Franchises and Lemons

The Auckland Business School study found that, unsurprisingly, a disproportionately large amount of all litigation involving the purchase of a business (30%) was brought by those who bought a franchised business. Empirically, the study found that franchised businesses account for only around 12% of businesses advertised so clearly a higher likelihood exists of litigation involving franchises.

Franchises and Lemons
Gehan Gunasekara argues the need for a code to protect those who buy franchises
Gehan Gunasekara

Buying a lemon is usually associated with the purchase of motor vehicles but a recent study conducted at the University of Auckland Business School has found that a significant number of those buying franchised businesses over the last twenty years have ended up in court alleging they were misled about what they were buying.

The Business School study is timely as it appears the Government in New Zealand may finally be moving forward to bring our laws governing franchising more in line with those of Australia where a franchise-specific Code has been in force for more than a decade. The Ministry of Economic Development released a Discussion Document last year and called for submissions from interested parties. At present the Franchise Association of New Zealand regulates those who choose to be its members. However at present less than half of the franchises belong to it.

Ironically, those buying a car from a dealer have more rights than those buying a franchise. Legislation such as the Consumer Guarantees Act does not apply to franchisees yet they are just as dependent as a car buyer is on a dealer for ongoing support such as servicing, repair and spare parts. Alarmingly, recent pronouncements from our Court of Appeal have hinted that franchise agreements are “commercial transactions” negotiated from positions of equality and therefore even the protections offered by the Fair Trading Act need not apply where the parties have an included an exclusion clause and have had separate legal advice.

However the reality is that franchise agreements are usually standard form contracts offered on a take it or leave it basis. Moreover the parties are hardly equal and the franchisor can revise its terms continuously through changes to the operations manual, as occurred in 2007 with the Auckland Super Shuttle franchise which resulted in an unprecedented strike by owner-drivers. Legal advice is often of a formal nature and franchisees are more likely to pay attention to assurances given from the franchisor, as to the viability of the business model, than to exclusion clauses in the contract which they might be expected to read with glazed eyes.

Business format franchising has been exceptionally successful globally and this has also been the case here with big global players (such as McDonalds and Subway) as well as home-grown chains (including some like Hell’s pizza that have expanded overseas). Franchising has also been popular in all sectors including construction and home services. Franchised businesses are undoubtedly more secure than other small businesses since, amongst other advantages, franchisees benefit from brand recognition, shared advertising costs and bulk buying discounts. In addition many who find themselves unemployed may consider buying a franchise as an option – the number of franchise sales tends to pick up in a downturn.

Those considering buying a franchise in New Zealand need to be wary, however, as the lack of franchise-specific code make them especially vulnerable in other respects. Laws such as the Fair Trading Act certainly provide a measure of protection but go no-where far enough. The Auckland Business School study found that, unsurprisingly, a disproportionately large amount of all litigation involving the purchase of a business (30%) was brought by those who bought a franchised business. Empirically, the study found that franchised businesses account for only around 12% of businesses advertised so clearly a higher likelihood exists of litigation involving franchises.

The study also found that although a majority of claims for misleading or deceptive conduct against franchisors succeeded, many more deserving claimants lost through legal technicalities. These included the fact that, with few exceptions, franchisors may choose what information to disclose to prospective franchisees (there is an “information imbalance”), statements of opinion or predictions as to the future cannot be complained about and neither can promises made by franchisors after the contract is concluded. Expressions of opinion and predictions made by franchisors will almost always be reasonable because, for instance, the business model may well be shown to be workable elsewhere, even overseas. This will be cold comfort though to a franchisee who finds the model is a flop in their locality as there is nothing in New Zealand law to require franchisors to include the facts and assumptions on which statements are based, or to disclose the extent of enquiries and research undertaken as to the market conditions in the territory concerned.

The Business School research found that franchisees who successfully alleged misleading or deceptive conduct by franchisors tended to be awarded large amounts of compensation (in the order of hundreds of thousands of dollars) reflecting the typically high franchise fees and other sunk costs involved in a franchise purchase. By contrast, counter-claims by franchisors for instance non-payment of royalties, tended to be less successful and amount to tens of thousands of dollars. The significant variation in the amounts suggests that franchisors have more to gain from the introduction of a mandatory Code requiring disclosure: a standard template for disclosure would most likely reduce the number of claims against franchisors.

A serious look at franchise law reform is well overdue.

Gehan Gunasekara is a senior lecturer at the University of Auckland’s Business School and has taught and written about franchise-related issues for over a decade.


Brought to you by WikidFranchise.org

Risks: Courts misunderstand relationship, Franchise agreements virtually non-negotiable, Imbalance of information and power, Independent businesses much higher profit than franchised ones, Independent businesses survive longer than franchised ones, Misrepresentations, Piling on: franchisor can afford a few awards but not hundreds, Sunk costs: franchisee's trapped capital keeps them chained to treadmill, Professor Timothy M. Bates, Tip of the iceberg, Unilateral changes in business model drive franchisees' profits down, Universities are in the business of pursuing objective truth, Universities provide unbiased expert knowledge, New Zealand, 20090615 Franchises and

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License