.

Further, the obligation of good faith may not be the saviour for franchisees it was once thought to be. While it will no doubt be enforced, such an obligation will not be breached simply because an individual franchisee’s circumstances were not considered, and will not require a party to a franchise agreement to subordinate their interests to the other.

As a practical measure, this case highlights the importance for franchisees of properly understanding the application of the franchise agreement, and the respective rights and obligations imposed, from the outset.

What this means for Franchisors

This case represents a sweet victory for franchisors. While there can be no question there will still be a requirement for franchisors to take reasonable care in implementing a particular strategy, the failure of same will not necessarily render them liable.

While franchisors must still be mindful of their obligation of good faith and to act honestly, this does not mean that a decision made in good faith and on reasonable grounds that proved to be unsuccessful in realising profits, does not automatically render the franchisor liable.

Further, the importance of having a clear, unequivocal and properly drafted franchise agreement that clearly establishes the rights of the franchisor to make decisions for the franchise network, is obvious.

Emma Jervis

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