Ebbing economic tide exposes retail shipwrecks
Some sectors such as household goods retailing, hospitality and services have had a decline in the trend estimate. But their negative trend is more than offset by the positive trend in food retailing, department stores, clothing and soft goods retailing.
Recent press surrounding administrations and insolvencies in the retail industry have created headlines more as a result of the brands involved rather than as a reflection of the retail industry as a whole or any sector of the retail industry.
Some recent examples are Kleins, Toy Kingdom and Groove Cosmetics.
The most recent mega-chain to make headlines was Starbucks, announcing the closure of 600 stores in the US and 61 of its 81 stores in Australia.
Each of these has been reported as having its own internal issues that are separate to or exacerbated by current economic conditions. For Kleins, it was the underwriting of franchisee lease arrangements and the failure to keep the brand and its products in step with current trends. Starbucks reportedly failed to adequately adapt its US model and product offering to the Australian market.
Starbucks is similar to the first attempt by Subway to enter the Australian market and the recent failure of the Quiznos chain. Subway’s initial inability to penetrate the Australian market saw them pull back only to return with a better adapted model.
The closure of the 61 Australian Starbucks stores will reportedly result in the redundancy of up to 685 employees. Downsizing, like insolvency, has substantial impact on employees, suppliers and franchisees.
In liquidation, creditors are paid out in accordance with the statutory priorities set out under the Corporations Act 2001. Employee entitlements are given priority over the claims of unsecured creditors.
Suppliers who have not taken security or (in the case of product supply) do not have functional retention of title arrangements, often find that there are no funds left after the employees and secured creditors have been paid out.
Franchisees are usually in an even more difficult situation where there has been an insolvency of the franchisor. Kleins is just one recent example. A University of New South Wales report in 2006 suggested that at least 40 franchisors ‘failed’ between 1990 and 2005 including Cut Price Deli (approximately 150 franchisees), Traveland (approximately 270 franchisees) and Century 21 Pty Ltd. The use of the term ‘failure’ in this context overstates the position because some brands such as Century 21 have continued to prosper under new ownership with an ongoing franchise model. The study does however demonstrate that large and established chains can fail.
Franchisees are in a difficult position because they are often unable to terminate the franchise agreement upon the insolvency of the franchisor or to ensure that the franchise agreement will continue.
In the absence of a specific provision in the franchise agreement, franchisees are left to pursue arguments such as frustration or fundamental breach of the franchise agreement and unjust enrichment if they want to exit the franchise arrangement.
Even if the franchisee wants to retain the franchise agreement the liquidator may disclaim the franchise agreement without leave of the Court if it is unprofitable. Similarly the franchisor may disclaim the premises lease and the franchisee’s occupancy right.
In January 2006, the research report prepared for CPA Australia, “When the Franchisor Fails”, used the example of Kernels Extraordinary Popcorn (Jatora Pty Ltd). All of the leases for the 24 Kernels stores (20 franchised, two operating under management and two company owned) were held by the franchisor. Following the appointment of the administrator all of the leases were disclaimed. This left the franchisees in a position of needing to negotiate their own occupancy with the owner of their store.
Further, franchisees who are not creditors of the franchisor will not be entitled to participate in the distribution of the insolvent estate or even participate in the creditors meetings during which decisions about the future of an insolvent franchisor are made.
This highlights the importance for all parties in a franchise relationship to ensure that the franchisor’s business operates efficiently and can adjust to market conditions and competition. While individual franchisees are focused on supporting initiatives that drive the financial performance and profitability of their own store, they also need to support initiatives that are in the best interests of the network. I am aware of one high profile franchisor that recently identified in-fighting between franchisees and lack of support for the system as the biggest risk ever faced by their network. This risk was seen to significantly outweigh the current economic environment as a risk factor.
As can be seen from the recent examples of Kleins and Starbucks, the underlying operations of the business need to be monitored and challenged and they need to be commercial and capable of constant change to keep up with changes in economic conditions, competition and consumer tastes.
This need for prudence applies equally for suppliers who should ensure that they have appropriate credit checks, credit limits, security arrangements and effective retention of title clauses built into their terms and conditions of trade. Suppliers should also be alive to The Personal Properties Securities Bill 2008 which, once passed, will significantly change the way security is taken over assets.
Under that bill, trade creditors that supply goods on retention of title arrangements and those who own goods that they lease to others may need to take additional steps, such as registration, to protect their interest in goods. The register will also be an additional source of information about the operations of the recipient of the supply.
To borrow a quote recently attributed to Solomon Lew, "Headwinds remain significant for retailers". Those headwinds are felt most by retailers who have developed inappropriate, uncommercial or inefficient practices during the recent good times. To stretch the analogy somewhat, a receding economic tide will expose shipwrecks and faulty bedrock.
The opposite is of course true - those with an efficient and adaptable business model who have the confidence in their business appear best placed to win market share in the medium term.
By Warren Scott, Partner - Mills Oakley lawyers
25.09.2008
FCA Member
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