Given the Federal Government's announcement on 4 January 2013 of a review of the Franchising Code of Conduct (Code) set for release in April 2013 (2013 Review),1 it is a fitting time to explore a vexed issue in franchise relationships affecting franchisors and franchisees alike: the issue of goodwill.
How do you determine who is entitled to the goodwill of the business when a franchise relationship has come to an end? Is the franchisee entitled to the goodwill developed during the course of the franchise relationship, even though one important source of this goodwill might be the franchisor's trade mark, branding or other assets? How effectively can franchisors protect the goodwill in their franchise systems?
The 2013 Review
The main purpose of the 2013 Review is to examine the effectiveness of amendments to the Code made in 2008 and 2010. It will also examine:
- the issue of good faith in franchising;
- franchisees' end of term rights, including recognition for any contribution they have made to the building of the franchise; and
- the provisions of the Competition and Consumer Act 2010 as they relate to enforcement of the Code.
While goodwill is not its sole focus, it is clear that the 2013 Review will involve consideration of goodwill issues. One of the amendments the 2013 Review will consider, for example, is the 2010 amendment requiring franchisors to disclose end of term arrangements to franchisees at the beginning of the franchise relationship, including whether franchisees are entitled to an 'exit payment' (often seen as a payment for goodwill).
The 2013 Review Discussion Paper has also already identified as a potential issue the "lack of clarity and/or fairness regarding the benefits the franchisee is entitled to when they leave the franchise, in recognition of their contribution to the 'good will' of the franchise system as a whole".2 It is therefore important to have a broader understanding of why goodwill can present such difficulties in franchising relationships.
The recent Northern Territory case of Murray Pest Management Pty Ltd v A&J Bilske Pty Ltd (2012)3 gives guidance about how to resolve goodwill issues in the context of franchise agreements. It is common to find in franchising agreements a clause reserving ownership of all goodwill to the franchisor. As Murray shows, though, the effect of such a clause is not always straightforward.
Murray Pest Management (the franchisor) had been granted a licence to use the Murrays Pest Control franchising system. It then sub-licensed the franchising system to A & J Bilske (the franchisee) for a 5 year term under a franchise agreement which authorised the franchisee to carry on a pest control business within a defined area of the Northern Territory. The sole directors / shareholders of the franchisee were Mr and Mrs Bilske.
When the initial term of the franchise agreement came to an end after 5 years, the franchisee did not exercise its option to renew the term. Instead, the Bilskes set up a new company, Bilske Investments, to carry out a similar pest control business in the same area of the Northern Territory. There was also evidence that the franchisee had actively helped Bilske Investments to establish its rival pest control business, and that Bilske Investments had attracted many of the franchisee's former customers.
The Goodwill Clause
The central question for the court was whether the goodwill in the customers attached to the franchisee's business or whether the franchisee was simply acting in a custodial role over the franchisor's business, so that the goodwill belonged to the franchisor.4
The franchise agreement provided that "The licensor retains ownership of the goodwill attaching to the franchised system, including goodwill developed by the franchised system's use in the business of the franchisee".5 The court's view was that the effect of this goodwill clause "was to ensure that any 'goodwill' attached to the name 'Murrays Pest Control' was returned to [the franchisor]" when the franchise relationship ended.6
However, this did not mean that the franchisee was stripped of all goodwill relevant to the business at the end of the franchise term. In examining the franchisor's claim that the Bilskes had solicited customers for their new rival business by using the franchisor's confidential customer list, the court commented:
The goodwill in the franchised system is ... not the same as the goodwill of the franchisee's business. The link which must be made is that the customers lost ... were part of the goodwill of the franchised system, as opposed to the personal attraction of Mr and Mrs Bilske who operated the system through [the franchisee].7
In this case, the court found that the Bilskes had relied on non-confidential sources to obtain customer contact details and that the franchisor could not validly claim to "own" the customers who began to use the Bilskes' rival services.
The Murray case highlights that courts do not necessarily regard a retention of goodwill clause as a case of the "franchisor takes all". In some circumstances, it may be appropriate to distinguish the franchisee's business from the business of the franchise itself, so that the franchisee remains entitled to the goodwill it has generated independently of the franchise system.
Restraints of Trade and Other Franchisor Protections
The NSW Court of Appeal's decision in BB Australia Pty Ltd v Karioi Pty Ltd (2010)8 shows that ownership of goodwill may also be an important factor in construing the effect of other provisions designed to protect a franchisor's goodwill at the end of a franchise relationship. Examples include provisions restraining the franchisee from competing with the franchisor for a certain period of time, and provisions intended to preserve the franchisor's ownership of the goodwill in the specific location of the franchisee's business.
Blockbuster (the franchisor) entered into two franchise agreements with Karioi (the franchisee) for the franchisee to run two video store businesses in Queensland as "Blockbuster Video Stores", using Blockbuster's distinctive retail store format and colour schemes. In the years prior to entering the franchise agreement, the franchisee had conducted successful video store businesses in those locations. After the 10 year term of the franchise agreements expired, the franchisee continued to operate its video store businesses, but as non-Blockbuster stores.
Reading Down Provisions of Franchise Agreements
The franchise agreements distinguished between mere expiry of the agreements after the terms had elapsed, and "termination" of the agreements, which was said to occur for certain events of default.
Nevertheless, the agreements contained an ambiguously-worded provision giving Blockbuster the right to require the franchisee to transfer the leases of the premises to Blockbuster for no consideration upon the agreement "being terminated or expiring for whatever reasons".9
On its face, the clause allowed Blockbuster to require the franchisee to transfer the leases even when no event of default had occurred under the agreement. Yet in the court's view, despite the wording of the clause, considerations of goodwill militated against this construction:
[The franchisee] had been operating the stores for a number of years prior to them becoming Blockbuster franchises, with each store having attached to it substantial goodwill that was to a significant extent based upon the locations of the stores. These facts suggest that it was most unlikely that reasonable people in the position of these parties would have intended to agree that, in circumstances where [the franchisee] was not in default under the agreements, [the franchisee] would have to transfer its leases to Blockbuster, and thereby transfer to Blockbuster the associated, valuable goodwill, for no return to [the franchisee].10
Although conflicting drafting elsewhere in the franchise agreement assisted the court in reaching its decision, the court was willing to read down the express terms of the franchise agreement to find in favour of the franchisee.
Restraint of Trade Provisions
The franchise agreements also restrained the franchisee from carrying on any rival business for a period of up to three years within a radius of 30km of any Blockbuster outlet in Australia.11 Blockbuster argued that the restraints were necessary to protect its legitimate goodwill interests, such as its interest in the stores' locations and confidential information.12
However, again the court was not willing to give effect to the restraint of trade provision. The court found that Blockbuster had no legitimate interest in the precise locations of the stores. The franchisee held the leasehold interests in the premises, so Blockbuster had no goodwill in their location.13 The court placed weight on the consideration that the franchisee had operated the stores for some years before entering into the franchise agreements. Accordingly it had built up substantial goodwill of its own.14
The court also considered that confidential information was sufficiently protected under the franchise agreements by other means (e.g. provisions requiring the return of confidential information and imposing restraints on its use).15
As the Blockbuster case demonstrates, courts may be reluctant to give full force to provisions in a franchise agreement designed to protect the franchisor's goodwill interest, even when the wording is clearly expressed, if to do so would be unduly detrimental to an experienced and already-established franchisee.
The cases discussed in this paper show that goodwill can be a contentious issue at the end of a franchise relationship. Key points for franchisors to bear in mind are:
- in the drafting of franchise agreements, franchisors are generally better served by taking care not to include over-reaching provisions regarding goodwill;
- the operation of standard goodwill provisions in franchise agreements may depend on complex factual questions about the nature of the franchise system and the circumstances surrounding the conduct of the franchisee's business; and
- it may be difficult for franchisors to have a "one size fits all" franchise agreement that will produce certain results in all situations.
Goodwill in franchising is a difficult issue, but with appropriate drafting franchisors may be better able to protect the goodwill in their franchise systems. Franchisors will have to accept, however, that there are limits to how much goodwill they can retain after the expiry of the franchise term.
In the meantime, we will be sure to keep you informed about the results of the 2013 Review, which, while mainly limited to reviewing specific Code amendments, will hopefully contribute to the ongoing debate about goodwill in the franchising context.
The assistance of Ryan Doherty, Graduate, of Addisons in the preparation of this article is noted and greatly appreciated.
2 Department of Industry, Innovation, Science, Research and Tertiary Education, Discussion Paper: Review of the Franchising Code of Conduct, 2013 at p 24.
3 Murray Pest Management Pty Ltd v A & J Bilske Pty Ltd  NTSC 5 (Murray).
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8 BB Australia Pty Ltd v Karioi Pty Ltd  NSWCA 347 (Blockbuster).
9 Blockbuster at  (emphasis added).
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.