B2B Lawyers on franchising

According to B2B Lawyers , the definition of solvency under the Corporations Act is: “A person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable.” In typically helpful statutory language: “A person who is not solvent is insolvent.” Whether a company is solvent or insolvent will depend on a number of factors, and is often a somewhat more nebulous question than the apparently straightforward statutory definition would suggest.

These factors will include a company’s net asset position, its cashflow situation and whether it has external financial support.

For example, a company may be able to pay its debts as and when they fall due, and therefore be solvent, notwithstanding a net negative asset position on the balance sheet if another party has pledged financial support. Conversely, a company may have a positive net asset position yet be insolvent if it is unable to liquidate assets with sufficient speed to pay its debts as and when they fall due.

Insolvent trading

Directors will often, unwittingly or otherwise, allow a company to continue to trade for some time after becoming insolvent, exposing themselves to civil penalties and personal liability for the company’s debts that have been incurred in the course of the insolvent trading, as well as potential criminal liability.

Liquidation

The ultimate result is often that the company is wound up in liquidation, usually on a creditor’s petition or by resolution of the directors. The assets of the company are sold up by the liquidator, who is usually appointed by the court or the board of directors, and the proceeds are distributed to creditors according to the securities they respectively hold and rules of priority set out in Part 5.6 Division 6 of the Corporations Act, and (in theory) any surplus capital is returned to the members.

The liquidator may be able to increase the pool available to creditors by taking action against directors for insolvent trading or by taking action to reverse related party uncommercial transactions, unreasonable director-related transactions or unfair preferences. An unfair preference essentially involves an unsecured creditor getting paid ahead of other unsecured creditors at a time when the company was insolvent and in the six-month period prior to a day defined in section 9 (the relation back day), which will be a day on or near the day the liquidation commenced. A creditor, in defending a preference action, may be able to rely on the defence in section 588FG(2) which, over-simplified, requires the creditor to have received the payment in good faith and have no reasonable grounds to suspect the company was insolvent. Unfair preferences that are recovered go into the pool of funds available for general distribution to creditors as a dividend.

Administration

Putting the company into administration can be a way of avoiding a winding up and ensuring the survival of the company, if this is desired. An administrator may be appointed:

• by resolution of the company’s directors if the company is insolvent or likely to become insolvent at some future time;

• by appointment in writing by a person who is entitled to enforce a charge on the whole, or substantially the whole, of the company’s property in the event of a default under the charge; or,

• by a liquidator.

Upon the appointment of the administrator, he or she assumes the control and running of the company’s affairs, and the powers of the company’s officers are suspended unless and only to the extent the administrator gives approval in writing.

The administrator is personally liable for debts incurred subject to an indemnity for such debts (and his or her remuneration) out of the company’s property.

The commencement of the administration triggers a moratorium during which:

• a court may and usually does adjourn any winding up application;

• all civil proceedings against the company are stayed and enforcement proceedings suspended;

• chargees have 10 days to decide whether to act upon their charges; and

• lessors cannot retake possession of property occupied by the company, without the administrator’s consent.

This enables necessary breathing space for the company’s affairs to be investigated for the purposes of administration, but also means the administration must proceed on a strict schedule.

Within five business days of the appointment, the administrator must convene a first meeting of creditors at which the appointment may be either confirmed or terminated by resolution of the creditors, who may also by resolution appoint an alternative administrator who has consented to act. To be carried, a resolution of creditors requires a majority in value (majority of total value of all debts whether secured or unsecured) and a majority in number. Unlike in a personal bankruptcy, a secured creditor can vote the full value of its debt without waiving its security. The administrator has a casting vote where a resolution is carried by either a majority in number or a majority in value, but not both.

A committee of creditors can also be appointed at the first meeting, with which the administrator has certain duties to consult and provide reports.

After confirmation of his or her appointment, the administrator is required to investigate the company’s affairs and form an opinion about whether it would be in the interests of the company’s creditors:

• for the company to execute a deed of company arrangement (DCA);

• for the administration to end; or

• for the company to be wound up.

A DCA is analogous to a Part X arrangement in bankruptcy law and will involve, at its simplest, creditors accepting a percentage of what they are owed in full and final settlement of their entitlements, thereby clearing the company’s debts so that it can survive and avoid being wound up in liquidation. This will also save creditors from preference actions and may save directors from insolvent trading claims that could occur if the company goes into liquidation and more fulsome investigations are undertaken.

The funds for a DCA are raised externally, for example by the directors or related parties of the directors. The administrator will recommend a DCA if it will result in a better return to creditors than a winding up. This involves the administrator making an assessment of the recoverability, if the company goes into liquidation, of unfair preferences, unfair loans, uncommercial transactions, and any insolvent trading losses for which compensation could be sought from the company’s directors (such action usually requiring further investigation).

An administrator is required to hold a second meeting of creditors within 21 days of being appointed (usually 14 days after the first meeting). At the second meeting (subject to any adjournments), the creditors may resolve:

• that the company execute a DCA (if one has been proposed by the directors on behalf of the company);

• that the administration should end;

• that the company should be wound up.

If there is a ‘hung vote’ with respect to a proposed DCA (that is, the resolution is supported by a majority of creditors in value but not number, or vice versa), the administrator will usually exercise a casting vote in accordance with his recommendation.

Receivership

A holder of a registered company charge will be able to appoint a receiver (or ‘receiver and manager’) in the event of default under the terms of the charge. The company need not be insolvent, although a company’s insolvency will in itself be an event of default under the terms of any charge.

The receiver takes control of the company’s assets, including the business itself, and manages them in protection of and in order to realise the chargee’s interest. However the receiver also owes duties to the body of creditors as a whole and the company’s members.

A receiver may work alongside an administrator, but if the administrator is appointed first, the chargee has only 10 days to decide whether to act on the charge. Often the chargee will simply let the administration take its course, as the receiver (unlike the administrator) will require remuneration and an indemnity from the chargee.

Franchisor business structures

Asset protection is the key insolvency-related issue with respect to planning a business structure.

It is advisable to operate a franchising business through a different entity from other business interests so that, if any one of these businesses is unsuccessful, losses will be contained within the relevant entity and the business assets in the other entities will (as much as possible) be unaffected.

The intellectual property of the franchise should be held in a separate, single purpose, non-trading company which licenses it to the franchisor. The franchisor should be a separate trading entity that sub-licenses the intellectual property to franchisees. Accordingly, if the franchisor becomes insolvent, the intellectual property of the franchise will not become available to the franchisor’s creditors. The licensor will be able to cancel the licence and license a new entity, and the franchising business can then be sold by the liquidator or administrator at a reasonable price to the new entity, which will be the only interested purchaser, and which can continue to operate the franchise. The intellectual property of the franchise business will include:

(a) the goodwill attaching to the business name and reputation;

(b) any registered trademarks, patents or designs;

(c) copyright in the design and presentation of goods or services, promotional and advertising materials, procedure manuals; and,

(d) confidential information such as customer lists, supplier lists, know-how and special practices.

The licence agreement should provide for payment of a fee by the franchisor to the licensor at a proper market rate. An accountant or registered valuer should be retained to determine the arm’s length market value of the licence.

The franchisor should also give a registered charge over the whole of its assets and undertaking in favour of the licensor to secure payment of the licence fees. To the extent licence fees fall into arrears, the assets of the franchisor (subject to any competing securities) will be protected for the benefit of the licensor ahead of unsecured creditors. For the same reason other related parties that advance loans to the franchisor should also be given registered charges to secure their investment.

A separate lease-holding company can also be set up to lease the premises that are sub-leased or licensed to franchisees. The guarantee to the landlord should be provided by the franchisee’s directors (at a minimum). This means that control of those premises can be retained and, at the same time, any liability arising if a franchisee breaches lease responsibilities can be quarantined within the leasing entity and, as much as possible, not become a direct liability of the franchisor. Similarly, if the franchisor becomes insolvent, control of leases will be retained by the separate lease-holding company, just as the intellectual property is retained by the intellectual property-holding company, thereby facilitating the transfer of the franchising business to the new entity.

Consideration should also be given to having company stores in a separate entity that is not owned by the franchisor entity (but perhaps owned by the owners of the franchisor entity) so that any losses incurred by a company-owned store are quarantined within that separate entity.

Under section 588V, a holding company can be held liable for the insolvent trading of its subsidiary. The entity owning and operating a company store might be a family trust.

Franchisee business structures

Anyone taking up a franchise offer should, for the reasons discussed above, hold the franchise and operate the franchised business in a separate entity from his or her other business interests.

Other than this, however, a franchisee will not have a lot of say or flexibility in determining its own business structure.

For example, the franchisor will not allow the franchisee to hold its rights under the Franchise Agreement in a separate entity from the entity operating the franchised business, even though this may be analogous to what the franchisor does.

Preparing Franchise Agreements and related securities

Invariably the franchisor prepares the Franchise Agreement and related documents, and there is generally minimal opportunity on the part of a franchisee to negotiate variations because of the desirability or necessity, from the point of view of the franchisor, that the same franchise arrangements apply to all franchisees. The Franchise Agreement should contain the following provisions to protect the franchisor’s interests in the event a franchisee becomes insolvent:

• If the franchisee becomes insolvent or commits an act of insolvency, this will constitute an event of default entitling the franchisor to terminate the Franchise Agreement. The occupancy agreement or sub-lease with respect to the franchisee’s premises should contain a similar provision to enable the lease-holding company to take possession of the premises.

• Similarly, an unauthorised change in control of the franchised operation must also be an event of default. This will take effect if, for example, a trustee in bankruptcy is appointed over the estate of an equal or majority shareholder of the franchisee company.

• An acknowledgment by the franchisee that the success or failure of the franchised operation is dependent on its own efforts and the franchisee assumes responsibility for the success or failure of the franchised operation. This is an attempt (albeit perhaps of limited effectiveness) to limit any damages claim against the franchisor; for example, for alleged misrepresentations or failure to provide appropriate assistance if the franchised operation fails.

• The franchisee is prohibited from mortgaging or encumbering the franchised operation or its rights under the Franchise Agreement, without the franchisor’s written consent (which the franchisor can withhold in its absolute discretion). This is to prevent third party interests getting in the way of the franchisor taking over the franchised operation in the event of termination.

• An authority in favour of the franchisor to make reasonable enquiries of the franchisee’s suppliers, customers, bank and trade personnel for information or copies of documents.

• Appropriate retention of title provisions with respect to stock that the franchisee has not yet paid for.

• If the franchise is terminated, the franchisor must have the option of taking over the franchised operation, or causing it to cease operating. To this end, the Franchise Agreement should provide that if the franchise is terminated:

i. The franchisee delivers up all documents relating to the franchised operation and ceases to use all intellectual property.

ii. The franchisee must, if required by the franchisor, transfer all leases of business assets in relation to the franchised operation to the franchisor, and the franchisor is appointed the franchisee’s attorney to implement such transfers.

iii. Alternatively, the franchisee must, if required by the franchisor, destroy all signs and features relating to the franchise appearing on the franchisee’s business assets.

The Franchise Agreement also needs to facilitate the protection of the franchising business in the event that the franchisor becomes insolvent. It should contain a provision allowing the franchisor to assign its rights and obligations under the Franchise Agreement in its absolute discretion, for two important reasons.

First, if the franchisor becomes insolvent, this could render it unable to fulfil its obligations under the Franchise

Agreement and entitle franchisees to terminate (notwithstanding there will be no express provision to this effect in the Franchise Agreement). If this occurs, it is also arguable that the restraints of trade entered into by the franchisee would be rendered unenforceable.

Second, where the franchising business structure discussed above has been adopted, such a provision will facilitate the transfer of the franchising business to a new entity if the licensor cancels the franchisor’s licence of intellectual property and licenses that new entity.

Additional securities

• Guarantee and indemnity by directors of franchisee in favour of franchiser. This must be prepared as a principal agreement as the guarantor may have fewer defences to an action for recovery of, say, franchise fees than the franchisee. If the guarantor becomes insolvent, this should also constitute an event of default under the Franchise Agreement, entitling the franchisor to terminate the franchise (notwithstanding that the franchisee itself may be solvent.)

• Registered charge by the franchisee in favour of the franchisor over the assets and undertaking of the franchisee. This will:

i. Secure outstanding franchise fees and other amounts owed by the franchisee to the franchiser, giving the franchisor priority over other creditors if the franchisee is wound up in liquidation;

ii. In the event of a default under the Franchise Agreement, give the franchisor power to appoint a receiver and thereby take control of the franchised operation, but not the costs and risks involved in the appointment of a receiver discussed previously;

iii. Give the franchisor power to appoint an administrator of the franchisee’s affairs if the franchisee becomes insolvent or commits an act of insolvency (for example, fails to comply with a statutory demand or leaves a judgment debt unsatisfied). Why this might be done by the franchisor is discussed below.

If the franchisee is an individual or a partnership of individuals, the franchisor should consider a registered mortgage or charge on real estate, or a chattel mortgage. In most instances, however, the franchisor should insist that the franchisee adopts a corporate structure so that the franchisor can have the comfort and powers given by a registered company charge.

Postponement of debt covenant

This is a security provided by the franchisee to the franchisor to ensure loan accounts of directors of the franchisee operation are not paid out in preference to making payments due to the franchisor or lease-holding company.

Chattel lease

This secures the franchisor’s interest where a franchisor-owned store is sold to a franchisee and the fitout is sold on terms to the franchisee.

Disclosure Document

It is in the interests of both franchisor and franchisee that the disclosure statement makes full and accurate disclosure of all matters required under the Franchising Code of Conduct, so that:

• The franchisee is fully informed in making a decision to enter into the Franchise Agreement and in the process of setting up the franchised operation; and,

• If the franchised operation fails, the franchisor is protected from a claim for damages for misleading and deceptive conduct or an attempt on this basis by the franchisee to exit the franchise without fulfilling exit obligations.

In particular, the franchisor’s business model and its underlying assumptions must be able to stand up to independent, expert scrutiny. If the model contains significant flaws, which result in the franchised operation failing, the franchisor may well be held to account for the franchisee’s trading and other losses.

Similarly, the application of the franchisor’s business model to the local conditions of the proposed franchised operation must also be able to bear expert scrutiny. Usually the franchised operation will be required to operate in a fairly rigid way, for example with respect to stock, pricing and marketing, in order to maintain uniformity across the franchise. Accordingly, the franchisor bears an especially large part of the responsibility for ensuring the franchised operation is located in a suitable area, having regard to the demographics of the local market, as the nature of the franchised operation will give it limited flexibility to adapt to local market conditions if they are unfavourable.

There is also an argument that where the Franchise Agreement imposes minimum sales performance obligations on the franchisee, this amounts to a representation that those sale performance requirements are achievable. If they are not achievable, due to flaws in the business model, the imposition of those requirements on the franchisee may come back to haunt the franchisor

For these reasons, it is strongly recommended that the franchisor retain a financial and business expert to review the business model and its application to the particular proposed franchised operation in order to ensure, and sign off on, its efficacy.

This is particularly important as an action by the franchisee for damages under section 82 of the Trade Practices Act may also lie against directors of the franchisor personally, who have engaged in misleading and deceptive conduct or been involved in the misleading and deceptive conduct of the franchise.

Franchisee focus

When a franchised operation begins to fail and the prospects of a reversal of fortune appear bleak, the franchisee’s imperative will generally be to find a way out of the franchise in a way that minimises its losses.

The Franchise Agreement will almost never contain express provisions regarding the circumstances in which a franchisee can terminate.

So, ideally, the franchisee can point to sufficiently serious breaches of the Franchise Agreement by the franchisor, or sufficiently serious misrepresentations by the franchisor, to terminate the agreement and have a claim for damages. If the franchisee purports to terminate without proper grounds, this will amount to a repudiation entitling the franchisor to terminate and claim damages against the franchisee and its guarantors.

In particular, the franchisee should note any history of breaches of the Franchise Agreement by the franchisor (including with respect to the provision of all proper assistance by the franchisor) and any history of misrepresentations (including in the Disclosure Document). The business model provided by the franchisor should be thoroughly investigated by a business expert in relation to the considerations discussed above.

If ammunition along these lines can be gathered against the franchisor, the franchisee will have some leverage in negotiating a controlled exit. An extra piece of ammunition might be the prospect of proceedings under section 82 of the Trade Practices Act against the directors of the franchisor personally for their involvement in contraventions by franchise of section 52 (misleading and deceptive conduct). The best way to achieve this is often at mediation, with a strong mediator, especially if the Franchise Agreement contains a mediation provision. Under the Franchising Code, mediation of disputes is compulsory. If the franchisee or a guarantor of the franchisee becomes insolvent, the franchisor will be entitled to terminate the Franchise Agreement as well as to act on personal guarantees from the directors with respect to outstanding franchise fees and the like.

There are, however, a number of reasons why the franchisor may not wish to see the franchisee go into liquidation:

• Payments by the franchisee for stock (in the absence of a charge) may be recoverable by a liquidator as unfair preferences, particularly given that the franchisor will usually have a detailed knowledge of the franchisee’s day-to-day affairs and will have trouble establishing a defence of receiving the fees in good faith with no reasonable grounds to suspect the franchisee was insolvent. Franchise fees will not ordinarily be vulnerable to preference claims unless the franchisee has fallen substantially into arrears and made ‘catch-up’ payments during the relation back period.

• Because of the franchisor’s close involvement in and control of the running of the franchisee’s business, the franchisor may be at risk of being deemed to be a ‘shadow’ director within the section 9 definition (if the directors of the franchisee are accustomed to acting in accordance with the franchisor’s instructions or wishes), in which case the franchisor could be liable for debts incurred by the franchisee in the course of insolvent trading.

• It will send negative signals to other franchisees in the group or prospective franchisees.

• A liquidator is in the privileged position of having the power to assign causes of action, and he or she may sell any cause of action the franchisee has against the franchisor to a third party.

If it is in the interests of the franchisee to enter a deed of company arrangement, as opposed to go into liquidation, these matters may give the franchisee some leverage in negotiations with the franchisor, which will probably be the main creditor. Alternatively, these arguments might be used to obtain concessions from the franchisor to prevent the franchisee becoming insolvent in the first place.

The appointment of an administrator, rather than a liquidator, will also freeze any action by a landlord to re-enter the franchisee’s premises, which is also to the benefit of the franchisor if the franchisor wishes to consider taking over the franchised operation.

The franchisor in this scenario will need to be wary of the risks it may face when deciding on the various options available to it, including termination of the franchise agreement and/or appointing a receiver or administrator if it has a charge over the franchisee’s assets and undertaking.

When the franchisor founders

If this occurs, the franchising operation will hopefully have a structure similar to what has been proposed in this article, in which case there will be some hope of the franchising operation surviving through a new entity.

As discussed, it will almost never be an express provision of the Franchise Agreement that the insolvency of the franchisor will constitute an event of default.

However, steps should be taken to ensure there is no lapse in the performance of the franchisor’s obligations under the agreement in order to avoid a situation whereby franchisees become entitled to terminate their agreements, thereby stripping the business of its value and putting at risk the collection of outstanding franchise fees by the receiver, administrator or liquidator.

If not, various scenarios are possible, among them:

• Franchisees might get together and purchase the franchisor’s business from a liquidator.

• Franchisees might be in a position to terminate their Franchise Agreements and potentially even be freed of any restraints if the insolvency of the franchisor has rendered it impossible for it to honour its obligations under the Franchise Agreement.

Help is at hand for those who want assistance with buying a franchise or running a franchise.