As a franchisee, it is important to be aware of the financial health of your franchisor.
While there are certain pieces of information that must be included in the franchisor disclosure document, access to detailed information about a franchisor’s finances may be limited. This can leave you vulnerable if your franchisor suddenly becomes insolvent.
In this article we will discuss why it’s important as a franchisee to stay informed about your franchisor’s financial standing and what rights you have should your franchisor become insolvent.
Overview of Franchisor Insolvency
Rights and obligations arising from Franchisor Insolvency
Administration and Liquidation arising from Franchisor Insolvency
Overview of Franchisor insolvency
A company is "insolvent" when it is unable to pay its debts as and when they fall due.
If a company becomes "insolvent" there are a number of options available, including liquidation and administration.
Franchisors that have become insolvent and have entered into administration or liquidation include:
- Century 21 (1998)
- Kleins (2008)
- Kleenmaid (2008)
- Angus & Robertson (2011)
- Billy Baxters (2012)
- Aussie Farmers Direct (2018).
If a franchisor enters into administration or liquidation, this may have consequences for its franchisees (which we will discuss further below).
While liquidation or administration are options arising from franchisor insolvency, section 588GA of the Corporations Act 2001 allows directors to continue to trade a company which is in financial distress, provided they are taking a course of action reasonably likely to lead to a better outcome. These provisions, known as "safe harbour" provisions are designed to enable a company to trade out of insolvency.
The ipso facto regime also aims to improve a company's chances of recovering from insolvency by limiting the power of its counterparts to terminate contracts or take other actions based only on the company's financial state.
Rights and obligations arising from Franchisor Insolvency
Disclosure of Materially Relevant Information
Clause 17(2) of the Franchising Code requires a franchisor to advise a franchisee or prospective franchisee in writing within a reasonable time (not more than 14 days) after the franchisor becomes aware of it, if the franchisor or an associate of the franchisor becomes a Chapter 5 body corporate.
A Chapter 5 body corporate means a body corporate:
-
- that is being wound up; or
- that is a CCIV of which one or more sub-funds is being wound up; or
- in respect of property of which a receiver, or a receiver and manager has been appointed (whether or not by a court) and is acting; or
- that is under administration; or
- that has executed a deed of company arrangement that has not terminated; or
- that is under restructuring or has made a restructuring plan that has not terminated; or
- that has entered into a compromise or arrangement with another person the administration of which has not been concluded.
Clause 17(2) of the Franchising Code is a clause 5A civil penalty clause. This means that if a franchisor fails to comply with clause 17(2) of the Franchising Code, clause 5A of the Franchising Code will apply. The penalties under clause 5A are significant (the minimum penalty being $10,000,000).
So what happens after a franchisee is notified that a franchisor or an associate of the franchisor has become a Chapter 5 body corporate?
Termination for Franchisor Insolvency
If a franchisee becomes bankrupt, an insolvent under administration or a Chapter 5 body corporate, subject to the ipso facto regime, clause 29 of the Franchising Code allows a franchisor to terminate a franchise agreement immediately if the franchise agreement was entered into before 1 July 2021, or on 7 days' notice if the franchise agreement was entered into after 1 July 2021.
However, the Franchising Code does not include a right for a franchisee to terminate the franchise agreement if the franchisor becomes an insolvent under administration or a Chapter 5 body corporate.
Franchise agreements also generally allow a franchisor to terminate the franchise agreement if the franchisee becomes bankrupt or insolvent (subject to the ipso facto regime).
Conversely, franchise agreements do not generally allow a franchisee to terminate the franchise agreement for franchisor insolvency.
In addition, because franchise agreements contain many obligations on the part of franchisees (including the obligation to pay fees), if a franchisor is not able to terminate the franchise agreement immediately (or on 7 days' notice) for franchisee insolvency, a franchisor can issue a Breach Notice (if the franchisee is in breach of the franchise agreement), providing the franchisee with a reasonable time to remedy the breach and giving the franchisor the right to terminate the franchise agreement if the franchisee does not remedy the breach.
However, given that franchise agreements are generally drafted in favour of the franchisor and do not usually impose specific obligations on the franchisor, a franchisee may be unable to terminate the franchise agreement for breach or repudiation even if the franchisor is insolvent and under administration.
Consequently, although the franchisor is insolvent and possibly under administration, a franchisee may be required to continue to operate the franchise business and to continue to pay fees under the franchise agreement.
The voluntary administration of Angus & Robertson provides an example of what can happen if a franchisee attempts to terminate a franchise agreement on the basis of franchisor insolvency.
Angus & Robertson was a book store franchise which went into voluntary administration in 2011. A group of franchisees issued termination notices arguing that they were no longer receiving the benefits of the franchise agreements. The administrators disagreed, arguing that the franchisees did not have the right to terminate the franchise agreements (for example the franchisees were still using the Angus & Robertson name). The parties attended mediation, after which the franchisees agreed to withdraw the termination notices.
Administration and liquidation arising from franchisor insolvency
While the franchisor may be able to trade out of insolvency, there may be circumstances under which the franchisor is forced to enter into administration and possibly liquidation.
If a franchisor enters into administration the voluntary administrator will investigate and report to creditors about the franchisor's financial circumstances. There are three options available to creditors of the franchisor:
- end the voluntary administration;
- approve a Deed of Company Arrangement;
- wind up the franchisor company and appoint a liquidator.
Given the franchisee, franchisor relationship is a contractual relationship, franchisees do not have the same rights as creditors if the franchisor enters into administration. For example franchisees do not have the right to receive information (although administrators and liquidators often provide franchisees with information) and franchisees do not have the right to attend or vote at creditor's meetings (unless invited by the administrator or liquidator).
In some limited circumstances, franchisees may also be creditors. For example some Kleins' franchisees were also creditors because their franchise agreements contained income guarantee clauses under which the franchisor owed the franchisees money.
If the franchisor enters into liquidation, a liquidator will be appointed to wind up the company. The liquidator protects, collects and sells the franchisor's assets the majority of which may be in the form of franchise agreements, leases, licences and other intellectual property (ie intangible assets).
While a franchisee generally will not have the right to terminate the franchise agreement as a result of franchisor insolvency, liquidators can disclaim leases, licences or franchise agreements if they are viewed as being onerous contracts.
If a liquidator disclaims a franchise agreement, the franchisee will lose the right to operate the franchise business even if the franchisee wants to continue to operate throughout the liquidation process.
Further, if the franchisor is the lessee under the lease, a liquidator may disclaim the lease, leaving the franchisee to negotiate directly with the landlord. As the franchisee is not a party to the lease, the franchisee will not have any rights under the lease (including the right to renewal).
If the franchisee is unable to negotiate directly with the landlord to secure the lease then the franchisee may incur significant losses in relation to the cost of the fit out as often the biggest cost for a franchisee in commencing operation of a franchise business is the fit out cost.
In the Kleins example, Kleins was underwriting franchisee leases for some franchisees by subsidising the rent (paying the landlord the full rent payable and charging franchisees a lesser amount). When Kleins went into liquidation some franchisees were unable to pay the full rental amount and consequently were unable to continue to operate from their current sites (even under another brand).
Marketing Funds
In 2019 the liquidators for Aussie Farmers Direct sought clarification from the Court about the status of the funds held in the marketing fund (RE: Stay In Bed Milk and Bread Pty Ltd (in Liquidation) (2019) VSC 181). The Court held that the funds held in the marketing fund were not to be returned to the franchisees on the basis that:
- the marketing fund was not expressly made a trust under the terms of the franchise agreement;
- the franchise agreement did not provide for a return of the marketing fund on termination of the franchise agreement;
- the franchisor was permitted to apply marketing funds at its discretion;
- the monies held in the marketing fund were not held on trust for the franchisees.
Consequently, generally if a franchisor goes into liquidation, the funds held in the marketing fund will not be returned to franchisees in preference to other creditors (unless the franchise agreement includes specific provisions in relation to the return of the funds held in the marketing fund).
In accordance with the principal of disclosure and education, the Key Facts Sheet (introduced in 2021) prescribed under the Franchising Code includes the following statement:
Note that if the franchisor becomes insolvent, you may not get money back that you have given to the franchisor, including contributions to the marketing funds.
Takeaways
The focus of the Franchising Code is disclosure and education rather than providing any specific rights for franchisees if a franchisor becomes insolvent.
Importantly:
- the introduction of "safe harbour" laws and the ipso facto regime may allow a franchisor to trade out of insolvency;
- the clause 5A penalties introduced under the Franchising Code should ensure that a franchisee is notified if a franchisor or an associate of a franchisor becomes a Chapter 5 body corporate;
- the appointment of an administrator or liquidator does not allow a franchisee to terminate a franchise agreement;
- a liquidator may choose to disclaim a franchise agreement, lease or licence that impacts the operation of the franchise business;
- franchisees do not generally have any rights to the assets of the marketing fund on liquidation.
While franchisees currently have limited rights if a franchisor becomes insolvent, the federal government has announced that it expects another review of the Franchising Code in the second half of 2023. Consequently, we will wait to see whether franchisor insolvency is an issue that forms part of the latest review.
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.
