Why SA’s proposal to regulate franchising is impractical

The recent announcement by South Australian Small Business Minister Tom Koutsantonis that SA will push ahead with specific legislation to regulate franchising beyond the existing provisions of the Federal Franchising Code of Conduct should trigger alarm bells for the sector nationally.

There are no state-specific issues for franchising at play that justify the intervention of a state government. Franchising as a method of doing business transcends state borders, which is perhaps why the proposed legislation which Koutsantonis has stated will be the template for the new laws has all the makings of a new – albeit de facto – national regulatory framework for franchising.

Koutsantonis, who was the chairman of the 2008 South Australian Economic and Finance Committee which conducted a state-based inquiry into franchising, has publicly lauded the work of his fellow former committee member, state MP Tony Piccolo, for continuing to champion the cause of franchise reform even though changes to the Franchising Code of Conduct were implemented by the federal government on July 1 this year.

In his media release announcing that new franchise regulations will be introduced into South Australia, Koutsantonis stated that the now lapsed private member’s bill which was introduced to the SA Parliament in December last year by Tony Piccolo, “…was influential in developing the proposed legislation”.

Note the use of the word “was”, indicating past tense.

While the rest of the Minister’s media release talked in the future tense, with a draft bill to be available for public consultation later this year for introduction next year, the use of “was” in the release could be a simple error.

Alternatively, it could indicate that the bill has in fact already been drafted and may substantially mirror if not completely replicate the bill proposed by Piccolo last December.

(If the bill has already been drafted, why not commence consultation with the franchise sector straight away?)

Either way, Piccolo’s bill from 2009 – which was presented on the last sitting day of parliament before the state election earlier this year and is yet to be retabled under the new parliament – should be examined for a glimpse of things to come.

For a start, Piccolo’s bill proposed to adopt the Franchising Code of Conduct as a South Australian law, and then embellish the Code with bits and pieces to address the national Code’s perceived deficiencies.

The bill was put up in December 2009 while the Federal Code was still under its own review, and which has since been amended with changes taking effect from July 1, 2010.

Nonetheless, the SA bill supposed at the time that the Federal Code wasn’t then (and wouldn’t ever) be likely to be good enough, and sought to add in the bits that Piccolo felt were missing.

A state law without borders

One of these “bits” creates a platform for any South Australian version of the Code to operate as a de facto national replacement for the federal Code, by the use of terminology that does not restrict the SA Code to South Australia only, but expressly allows it to apply to any “..acts, transactions and (franchise) agreements” both inside and outside SA.

The implications of this provision alone are monumental and may be unconstitutional.

In his parliamentary speech when presenting the bill on December 3, 2009, Piccolo announced that the SA laws would provide “..broad coverage to ensure that franchisors do not seek to shift the jurisdiction in which the franchise agreements are entered into.”

There may be constitutional implications for such a radical extension of South Australian law to be applied universally, let alone the practical implications of enforcing such regulations.

In adopting and then seeking to embellish the Franchising Code of Conduct, the SA proposal purports to usurp the 1998 amendments to the Trade Practices Act (TPA) which allowed for the creation of mandatory industry codes, and which led to the establishment of the Franchising Code of Conduct.

In turn, this leads to a jurisdictional problem.

The Australian Competition and Consumer Commission (ACCC) is tasked with enforcing the Trade Practices Act and its mandatory industry codes of conduct. If new South Australian laws adopt and embellish the Franchising Code, would this not undermine the ACCC’s authority to enforce the federal Code in SA, if not Australia-wide?

Again, there may be constitutional implications here, as Section 92 of the federal constitution provides for freedom of trade and commerce among the states, while Section 109 provides that where state and federal laws are inconsistent, the federal law prevails.

At the very least, a duplication of state and federal regulation is not only manifestly undesirable and a waste of taxpayer’s money, but also a complete contradiction of the Australian Labor Party’s 2007 federal election promise of “one in, one out” for all new regulations affecting small business.

An all-powerful Commissioner

Beyond this, the 2009 Piccolo bill proposed to create a Commissioner of Franchises, with powers not only to mediate in franchise disputes, but where mediations remain unresolved the Commissioner is empowered to determine what the outcome should be.

Under this proposed system, neither party to the dispute has any legal recourse to challenge the determination once it has been made.

(And it’s also worth noting that this proposal also prohibits lawyers and professional advisors from attending mediations unless both parties agree to their presence).

This seems incredibly severe. Even people charged with the most violent and heinous of crimes have a right to an appeal, but if this part of the bill is adopted for any future legislation in South Australia, it would mean that both franchisors and franchisees to a dispute resolved in this manner will have less rights than common criminals.

Perhaps Koutsantonis’ announcement signals a move away from such a hard line to something less severe, but still with a sting in its tail. His announcement proclaims that SA will create an Office of the Small Business Commissioner (in lieu perhaps of the Commissioner of Franchises) and based on the existing Victorian model of the same name.

The Victorian Small Business Commissioner model did receive a number of honorary mentions in the federal review of the Franchising Code, and is widely lauded for its high success rate in resolving small business disputes and substantially reduced mediation costs.

This may be a promising sign, as the Victorian model – unlike the proposal in the 2009 draft bill from South Australia – appears to be far more practical and accepted in the business community.

What remains to be seen however, is the nature of penalties to be applied for non-compliance. The 2009 bill proposes a maximum penalty of $20,000 just for failing to provide information requested by the Commissioner, plus $10,000 for each breach by individuals and $100,000 for each breach by companies.

The cost of even one breach to a small franchisor could prove financially fatal to their entire system under penalties of this nature.

Good faith

Both the 2009 bill, and the Minister’s announcement last week are consistent in their determination to include the concept of good faith in legislation.

The 2009 bill offered a definition of good faith as acting “…fairly, honestly, reasonably and in a cooperative manner”, and the same or something similar will probably be considered going forward.

Legal commentators have already noted that there exists an implied duty of god faith in franchise dealings, and the July 1 changes to the Franchising Code of Conduct have acknowledged the potential for such a concept to exist, but shied away from creating a definition.

Perhaps the reason for this is the inherent difficultly in defining a concept that is not entirely black and white, like unconscionable conduct which also is not defined by either the Franchising Code of Conduct or the Trade Practices Act.

The good faith definition proposed in the 2009 bill relies heavily on reasonableness. This alone can be problematic depending on who is assessing the reasonableness of any proposed transaction.

A franchise is a conditional grant after all, and varying interpretations of reasonableness risk compromising the very conditions that give a franchise its system-wide uniformity and competitive advantage.

The interpretation of “reasonable” has the potential to create so many different perspectives as to render this element, and potentially the definition as a whole, unworkable.

Potential consequences of state franchise legislation

Beyond the wording of any proposed legislation itself, the practical and commercial consequences of franchise legislation in South Australia (or any other state), should be considered.

The creation of any new regulations in any field often results in behaviour designed to avoid the rules or mitigate their effect.

For potential franchisors, the cost and risk of non-compliance with the SA rules may be greater than the risk of changing their franchise plans and restricting themselves to licensing arrangements instead.

The pipeline of new franchise systems emerging in South Australia – which has provided many national and some international franchise brands – could wither or dry up altogether.

A move away from franchising to licensing would not alleviate the issues that are perceived to justify the creation of state-based legislation. If anything, a move by businesses toward licensing instead of franchising would actually reduce the protections available to potential licensees who would no longer be covered by the provisions of either state or federal versions of the Franchising Code of Conduct.

In what way could this possibly help “mum and dad” business buyers who would otherwise consider franchising?

Similarly, those involved in providing advice, finance, facilities or other inputs to franchisees are likely to be bound by the proposed legislation with the 2009 bill encompassing “a person in connection with… the making of a franchise agreement”.

The extension of the law to include parties other than those named in a franchise agreement itself could result in a significant withdrawal of services to the franchise sector if professional indemnity risks are considered too great.

If lawyers, accountants, business advisors and bankers are no longer willing to engage in franchising activities for fear of prosecution, how can this possibly be of benefit to franchisees or franchisors?

For existing franchisors, compliance costs will of course increase, as well as the risk of fines and penalties should legislation similar to the 2009 proposal proceed.

In managing this risk, franchisors have two choices.

One is to scale back their franchise operations in South Australia, and replace these with company-owned operations that will generate similar levels of employment. However company-operations will not create the kind of entrepreneurial opportunities and potential for individual personal growth and wealth-creation available to franchisees.

The other choice is for franchisors to maintain or grow existing franchise operations, but allow for their higher compliance costs and risks associated with fines and penalties by increasing both the initial investment cost of their franchise offers, as well as their ongoing royalties.

This could result in the absurd proposition that a franchisee in South Australia pays more upfront and ongoing than a franchisee of the same system in another state. Given that market forces usually place an upper limit on the prices customers are prepared to pay for goods or services, any increase in the investment or operating costs of a franchise at unit level are bound to reduce the profits available to franchisees.

Unless a franchisee is making no profit whatsoever, the prospect of reduced profits in return for further legislative protection is unlikely to be popular as self-interest will inevitably veer toward higher profits instead.

The domino effect

Any introduction of franchising legislation in South Australia (not withstanding that the existing bill proposes to transcend borders) creates a precedent for the introduction of franchising regulation in any other state.

In his own words when proposing his bill in 2009, Tony Piccolo announced that “..this bill is important.. because it outlines the scope of reform and legislative model available to state and territory governments to introduce reforms to franchising should they choose to do so”.

The invitation and implication is clear for all to see – Piccolo is inviting other states to follow South Australia’s lead in the further regulation of franchising.

Like dominos, once one state falls this way, the others can be expected to follow, leading to even greater compliance costs for franchisors and franchisees, and the potential for a shambolic mish-mash of state versus national regulations.

Should such a situation occur, Australia’s appeal to international franchise brands will be badly tarnished and they will likely reprioritise their growth into other markets with lower compliance costs and barriers to entry.

Similarly, homegrown systems can be expected to be less interested in domestic expansion and more aggressively seek growth opportunities offshore.

Less stick, more carrot

If the 2009 proposed South Australian franchise bill is any indication, future state legislation will be heavily concentrated on regulation and retribution for non-compliant parties.

What was overlooked then, and which can create a far more positive approach now, is an endorsement of and real action toward educating franchisors and franchisees in best practice before entering into and during a franchise relationship.

Such an approach would be entirely consistent with recommendations accepted by both the Western Australian and South Australian franchise inquiries, as well as the federal franchise inquiry which all recognised the value of education in improving franchise outcomes.

Yet the 2009 bill does not propose or recommend any form of pre-entry education for either franchisees or franchisors.

Rather than taking a big stick to the franchise sector that will create confusion and unnecessary cost and risk, the South Australian government should consider measures designed to improve franchisees’ knowledge and business skills prior to buying a franchise, as well as improving franchisors’ understanding of best practise in developing and maintaining business models that are profitable for themselves and their franchisees.

In this regard, excellent work has already been done on a very limited budget through the Asia Pacific Centre for Franchising Excellence attached to Griffith University*, which has created a free online pre-entry education program for potential franchisees that has already attracted more than 600 participants in less than three months since its launch. (See www.franchise.edu.au for more details).

Further government support of this and other franchise education initiatives will provide better outcomes for franchisors and franchisees.

Rather than threatening the sector with the introduction of additional legislation, the South Australian and other state governments are encouraged to look more carefully at how the growth of franchising can be helped, not hindered.

Franchise education initiatives are an obvious choice.

Jason Gehrke is a director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and advisor level. He provides consulting services to both franchisors and franchisees, and conducts franchise education programs throughout Australia. He has been awarded for his franchise achievements, and publishes Franchise News & Events, Australia’s only fortnightly electronic news bulletin on franchising issues.

The comments contained in this article are not intended to constitute legal or other professional advice. The Franchise Advisory Centre is not a law firm and does not offer legal advice. Readers are strongly advised to seek their own legal advice relating to their own particular circumstances.