FALL-OUT

Stewart Germann and Khushbu Sundarji review three recent cases where franchisors and franchisees went to court seeking legal injunctions – and weren’t successful

Serious disputes between franchisors and franchisees are relatively uncommon in New Zealand, which is why they tend to make headlines when they do occur. But when something serious happens, it may need to end up in court action.

That can be a lengthy process, though, which is why one of the parties will sometimes seek what’s called an interim injunction to stop any further perceived damage to their business before trial. Three recent cases show that this won’t always be granted.

How serious is it?

A hotel is a significant investment, so when things aren’t going right then you need to put them right fast. The case of Prominent Investments Ltd v Quest Apartment Hotels (NZ) Ltd suggests that both franchisors and franchisees need to act in a timely manner.

Background

Prominent Investments Limited (Prominent ) is a Quest franchisee in Ponsonby under a franchise agreement from Quest Apartment Hotels (NZ) Limited (Quest). The agreement was dated 28 September 2012 for an initial term of 5 years with three rights of renewal of 5 years each. Any renewal request had to comply with clauses 5.1.1 to 5.1.6 of the franchise agreement, including: providing notice as required under those clauses; not to default; and that Prominent had substantially complied with the terms of the franchise agreement during the term.

In March 2017, Quest sent Prominent a list of compliance issues to be rectified before renewal could be considered, including that Prominent had to acknowledge by a certain date that Quest’s approval depended on the rectification of the compliance issues raised in the letter. There was various correspondence (and meetings) in March 2017 between the parties recording that Prominent had to comply with the list of issues.

The franchise agreement was not renewed and continued on a holdingover basis. After discussions between the parties, on 25 June 2018 the parties entered into a Deed of Variation which extended the term of the agreement to 1 April 2019, allowing Prominent more time to meet the renewal requirements. However, Prominent did not request a renewal of the franchise agreement, so it continued on a holding-over basis from 1 April 2019.

On 26 June 2020 Quest wrote to Prominent saying that it had no confidence that Prominent would comply with the requirements and the letter also indicated that a third party offered to purchase the business and it offered Prominent time to negotiate directly with the third party. Subsequently on 9 July 2020, Quest forwarded Prominent a further increased offer from the third party but before that could be acted upon Quest issued a Notice of Termination of Franchise Agreement.

Prominent sought an interim injunction preventing Quest from terminating the franchise agreement and arguing that Quest had breached the franchise agreement by not providing renewal documentation in a timely manner prior to 28 September 2017 – in effect, Quest denied Prominent’s rights to a renewal by issuing a one month notice of termination. Prominent also alleged misleading and deceptive conduct.

The Issues and the Law

Renewal of the franchise agreement was conditional on Prominent meeting the requirements contained in clause 5.1.1 of the agreement, including the requirement that Prominent could not be in default. Quest argued that it could terminate the franchise agreement under this clause, as Prominent had not complied with its renewal requirements and these issues were raised well before 2017, which was acknowledged by Prominent. However, Quest continued to work with Prominent and acknowledged that some issues were beyond its control. Accordingly, Prominent was never told that its request for renewal was declined.

Quest argued that Prominent had failed to perform and there was reputational damage. However, the Court noted that Quest continued to work with Prominent and if the reputational damage was so great, it would have terminated the franchise agreement well before 2020.

The Court noted that if the injunction was not granted, Quest could terminate the franchise agreement which would leave Prominent with no business. Damages were limited under the franchise agreement to $11,200. Accordingly, damages were not an adequate remedy for Prominent.

Relief

The Court agreed with Prominent and granted the injunction. Quest was not permitted to terminate the franchise agreement pending the trial. There was a serious question to be tried and furthermore, Quest faced little damage if the injunction was granted, whereas Prominent would suffer the loss of its business. We understand that this case is scheduled for trial in 2024.

Keep on top of the paperwork

There are two big lessons for franchisors in the case of On-Line Digital Solutions Ltd v Riddick. First, keep your paperwork in order; second, act promptly if you think a franchisee or former franchisee is in breach of their agreement.

Background

On-Line Digital Solutions Limited (On-Line) was the regional franchisor of the Open2View real estate photography business. Riddick purchased the area franchise for Taranaki-Whanganui from On-Line in 2006, and in 2010 purchased the area franchise for the Hawkes Bay-Manawatū-Kapiti area under an assignment of a franchise agreement dated 1 October 2005.

The franchise agreement for Taranaki-Whanganui area was for an initial five year term which expired on 31 August 2011. Riddick could renew the franchise agreement for a further 3 terms of 5 years each. In order to do, Riddick had to give notice pursuant to the agreement, pay fees and not be in breach of the agreement. The renewal term was defined as ‘that specified in item 24 of the Schedule’ and the agreement said that there were 3 terms of 5 years each.

Riddick did not provide written notice in 2011. Pursuant to the agreement, it could be terminated by the other party giving 1 month’s notice.

Clause 38 of the agreement contained a restraint of trade provision which stated that from the termination date, the Area Franchisee (Riddick) and Guarantor could not be involved in a market competitor or imitation of the Open2View system for the restraint period, restraint area and restraint business (the business carried on by the area franchisee). There was no agreed restraint area or restraint period between the parties and the definitions were ‘cascading restraints’, with the largest restraint being the territory for 3 years.

In 2016 issues arose between On-Line and Riddick regarding the Hawkes Bay-Manawatu-Kapiti Area. In 2018, On-Line served two breach notices on Riddick which required remedial steps to be completed by Riddick and On-Line being satisfied by the steps taken. On 1 November 2018 OnLine terminated the Hawkes Bay-Manuwatū-Kapiti franchise agreement, alleging that the agreement had expired on 20 September 2010 and was not renewed. Subsequently Riddick established a new business in the territory in competition with On-Line because he considered that the restraint of trade was unenforceable.

By mid-2020 On-Line was frustrated by Riddick’s failure to attend area meetings and the breakdown of the relationship. Riddick attempted to sell the Taranaki territory but the sale fell down due to Riddick not providing an adequate restraint of trade to the prospective purchasers.

On 5 August 2020, On-Line terminated the Taranaki franchise agreement as Riddick had continued to provide real estate photography to the Taranaki market and it sought to enforce the restraint contained in the franchise agreement. On 24 August 2020 On-Line’s solicitors wrote to Riddick’s barrister requiring an undertaking that Riddick would comply with the restraint of 50 kilometres within the territory for 2 years. A subsequent letter dated 6 October 2020 from On-Line’s solicitors advised that it was instructed to apply for an interim injunction to restrain Riddick. Riddick’s lawyer declined to provide the undertaking so in June 2021 (nearly nine months later), On-Line issued proceedings to enforce the restraint of trade and to require that Riddick had to provide the Facebook page and telephone numbers for the business.

The Issues and the Law

Immediately following the termination of the Taranaki franchise agreement, Riddick started a competing business offering real estate photography and marketing services, which included services offered by Open2View. Riddick subsequently relinquished control of the Open2View Taranaki Facebook page and did not use the telephone number on that page.

In relation to the non-renewal of term, Riddick argued that in 2011 OnLine’s director and principal Christopher Bates said that ‘renewals were unnecessary as the agreements automatically renewed.’ Accordingly, On-Line’s termination was a repudiation of the contract and it could not enforce the restraint. Alternatively, the restraint applied from 30 August 2011 and was therefore expired and On-Line was prevented from enforcing a restraint that had expired. Finally, Riddick argued that the restraint was so broad that it could not be seen as reasonable and enforceable.

The restraint was not clearly defined and On-Line’s solicitors said that the Court could amend the restraint using section 83 of the Contracts and Commercial Law Act 2017. However, the Court declined to do this at the interlocutory stage.

Riddick argued that a restraint should be assessed against the loyalty to the venture that both parties made. A commercial relationship renewable and capable of being terminated on a month-by-month basis could not warrant a restraint of trade extending for two years after termination. On-Line argued that the key factor was the length of the time Riddick occupied that area – over 14 years – which meant that any new-entry franchisee could not establish itself in that market. Therefore, a restraint was necessary for On-Line to re-establish a presence, and it said that it had great difficulty in doing so at the present time.

The Court commented that if Riddick was on a month-to-month contract, then Riddick ceased as a franchisee in September 2011. The fact that Riddick signed up for 20 years to recover the capital investment but only received 5 years was material to the reasonableness of any restraint.

Relief

The Court declined to grant the restraint. On-Line decided to cancel the agreement as opposed to working through any issues. If the interim injunction had been granted, it would be disastrous for Riddick as it would have prevented him from earning a living. Importantly, On-Line’s delay in bringing proceedings was taken into account as it caused the status quo, which was different from a franchisee attempting to establish a competing business. On-Line had been aware for some time that Riddick was operating a competing business but it had delayed in bringing legal proceedings.

Highway to hell

A court is unlikely to force two parties to go on working together when they clearly don’t trust each other any more, as the case of DEVGNZ Ltd & Ors v The Depths LP demonstrates.

Background

DEVGNZ Limited (the franchisee) owned and operated a Hell Pizza store in Richmond under a franchise agreement from The Depths (Hell Pizza) which was renewed in 2020 until May 2025.

Hell Pizza operators provided a ‘delivery promise time’ to its customers – ie that the pizza would be delivered within a specified time. There was a financial rebate payable to all franchisees who met certain key performance indicators, including complying with the delivery times. All information by the franchisees was entered into the Hell Pizza online portal known as MyHellHole.

In September 2020, the franchisee raised complaints about The Depth’s conduct, mainly around bullying or sinister conduct, but very little evidence was provided regarding that conduct. The parties engaged in multiple mediations, the last one occurring on 3 August 2021, and the issues were not resolved.

On 11 October 2021 the director of the franchisee Sam Singh said that a customer, along with another person known to The Depths, entered the Richmond store and started behaving in a rowdy manner, saying ‘we know everyone at Head Office’ and that this incident was done purely to intimidate the franchisee.

The Depths received a customer complaint about Mr Singh’s behaviour, with the customer saying that Mr Singh approached them in the carpark and threatened bodily harm. The Depths requested CCTV footage which the franchisee refused to provide, which led to a further breach notice from The Depths. The franchisee then said the CCTV footage would not have captured any altercation and the footage was erased.

The Depths received a customer complaint that the pizza from the franchisee’s store was delivered two hours late in July 2021. However the store’s delivery data stated that it was delivered an hour earlier. The Depths sought clarification from the franchisee via a series of emails and Mr Singh initially said that the order was late due to ‘farmer agitation’ but did not give any explanation for the discrepancy. After this an investigation was launched by The Depths in mid-July 2021 that showed Mr Singh manipulated the delivery data for July 2021 and that it could be tied to his unique user ID.

The Depths’ solicitors sent a letter to the franchisee’s lawyers with the results and asked for clarification. The franchisee denied this and there was extensive correspondence between the parties. The Depths also obtained two independent forensic reports which came to the same conclusion – that Mr Singh had manipulated the data. A systemwide analysis was also undertaken, showing that Richmond Hell Pizza modified delivery times at a rate at least 17 times higher than the group average.

These reports were sent to the franchisee’s lawyers on 5 November 2021, seeking a response and advising that The Depths had resolved on preliminary basis to terminate the franchise agreement on the basis that (among other things) the data manipulation was fraudulent and dishonest, which was a ground that allowed the Depths to terminate the franchise agreement immediately. However, they wanted to give the franchisee an opportunity to provide an alternative explanation. No such explanation was provided and the franchise agreement was terminated on 22 November 2021.

The franchisee alleged that The Depths manipulated the data to show that it was lying about the delivery promise time and used this information to terminate the franchisee and that the incident on 11 October 2021 was used to further intimidate the franchisee. This in turn would mean that the franchisee would not receive the marketing rebate linked to meeting delivery times and sought an interim injunction stopping The Depths from terminating the franchise agreement.

The Issues and the Law

The franchisee raised serious issues of fraud which, if proven, would amount to a criminal offence. However, it never provided any proof of the allegations, only saying that the other party with access to the system was The Depths, and therefore it had manipulated the data.

The Depths had credible grounds under the franchise agreement to terminate the franchisee and had corroborating evidence from the forensic reports and multiple customer complaints about late delivery times. Furthermore, a franchisee in Christchurch admitted to altering the same data at her store and demonstrating how it could be done. DEVGNZ said that this evidence should not apply as it was a conflict of interest, and that if the Christchurch franchisee had altered the data, she should have been the top of the leader board for deliveries on time.

While the economic impact of the termination on the franchisee would be profound, damages could be an adequate remedy, even though the franchisee did not provide any quantification of that impact. The franchisee said that employees would be laid off and support by the franchisee to various charitable and community causes would be cut off.

The Depths said damages would not be adequate. Although it would receive fees under the franchise agreement, it would suffer reputational harm to its standing and the Hell Pizza brand. Furthermore, the relationship between the parties was beyond repair and the manipulation of the data by the franchisee struck at the heart of the integrity of the franchise’s online ordering system and would encourage other franchisees to do the same and conceal it from The Depths.

Relief

The Court declined to grant the interim injunction preventing termination. A critical factor was the parties’ mutual allegations of fraud against each other. The allegations by the franchisee undermined any hope of a sustainable business relationship with The Depths and it would not be in the interests of justice to force the two parties to work with each other under a franchise agreement ‘under which trust and confidence in the other are basic requirements’

About the Authors

This article is written by Stewart Germann and Khushbu Sundarji of Stewart Germann Law Office, a specialist commercial law firm at Auckland with over 40 years of franchising experience.