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Franchise Code: Issues of Franchise Failure, Part 1

The Federal Government is seeking comments in relation to many of the recommendations made by the Senate Inquiry into Australian franchising.  The Options Paper divides the Senate recommendations into 4 parts, the first part dealing with franchisor failure and whether any better avenues exist to balance rights and liabilities in the event of franchisor failure.  Here are some my thoughts on the subject:

Part 1 - issues impacting on franchisees in the event of franchisor failure

Recommendation 1 of the Senate Committee is that disclosure documents provide a clear statement by franchisors of the liabilities and consequences applying to franchisees in the event of franchisor failure (referred to herein as a "clear statement").

The first significant problem with this recommendation is that the liabilities and consequences of franchisor failure cannot be fully known in advance and are significsantly dependent upon the actions of third parties, such as secured creditors or administrators/liquidators.

For example, until an administrator decides whether to disclaim obligations such as supply contracts, leases of premises - and even the franchise agreements themselves - whether the franchised business can continue will be unknown, meaning that the franchisor can do no more than guess what the possible consequences of a franchise failure might be.

The clearest statement that can be made by a franchisor is that a franchisee, through no fault of their own, could lose his or her investment, business, business premises, income and personal assets (and face the possibility of bankruptcy) in the event that the franchisor cannot meet its financial obligations as and when they fall due.

This is of course largely meaningless in disclosure terms because it does nothing more than restate the actual position of any franchisee in any franchise system.

In some circumstances the failure of a franchisor has little consequence for a franchisee where they lease (or own) the premises directly, have access to suppliers and have a profitable business.  These franchisees may immediately trade independently however it is the franchisees with high levels of debt to service and who occupy the premises under a sub-lease that are most at risk from a franchisor failure.

Trade Practices Act consequences

For a corporation to make a representation about future matters it must have reasonable grounds for doing so, otherwise it will be deemed to be a misrepresentation (s.51A TPA). 

The result of requiring a "clear statement" where the consequences cannot be accurately assessed may trigger a breach of the Trade Practices Act.

This affects not just the franchisor corporation, but potentially also its officeholders for a participatory breach (s.75B TPA). 

The benefits of ‘earlier disclosure'

Disclosure Documents are largely historical documents and require annual updating, except to the extent that ‘any materially relevant facts' are to be disclosed.  However disclosure does not give rise to rights if the franchisee is already in the system, so 'earlier disclosure' of franchsor failure is a somewhat curious concept. 

By the time the materially relevant facts are known it is generally too late for the franchisee to alter their position. 

To have any meaningful effect, franchisees would require ongoing reports as to the financial status of the franchisor - effectively a regime whereby franchisors would have to report in a similar manner as listed public companies, which is a disproportionate response.

In certain circumstances the relevant information will not be known until the event occurs (such as a failure event or the appointment of the administrator) and hence an "earlier disclosure" is not possible.

Including a "clear statement", as proposed, will do nothing to alleviate or prevent the causes of franchisor failures; the Kleenmaid and Kleins failures are prime examples. 

The Senate recommendations are also silent as to what, if any, rights might accrue to a franchisee from even a timely disclosure of franchisor financial difficulties - the franchisor will have not committed any breach of its obligations to the franchisee until at least it has defaulted upon its obligations to third parties and perhaps not even then.

A regime of further financial disclosure by franchisors will only benefit prospective or renewing franchisees who have the option to decline the franchise - it will do nothing to protect or enhance the rights of the existing franchisees. 

Legal advice and legal rights upon appointment of administrators

A legal adviser, when faced with the "clear statement" can do nothing more than draw his client's attention to the warning and will be largely unable to advise on the extent of the risk because of the range of possible future events.

Prospective franchisees often do not properly access legal, accounting or business advice prior to entering into a franchise agreement in any event (often being caught up in the excitement of the transaction to such an extent that they cannot or will not contemplate anything other than the success of the venture). 

This is compounded by a general lack of appreciation by legal advisers of the issues that are relevant to advising a prospective franchisee about the franchise agreement.   

Negotiation of agreements is generally not favoured by franchisors (citing the need for uniformity within the franchise system).  Changes that may be agreed are usually not significant; for example, I have not heard of a successful negotiation for the grant of a personal guarantee from the directors of a franchisor to secure the financial interests of a franchisee in the event of a franchisor failure.

I am not aware of a franchise agreement that gives the franchisee the right to terminate the franchise agreement in the event that the franchisor fails.

However section 23 of the Code provides that a franchisor does not have to comply with the termination provisions of the Code - that is, the franchisor can immediately terminate the franchise agreement - where the franchisee becomes bankrupt, insolvent, under administration or an externally administered body corporate. 

There is no reciprocal provision for franchisees.

Most common problems in franchisor administration

By far the most significant problem for franchisees when administrators have been appointed to the franchisor is the actions of the administrator itself.

The administrator has the power to disclaim (and hence terminate) leases of franchised premises (the landlord is preventing by law from terminating the lease) leaving the franchisee without premises.  The administrator can also disclaim supply contracts, delivery agreements and even the franchise agreement itself as a normal part of the administration. 

Even if the franchisee secures its premises, dealing with the administrator in the role as franchisor can be a highly unsatisfactory experience. 

The administrator will usually inform the franchisees that they are required to comply with the terms of their franchise agreements.  However - and this is most important - no administrator is prepared to accept the liabilities and ongoing obligations of the franchisor.

Arguably, if the administrator has not disclaimed the franchise agreement, it is obliged to ensure that the franchisor continues to meet its contractual obligations. However because of the long term nature of some of these obligations (such as leases, supply contracts, income guarantees or rental rebates) the administrators cannot agree to accept those obligations.

This leaves the franchisee in a confused position - even at law - because on the one hand they are being required to comply with their franchise obligations but are dealing with an administrator who will not accept the franchisor's full role. 

If the franchise system is sold the franchisee may find that their franchise agreement has been transferred to a competitor without any input into the process.

Depending upon the wording of the franchise agreement, the administrator may even have the power to compel the franchisee to accept and pay for stock and so improve the net position of the franchisor at the expense of the franchisee (e.g. Kleins).

Finally, if the franchisee is owed money by the franchisor, the franchisee is only an unsecured creditor receiving no priority for the payment of their debt.

Comments in relation to Recommendation 4 and general suggestions

In order to balance the rights and obligations upon franchisor failure (Senate reommendation 4), certain steps can be taken:

1. Amend clause 23 of the Code to allow a franchisee the right to terminate the franchise agreement if a franchisor becomes bankrupt, insolvent, under administration or an externally administered body corporate.

This will reduce the prospect of selling the franchise system as a going concern but will give the franchisee greater options tp participate in any sale.

Where the franchisee (or the administrator) terminate the franchise agreement, the administrator should supply the franchisee with all information relevant to the franchised business including matters where relevant such as the lease of the premises, the terms of supply agreements and suppliers, delivery contracts and whether any further stock is available from the administrator or another member of the franchise group.

The franchisee should also have a limited use of the Intellectual Property of the franchisor to allow a transition to another franchise group or to an independent business - say 30 days.

No restraint of trade should be permitted to be enforced against a franchisee in the event of a termination due to franchisor failure.

2. Make a debt owed to a franchisee by the franchisor a priority in the administration, ranking behind secured creditors but ahead of unsecured creditors.

3. Ensure franchisees are able to occupy the franchised premises during the course of an administration provided that the franchisee pays the rent.

This will be a limitation upon the powers of administrators to disclaim leases in circumstances where the franchisee occupies the premises pursuant to an arrangement with the franchisor.

4. Limit the ability of administrators to supply stock to franchisees except as may be required by the franchisee, or as requested by the franchisee.

5. Require franchisors to provide to each prospective franchisee consolidated (or benchmarked) data for the financial performance of the franchise network - including a reference to the average earnings of a franchise based upon their length of time in the system - for the preceding 3 years.

Rather than attempting to focus upon franchisor viability, which is always subject to rapid variation as with any business, by providing a prospective franchisee with the actual historical earnings of the franchise network, without identifying individual stores, the prospective franchisee will be able to obtain a much better picture of the financial health of the franchise store and the franchise network overall. 

By referencing the age of each franchise store, a prospective franchisee will have a much better idea of the likelihood of trading profitably in the first years of operation, based upon the experience of others using the franchise system.

This approach will also limit the ability of franchisors to ‘churn' unsuccessful franchise locations and systems.

The franchisor will have to ensure that the information provided is accurate, but will not have to make any representation that the prospective franchisee will achieve similar results.

6.  And for something a bit left field how about....

Develop (in conjunction with the relevant Law Associations) a protocol for lawyers to follow when advising on franchise agreements - including the information to be supplied - and make it compulsory for the prospective franchisee to provide a copy of the lawyers conclusions to the franchisor for further disclosure or response.

This is part 1 of the following 4 part series:

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