Australia: Franchisee Or Licensee?

Many existing and prospective franchisors are currently concerned with the effect that the impending amendments to the disclosure requirements of The Franchising Code of Conduct (the Code) will have on their businesses. These amendments, not yet in final form, but anticipated for introduction as early as July 2007, are likely to spell increased compliance costs for franchisors. Unfortunately for franchisees, rather than allowing these costs to chew up their profit margins, many franchisors will be considering revising their fee structures to allow the slack to be taken up at the lower end. The reality of this situation is forcing many, particularly smaller and prospective franchisors to seek advice as to how they may be able to get around the requirements of the Code. One way that this may be achieved is by granting licenses rather than franchises.

It is theoretically possible to set up a quasi-franchise system that can be licensed out for a fee and that will avoid the scope of application of the Code. The basis for this is found in the legal distinction between a ‘franchise agreement’ as defined under the Code and a license. Due to the difficulty in determining the boundary of the legal definition of a franchise, prospective licensors must be very careful in regard to both the drafting of any documentation they provide and the nature of any interaction that they have with their licensees. As a separate practical consideration, the marketability of the proposed licensed system relative to running it as a franchise must also be assessed.

What is a franchise?

The definition critical to determining whether a particular system is a franchise is the definition of ‘franchise agreement’ as set out in section 4 of the Code. There are four requirements included in the definition:

1. An agreement. This can be written, oral or implied.
2. Grant of a right to carry on the business of offering, supplying or distributing goods or services in Australia under a system or marketing plan substantially determined, controlled or suggested by the franchisor or an associate of the franchisor.
3. Operation of the business is substantially or materially associated with a trade mark, advertising or a commercial symbol that is owned, used, licensed or specified by the franchisor or an associate of the franchisor.
4. Payment of an amount by the franchisee to the franchisor or an associate of the franchisor.

A license arrangement will still necessarily satisfy requirements 1, 3 and 4. There will be a license agreement for the use of certain branding (eg a registered trade mark) and a fee will be paid for this license. In order to avoid application of the Code it is necessary to ensure that the license agreement does not satisfy requirement 2. It is important to note that merely calling something a ‘license agreement’ will not prevent a court from determining on the facts in front of it, that it is in actuality a franchise agreement and subject to the Code. Unfortunately, there has been little by way of judicial consideration of what is actually required to satisfy requirement 2.

Although not yet clearly defined in any judgement, there is a threshold of what will constitute a ‘system or marketing plan’ for the purposes of the Code. It is likely that when a court considers the facts of a given case, it will look to see whether the materials and information provided describes a method of conducting business to be reproduced by the franchisee. In the case of Agro Holdings Ltd v Flexi-Coil (Australia) Pty Ltd which related to a dealership, requirement 2 was found not to be satisfied although the dealer had been supplied with advertising material (posters and editorial material), product parts, manuals, sales manuals, spare parts, a CD-ROM, price books and service operator manuals. This suggests that in certain circumstances, information such as this may be provided to licensees without them being considered franchisees. However, the provision of an all-inclusive operations manual addressing each area of the business should be avoided. This begs the question, what can a licensor sell to the licensee?

A licensor must be very careful about anything they are selling to the licensee pursuant to the license agreement in excess of the right to use branding owned by the licensor. Aside from the start-up kit that was provided in Agro Holdings some initial training was provided by the distributor. The training supplied by many franchisors is comprehensive, peculiar to their system and often linked to an operations manual. This sort of training should not be supplied by a licensor. Training that may be able to be provided will include specific training in the use of essential equipment, and possibly generic bookkeeping training. There should certainly be nothing targeted at the overall running or promotion of the business.

Traditionally at law, the distinction between franchise and license agreements is that license agreements will focus on quality control restrictions in relation to goods or services produced or supplied under the license, whereas a franchise agreement will regulate the manner in which the franchisee operates a business. The difficulty that arises from the wording of the Code is that the words ‘or suggested’ in requirement 2 indicate that a franchise agreement may still be present even where the franchisor does not compel the franchisee to comply with the system or marketing plan. For example, any commentary or information provided to the franchisees relating to methods of best practice, even if application of these methods is expressed to be optional could bring the agreement within the definition of a franchise.

In order to avoid being labelled a franchise, a license agreement should limit any requirements of licensees to that necessary to protect the integrity of the material being licensed. For example, it could include a general requirement that the licensee will not use the licensed material in any way that causes damage to the goodwill in that material. This may also be tied to an obligation that the licensee indemnify the licensor for loss associated with any such damage. It is important that the license agreement and any other material provided to the licensee does not suggest any particular method of operation that may be applied in its business.

A practical consideration is that it will be difficult for a licensor to find a large number of people who are willing to pay a sizeable license fee without this buying them the security of a tested or at least developed method of operating their businesses. Many people who invest in franchises are looking to be guided in the way that they operate. Accordingly, marketing of a licensing arrangement in place of a franchise may be difficult in certain cases. Franchisors considering heading down the licensing path should consider whether their brand is strong enough and whether the nature of the goods and services to be supplied by licensees is such that those licensees may be happy to work things out for themselves.

With the proposed amendments to the disclosure requirements under the Code looming large, more and more franchisors are viewing licensing as an attractive alternative to the regulatory requirements that come with selling franchise businesses. Due to the broadness of the definition of a franchise under the Code, containing one’s business to a licensing arrangement requires careful consideration of both the nature and content of any materials and guidance provided to licensees. The wording of the license agreement and any supporting documentation must be carefully limited such that it cannot be construed as providing the licensee with a comprehensive system or marketing plan. A preliminary assessment of the marketability of the license arrangement should also be made given that licensees will be obtaining little more than the right to use branding owned by the Licensor.

Phillips Fox has changed its name to DLA Phillips Fox because the firm entered into an exclusive alliance with DLA Piper, one of the largest legal services organisations in the world. We will retain our offices in every major commercial centre in Australia and New Zealand, with no operational change to your relationship with the firm. DLA Phillips Fox can now take your business one step further − by connecting you to a global network of legal experience, talent and knowledge.

This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.