Significant Capital Expenditure - Updating Your Disclosure Document

The Franchising Code of Conduct (the Franchising Code) was amended on 1 June 2021, with most amendments applying from 1 July 2021. Given it is the time of year when franchisors must update their disclosure documents, in this article we revisit the current Franchising Code requirements for Significant Capital Expenditure.

There may be a number of reasons why a franchisee is required to undertake refurbishments or upgrades during the term of the franchise agreement. A franchisor may wish to upgrade its image or a landlord may require the refurbishment of the premises on the renewal of the lease.

Whatever the reason, a franchisor must comply with the obligations under the Franchising Code in relation to Significant Capital Expenditure. The maximum penalty for a failure to comply is 600 units (from 1 July 2023 $187,800.00).

Image Upgrades

As a franchisor you may want to undertake an image or brand upgrade to  revive an older brand or to realign a brand with its target market.

An image or brand upgrade can include upgrading your logo, changing your brand colours and revitalising your website and social media channels.

A more significant brand upgrade may also include changing the look and feel of your shop fronts.

As we discussed in our article "Why is Brand Consistency Important in Franchising", your brand identity (ie your logo, your colour palette, your website, your fonts, your packaging) must be consistent across the franchise network.

An image upgrade can be rolled out in a franchise network in a variety of ways. However, if you want a franchisee to undertake a brand or image upgrade during the term of their franchise agreement,  the requirement to upgrade must not amount to Significant Capital Expenditure under the relevant provisions of the Franchising Code.

Lease Renewals

The requirement to undertake a premises upgrade on the renewal of a lease is common.

However, this requirement can become problematic if the term of the franchise agreement and the term of the lease do not align, especially if the franchise agreement does not contain a right of renewal.

In these circumstances, a franchisee may not have time to recoup the capital expenditure before the franchise agreement expires.  

Again, any requirement for a franchisee to undertake a premises upgrade to comply with the terms of a lease, must not amount to Significant Capital Expenditure under the relevant provisions of the Franchising Code.

The Franchising Code - Significant Capital Expenditure - Historical Provisions

Prior to 2014 a franchisor was required to disclose in its disclosure document whether the franchisor would require a franchisee to undertake "unforeseen" significant capital expenditure that was not disclosed by the franchisor before the franchisee entered into the franchise agreement.

The 2013 Wein review into the Franchising Code noted concerns about the practicality of the use of the term "unforseen". 

In 2014, the provision referred to above was removed from the disclosure document and the Franchising Code was amended to prohibit a franchisor from requiring a franchisee to undertake Significant Capital Expenditure unless:

• the expenditure had been disclosed by the franchisor in the disclosure document; or
• the expenditure had been approved by a majority of franchisees (who were required to incur the expenditure); or
• the expenditure was incurred by the franchisee to comply with legislative obligations; or
• the franchisee had agreed to the expenditure; or
• the franchisor considered the expenditure necessary as capital investment in the franchised business. 

The Franchising Code did not define "Significant Capital Expenditure".

In 2019, the Fairness in Franchising report recommended that the Franchising Code include a clear definition of what constitutes "Significant Capital Expenditure".

When the Federal Government released its response to the Fairness in Franchising Inquiry in August 2020, the government indicated that it proposed to amend the Franchising Code to:

• prohibit franchisors from requiring franchisees to undertake Significant Capital Expenditure, except where it has been disclosed before entering into a franchise agreement, is legally required, or is agreed by the franchisee during the term;
• introducing an obligation to discuss Significant Capital Expenditure prior to entering into an agreement;
• requiring disclosure of the circumstances under which franchisees are likely to recoup the expenditure;
• specifying as far as practical, the amount, timing and nature of the expenditure to be provided.

The Franchising Code - Significant Capital Expenditure - Current Provisions

Clause 30 of the Franchising Code provides that a franchisor must not require "Significant Capital Expenditure" during the term of a franchise agreement.

The maximum penalty for a franchisor requiring Significant Capital Expenditure by a franchisee during the term of  the franchise agreement is 600 penalty units (from 1 July 2023 $187,800.00). 

While the Franchising Code still does not define Significant Capital Expenditure, clause 30(2) of the Franchising Code states that Significant Capital Expenditure excludes:

• expenditure that is disclosed to a franchisee in the disclosure document provided before the franchisee enters into, renews or extends the scope of the franchise agreement; or
• if expenditure is to be incurred by all or a majority of franchisees, expenditure approved by a majority of those franchisees; or
• expenditure incurred by franchisees to comply with legislation; or
• expenditure agreed by the franchisee.

The Franchising Code also now requires a franchisor to include the following information if the franchisor's disclosure document discloses Significant Capital Expenditure:

• the rationale for the expenditure;
• the amount, timing and nature of the expenditure;
• the anticipated outcomes and benefits of the expenditure; and
• the expected risks associated with the expenditure.

We discuss these in more detail below.

In addition to the disclosure requirements, as foreshadowed by the government in August 2020, the franchisor must discuss the expenditure with the franchisee before entering into, renewing or extending the scope of a franchise agreement.

The Rationale for the Expenditure

The rationale for capital expenditure may be varied. As we have already noted, a franchisor may wish to undertake an image upgrade or a landlord may require a refurbishment on renewal of a lease.

In addition, a franchisor may require a franchisee to undertake capital expenditure if the franchisee's shop front is looking tired and in need of repair or if the franchisee's equipment is worn out or obsolete.

An example of the rationale for a franchisee to co-operate in an image upgrade is so that there is consistency across the franchise network. Additionally, an example of the rationale to upgrade or replace equipment is to improve the function of the equipment and/or to improve consistency in the products offered by the franchisee.

The Anticipated Outcomes and Benefits of the Expenditure

Examples of the benefits of an image or brand upgrade may include attracting new customers to the brand and increasing customer experience with a updated or modern environment.

Examples of outcomes and benefits of updating equipment include increased efficiency and reduced maintenance costs.

The Expected Risks Associated with the Expenditure

One of the greatest risks in requiring a franchisee to undertake capital expenditure during the term of the franchise agreement is that the franchisee will not have time to recoup the investment. Clearly this is an expected risk that should be disclosed.

In its submission to the Parliamentary Inquiry into Fairness in Franchising, McDonalds Australia pointed out  that given the high fit out costs for a McDonalds site, McDonalds grants franchises for 20 year terms (which is substantially higher than the market average of approximately 5 years). The increase in term theoretically allows a franchisee more time to recoup capital expenditure.

Discussing the Expenditure with the Franchisee

As set out above, in addition to its disclosure obligations, a franchisor must also discuss the possible expenditure with the franchisee before entering into, renewing, or extending the scope of the franchise agreement.

Some franchisors are adding expenditure discussions to their franchise grant process, so that they can be certain that they have met the required obligation for each franchisee who enters into, renews or extends the scope of the franchise agreement.

Key Takeaways  

When updating your disclosure document you need to be aware of the obligations under the Franchising Code in relation to Significant Capital Expenditure. 

If you include in your disclosure document an amount for capital expenditure during the term of the franchise agreement, you will also need to disclose:

• the rationale for the expenditure;
• the amount, timing and nature of the expenditure;
• the anticipated outcomes and benefits of the expenditure; and
• the expected risks associated with the expenditure.

In addition to disclosure, you will need to discuss the expenditure with the franchisee before the franchisee enters into, renews or extends the scope of the franchise agreement.

Disclaimer

The information in this article is general in nature and is not intended to address the circumstances of any person or other entity. Although we do our best to provide timely and accurate information, we do not guarantee that the information in this article is accurate or that it will continue to be accurate in the future.