07 Feb 2019

Out of tune with Australia's franchising laws - Ultra Tune fined $2.6m in landmark decision

By Richard Hoad

Repeated breaches of the Franchising Code, plus a cover-up, have led to a penalty of more than $2.6 million and important guidance on the level of detail which franchisors must include in marketing fund financial statements, in the first proceedings brought by the ACCC under the "good faith" provisions of the Franchising Code of Conduct.

Australia's franchising sector has been under sustained scrutiny of late, with a few bad apples making life more difficult for the many honest and reputable franchisors which run successful franchise systems, treat their franchisees well, and pay their staff properly.

The ACCC has been keeping a close eye on the franchising sector for several years. In 2017, the ACCC brought proceedings against Ultra Tune in the Federal Court alleging that Ultra Tune had breached the Franchising Code in failing to comply with its disclosure obligations generally, and specifically in its dealings in relation to a prospective franchisee.

Breaches of disclosure obligations

The Franchising Code imposes quite prescriptive regulations on the dealings between franchisors and franchisees. One of the most important of those obligations is a requirement for franchisors to give detailed disclosure of certain matters to franchisees and prospective franchisees in a "disclosure document". This recognises the high degree of control exercised by a franchisor in a franchise system, as well as the fact that franchisees are frequently people with limited business experience.

Ultra Tune ultimately admitted to a number of contraventions:

  • failing to update its disclosure documents by the required deadline;
  • failing to prepare financial statements for its marketing funds by the required deadline;
  • failing to provide audited marketing fund financial statements to franchisees by the required deadline; and
  • failing to provide a disclosure document on request by a franchisee.

In addition, the ACCC alleged that Ultra Tune's marketing fund statements did not include "sufficient detail" as required under the Franchising Code. Ultra Tune contested this allegation, but, as explained below, the ACCC was successful in its arguments.

Adequacy of marketing fund disclosure

Clause 15 of the Franchising Code requires franchisors to prepare marketing fund statements which have "sufficient detail" of receipts and expenses in order to give "meaningful information" regarding sources of income and items of expenditure. The Code does not specify the degree of disclosure which is required, and the issue had not been decided in any previous cases.

For that reason, the guidance provided in this case is particularly instructive. Justice Bromwich held that marketing fund statements "must have some explanatory force and permit meaningful insights to be gained by the franchisee" and that, as a general rule, "the more significant an expense is, the more important it will be to a franchisee, and therefore the greater the level of detail that will be required to facilitate an informed assessed by the franchisees concerned". The Court suggests that there may be less need for granularity in relation to more minor expenses which are relatively fixed in nature (such as accounting fees and bank fees). However, the level of detail that is required will depend on all of the circumstances. What is ultimately required is that the detail is sufficient for franchisees (who may not have any accounting expertise) to "be placed in a position to understand how marketing funds are being deployed and to form a view as to whether the expenditure is appropriate".

In this case, the statements prepared by Ultra Tune included various items – such as "Gift Vouchers", "Printing and Stationary" [sic], "Seminars and Meetings", "Administration Fees", "Fleet Administration" and "Customer Support" – which collectively accounted for around 20% of expenditure. However, more than 75% of expenses were described simply as "Promotion & Advertising – Television".

Justice Bromwich held that the marketing fund statements did not even come close to meeting the requirements of clause 15 of the Franchising Code. His Honour noted that, based on the marketing fund financial statements, it was unclear to whom the television advertising fees had been paid, what services were obtained, and when. The fact that franchisees received an in-house newsletter which reported on advertising and marketing activity was not considered relevant by the Court; the "sufficient detail" needed to be included in the financial statements themselves.

The Court held that "this was a serious contravention and, especially for a larger franchisor spending such a large sum of money in a marketing fund, a serious contravention… [Ultra Tune's] stubborn approach [in denying the contravention] calls for a significant penalty, to encourage future and ongoing compliance by Ultra Tune, as well as franchisors more generally who might otherwise be tempted to skimp on the information provided to their franchisees".

Unlawful dealings with prospective franchisee

The second part of the ACCC's case concerned Ultra Tune's dealings with one individual, Mr Ahmed, who was interested in becoming an Ultra Tune franchisee. This was the issue that originally piqued the ACCC's interest - specifically, the fact that, when Mr Ahmed decided not to become a franchisee, Ultra Tune refused to refund a $33,000 deposit he had paid. As the judge noted, "Ultra Tune's decision to retain Mr Ahmed's deposit has been calamitous for it, opening the door for the ACCC to examine a myriad of deficiencies" in Ultra Tune's practices (including the disclosure breaches discussed above).

The Court made the following factual findings which were devastating to Ultra Tune's defence of the allegations concerning its dealings with Mr Ahmed:

  • Ultra Tune had understated the rent and purchase price in its dealings with Mr Ahmed.
  • Ultra Tune had told Mr Ahmed that the store had only been open for 6 months, whereas in fact it had been open for 18 months.
  • A key piece of correspondence which was put into evidence by Ultra Tune – a letter purportedly sent to Mr Ahmed stating that the deposit would be used to purchase equipment – was a fabrication created after Mr Ahmed decided not to proceed with the franchise opportunity. The letter was "backdated to make it look like it had existed at the relevant time… to bolster the basis for resisting the return of the deposit to Mr Ahmed". Justice Bromwich noted that the purpose of the fabrication was clearly to deceive the ACCC.
  • The Court also found that other correspondence and invoices relating to the alleged purchase of equipment were also fabricated by Ultra Tune to aid its defence. It was only a forensic examination of contemporaneous invoices by the ACCC that unearthed the fabrication.
  • The evidence of Ultra Tune's key witnesses was unreliable and evasive, conveying the impression that "they were making up parts of their stories as they went along". (The Court noted the possibility that criminal prosecutions may be brought against one of Ultra Tune's witnesses for giving false evidence on oath.)

The Court's observations regarding Ultra Tune's conduct were excoriating:

  • Ultra Tune "predominantly manifested the wrong kind of sorry – that is, sorry that it has been caught – rather than sorry that it engaged in the conduct… in the first place";
  • being a substantial franchisor with over 200 franchisees, "[i]t ought to be among the most professional of franchisors, yet plainly it is far from that and appears to have little or no aspiration to be of that calibre";
  • "there was no evidence to indicate that the contravening conduct was aberrant or out of character for Ultra Tune, as opposed to the robust and headstrong way it chose to do business";
  • the contraventions took place of a substantial period of time and involved the most senior levels of management at Ultra Tune (including its in-house counsel);
  • "the corrective response, to the extent it was shown at all, was, at best, leisurely"; and
  • Ultra Tune has "failed to take its franchisor obligations seriously".

Not surprisingly, the fabrication of evidence drew the harshest condemnation from the Court: "There must be no tolerance for manufacturing evidence to deceive a regulator, and even less when the deception is maintained in this Court."

The Court found that Ultra Tune had failed to act in good faith in its dealings with Mr Ahmed (in breach of the obligation in clause 6 of the Franchising Code), made false or misleading representations to Mr Ahmed regarding the rent, purchase price and the period for which the venue had been operating (in contravention of section 29 of the Australian Consumer Law), and failed to give a disclosure document to Mr Ahmed within the required timeframe (breaching clause 9 of the Franchising Code).

Orders made against Ultra Tune

Taking into account that Ultra Tune's conduct was "deplorable"  and in some respects "serious enough to fall within the worst category", the Court imposed fines totalling in excess of $2.6 million.

In addition, Ultra Tune was ordered to:

  • refund the deposit paid by Mr Ahmed (together with interest);
  • publish a corrective notice on its website and in all major metropolitan newspapers and send a copy of the notice to all current franchisees; and
  • implement a corporate program to ensure compliance with the Competition and Consumer Act, the Australian Consumer Law, and the Franchising Code.

Finally, Ultra Tune was ordered to pay the ACCC's legal costs on an "indemnity basis". This type of costs order – which requires Ultra Tune to cover essentially all of the ACCC's legal costs – is only made in exceptional cases. Justice Bromwich decided that such an order was appropriate, particularly in light of "[t]he attempt to cover up the deplorable conduct of Ultra Tune towards Mr Ahmed". Justice Bromwich said that "[t]his was not a case which was prudently defended" but rather "probably should not have been more than a penalty hearing conducted on an agreed statement of facts".

Ultra Tune has indicated that it will appeal the decision.

Lessons learnt for franchisors

As we teach our children: if you make a mistake, admit it – and then fix it. You will be caught in the end and, as Ultra Tune found out the hard way, the consequences will be so much worse if you have tried to cover it up. It always pays to be particularly scrupulous in your dealings with regulators.

The case also provides some practical guidance regarding the disclosure obligations placed on franchisors under the Franchising Code, particularly in relation to the level of disclosure required in marketing fund statements. In terms of a guiding principle, Justice Bromwich puts it well: "A franchisor may be well advised to err on the side of candour, rather than secrecy, or take the risk of expensive adverse consequences and significant reputational harm. Candour is wise in any event, because it inevitably helps to build trust with franchisees, which in turn is likely to facilitate advancing their mutual interests." The best franchisors already know this and put it into practice on a daily basis.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.