Landmark ruling confirms increased risk profile for responsible franchisors

Consistent with these trends, the Fair Work Ombudsman (FWO) recently secured the first ever penalties against a franchisor in respect of staff underpayments and record-keeping breaches by its franchisees (Fair Work Ombudsman v 85 Degrees Coffee Australia Pty Ltd [2024] FCA 576 (FWO v 85 Degrees)).

The $1.44 million in penalties, imposed by Justice Bromwich on global Taiwanese-based coffee chain 85 Degrees Café, are the third-highest ever secured by the FWO. Significantly, they represent the FWO’s first successful use of section 558B of the Fair Work Act 2009 (Cth) (Fair Work Act), which extends liability for contraventions by franchisees to their ‘responsible franchisor’.

In this Insight we discuss the decision and consider the main takeaways for franchisors, and the steps they can take to mitigate the risks of non-compliance by their franchisees.

Legislative background

In 2017, in response to ‘increasing community concern about the exploitation of vulnerable workers (including migrant workers) by unscrupulous employers’, the Turnbull Government introduced (and Parliament subsequently passed) legislation aimed at addressing those concerns. The legislation introduced new provisions to extend liability for contraventions of the Fair Work Act (and fair work instruments) by franchisees to a ‘responsible franchisor’ (defined by the Fair Work Act as a franchisor with a significant degree of control or influence over the franchisee entity’s affairs).

Under the provisions, a responsible franchisor is liable for a franchisee’s contraventions if it (or an officer) knew, or could reasonably have been expected to have known, that a contravention by the franchisee of a similar character was likely to occur. However, a defence applies where the responsible franchisor takes ‘reasonable steps’ to prevent contraventions of that character by the franchisee entity.

Background: FWO v 85 Degrees

In FWO v 85 Degrees, the responsible franchisor, 85 Degrees Coffee Australia Pty Ltd (85 Degrees) moved to a franchise business model from around 2015, having originally owned and operated its stores directly. Shortly before that structural change, 85 Degrees admitted to committing a number of contraventions of the Fair Work Act and relevant modern awards.

These contraventions included failures to pay minimum various monetary entitlements under those awards (such as minimum rates of pay, overtime and penalty rates and allowances), breaches of record-keeping obligations (including provision of pay slips) and failures to provide staff with statutory leave entitlements. 85 Degrees admitted these contraventions after a 2014 FWO investigation and entered into an enforceable undertaking on the basis of those admitted contraventions in 2015.

Upon subsequently moving to the franchise model, 85 Degrees imposed stringent controls on its franchisees. These controls ensured that franchisees ran their stores in the way that 85 Degrees had directly operated its stores prior to the transfer to the franchise model. Requirements included:

• compliance with the 85 Degrees ‘System’, being a method of promoting and selling products in stores;
  

• compliance with a detailed operations manual (specifying minimum performance standards and specific procedures for management of stores); and
  

• a requirement to sell products purchased from 85 Degrees to customers at prices set by 85 Degrees.

As a result, franchisees effectively inherited many of the problematic features of 85 Degrees’ business model which contributed to its own earlier contraventions. Additionally, the franchisees were owned and operated by individuals who spoke limited English, had limited or no experience in operating a retail business in Australia, and limited or no knowledge of Australian workplace laws. These franchisees had also not obtained business or accounting advice before entering into their respective franchise agreements.

When the FWO investigated those franchisees in 2019, it identified a range of contraventions similar to those previously committed by 85 Degrees directly. Given that the franchise model implemented by 85 Degrees was based on its own non-compliant business operations, 85 Degrees admitted that it could reasonably be expected to have known that contraventions of the same or a similar character by its franchisees were likely to occur. 85 Degrees also admitted that these contraventions were within its actual knowledge for much of the contravening period.

85 Degrees did little to assist franchisees to comply, simply issuing two letters (after the FWO’s investigation commenced) reminding them to comply with their workplace obligations (but without setting out the nature of those obligations).

Decision

Given that 85 Degrees admitted all the contraventions alleged by the FWO and accepted it was liable for its franchisees’ breaches as a responsible franchisor, Justice Bromwich’s task was limited to imposing the appropriate penalty. In reaching the $1.44m figure, Justice Bromwich noted that:

• 85 Degrees had an unusual level of familiarity with the detail of the operations of its franchisees, as it had previously directly operated the 85 Degrees retail business, including two of the store locations later transferred to franchisees.
  

• Under the contractual arrangements with franchisees, 85 Degrees could have readily ascertained what was happening and taken reasonable steps to prevent the contraventions from occurring. Because of the inadequacy of 85 Degrees’ efforts to ensure compliance by its franchisees, it could never realistically have established the reasonable steps defence.
  

• As a result of 85 Degrees’ intimate knowledge of its franchisees’ operations, and its failure to genuinely attempt to prevent its franchisees replicating substantially the same conduct previously engaged by it as an employer, a ‘condign penalty’ was warranted.

Notably, a core focus of Justice Bromwich’s reasons was the prevalence of non-compliance in the franchise sector more broadly. In pointed comments, Justice Bromwich noted that:

• The exposé of systemic non-compliance by franchisees, particularly in the food retail industry and particularly affecting vulnerable workers on temporary visas, was the background to the package of reforms that introduced the franchisor liability provisions. The relevant Explanatory Memorandum makes specific mention of systemic underpayments by franchisors in the industry in the past as an impetus for its reforms.
  

• A report tendered by the FWO (and unchallenged by 85 Degrees) further highlighted the scale of non-compliance by franchises in the food retail sector and, in turn, the ongoing need for general deterrence. From 2011 to 2015, the FWO investigated seven emerging franchisor businesses in the fast food, restaurant and café sector, including 76 franchisee businesses. Those investigations found that 78% of businesses were non-compliant with employment obligations (FWO Report).
  

• Various reasons might explain such non-compliance rates. Like 85 Degrees, six of the franchises investigated by the FWO were international chains that had recently entered the Australian market. The FWO Report noted that, again like 85 Degrees, such franchisors often have limited or no experience with Australian workplace laws, and their franchisees employ in large part temporary visa holders, who are often more vulnerable to workplace exploitation.
  

• Lopsided arrangements between franchisors and franchisees may also contribute to rates of non-compliance. The FWO reported that, in previous high-profile cases, some franchisors’ business models encouraged underpayments of workers. This was because of a limited opportunity for franchisees to turn a profit after the franchisor was paid the amounts owing to it under the franchise agreement. Although similar facts were not alleged or admitted in this case, if they were, His Honour said this would likely have justified an even stronger penalty response.

Implications

Notwithstanding the egregious nature of the contraventions in this case, the decision is a cautionary tale for all franchisors of the risks of non-compliance by franchisees. In particular:

• Franchisors who enjoy high levels of legal and practical control over their franchisees’ affairs should carefully consider how that control is exercised to ensure that their franchisees comply with legal obligations to staff.
  
  
• Merely informing franchisees of their obligations is unlikely to suffice as ‘reasonable steps’. Instead, franchisors should consider regular training, provision of meaningful guidance to franchisees, and assistance with design and implementation of compliance mechanisms (such as policies, reporting procedures and audits) to ensure that breaches are promptly identified and addressed.
  
  
• Onerous franchise terms which limit the capacity of franchisees to be profitable (for instance, stringent controls on business arrangements, or significant fees and charges) may drive non-compliant practices by franchisees, as Justice Bromwich noted. In its response to recommendations made in the Franchising Code of Conduct Review earlier this year, the Federal Government agreed with introducing a broad requirement for all franchise agreements to provide a reasonable opportunity for franchisees to make a return on their investment.
  
  
• The well-publicised prevalence of compliance issues in the franchise sector (as observed by Justice Bromwich), in conjunction with increased regulatory, government and legislative attention on franchise arrangements, means franchisors can expect to continue to face legal scrutiny. However, two recent developments specific to the workplace context increase the risk profile even further:
  
  
  • First, pecuniary penalties for staff underpayments or breaches of other workplace protections (such as record-keeping) have increased significantly, and will increase significantly again in 2025. In February 2024, applicable penalties were raised fivefold, generally from 60 to 300 penalty units ($18,780 to $93,900 as of June 2024) or for serious contraventions, from 600 to 3,000 penalty units ($187,800 to $939,000). In addition, effective 1 January 2025, a court will be able to impose a penalty of the greater of the aforementioned amounts or three times the value of the underpayment.
    
    
  • Second, the recent federal budget has allocated the FWO $28 million in additional funding over the next four years to pursue underpayments by large corporate employers specifically. Large franchises can expect to be targeted by the FWO under this funding package.

Given the risks outlined above, we recommend that franchisors review, consider and (where necessary) update their franchisee compliance arrangements.