One of the key amendments to the Code concerns the area of capital expenditure. Since the previous Code changes in 2010, a franchisor has been required to state in its disclosure document whether it will require a franchisee to undertake “unforeseen significant capital expenditure” that the franchisor did not disclose prior to the franchisee entering into the franchise agreement. Costs associated with premises refurbishment and refit, equipment upgrades (such as point of sale systems) and software upgrades have typically been disclosed in this section.
Use of the term “unforeseen” has never sat comfortably in this context. If expenditure is unforeseen, it logically follows that a franchisor would not be in a position to know and detail such future expenditure.
Franchisors have also been obligated to disclose whether any significant capital expenditure (unforeseen or otherwise) undertaken by the franchisee would be considered at the conclusion of the franchise agreement. This has been required for franchise agreements entered into in a financial year commencing 1 July 2011 onwards, and relates to specific periods in which the expenditure was incurred.
New Code provisions
A franchisor must not require a franchisee to undertake significant capital expenditure in relation to a franchised business during the franchise agreement term. The term “unforeseen” has been dispensed with.
The new Code goes on to specifically exclude a number of expenditures from falling within the scope of “significant capital expenditure”. Put simply, a franchisor will be permitted to require a franchisee to undertake expenditure that satisfies at least one of the following:
1. It has been disclosed to the franchisee in the disclosure document (prior to the franchisee entering into, renewing or extending the term/scope of the franchise agreement);
2. It is to be incurred by all or a majority of franchisees and it is approved by a majority of franchisees;
3. It is incurred by the franchisee to comply with legal obligations (for example, changing health and safety requirements);
4. It is agreed to by the franchisee;
5. The franchisor considers the expenditure necessary as capital investment in the franchised business. For a franchisor intending to rely on this provision, it will need to justify its decision by providing a written statement to each affected franchisee, which addresses the following:
- The rationale for making the investment
- The amount of capital expenditure required
- The anticipated outcomes and benefits
- The expected risks associated with making the investment
The obligation to disclose whether any significant capital expenditure undertaken by the franchisee in the most recent three financial years would be considered in determining end of franchise term arrangements remains.
Franchisor considerations
For franchisors intending to require one or more of its franchisees to undertake significant capital expenditure during the franchise term, it is item 5 that is discretionary and accordingly, will require sound judgment in its application.
It is implied from the wording of the new Code that the capital expenditure needs to have a demonstrative benefit for the affected franchisees, although this need not necessarily be financial. When defining the anticipated benefits, franchisors will need to ensure that the (positive) representations made are soundly based, and do not overstate the likely benefits.
It is interesting to observe that the new Code makes no attempt to determine what qualifies as “significant”. A layman interpretation would suggest that “significant” means expenditure that would have potential implications for the financial viability of a franchisee. However, franchisors should not assume that relatively cheaper expenditures by franchisees on fixed assets will escape the required franchisee notification process.
Franchisors need to give careful consideration to implications for end of term arrangements, particularly where capital expenditure is incurred within the three financial years prior to the date of the franchise cessation.
The new Code provisions will mean that a franchisor cannot rely on its restraint of trade provisions in circumstances where a compliant, departing franchisee has requested a new franchise agreement (on substantially similar terms), which the franchisor does not grant, and for which the franchisee does not receive adequate compensation. It would be logical to conclude that a franchisee’s significant capital expenditure during the term would be considered in a determination of fair compensation.
Take action
The Code amendments have placed a greater obligation on franchisors to justify requiring franchisees to incur significant capital expenditure. Franchisors will need to be able to demonstrate sound commercial reasoning for the expenditure, and potentially be prepared to compensate franchisees, in particular where such expenditure is incurred nearing the conclusion of the franchise term.
Franchisors need to:
- Seek advice
- Carefully consider imposing capital expenditure requirements not included in the disclosure document.
- Seek and retain evidence to justify imposing capital expenditure requirements on franchisees.