Pizza Hut franchisees fail in their legal challenge to Pizza Hut's new product and pricing policy - Franchising

Justice Bennett of the Federal Court in Diab Pty Ltd v YUM! Restaurants Australia Pty Ltd¹ has rejected a representative proceeding brought on behalf of a number of Pizza Hut franchisees.

The franchisees claimed that the franchisor had breached its obligations under the franchise agreement, was negligent and had engaged in unconscionable conduct when it introduced a franchise-wide strategy to reduce its pizza prices.

The decision follows an unsuccessful application by 80 Pizza Hut franchisees before Justice Jagot in June 2014 seeking an interlocutory injunction to prevent the franchisor from implementing the strategy.

The decision will be welcomed by franchisors seeking to introduce franchise-wide strategies and provides guidance on the Court's approach to implied contractual obligations, contractual interpretation and unconscionable conduct in franchise agreements.

BACKGROUND TO THE PROCEEDINGS

The proceedings were brought by Diab Pty Ltd, a franchisee and owner of six Pizza Hut outlets, as representative applicant for roughly 190 of the 200 affected Pizza Hut franchisees across Australia (the Franchisees). The proceedings were brought against the franchisor, Yum! Restaurants Australia Pty Limited (Yum), in relation to Yum's decision to implement a new 'Value Strategy' (VS) across all of its franchisees' stores.

The VS involved:

reducing the number of pizza ranges from four to two;
reducing the maximum price for pizzas in the "Classics" range from $9.95 to $4.95; and
reducing the maximum price of pizzas in the "Legends" range from $11.95 to $8.50.

GROUNDS FOR THE PROCEEDINGS

The Franchisees alleged that Yum, in implementing the VS, had:

Breached an implied contractual obligation to set maximum prices that would enable a franchisee to make, maintain or increase its profits;
Breached its duty of care to avoid causing economic loss to the franchisees;
Breached an implied contractual obligation to cooperate with the Franchisees;
Breached an implied obligation of good faith requiring them to comply with reasonable standards of conduct; and
Engaged in unconscionable conduct under the Australian Consumer Law by exercising its powers under the agreement solely and disproportionately in favour of its own interests.

The Court rejected each of these claims.

NO DUTY TO SET PROFITABLE PRICES OR TO PREVENT CAUSING ECONOMIC LOSS

The Court rejected the Franchisees' claim that Yum's power to set maximum prices for each pizza was subject to an implied obligation that those prices be profitable for the Franchisees. In reaching this conclusion, the Court noted that:

The objective of the franchise agreement was to generate profits for the overall business and to reasonably enable the franchisees to have the opportunity to run a profitable operation.
Each pizza sale did not have to generate profit . The reduced prices for some pizzas may have enticed more customers to come to Pizza Hut stores and franchisees could still make a profit from other items, such as side dishes or pizzas from a different range.
The franchise agreement expressly stated that Yum did not guarantee a profit to a franchisee and that Yum would not be liable if its marketing campaigns did not result in increased profits.
An implied obligation to set profitable prices would have been inconsistent with the express terms of the franchise agreement and was not necessary to realise the objectives of the agreement.
An implied obligation for Yum to guarantee profits for each franchisee would have been commercially unworkable in a standard-form franchise agreement where the profitability of each franchisee was affected by different commercial factors.

For similar reasons, the Court rejected the Franchisees' argument that Yum owed a duty of care to avoid causing economic loss to the franchisees.

NO BREACH OF AN IMPLIED CONTRACTUAL OBLIGATION OR UNCONSCIONABILITY

The Court also found that Yum had not breached any implied contractual obligations or engaged in unconscionable conduct in the design and implementation of the VS. The Court considered that:

Yum was subject to an obligation under the common law to act in good faith and had a duty to comply with standards of conduct that were reasonable having regard to the interests of the parties to the IFA.
While Yum's power to set maximum prices under the franchise agreement was subject to an implied obligation that it be exercised in good faith and with reasonable cause, Yum had not breached this implied obligation. The Franchisees had not proved that Yum exercised its power to set maximum prices arbitrarily, capriciously, unreasonably or dishonestly.
Yum had "agonised" over the pricing issue and had taken into account its own financial modelling, data from trials of the VS in the ACT and results from New Zealand where a similar strategy had been implemented;
While Yum's modelling and its treatment of the data from the ACT and New Zealand could be criticised, it was not enough to show that Yum had acted unreasonably or dishonestly.
Yum had consulted and sought input from the franchisees as well as its own executives before implementing the VS even though it was under no contractual obligation to do so;
The Franchisees had not proved that the decision to implement the VS was made solely to benefit Yum or Yum's parent company in the US. The Franchisees also failed to prove that Yum did not believe the decision was in the best commercial interests of the business as a whole; and
Part of the reason why the VS had produced poor results was because Dominos Pizza, a major competitor of Yum, had pre-empted the VS and reduced its own prices accordingly, causing Yum to lose its "first-mover advantage".

APPEAL?

The Franchisees have not yet appealed the judgment. By an order made on 8 March 2016, the Franchisees have been allowed until 7 September 2016 to file an appeal.

TAKE-AWAY POINTS FOR FRANCHISORS

For franchisors, the decision suggests that a court will take a "whole of network" view to assessing the effect of new business strategies on franchisees. Moreover, a court will be unlikely to imply an obligation to protect franchisees' profits in a standard-form franchise agreement if this would be inconsistent with other express terms of the contract. Franchisors should consider including express terms which take account of this approach, for example, expressions to the effect that:

the franchisor does not guarantee that activities undertaken by the franchisor or franchisee will generate profits; and
the franchisor is free to determine and implement new product and pricing strategies from time to time.

However, franchisors should not assume they have an unfettered right to take whatever action they choose in relation to the franchise system. The Court noted that a franchisor's powers and discretions were still subject to an implied obligation that they would be exercised in good faith and with reasonable cause. This will generally be the case where the franchisor makes a decision that it believes is in the best interests of the business as a whole (even if it may harm some individual franchisees) and that decision has been properly considered and reasoned.

Franchisors seeking to implement significant business strategies (including those which may pose a commercial risk for franchisees) should plan and implement the strategy with care.

Franchisors should consider taking the following steps to ensure they comply with their good faith obligations and to reduce the risk of any allegations of negligence or unconscionable conduct:

conduct and review trials of the proposed strategy in an appropriate market;
devise financial models to assist in the development of the strategy but be aware that those models may be subject to rigorous analysis by expert witnesses before a court;
review any available data objectively. Avoid excluding or modifying data unless there are legitimate reasons to do so;
review the terms of the franchise agreement to check if the strategy is consistent with the terms and overall objectives of the agreement;
if appropriate, consider consulting with franchisees and senior executives about the proposed strategy and seek their input;
only proceed with the proposed strategy if you are confident that it is in the best interests of the business as a whole;
keep records of the consultations, reviews and analysis which could be later produced if required; and
if the new strategy will require franchisees to expend significant capital expenditure, ensure compliance with clause 30 of the Franchising Code of Conduct (which prohibits a franchisor from requiring such expenditure by a franchisee except in limited circumstances).

Footnote

¹[2016] FCA 43 (5 February 2016).

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