• Introduction
• All recent publications
• Intellectual Property publications
• Intellectual Property services

Focus: Franchising – August 2007

Franchising agreements and illegality

In brief: In Ketchell v Master of Education Services Pty Ltd, the New South Wales Court of Appeal held that a franchising agreement was illegal because it contravened clause 11 (1) of the Franchising Code of Conduct. Partner Andrew Wiseman (view CV) and Lawyer Andrew Dyer report on the major implications stemming from the decision for both franchisees and franchisors. 

• The Ketchell case
• Implications for franchisors and franchisees
• Conclusions

The Ketchell case

Section 51AE of the Trade Practices Act 1974 (Cth) (the Act) provides that regulations may prescribe an industry code and declare it to be mandatory. Section 51AD states that a corporation 'must not, in trade or commerce, contravene an applicable industry code.' Clause 3 of the Trade Practices (Industry Codes – Franchising) Regulations 1998 (Cth) prescribes the Franchising Code of Conduct (the Code) and declares it to be a mandatory industry code. At the time that the franchising agreement the subject of dispute in Ketchell v Master of Education Services Pty Ltd [2007] NSWCA 161 was entered into (11 February 2000), clause 11 (1) of the Code provided that:

the franchisor must not: (a) enter into, renew or extend a franchise agreement; or...(c) receive a non-refundable payment under a franchise agreement; unless the franchisor has received from the franchisee or prospective franchisee a written statement that the franchisee or prospective franchisee has received, read and had a reasonable opportunity to understand the disclosure document and this Code.

The respondent sued the appellant for money due to it as franchisor under the agreement. The appellant pleaded as a defence that the contract was illegal and unenforceable as it entered into it without having received from the franchisee a written statement that the franchisee had received, read and had a reasonable opportunity to understand the disclosure document and the Code. It also argued that if the contract was enforced, the respondent would receive a non-refundable payment contrary to clause 11 (1) (c) of the Code.

The respondent argued that Part VI of the Act, when viewed as a whole, failed to support an intention that contravention of the Code would spell unenforceability of the agreement. It placed considerable reliance on the decision of Justice Windeyer in The Cheesecake Shop v A & A Shah Enterprises [2004] NSWSC 625, where his Honour held that s51AD 'does not make contracts made in contravention of the Code illegal' but, rather, prohibits conduct. Part VI of the Act provides for remedies for such contraventions, including a power to declare a contract void. According to Justice Windeyer, if a contract breaching a Code was void for illegality there would be no need to provide for this remedy in Part VI.

President Mason (with Justice Basten and Acting Justice Handley agreeing) disagreed, holding that the contract was illegal and unenforceable. His Honour followed Trade Practices Commission v Milreis Pty Ltd (1977) 29 FLR 144 (approved by the High Court in SST Consulting Services Pty Ltd v Rieson (2006) 225 CLR 516), where it was held that 'the general rule is that if the legislature prohibits the making of a contract, the making of the contract does not give rise to an enforceable right or obligation.' Where, as with clause 11 (1) of the Code, a statutory provision expressly prohibits the making of a particular contract, a contract made in breach of such a prohibition will be illegal and unenforceable unless the statute provides otherwise, either expressly or by implication.

President Mason held that there were no words in clause 11 (1) to displace the presumption of illegality and unenforceability. He stated that 'section 51AD read with cl 11 directly prohibited the contract in question and the recovery of the moneys claimed'. His Honour placed particular emphasis on the words 'must not' in clause 11 (1) of the Code.

President Mason also rejected Justice Windeyer's argument that the power to declare a contract void in Part VI of the Act impliedly excluded the general application of the common law of contractual illegality. His Honour held that Part VI:

provides for an order declaring a contract void in certain circumstances as one of many possible remedies vested with jurisdiction...It does not preclude illegality from being pleaded by way of a defence to an action for damages in a court of general jurisdiction.

President Mason stated that his approach was consistent with Carlton and United Breweries Ltd and Another v Castlemaine Tooheys Ltd and Another (1986) 66 ALR 347, where the High Court unanimously held that sections of the Act clearly envisage that contravention of the Act may attract legal consequences other than those provided for by Part VI.

Implications for franchisors and franchisees

Contravention of clause 11(1)

Ketchell is clear authority for the proposition that if a franchisor contravenes clause 11 (1) of the Code the resulting contract will be unenforceable and illegal. As it is a unanimous decision of the NSW Court of Appeal it seems unlikely to be overturned, particularly as it seems to be consistent with the CUB decision, a unanimous High Court authority on this point.

CUB did not concern clause 11 (1) or, for that matter, any other clause in the Code. Rather, it involved a claim that a sale of shares agreement was invalid as it contravened ss 45 and 45D of the Act. The appellants in CUB claimed that the NSW Supreme Court lacked jurisdiction to hear the matter, and contended that the only consequences that flow from any contravention of the Act are those for which the Act itself provides. Nevertheless, President Mason regarded CUB as being on all fours with Ketchell on the basis that:

• the relevant provisions prohibited the making of a contract in certain circumstances; and
• it was held that these provisions had mandatory and not merely directory effect, regardless of the presence in Part VI of the Act of provisions stating consequences of contraventions of the Act.

While Cheesecake is authority for the view that a contravention of clause 11 (1) will not lead to a contract being held illegal and unenforceable, President Mason noted in Ketchell that CUB was not drawn to Justice Windeyer's attention in that case. Moreover, as noted above, it appears to be impossible to reconcile with this High Court authority and is therefore most unlikely to be followed.

Contravention of other clauses of the Code

Whether contravention of other provisions of the Code will lead to franchising agreements being struck down is less clear. Indeed, President Mason left open the possibility that 'breaches of other clauses in the Code may be entirely different in their impact upon contractual causes of action.' As noted above, his Honour placed a great deal of emphasis on the words 'must not' (enter a franchise agreement) in clause 11 (1). Accordingly, whether breaches of the code lead to contracts being held to be illegal and unenforceable would appear to depend upon whether there are words in the relevant provision negating the general rule stated in Trade Practices Commission and SST Consulting.

For example, clauses 6(1) and 10 of the Code are among the regulations that create obligations for the franchisor before it enters a franchising agreement. Clause 6 (1) states that a franchisor 'must, before entering into a franchise agreement, and within 3 months after the end of each financial year after entering into a franchise agreement, create a [disclosure] document for the franchise in accordance with this Division'. The disclosure document must be in accordance with Annexure 1 if the franchised business has an expected annual turnover of $50,000 or more, and in accordance with Annexures 1 and 2 if the business has an expected annual turnover of less than $50,000 (clause 6 (2)). Clause 10 states that a franchisor 'must give a copy of this code and a disclosure document...to a prospective franchisee at least 14 days before the prospective franchisee:...enters into a franchise agreement'.

It would appear to follow from President Mason's reasoning that failure to create a disclosure document before entering into a franchising agreement would lead to the agreement being held to be illegal and unenforceable (as the disclosure document must obviously be in existence if clause 11 (1) is to be complied with). However, it is unclear whether Ketchell would apply if the franchisor produces a disclosure document that is not in accordance with the specifications set down in the relevant annexure(s). Clause 6 is phrased differently from clause 11. It does not state that the franchisor must not enter into an agreement unless it has first produced a compliant disclosure document. Rather, it states that before entering the franchise agreement the franchisor must create such a document. It may be argued that this different language means that clause 6 merely sets down a directory, as opposed to a mandatory, requirement, and that the franchisor's failure to comply will not lead to the agreement being held to be illegal and unenforceable.

The position is similar in respect of clause 10 of the Code. It is arguable that if the franchisor provided a copy of the Code and disclosure document later than 14 days before the franchisee entered into the agreement, the agreement may, on this ground alone, be struck down. Clause 10 may be said to implicitly prohibit the making of an agreement unless the 14 days requirement is observed. In addition, there are no words in clause 10 to displace the general rule in SST Consulting.

On the other hand, it might be argued that while clause 11 expressly states that the franchisor must not enter into a franchising agreement unless certain requirements are met, clause 10 contains no such prohibition on entering such an agreement. It merely states that particular documents must be provided to the franchisee, without spelling out any consequences of a failure to do so. Accordingly, it might be said that this clause too is merely directory and that failure to strictly comply with it will therefore not lead to the agreement being held to be unenforceable.

Contravention as a sword rather than a shield

As stated above, in Ketchell the claim that the franchising contract was illegal and unenforceable was raised as a defence to the franchisor's attempt to sue on this agreement. However, what would the position be if the franchisee raised the claim of illegality not as a defence but rather in an attempt to have an agreement that had been on foot for a period of time to be declared unenforceable? The answer is clear. At any time while a contract is on foot, a franchisee may seek an order that the contract is unenforceable and illegal due to the franchisor's failure to comply with clause 11 (and arguably its failure to comply with clause 6 or 10, for example).

Marks v GIO Australia Holdings Ltd (1998) 196 CLR 494 appears to provide some guidance on the question of gaining damages in this situation. Damages may be awarded under s 82 of the Act if loss or damage has been suffered as a result of conduct that contravenes a provision of Part IV, IVA, IVB or V of the Act (s 51AD is located in Part IVB of the Act). However, Marks is authority for the proposition that the contravening conduct must be a cause of the alleged loss or damage. In other words, according to the majority in that case, 'a comparison must be made between the position in which the party that allegedly suffered the loss of damage is and the position in which that party would have been but for the contravening conduct'. Only if an alternative, less detrimental or more beneficial, course was available to the party at the time it entered the relevant contract would it be able to claim damages.

Applying this to a case where the franchisor has breached clause 11 (1), it would appear that the franchisee who has entered a franchising agreement following such a breach would only be able to claim damages under s 82 of the Act if it could prove that it would have been in a more favourable position but for the contravention. For example, if but for the contravention of clause 11 (1) the franchisee would have entered either that agreement or another agreement on different, more beneficial, terms (or would not have entered such an agreement at all) it appears that it could claim damages from the franchisor for the loss suffered.

Another remedy possibly open to the franchisee in these circumstances is restitution. However, again, its availability would appear to depend on the franchisee being able to prove that, had the contravention of clause 11 (1) not occurred, it would have entered the agreement on more beneficial terms.

In Ovidio Carrideo Nominees Pty Ltd v The Dog Depot Pty Ltd [2006] VSCA 6 the defendant leased premises to the plaintiff without first providing it with the disclosure statement required by s8 of the Retail Tenancies Reform Act 1998 (Vic). Section 8 (2) (b) of this Act provided that, in these circumstances, 'the tenant is not liable to pay the rent attributable to the period before the landlord gave the tenant a copy of the disclosure statement'. Accordingly, the plaintiff sued for the sum of nearly $65,000 that it had mistakenly paid to the defendant during the period when it had not yet received the statement.

The Victorian Court of Appeal unanimously refused to order the defendant to pay restitution. It held that a restitution order would be unjust as:

• the tenant had received good consideration for the money it paid (use and exclusive possession of the relevant premises), and
• when the tenant was eventually given a disclosure statement, it did not suggest that its decision to enter into the lease on the terms that it did would have been any different had the statement been provided earlier.

It follows that a restitution claim may only be open to a franchisee who has entered an agreement following a breach by the franchisor of clause 11 (1) (or possibly provisions such as clauses 6 and 10) if it can establish that it did not receive good consideration from the franchisor or that, but for the contravention, it would have entered the lease on more beneficial terms.

Conclusions

The Ketchell decision confirms the general rule that if a provision prohibits the making of a contract the contract will not be enforceable. The NSW Court of Appeal concluded that there were no words in clause 11 (1) to displace this rule and that the contravention of that clause by the franchisor meant that the relevant franchising agreement was illegal and unenforceable. It follows from this that whether franchising agreements are held to be illegal and unenforceable due to contraventions of other clauses in the Code depends on the wording of these clauses. Finally, it appears that a franchisee who raises a claim of illegality on the basis of a contravention of clause 11 (1) not as a defence, but rather in an attempt to have an agreement that had been on foot for a period of time to be declared unenforceable, should be able to obtain that declaration, but will only succeed in an action for damages under s 82 of the Act if it can prove that but for the contravention it would have been in a more beneficial, or less detrimental, position. The availability of a restitution order would also appear to depend on the franchisee being able to prove that, had the contravention of clause 11 (1) not occurred, it would have entered the agreement on different, more beneficial, terms.

For further information, please contact:

• Andrew WisemanPartner, Sydney
  Ph: +61 2 9230 4701
  Andrew.Wiseman@aar.com.au
• Tim GolderPartner, Melbourne
  Ph: +61 3 9613 8925
  Tim.Golder@aar.com.au
• Peter JamesPartner, Brisbane
  Ph: +61 7 3334 3360
  Peter.James@aar.com.au
• Andrew PascoePartner, Perth
  Ph: +61 8 9488 3741
  Andrew.Pascoe@aar.com.au

Bookmark with What are these?