Over recent times we have been flooded with stories of increased interest rates, increased costs and overheads and generally a reduction in consumer confidence in operating businesses in Australia.
The franchise sector is not immune from such things and recent stories in the press, such as the collapse of the Kliens Jewellery chain, highlight the tensions between franchisors and franchisees. When business conditions deteriorate, each of the stakeholders will focus on the key issues that affect their business.
The franchisor will obviously focus on the following key points:
- maintaining or growing sales;
- controlling costs; and
- collecting debts
This can be particularly important in the retailing environment which has of recent times been hit hard with difficult trading conditions.
A classic situation is a franchisor who has a retail business, has an exposure to renting multiple premises with fixed rent increases and stagnant or declining sales and increased overheads. Coupled with a business model which is both tired or obsolete, one has created then an explosive cocktail that ultimately could burst.
The Franchising Code of Conduct provides that if a Franchisee becomes insolvent or is under administration or abandons the franchise agreement, the franchise can be terminated by the franchisor. There is no such right for the franchisee to terminate the Agreement if the Franchisor becomes insolvent, under administration or ceases to trade. The franchisee has to rely on his contract to enforce his rights to terminate or unilaterally take the risk to terminate the franchise if the franchisor becomes insolvent.
What we find is a sad case of franchisees who are often reliant on supply of product and they have no control over their own destiny.
What the franchisors can do (to protect the position of the company) is to appoint an Administrator over the affairs of the business. Once the administrator is appointed, the Corporations Act prohibits the landlord or owner of the property of the company taking possession of it without the consent of the administrator or the court. Likewise, proceedings cannot be commenced nor guarantees enforced against directors or spouses or de factos of such directors.
As was the case in Kliens, the administrator uses the period of time of the administration with an effort to endeavour to secure a buyer of the business or otherwise restructure the company to ensure its survival.
As you can see from the above, the administrators are in a powerful position and the franchisees often feel frustrated and powerless in respect of their relationship with the administrators and in many cases the franchisees are captive of the franchisor. If they are owed money by the franchisor and the franchisees have done deals within six months of the appointment of the administrator, the franchisee may be asked by the administrator to pay back those monies. These are called voidable transactions.
Where a franchisee becomes insolvent, rather than the franchisor, the franchise agreement normally sets out in clear terms the ability of the franchisor to either terminate the franchise, buy back its assets or manage the franchise. Difficult situations arise where a franchisee appoints an administrator or worse still has one appointed by its creditor or a bank. Conflicts often arise in respect of working together, as the franchisor's key concern is to ensure that the franchised business model is maintained and obviously that he receives his royalties.
During the course of any potential insolvency, either the franchisor or the franchisee will have to deal with their bank. The worst possible scenario would be to hide relevant information from your bank so that they are surprised by the financial positions of the company. In such circumstances, a failure to work out difficult trading conditions and to be up front with the bank may result in the bank taking a hard line in relation to any defaults. The banks generally will have substantial security with charges or rights of re-entry in respect of taking possession of equipment and appointment of receivers or administrators.
One area that needs to be looked at carefully is dealing with various suppliers. When a supplier supplies products to either a franchisee or a franchisor, suppliers often have what is called a romalpa clause which is designed to keep ownership of the relevant goods until all monies are paid by the customer to the supplier. The difficulty arises when franchisors acquire products from suppliers and then on-supply it to franchisees. If the franchisor becomes insolvent, a difficult and complex issue arises relating to ownership of those products if the relevant supplier has not been paid.
There are always consequences of a franchisor failing and becoming insolvent for all parties involved.
In particular, when a franchisor fails, its franchisees experience a number of outcomes including the opportunity of going alone, becoming part of another franchise system, unemployment and the associated consequences such as marriage breakdown and relocation and, in most cases, financial loss.
The effect of the franchisor's failure will be different for every franchisee depending on:
- the amount of money the franchisee borrowed;
- how long the franchisee has been running its franchised business;
- how long the franchisee has been operating in a particular industry;
- the franchisee’s age and personal commitments;
- the franchisee's commitments in relation to the franchised business (leases, contracts, etc) and the remaining term left in relation to those commitments; and
- other considerations, depending on each system
Unless a franchisee is a creditor, it will not have a voice in the franchisor's insolvency, it will not share in the franchisor's insolvent estate and it may no longer hold the right to use the franchisor's brand unless a third party buys the franchisor's business and grants such right.
The franchisees often do not think to check their franchise agreement prior to signing it as to the consequences of the franchisor's insolvency, if any, as most franchise agreements do not provide for the franchisees to be able to terminate the franchise agreement if the Franchisor becomes insolvent.
When the franchisees first find out that the franchisor is in trouble, the franchisees' best option is to band together. However, they often only know of each other through the franchisor or loose networks and may not have the means of finding out each other details easily. (This is more often the case for mobile franchises or those with ability to work from home). In any case, the franchisees must always remember that they are still contractually bound to the franchisor or whoever purchases the franchise from the administrator or liquidator even if the franchisor is insolvent. Franchisees must meet other contractual obligations entered into as a consequence of becoming a franchisee, such as those to landlords, financiers, suppliers and employees. None of these will be contingent on the solvency of the franchisor.
It should not be forgotten that the buyer of the failed franchisor may choose not to buy the franchise agreements, or wish to re-negotiate the Franchise Agreements or to shelve the brand or merge. In this case, a franchisee may want to debadge his or her business from the franchisor's name and image and attempt to operate the same business on his or her own. Difficulties will arise if the franchise agreement contains restraint clauses (as is the usual case).
Any franchisee's best protection lies in prevention. Before entering the franchise agreement, a potential franchisee should consider how the franchisor’s failure would affect him or her and take it into account in the negotiations, as it would be the worst case scenario for a potential franchisee in the future. It should be remembered, however, that the franchisee is signing a fairly standard contract. The franchisee should try to include some basic clauses in its franchise agreement to mitigate its worst potential exposures, although this would still not prevent liquidators from disclaiming all contracts, including leases and franchise agreements. These clauses must be discussed with the franchisee's lawyer prior to signing of the franchise agreement in an attempt to include them in it.
Mason Sier Turnbull is one of Australia's leading franchising law firms with offices in Melbourne and Sydney and affiliations in New Zealand. Our franchise team is headed by Philip Colman, John Sier and Tony Garrisson and supported by a further 10 franchise lawyers and 6 support staff.
23-Sep-2008