June 23, 2016

What Can Cheap Pizza Teach Us About Franchise Agreement Fine Print?

Cut Price Pizza – A Win For Franchisors

In a decision that will set an important precedent in the franchising industry, a class action by a group of disgruntled Pizza Hut franchisees against their Australian franchisor has failed.

The case highlights the importance for franchisees of fully understanding their rights and limitations before entering into a Franchise Agreement. It also points to the necessity for franchisors to be mindful of their good faith obligations towards franchisees.

In July 2014, Yum! Restaurants Australia Pty Ltd, the franchisor for Pizza Hut, cut the prices of pizzas in the ‘Classics range’ offered by franchisees from $9.95 to $4.95. This move was known in commercial terms as the ‘Value Strategy’.

Pizzas in the ‘Favourites range’ were then cut from $11.95 to $8.50 and two other pizza ranges were cut from the menu entirely. The franchisees claimed that this Value Strategy was not profitable and caused their businesses substantial loss.

The Value Strategy and franchise profit in Australia

The franchisor justified the Value Strategy based on:
• a successful market testing of the $4.95 Classics range in a store located in the ACT
• a successful campaign previously implemented in New Zealand
• gaining ‘first mover advantage’ over their rival Dominoes.

Whilst franchisees would not make a profit on each individual pizza sale, their profit and benefit would arise from the side orders purchased by customers enticed by the low cost pizzas. The formula behind the Value Strategy also required the input of additional labour in order for franchisees to achieve a profit.

Pizza Hut would have been the only party in the market offering $4.95 pizzas. This would give them a distinct advantage over Dominoes, who would still be offering full price pizzas. Unfortunately for Pizza Hut, the cat was let out of the bag early and Dominoes pre-empted the Value Strategy by launching their own $4.95 pizza range. The franchisor blamed the leak on Pizza Hut franchisees who were strongly opposed to the Value Strategy.

Whilst Pizza Hut had lost their first mover advantage, they nonetheless made the decision to proceed with implementing the Value Strategy. Pizza Hut argued that this would reverse declining profits in the franchise system and result in increased profits for their franchisees.

Unfortunately for the franchisor and franchisees, the Value Strategy did not prove successful, with franchisees claiming that they struggled to make a profit in their businesses.

Understanding the Franchise Agreement

Under the Franchise Agreement, the franchisor had the right to implement the Value Strategy because they could dictate the products to be sold by franchisees along with the maximum price. The franchisees were also required to participate in marketing campaigns.

Importantly, the Franchise Agreement expressly provided that the franchisor did not guarantee a profit to franchisees, and that the franchisor was not liable if marketing campaigns did not result in increased profits.

The Court’s decision – in favour of the franchisor

The franchisees argued that the franchisor had an obligation to set prices that would allow franchisees to make, maintain or increase profits. The franchisees acknowledged that part of any franchise system is uniformity and that success of their businesses would depend on their own skills and financial capacity. Under the bargain of the Franchise Agreement, the franchisor received a royalty stream and increased goodwill in its brand. The bargain awarded franchisees profits from their businesses and a capital gain when selling their franchise outlet/s.

The franchisees also argued the franchisor had a duty of care towards franchisees when exercising its contractual powers. It was argued that the change in pricing represented a fundamental change in the nature of the bargain, requiring franchisees to work harder and incur greater costs while receiving no greater reward.

On the other hand, the franchisor argued that the franchise system was developed for the franchisor’s benefit, and that franchisees were only granted the right to participate in this system.

The Court ruled that the franchisor did not have unfettered discretion under their Franchise Agreement, and had the obligation to act in good faith, honestly, reasonably and with reasonable cause. This however did not extend to a strict liability to make decisions which only resulted in success and more profits for franchisees.

The franchisor had carried out their pre-launch test of the Value Strategy in the ACT, and had consulted with franchisees before implementation. The franchisees failed to establish that the franchisor’s decision to implement the $4.95 pizzas was not made in good faith or on unreasonable grounds.

The Court noted that it was not the Court’s duty to rewrite the bargain between the parties or the powers under the Franchise Agreement, but to ensure that that powers were not abused. The Franchise Agreement did not have the obligation for the franchisor to ensure the profitability of franchisees. To imply terms into the Franchise Agreement that the franchisor had the obligation to do all things necessary to enable a profit would be to rewrite the contractual bargain.

The Court ultimately found that the franchisor had not engaged in unconscionable conduct nor breached any legal obligation towards the franchisees, and was therefore not liable for any loss suffered by franchisees from the Value Strategy.

Takeaway points and implications

The Court’s decision was largely based on the drafting of the Franchise Agreement. The Agreement did not impose a duty on the franchisor to ensure franchisees made a profit. Rather, the franchisees were simply allowed the right to participate in the system which the franchisor operated. The decision also gives weight to the principle that an obligation to act in good faith does not prevent a party from acting in their own legitimate business interests.

There are some important takeaway points from this case, which anyone operating a franchise in Australia should note. This case is of particular relevance when seeking to introduce franchise-wide marketing campaigns.

1. Have a well drafted Franchise Agreement.

2. Carry out market research and have a sound commercial basis before implementing a new campaign.

3. Consult with franchisees first and ensure that franchisees understand the basis for the campaign.

4. Be wary and always remain mindful of your good faith obligations towards franchisees. We feel Pizza Hut (as franchisor) received a very favourable outcome in this case that will not necessarily be repeated.

Need advice about your next Franchise Agreement or any aspect of commercial law? Contact the experts at Rouse Lawyers today.