FRANCHISOR LIABILITY FOR FRANCHISEE MISCONDUCT
Introduction
This article discusses the circumstances in which a franchisor may be held liable for the fraud or misconduct of a franchisee outside of statutory liability imposed under acts like the Trade Practices Act 1974 (Cth).
To date, the issue of franchisor liability for franchisee misconduct has been extensively litigated in the United States. However, Australia has been relatively immune from the primarily American developments in this area of the law. Nonetheless, franchisors should be aware of, and introduce strategies to limit, their possible exposure to liability for franchisee misconduct[1].
Franchisor liability generally
A franchisor's liability for a franchisee’s misconduct may be based on two broad legal principles:
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Vicarious liability, where the franchisor is vicariously liable for conduct of a franchisee irrespective of fault or otherwise on the part of the franchisor.
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Direct liability, where the franchisor is directly liable for conduct of a franchisee because of some fault on the part of the franchisor.
The extent of franchisor liability depends heavily on the nature and scope of the franchise relationship. Needless to say, determining liability is complicated in intricate franchising arrangements, such as relationships involving intermediary master franchisors.
Vicarious liability
A franchisor may be held vicariously liable for the fraud of a franchisee if the relationship between the parties is found to fit within one of the following categories:
- employment
- partnership
-
agency[2]
Generally, liability in these circumstances depends on the level of control exercised by the franchisor over the franchisee’s business and dealings with third parties.
Employment
Typically, a franchise agreement will disclaim an employer/ employee relationship between franchisor and franchisee. To date, there has been little judicial support for the finding of an employment relationship in a franchising context in the US or the Commonwealth. However, notwithstanding a disclaimer and the lack of judicial support, it is still possible for a Court to find an employment relationship exists between franchisor and franchisee if the franchisor is found to have sufficient control over the actions of the franchisee. This is particularly relevant in circumstances were the franchisee is an individual working within the franchisor’s business (as opposed to a separate business or corporation trading under the franchisor’s trading name).
Partnership
A franchise agreement will also usually disclaim the existence of a partnership relationship between the franchisor and franchisee. However, and like the employment relationship, a disclaimer will not preclude the Court from finding that the franchise relationship is in fact a partnership if the parties conduct evidences the hallmarks of a partnership relationship. The key indicia evidencing a fanchise relationship is, in fact, a partnership is usually “sharing of profits” between the franchisor and the franchisee (as opposed to a set franchising fee).
Agency
A franchisor may be held liable for a franchisee's misconduct under the laws of agency where the franchisee is found to be an actual or apparent agent of the franchisor.
Actual agency
A finding of an actual agency relationship is rare in franchising. Some US Courts have found franchisors liable for the acts of their franchisees by virtue of an agency relationship when the franchisor has imposed extensive restrictions (or enforced detailed controls over the operation of their businesses) so as to control day-to-day franchisee operations. The majority of decisions, however, have found that insufficient control existed for actual agency to arise.[3]
Factors relating to control which tend to establish a relationship of agency include:
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a right of detailed control over the franchisee’s daily operations;
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a right to hire and fire the franchisee’s employees;
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a right to fix the wages of the franchisee’s employees; and
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a right to share in franchisee profits.[4]
Arguably less significant factors are:
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the right to require reports;
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the right to inspect; and
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the right to require compliance with agreed procedures and terminate the franchise agreement for non-compliance.[5]
Apparent or ostensible agency
Apparent or ostensible agency may arise where the franchisor leads a third party to believe that the franchisee is authorised to act on their behalf. The US Courts have been prepared to conclude that apparent authority exists where the franchise is operated in such a manner so as to create the appearance that the business is owned and operated by the franchisor. [6]
There are two major limitations to this doctrine. Firstly, the agent must appear to be acting in a way in which a person in their position would normally act. For example, a franchisor was not liable for a franchisee tax agent’s conduct where the franchisee gave investment advice rather
than income tax advice.[7]
Secondly, there must be reliance on the representation by the aggrieved party. For example, McDonalds was not held liable when a third party went to a franchise believing he was dealing with an agent of the McDonald’s corporation, but not in reliance on that fact.[8]
Direct liability
A franchisor may be held directly liable for a franchisee’s misconduct because of the franchisor’s own negligence. For example, failing to ensure the franchisee is duly qualified or failing to provide the franchisee with adequate instructions. [9]
Direct liability imposed on a franchisor for negligent selection of franchisees is yet to be tested by the Courts. The principles that are likely to be employed to determine any future litigation in this area are well described in the following passage:
“In the context of franchising, the less the right to supervise, the less the prospect of the franchisee being held to be the franchisor's agent; conversely, the more likely that the franchisee is an independent contractor. Except in the case of statutory duties or inherently dangerous activities, there is generally no duty on the part of an employer to supervise the performance of an independent contractor.” [10]
In the United Kingdom, it is unclear what circumstances the English Courts will find such a duty arises.[11] It may be possible to argue that a franchisor does have a duty to enter into franchise agreements with competent franchisees, and to ensure that franchisees comply with their operating methods. The extent of this duty remains uncertain.[12]
In the US, the Court of Appeal has held that a franchisor does not have a duty to supervise a franchisee’s conduct, or to terminate the franchise agreement, following fraudulent dealings by a franchisee. In that case, the Court determined that it was not reasonably foreseeable that the franchisee would engage in criminal conduct because there was no evidence of prior dishonesty.[13] A similar result was reached in Goldberg v Casanave,[14] where the Florida District Court of Appeal held that the franchisor was not liable for a franchisee's misconduct. In that case, the Court held that the franchisees were independent contractors and that the franchisor had no right to supervise their financial activities.
Despite the decisions considered above, if a franchisor becomes aware of misconduct by a franchisee and takes no steps to correct the misconduct (and the misconduct causes loss to a third party) a franchisor may be held jointly liable for the loss suffered. [15]
Franchisor liability for a franchisee as an independent contractor
A franchisor will rarely be liable for the misconduct of a franchisor who is an independent contractor. [16] Vicarious liability depends on the degree of control that a franchisor has over the activities of its franchisee. A franchisor may have some degree of control over independent contractors without being vicariously liable for their misconduct. [17] The franchisor will not be liable simply because they preserve a general right to order the work stopped or resumed, to inspect work progress or receive reports, to make suggestions or recommendations that need not be followed, or to prescribe alterations and deviations. [18]
A franchisor will be liable for franchisee misconduct on agency grounds if they retain control over the “operative details” of any part of the work. [19] If the franchisor retains some supervisory control over the manner in which the work is done, which falls short of control over the “operative details”, they will be subject to liability in negligence in the exercise of that control. [20]
Reducing franchisor liability for franchisee misconduct
There are a number of strategies a franchisor can adopt to reduce the risk of being liable for misconduct by franchisees. These strategies need to be tailored to the individual franchise business in order to address various aspects of franchisor control over franchisee operations. If you would like to know more about implementing strategies to reduce franchisor risk, please contact our franchising team.
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[1] LexisNexis, Franchising Law and Practice [5.0100].
[2] LexisNexis, Franchising Law and Practice [5.0120].
[3] Wickham v Southland Corp 213 Cal Rptr 825 (1985); Goldberg v Casanove 513 50 2d 751 (Fla App 1987).
[4] J S Kos, “Franchisor liability for franchisee misconduct”, a paper presented at the Franchising and the Law Forums, conducted by FAANZ, 1990, citing Salmond & Heuston on the Law of Torts, 19th ed, 1987, pp 544-551.
[5] J S Kos, “Franchisor Liability for Franchisee Misconduct”, a paper presented at the Franchising and the Law Forums, conducted by FAANZ, 1990, citing Salmond & Heuston on the Law of Torts, 19th ed, 1987, pp 544-551.
[6] McDonald v Century 21 Real Estate Corp, 331 NW 2d 606 (Wis App 1983).
[7] Fitzgerald v H&R Block Income Tax People, June 1990, High Court of New Zealand, unreported judgment (noted (1990) 5 Journal of International Franchising and Distribution Law 37).
[8] O'Banner v McDonald's Corp 1996 Ill Lexis 67 C (31 May 1996).
[9] LexisNexis, Franchising Law and Practice [5.0130].
[10] J S Kos, “Franchisor Liability for Franchisee Misconduct”, a paper presented at the Franchising and the Law Forums, conducted by FAANZ, 1990, citing Salmond & Heuston on the Law of Torts, 19th ed, 1987, pp 544-551.
[11] Pratt, Franchising Law and Practice, looseleaf, Sweet & Maxwell, London, para 9-094.
[12] D & F Estates Ltd v Church Cmrs for England [1989] 2 All ER 992.
[13] Cullen v BMW of North America Inc (1982) 531 F Supp 555 United States Court of Appeals (2nd Circuit).
[14] (1987) Business Franchise Guide, CCH, US, para 8967.
[15] Pratt, Franchising Law and Practice , looseleaf, Sweet & Maxwell, London, para 9-094
[16] LexisNexis, Franchising Law and Practice [5.0140].
[17] J S Kos, “Franchisor Liability for Franchisee Misconduct”, a paper presented at the Franchising and the Law Forums, conducted by FAANZ, 1990, citing Salmond & Heuston on the Law of Torts, 19th ed, 1987, pp 544-551.
[18] Coty v US Slicing Machine Co Inc (1978) 373 NE 2d 1371, 1375.
[19] Coty v US Slicing Machine Co Inc (1978) 373 NE 2d 1371, 1375.
[20] Coty v US Slicing Machine Co Inc (1978) 373 NE 2d 1371, 1375.
NEW REQUIREMENTS FOR SETTING UP A FRANCHISE IN CHINA
As many people have recognised, China is a market which has huge potential. However, before deciding whether to enter that market, franchisors should consider the effect of the new Regulation on Administration of Commercial Franchises (“the Regulation”) which came into effect on 1 May 2007.
The purpose of the Regulation is expressed at Article 1 as “regulating commercial franchises, promoting the healthy and orderly development of the commercial franchise industry and maintaining the market order”. The intention is to create more order in the chaotic world of the Chinese franchise market. We will have to wait and see whether the Regulation has the intended effect.
Who can be a franchisor?
Only a corporation can be a franchisor. The franchisor must have a mature business model and be capable of providing the franchisee with business guidance, technical support, business training and other services.
The franchisor must have at least two direct sales stores and have conducted such business for more than one year. It is not clear whether the two direct sales stores must be in China or whether it is that those direct sales stores must have been in place for more than one year.
Information to be provided to the authorities
Within 15 days of entering into the first franchise agreement, the franchisor must file it with the relevant commercial authority. A franchisor must also file the following documents with the authority:
The franchise agreement
There must be a written franchise agreement for a term of not less than three years. The franchise agreement must include terms dealing with the following:
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A copy of the business licence or enterprise registration certificate;
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A brochure for franchised operations;
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A marketing plan;
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A written commitment and related certification materials testifying that the franchisor can comply with the requirements as to having a mature business model, two direct sales stores and conducting the business for more than one year.
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Quality and standards for the product or service;
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Sales promotions, advertising and publicity in respect of the product or service;
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Arrangements for the protection of consumers’ rights and interests and the assumption of compensation liabilities in the franchise;
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Alteration, release and termination of the franchise contract;
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Liabilities for breach of the contract; and
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Dispute resolution methods.
The franchise agreement must include a cooling off period for the franchisee during which it can unilaterally terminate the contract. However, the length of that cooling off period is not specified.
The franchisor must not resort to fraud or misleading conduct in promotions or publicity and its advertisements must not include a statement that any franchisee has gained proceeds from engaging in the franchise.
The franchisee must get the franchisor’s consent to transferring the franchise. A franchisee must not divulge the franchisor’s business secrets.
The franchisor’s disclosure
At least 20 days before the franchisee enters into the franchise agreement, the franchisor must disclose the following information:
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Basic information about the franchisor and the franchise operations;
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Basic information in respect of the registered trademark, enterprise mark, patent, know-how and business model of the franchisor;
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The type and amount of franchising fees and payment method;
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Prices and requirements for providing the franchisee with products, services and equipment;
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The content of the business guidance, technical support, business training and other services to be provided to the franchisee as well as the methods of providing those services and the implementation plans;
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Concrete measures for guiding and supervising the business activities of the franchisee;
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The investment budget for the franchise outlet;
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The quantity, distribution and business evaluation of franchisees currently existing within China;
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Financial statements and audit reports for the last two years audited by an accountant;
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Conditions in respect of franchise-related lawsuits and arbitrations for the last five years; and
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Any record of major illegal business operations by the franchisor or its legal representative.
Please don’t hesitate to contact us if you have any queries about these new regulations.
If you would like more information, please contact a member of our National Franchising Team listed on the right hand side of the screen.
To view a print friendly version please click on the PDF link below.
