Australia: Yum successfully defends Pizza Hut reduced price strategy

Change management is complex in a franchise network, as change cannot be imposed upon a network of independent business owners in the same way as it can across a corporate network. Franchisees rightly need to be part of the decision making process, but there is also a need for confidentiality. Leadership needs to be provided, but consultation is essential, and decisions need to be embraced to deliver a consistent customer outcome.

The decision in Diab Pty Ltd v Yum! Restaurants Australia Pty Ltd [2016] FCA 43 provides good guidance to franchisors seeking to manage significant network change, but it also demonstrates the challenges in achieving consensus across a network of independent business owners. Each franchisee will bring their own perspective to the matter, and assess the need for change against their own circumstances. Despite the need for a consistent approach across a network, and general acknowledgement of the strategic challenges, the fact is that not all franchisees will see the issues the same way. A franchisee in a rural or regional location is likely to face less competitive pressure than a franchisee in a high traffic city location, and may have less potential to pick up market share due to the absence of a direct competitor.

The Yum decision was not surprising, and is consistent with similar cases decided in Canada in relation to the Canadian duty of good faith. However the case also shows that a franchisor can be "damned if you do, damned if you don't" in the eyes of a franchise network. The cost of the litigation, and the extent to which franchisees challenged Yum, are sobering elements for any franchisor to note.

Background

In 2014 Yum! Restaurants Australia Pty Ltd (Yum) implemented a strategy known as the "value strategy" (VS) across the network of Pizza Hut stores. The VS was comprised of a number of elements. Crucially though, the VS provided for (1) the removal of 2 lines of pizzas; and (2) the reduction of the price of 2 lines of pizzas.

Prior to implementing the VS, Yum trialled the VS in the Australian Capital Territory (the ACT Test). Yum took steps to normalise the results and, based on these adjustments, predicted that the introduction of the VS should result in an increase in sales across the majority of Pizza Hut outlets.

Following the ACT Test, Yum met with franchisees in a number of States to discuss the ACT Test and the outcomes from the test. Yum also prepared a "model" (the Yum Model) to further assist in considering whether to implement the VS. The Yum Model was a tool that could be manipulated by inputting different information to see the impact on outputs. Diab Pty Ltd (DPL), the Applicant, suggested that the Yum Model was essentially a model of profitability. However, Yum contended that the Yum Model was used simply as a "break even" assessment to determine how many additional transactions would be required for the national average store to retain the same level of profitability. There were several reiterations of the Yum Model and evidence was given that at least one version of the model was shown to a number of franchisees prior to the introduction of the VS.

On 10 June 2014 the decision to implement the VS, with effect from 1 July 2014, was announced to Pizza Hut franchisees.

On 24 June 2014 the Federal Court heard and determined an interlocutory application made by A & A (Sydney) Pty Ltd and 80 applicant franchisees (including DPL) seeking to restraining Yum from implementing the VS. The application was not successful and the Federal Court did not grant the interlocutory injunction.

Meanwhile, Domino's had learnt of Pizza Hut's proposed plan to introduce reduced price points. On 19 June 2014 Domino's notified its franchisees of its decision to pre-empt Yum and to launch an all-day every day $4.95 price point. The Domino's pricing strategy was essentially limited to one range of pizzas (take away) only – it did not extend across the entire range and Domino's did not delete any lines. Domino's implemented their reduced price strategy on 24 June 2014, before Pizza Hut implemented the VS, and therefore obtained any "first mover" advantage.

Yum implemented the VS on 1 July 2015.

Claims against Yum

DPL, acting both in its own capacity and as the representative applicant for approximately 190 franchisees operating under an international franchise agreement (IFA) with Yum, commenced action against Yum following the implementation of the VS. DPL made a number of claims against Yum.

The IFA

All Pizza Hut franchisees were party to an IFA with Yum. The IFA, which was essentially a standard form document, included a number of relevant clauses. In particular, the IFA:

  • Prohibited the franchisee from selling "Approved Products" above the maximum prices advised by Yum. (Clause C1)
  • Required the Franchisee to participate in national and regional advertising and promotions that Yum required. This clause also provided that the franchisee would have no claim against Yum in connection with the level of success of such advertising or promotion.

DPL argued that pursuant to Clause C1, Yum was obliged to set profitable prices – being prices that allowed franchisees to maintain or increase their profits.

DPL also argued that Yum was subject to, and breached, a number of implied duties including:

  • A duty to cooperate with franchisees to achieve the objectives of the IFA; and
  • A duty to comply with standards of conduct that were reasonable having regard to the parties of the IFA.

Negligence and unconscionability

In addition DPL argued that Yum:

  • had a duty of care to each franchisee in relation to any conduct or decision by Yum in providing services as franchisor and in the exercise of its powers under the IFA; and
  • had acted unconscionably, in breach of section 21 of the Australian Consumer Law.

The Federal Court's decision

The Federal Court generally accepted Yum's submissions and found that DPL had not established that Yum was in breach of its legal obligations in implementing the VS.

Implied duty of profitability?

The Federal Court considered that an obligation to ensure profits for each franchisee with respect to a given promotion was not only contrary to the express terms of the IFA, but was also commercially unrealistic. Given this, the Federal Court found that no such implied obligation should be imported into the IFA. To do so would be to essentially rewrite the bargain between Yum and the franchisees.

While accepting that Yum could set maximum prices, the Federal Court J noted that Yum's discretion under the IFA was not unfettered and:

"...had to be exercised in good faith and reasonably with reasonable cause. Yum had an obligation to act honestly and with fidelity to the bargain but that does not mean that Yum was under a strict liability to make decisions that only resulted in success and more profits for the Franchisees. That does not mean that a decision made in good faith and on reasonable grounds that proved to be unsuccessful in realising profits...renders Yum liable for any Franchisee losses...."

Breach of good faith?

DPL suggested that Yum had implied duties to cooperate with franchisees to achieve the objectives of the IFA and to comply with standards of conduct that were reasonable having regard to the parties of the IFA. DPL sought to establish a breach of these implied duties by pointing to a number of different matters including:

  • Yum's interpretation of the results of the ACT Test (which DPL argued were incorrect)
  • the input figures used in the Yum Model (DPL argued that the labour hours were too low, therefore skewing the results) and;
  • the degree of engagement Yum had with the franchisees in relation to the VS.

In considering, and ultimately rejecting DPL's argument, the Federal Court noted that:

  • Yum had carefully considered ("agonised over") the appropriate maximum price to include as part of the VS, taking into account that it was part of an overall strategy.
  • Yum had met with numerous franchisees before finalising the Yum Model and there was no evidence to suggest that any of those franchisees had complained about the parameters used in the Yum Model (including the labour hours)
  • Yum was of the view that the VS was capable of:
    • delivering the same profits to the franchisees, as the Yum Model indicated a 34.5% uplift in transactions; and
    • Reversing a perceived downward trend in market share that Pizza Hut was experiencing.

The Federal Court's position supported the findings of the earlier interlocutory application. During that interlocutory application, the Federal Court had found that DPL's argument, "that Yum had not cooperated with the Franchises in the advancement of interests of the business in good faith about the modelling and that modelling was not objectively reasonable...was a weak one." The Federal Court noted, in considering the interlocutory application, that Yum had "shown great care in developing the VS and that it was not a strategy that was developed capriciously or arbitrarily...even if the modelling was wrong, it did not necessarily mean that Yum had breached any implied term or engaged in unconscionable conduct."

Negligence

DPL argued that Yum owed a duty of care to franchisees in respect of any conduct or decision by Yum in providing services as franchisor and in the exercise of its powers under the IFA. DPL argued that the duty takes into account the franchisee's vulnerability to risk of harm and its reliance on Yum to deliver its services with all due skill and care. DPL alleged that the services included the preparation of plans, policies, models and forecasts.

Based on the existence of a duty of care, DPL alleged that Yum had acted negligently in relation to modelling, the likely Domino's response and the design and implementation of the VS. In making the accusations, DPL pointed to a number of matters, including:

  • Yum's ability to be able to properly model the proposed VS;
  • Yum's knowledge that Domino's would respond to the implementation of the VS, therefore resulting in reduced transaction growth;
  • The fact that Yum provided marketing support for the ACT Test which it would not do on a national level;
  • The methodology and end result of providing for insufficient labour hours in the Yum Model; and
  • The design of the VS was flawed and negligent and the price point was determined without any modelling or regard for franchisee profitability. Instead, the Yum Model was just used to justify a desired price point.

Yum denied a duty of care as argued by DPL. Yum argued that, if such a duty cannot be implied into the contract, there cannot be such a duty as it would be inconsistent with the terms of the contract. Further, Yum argued that a duty of care in tort will not be imposed between parties where a contract is intended to be a complete statement of the parties' obligations.

In support of its arguments, Yum submitted that:

  • the franchisees did not engage Yum to develop the VS and the Yum Model on their behalf or to advise them. The VS was Yum's idea and could have been implemented by Yum, regardless of whether franchisees consented, based on Yum's contractual rights.
  • it had discretion in relation to the design and implementation of the VS – the franchisees did not engage Yum to develop and implement the VS - and therefore no duty of care should be implied into the contract as that would fetter the discretion.
  • the Yum Model was "utilised" and the "outcome of the modelling" was one of the matters Yum took into account when it decided whether or not to implement the VS.

Yum refuted the major basis of the alleged breach of duty (incorrect labour assertions, the form of analysis undertaken, failing to model the cost of capital) and the allegation of negligence for entering into a "price war" with Domino's.

The Federal Court ultimately accepted Yum's submissions as to its obligations under the IFA and the exercise of those powers. The Federal Court held that DPL had failed to establish that Yum owed the franchisees a duty of care in relation to the provision of services provided by Yum as franchisor. The Federal Court also held that Yum was not under a duty to ensure profitability of each franchise, nor under a duty to ensure that profits were maintained or increased.

Unconscionability

DPL also sought to argue that Yum had acted unconscionably, in breach of section 21 of the Australian Consumer Law. Specifically, DPL suggested that:

  • the implementation of the VS would see a movement of wealth from franchisees to Yum and that the decision to implement the VS was made by Yum's management, without consideration for the franchisees "ruthlessly and for the purposes of their US superiors".
  • The decision to implement the VS was so unreasonable that no reasonable person would have made it.

Yum countered DPL's arguments noting that the franchisees had entered into the IFA without any promise of profitability. Yum argued that it made a number of decisions in relation to its own business which, pursuant to the IFA, became binding on the franchisees. Additionally Yum argued that "is not for the Court to rewrite or reshape that contractual, commercial bargain and that the fact that a commercial bargain is disadvantageous to a party does not make it unconscionable".

While finding that Yum may have been naďve or demonstrated poor business judgement, the Federal Court found that this did not equate to unconscionable behaviour. The Federal Court found that Yum had made what it considered to be the best decision from the point of view of Yum and the future profitability of the franchisees. Whether the reasons for such belief were right or wrong, they were made reasonably. On this basis, Yum did not act unconscionably.

Learnings

Yum was ultimately successful in this case, even if the implementation of the VS did not have the positive impact on Pizza Hut businesses that Yum had hoped for.

The evidence in this case indicated that Yum expended considerable time and effort considering, developing and testing the VS. Yum looked to other jurisdictions to see what had worked there, developed its own plan then sought to test and improve the strategy before implementing it. Yum also consulted with franchisees about the VS prior to it being implemented. The considerable care shown by Yum in developing the VS was highlighted by the Federal Court in both the interlocutory application and in the judgement following the trial.

This case clearly offers support for franchisors seeking to make substantive changes to their operations. However, it also confirms that there is a relatively high bar that franchisors must meet in implementing changes - not surprisingly, franchisors cannot simply do as they please. In order to ensure legal compliance franchisors should ensure that they:

  • act within the scope of their franchise agreements;
  • include provisions that impose clear obligations on franchisees to participate in marketing initiatives;
  • undertake a detailed analysis of the proposed changes, including how the changes will impact franchisees;
  • endeavour to consult with franchisees to obtain input from them and consider that input
  • undertake financial modelling of the proposed changes;
  • test the proposed changes in the franchise network; and
  • act in good faith and not arbitrarily or capriciously, noting that this does not necessarily mean that they must act against their own interests.

Change management is probably the most complex challenge faced by franchise networks, particularly where changes are fundamental and involve some commercial risk or uncertainty. Franchisors are expected to show leadership, but they must objectively consider all of the above factors and consult in a manner that is genuine and respectful of the interests of all franchisees. Although the Yum case provides helpful guidance, our experience is that franchisors seeking to implement network change sometimes can be too close to the decision making process to be objective.

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