Australia: Franchisee fraud – A refresher and a non-monetary perspective

Fraudulent conduct is an occasional feature of behavior within franchise relationships. Most commonly, it involves concerns over the misappropriation of money or the under-reporting of sales by the Franchisee resulting in reduced royalties being paid to the Franchisor. This article provides a brief refresher on the key principles regarding establishing fraud by Franchisees and it also provides a perspective on the non-monetary types of fraudulent conduct which may arise.

The Refresher

The key principles regarding fraud are as follows:

  1. Fraud typically involves conduct which is dishonest and which is directed at, or results in, a monetary benefit being improperly obtained by a person at the expense of another. Deliberate under-reporting of sales by a Franchisee is a common example of fraudulent conduct.
  2. Given the seriousness of an allegation of fraud and the serious consequences of a determination that it has occurred, the Courts require strict proof of it. The evidence of fraud must be compelling before a Court will make a determination that it has occurred.
  3. Most Franchise Agreements contain an express term that entitles a Franchisor to terminate a Franchise Agreement immediately for fraud.
  4. Under the Franchising Code of Conduct, a Franchisor may terminate a Franchise Agreement immediately, without complying with other Code provisions requiring that a period of notice of the termination and an opportunity to remedy misconduct be given, provided that the Franchise Agreement gives the Franchisor the right to terminate should the Franchisee act fraudulently in connection with the operation of the franchised business.
  5. Typically, the amount of money involved in any fraudulent conduct is immaterial to the entitlement of the Franchisor to terminate the Franchise Agreement. The relationship of trust and confidence and the need for the parties to act honestly towards each other are of such paramount importance in franchise relationships that even a triflingly low amount of money which is the subject of fraudulent conduct can be sufficient to warrant legitimate termination.

Common ways in which evidence is typically obtained by Franchisors to establish fraudulent conduct by Franchisees involved in retail businesses include a combination of the following:

  1. Patterns of unusually high levels of voided sales occurring, as being indicative of under-reporting.
  2. Mystery-shopper evidence of specific transactions being made at the franchised business which then directly correspond to transactions which have been voided.
  3. A consistent and significantly higher volume of goods being purchased for the operation of the franchised business than that which would typically be required to generate the level of reported sales.
  4. Whistle-blowing disgruntled employees or business associates of the Franchisee.
  5. Covert surveillance of the operation of the franchised business.1
  6. Non-Monetary Perspective

Fraud is usually considered by Franchisors in a monetary context. However, fraud can occur in a wide variety of non-monetary ways.

The following points are worth noting:

  1. The term "fraud" is used in a relatively wide sense under the law. It can involve conduct where the wrongdoer has gone beyond that which merely amounts to a civil wrong,. Perhaps the Franchisee has indulged in sharp practice, something of an underhand nature where the circumstances required good faith, something which commercial people would say was a fraud or which the law treats as entirely contrary to public policy.2
  2. Fraud can take the form of a false representation if the Franchisee made the representation knowing it to be false, or recklessly, neither knowing nor caring whether it was false or true. This could occur in a variety of circumstances – examples could include:
    1. The provision of false information about the operation of the franchised business or its performance.
    2. The provision of false information about the status of commercial arrangements that the Franchisee has in place with 3rd parties – such as the tenure under a lease, the payment of monies owed to creditors or compliance with obligations owed to employees.
    3. The provision of false profit and loss information in relation to the Franchisee.
  1. Fraud can also involve the Franchisee's conduct vis-ŕ-vis 3rd parties. Examples of this could include:
    1. Underpayment of staff in breach of workplace laws and the resulting underpayment of group tax and superannuation contributions.
    2. Under-reporting of income to the ATO and thus the underpayment of tax and any applicable superannuation.
    3. Dishonesty in dealing with suppliers.

A Final Note of Caution

Franchisors need to remain constantly vigilant in monitoring Franchisees' conduct for evidence of fraud. This article encourages Franchisors to familiarize themselves with key concepts in relation to fraud and to think outside of the normal monetary focus when considering the types of conduct which might be fraudulent.

However, establishing fraud to the satisfaction of a Court is usually a challenging task. It requires carefully prepared and compelling evidence. Accordingly, prior to alleging fraud and certainly prior to terminating for fraud, Franchisors must proceed very carefully and with considerable caution and with the benefit of legal advice.

Footnotes

1 Various laws exist in each State which govern a Franchisor's ability to conduct covert surveillance.
2 London Borough of Brent v Kane [2014] EWGC 4564

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