Don't put your foot in your mouth

July 2002

 

Introduction

A distinctive characteristic of a franchise arrangement is that after the franchisor sells a business to a franchisee, the relationship between the parties does not end. It continues as an integral factor in the success of both parties' businesses. This makes what is said during all discussions of particular importance - not only during the "buy" phase but during the ongoing relationship as well. We highlight below some of the issues surrounding "pre-contractual" representations - what the franchisor might tell the prospective franchisee to encourage a sale of a franchise.

In general, franchisors do not intentionally mislead prospective franchisees during negotiations. However, there is often a fine line between sales pitches, opinions, and misrepresentations. This may explain why pre-contractual representations result in more court action than any other aspect of the franchising process.

What is said in negotiations can in many circumstances be relied on by the franchisee. Set out below are some general principles about the law of pre-contractual representations. Remember that while this article is concerned with franchisor representations, the law can apply equally to representations a franchisee may make to a franchisor.

Of course, this discussion cannot replace the need for franchisors to have ongoing advice from a specialist franchising lawyer during all dealings with prospective and existing franchisees.

The Law

In the context of negotiations between a franchisor and a prospective franchisee, what is a pre-contractual representation that a franchisee might be able to sue on?
Any representation (oral or written) the franchisor makes to the prospective franchisee, which:

• encourages the prospective franchisee to sign the franchise agreement, and

• is incorrect,

may be an actionable pre-contractual representation.

Franchisors who are sued for making incorrect statements during negotiations with a prospective franchisee are generally held liable in one of two ways:

• Under the Fair Trading Act 1986 for engaging in conduct that is misleading or deceptive. A franchisor that is held liable under the Fair Trading Act may be ordered to refund money or return property to the franchisee, and to pay compensation to the franchisee for loss suffered.

• Under the Contractual Remedies Act 1979 where the franchisee is induced to enter into the franchise agreement by the misrepresentation made by the franchisor or on the franchisor's behalf. A franchisor that is held liable under the Contractual Remedies Act may be ordered to pay compensation to the franchisee for trading losses, lost profit, and time spent.

Franchisors should be aware, that "out" clauses - "entire contract", "no warranties", "no representations", "no reliance" clauses and the like - will not necessarily protect them from liability for misrepresentation under the Contractual Remedies Act 1979, or for misleading conduct under the Fair Trading Act 1986. Therefore, franchisors should not rely on "entire agreement" type clauses as a safety net to avoid liability for exaggerated sales pitches that do not measure up.

A recent case - Valda Video Limited v United Video Franchising Limited

Mr and Mrs Kirby successfully argued that they were induced to buy a new United Video franchise by incorrect representations about turnover and profitability. A document entitled "Estimated Store Operating Costs" showed a weekly turnover of $10,000. The couple was sorely disappointed when the business generated a weekly turnover of only $4,000 to $5,000. The franchisor argued that the turnover representation was only an estimate. The Judge concluded that Mr and Mrs Kirby were entitled to expect that there was a proper factual basis for the representation that the business could achieve turnover of $10,000.

They were awarded compensation of $552,990 for trading losses, time spent operating the business, and lost profits.

This case illustrates how risky it is for franchisors to give turnover forecasts for newly established franchises without suitable qualification. Where a franchise outlet does not have an established track record, franchisors are strongly recommended not to give estimations of performance, but instead to provide historical performance information relating to an established franchise outlet.

Checklist - how should franchisors protect themselves against liability for misrepresentation?

While in reality a franchisor has to make a sales pitch of some sort, the following points should be adhered to:

• Take care with all representations you make. Particular risk areas include statements about:

  • Performance/profitability of the franchise business (eg turnover, strength of goodwill, popularity of goods/services sold).

  • Goods/services you will supply to the franchisee (eg training and support you will provide).

  • Your level of skill and experience.

  • Exclusivity.
  
  

• Provide information that is accurate and specific.

• Only make promises that you can fulfil.

• Avoid expressing opinions, and if you do, only express genuine opinions which you have a good basis for holding.

• Specify risk areas that are outside your control.

• Do not give predictions of performance or profitability. Only give performance and profitability information that is factual and historical.

• Require prospective franchisees to obtain independent legal and accounting advice prior to signing the franchise agreement, so that the information provided by you is balanced by their own professional advisors.

• Ensure that your employees or agents do not make pre-contractual misrepresentations - you are likely to be liable for their mistakes.

• Seek ongoing advice from a specialist franchise lawyer about representations you propose to make verbally, in advertising and promotional materials, and in the franchise agreement itself.

Conclusion

As a franchisor, you must take care that any statements you, your employees and your agents make during negotiations with prospective franchisees are true and correct - "hard sell" sales pitches that do not accord with reality are likely to be a costly mistake. Above all, remember that your relationships with franchisees will continue for several years, and your financial success is reliant upon these relationships remaining harmonious.