Australia: Unfair terms in small business contracts

Until now, the principle of freedom of contract has been sacrosanct in the context of business to business contracts. However, from 12 November 2016, this premise will change because unfair contract terms will be prohibited in standard form contracts where one of the parties is a small business. The prohibition will be achieved through the Treasury Legislation Amendment (Small Business and Unfair Contract Terms) Act (UCT Legislation) which amends the Australian Consumer Law (ACL) and the Australian Securities and Investment Commission Act 2001 (Cth) (ASIC Act) to extend the application of the existing consumer-focused unfair contract term protections to small businesses.

The legislation

The UCT Legislation aims to protect small businesses from "unfair" contract terms in standard form contracts. The UCT Legislation will come into full force on 12 November 2016 (after a 12 month transition period) and will apply to standard form contracts, where one or more parties to the standard form contract is a small business, entered into, varied (but only to the parts varied), renewed or rolled over after that date.

In respect of the franchising sector, the UCT Legislation will be enforced by the ACCC and to some extent by Small Business Commissioners in each State and Territory. Despite the protections for small businesses in the Franchising Code of Conduct, franchise agreements will not be exempt from the UCT Legislation and the ACCC has advised that it will be focusing on the franchising sector as a priority with respect to compliance with the UCT Legislation.

Key definitions

What is a "small business"?

A small business is defined as being a business with less than 20 employees. This is assessed on a head count basis at the time the contract is entered into, varied or renewed and includes casual employees employed on a regular and systematic basis.

What is a "small business contract"?

A "small business contract" is a contract where:

  1. at least one party is a "small business"; and
  2. the "upfront price" required by the contract does not exceed:
    1. $300,000 if the contract is for 12 months or less; or
    2. $1,000,000 if the contract is for a duration of more than 12 months.

The upfront price is the consideration (which may comprise a number of different types of payments) under the contract, that is disclosed at or before the time the contract is entered into (or varied or renewed). It is important to note that the upfront price can comprise amounts that are payable by the franchisee to the franchisor (for example, the franchisee fee) and conversely, by the franchisor to the franchisee (for example, a predetermined royalty amount). However, the total potential value of the contract cannot be used to determine the monetary threshold. Accordingly, a franchise agreement under which a franchisee may receive more than $300,000 (or $1 million in the case of multi-year contracts) through commissions and percentage based royalties will not be exempt from the UCT Legislation, because whether or not such amounts will be earned by the franchisee is not certain at the time the contract is entered into; the payment of such amounts will ultimately be determined by the franchisee's performance under the franchise agreement.

What is a "standard form contract"?

The term "standard form" is not defined in the UCT Legislation, the ACL or the ASIC Act. However, it is generally understood to be a contract that is provided by one party to another on a "take it or leave it" basis. Accordingly, most template franchise agreements will be caught by the UCT Legislation, unless the parties have engaged in a genuine negotiation of the contract.

In the recent case Diab Pty Ltd v YUM! Restaurants Australia Pty Ltd [2016] FCA 43 (discussed in more detail in this edition of Franchising Focus), the Federal Court noted that the international franchise agreement to which Yum and the franchisees were parties, was a "standard form" contract.

Accordingly, unless there has been extensive negotiation of the terms of a franchise agreement, we consider it likely that most franchise agreements will be considered standard form contracts.

What is an "unfair term"?

A small business contract will be "unfair" if it:

  1. would cause a significant imbalance in the parties' rights and obligations arising under the contract; and
  2. is not reasonably necessary to protect the legitimate interests of the party who would be advantaged by the term; and
  3. would cause detriment (whether financial or otherwise) to a party if it were to be applied or relied on.

For a court to declare a term to be unfair, all three of the above elements must be proven. The burden of proof is on the party advantaged by the term to prove the term is reasonably necessary to protect their legitimate interests. In determining whether a term is unfair, the court must take into account the extent to which the term is transparent, and the context of the term in the contract as a whole. A term will be transparent if it is expressed in reasonably plain language, legible, clearly presented and readily available to any party affected by the term. However it is important to note that a term may be transparent, but still be declared unfair.

The ACL contains a list of the types of terms which may be unfair, however these are largely generic terms that would be found in most commercial contracts. Of greater practical assistance when reviewing template contracts for unfair terms, are the 8 core areas identified by ACCC as being of concern. These are:

  • unilateral rights of variation;
  • early termination fees;
  • auto-renewals/rollover provisions;
  • limited or no liability clauses;
  • liquidated damages clauses;
  • unilateral right of termination;
  • indemnity clauses; and
  • forfeiture clauses.

The ACCC has also published a list of ten scenario-based examples of terms which it considers may be unfair. Notably, 3 of the examples relate to franchise agreements.

What happens if a term is unfair?

If a court declares a provision "unfair", the term will be void and therefore unenforceable. However, the contract will continue to bind the parties if the contract can operate without the unfair term. A franchisor who seeks to enforce a declared unfair term, will contravene the ACL. Such a contravention may result in an injunction, an order to provide redress to the small business affected, or any other order that the court considers appropriate.

Are any terms exempt from the UCT Legislation?

There are some terms to which the UCT Legislation will not apply. Section 26 of the ACL provides that the unfair contract term provisions will not apply to the term of a small business contract to the extent, but only to the extent, that the term:

  1. defines the main subject matter of the contract;
  2. sets the upfront price payable under the contract; or
  3. is a term required, or expressly permitted, by a law of the Commonwealth, a State or a Territory (for example those terms required under the Franchising Code of Conduct).

Terms that set the upfront price payable

The upfront price payable includes any consideration (including future payments) payable under the contract which are referable to the supply, sale or grant the subject of the contract and which are disclosed at or before the time the contract is entered into.

In franchise agreements, terms that set the franchise fee, annual administration fee, royalties, bonuses and commissions are all terms which set elements of the upfront price payable under the agreement, and would be exempt from the UCT Legislation. It is important to note the distinction between the use of upfront price to determine whether the contract falls within the ambit of the legislation (in which case royalties, commissions and bonuses based on a percentage of a franchisee's earnings are excluded) and the application of the UCT Legislation to terms which impose an obligation on a party to the contract to pay certain amounts under the agreement.

Amounts which are contingent on the occurrence or non-occurrence of a particular event are not exempt from the Legislation and could be declared unfair. Examples of such amounts are penalty interest, termination fees, renewal fees, relocation fees, transfer fees and premises upgrade fees.

Risks and recommendations

Risks

The most obvious risk is, of course, the declaration of an "unfair term" in a small business contract resulting in either a term, part of a contract or an entire contract being found enforceable. The flow on effect of terms being unenforceable is much more uncertain and potentially far reaching.

Brand and reputation damage following class actions or other legal proceedings is also a foreseeable risk. This risk is particularly relevant to franchise networks, where disgruntled franchisees are more likely to collaborate.

Notwithstanding the above risks, franchisors can take some comfort from the significant disclosure requirements placed on franchisors under to the Franchising Code of Conduct. Given the emphasis on disclosure and transparency, if franchisors have been compliant with the Franchising Code of Conduct in their dealings with franchisees, it is less likely that terms in franchise agreements, in particular those regarding an amount or obligation arising from a contractual term that is further explained in the disclosure document, will be considered unfair. That said, disclosure of information does not necessarily equate to transparency. Accordingly, franchisors should ensure that the terms of their franchise agreements are transparent (expressed in reasonably plain language, legible, clearly presented and readily available to a party affected by the term) to further reduce the risk of a declaration of unfairness. Franchisors may also wish to consider reducing the size of their agreements.

Franchisors also need to be aware that the UCT is not limited to just franchise agreements. It covers all standard form contracts, where one or more parties to the contract is a small business, entered into, varied (but only to the parts varied), renewed or rolled over after 12 November 2016. As such, franchisors should also be considering and reviewing any other agreements that they routinely use, such as supply agreements.

Review of contracts

We recommend that franchisors conduct a term by term review of their franchise agreements for potential unfair terms. Such a review should include any additional documents or conditions which are referred to in the franchise agreement, such as the operations manual as they will form part of the agreement.

In reviewing each term consider:

  • is the term transparent in that it is written in plain English and clearly expressed;
  • is there a legitimate reason for the term to be in the contract. If so, this should be documented;
  • are the restrictions, limitiations or obligations are really necessary;
  • is the term largely redundant in that the franchisor rarely enforces or relies on it; and
  • are there other terms in the contract which mitigate the unfairness of a term, for example a right of termination for the franchisee where price increases exceed a certain amount.

In addition, franchisors should consider whether they use any other standard form contracts that may be impacted by the UCT Legislation. If so, these contracts should also be reviewed on the same basis that the franchise agreement is reviewed.

Drafting trends in franchise agreements

We consider that the implementation of the UCT Legislation will see some new drafting trends in franchise agreements. In particular, it is quite possible that franchisors will want to move to shorter form documents as they seek to ensure that their franchise agreements are transparent and easier to comprehend.

In relation to the subject matter of the franchise agreement, clauses which grant the franchisor a unilateral right to vary certain terms of the franchise agreement (for example, increasing minimum performance standards, increasing fees or decreasing commissions) may need to be amended to allow franchisees the right to dispute the variation or to terminate the franchise agreement on notice following a variation if they can show that such a variation jeopardises their franchise business.

Providing a franchisee with the right to exit the business if a unilateral change decreases the viability of its business beyond originally expected limits , is fairer than requiring the franchisee to "stick it out" for the remainder of the contract term. Such a right, though not traditionally present in franchise agreements, is not as alarming a prospect as it initially appears because it provides franchisors with opportunities to avoid having to enforce performance management criteria for franchisees who have already emotionally left the system. Accordingly, a right of termination for convenience in such circumstances does provide franchisors with a timely opportunity to "refresh" their network.

The UCT Legislation has the potential to have a big impact on standard form agreements used within franchise networks. However, by spending some time reviewing and considering your standard form agreements now, you can minimise the likelihood that your agreements will be found to contain unfair clauses which are then struck out.

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