Australia: Protecting your position when franchisees become insolvent

Franchising Focus

In many businesses you can see insolvency coming, but in franchising it often comes out of the blue. And it is just as likely to be caused by extraneous factors as by the business itself. Sometimes the only indication that a franchisor has that one of its franchisees is in trouble will be increased personal disengagement, or queries from third party suppliers about the franchisee's failure to pay. This is even the case where franchisors receive regular reporting on turnover and other key indicators, as rarely does that information include external personal commitments of the franchisee.

There are a number of practical measures that franchisors can take to deal with threatened or actual insolvency by franchisees, and to ensure that the franchisor's rights in relation to the insolvent franchised business are protected. This article looks at these measures, and discusses what might happen should a franchisee become insolvent.

Reporting and solvency statements

One simple but effective way to monitor the financial state of franchisees is to include in your standard franchise agreement a provision requiring franchisees to provide, on demand and within a stipulated time period, details of all business and personal expenditure of the franchisee together with a solvency statement. The solvency statement is a declaration from the franchisee that there are reasonable grounds on which the franchisee will be able to pay its debts, including personal or non-business debts, as and when they fall due. On its own the solvency statement may not be sufficiently convincing, so the franchisee should be required to support the statement with financial evidence of its solvency state.

These requirements flush out personal expenditure commitments, and give a more complete picture of the franchisee's financial position. The value of the solvency statement requirement is that where the franchisee fails to provide the statement or supporting evidence, the franchisor can either conduct an audit of the financial records of the franchisee, or initiate the notice of breach process under clause 21 of the Franchising Code of Conduct (Code).

Do you terminate the franchise agreement?

Franchisors will have immediate termination rights that comply with clause 23 of the Code where a franchisee becomes bankrupt, insolvent, under administration or an externally administered body corporate. But termination may not be the desired approach, as it may crystallise other things including options to purchase and the rights of banks and landlords to take action. The franchised business typically will have far greater value as a going concern. A franchisor will want to recover all money owing by the franchisee, and may wish to take over an unfulfilled orders placed by clients of the franchisee, and purchase current inventory from the franchisee. The franchisor will also want to protect the reputation and goodwill of the brand and system.

Recovering money owing by the franchisee may prove a difficult and frustrating exercise for a franchisor. This will be particularly so where the franchisor is an unsecured creditor. In such circumstances, the franchisor is likely to find itself waiting in a long queue with other unsecured creditors for payment of its debts (or most probably a reduced percentage of those debts). As an unsecured creditor, the franchisor's rights will be subject to the priority rights of secured creditors (ie: secured creditors get paid first).

If the franchisor refrains from terminating, and uses the power of future termination as a lever in negotiations with the liquidator, administrator or receiver a better net outcome may be possible. On the flip side, in some forms of insolvency termination is not possible once a person is appointed. So it is necessary to assess the specific circumstances prior to taking any action. Once lawfully terminated, a franchise agreement cannot as a matter of law be un-terminated.

Protecting goodwill

Where a franchisee cannot trade out of its debts or has simply had enough, it might appoint a voluntary administrator to manage a sale by gathering up the assets of the franchisee and seeking a purchaser to enable the franchisee to satisfy all outstanding debts. In circumstances such as this, protecting the goodwill of the system should be at the forefront of the franchisor's mind.

Critical to this exercise will be ensuring that adverse brand publicity does not result from the insolvency, or indeed from the actions of the insolvency practitioner in trying to realise the assets. It may be that the franchisor wants to be able to "step in" and operate the business that is insolvent to protect goodwill and reputation, and also to trade the business to a point where it is a sufficiently attractive proposition for a third party purchaser to acquire the business as a new franchisee. It may be that the franchisor wants to control the sale process, or prevent the use of the brand in the sale advertisements. These options can be included in a well-drafted franchise agreement.

If the franchisor wants to secure operational control and step in to the business the most effective means is to register a charge over the assets of the franchised business. Where franchisees are able to run up large debts with franchisors, for example by ordering stock, it is sensible for franchisors to obtain a fixed and floating charge over the business and assets of the franchisee. This should take place when the franchise is granted.

In addition to securing any and all moneys owing to a franchisor, the charge will (if properly drafted and registered first in priority) permit the franchisor to exercise an extensive range of additional rights ahead of the rights that other creditors may have. One of the most important of these is the ability to appoint a receiver. Other powers include step in rights empowering franchisor's to operate the franchisee's business in the event of insolvency or the appointment of a liquidator, and the right to receive income from the business, etc.

By exercising its rights under a charge to control a franchised business, the franchisor will become a controller under the Corporations Act 2001 (Cth). This has a number of consequences:

  1. on the franchisor taking possession of franchised business, ASIC must be notified of the appointment of a controller;
  2. the franchisor must file a report with ASIC within 2 months of taking over; and
  3. the franchisor must take reasonable care to sell the charged property for not less than market value.

Once a charge is registered it will rank in priority ahead of all subsequent fixed and floating charges. This is critical where the franchisee, over the term of the franchise agreement, borrows money from financial institutions and secures its repayment obligations by the granting of charges. The franchisor's fixed and floating charge will not however "trump" any fixed and floating charges that have been registered earlier, or fixed charges (which normally secure the payment of debt by charging specific fixed assets such as motor vehicles).

Where the franchisee intends to take out security over it business assets, the inclusion of a provision in your standard franchise agreement requiring the franchisee to provide notice to, and obtain the consent of, the franchisor, is suggested.

Dealing with landlords

If the franchisor chooses to step in and operate the franchisee's business, consideration will need to be given to the existing tenancy arrangements in respect of the business premises operated by the franchisee. Where the franchisor has the head lease over the franchise business premises, the franchisor will be able to terminate the sublease that it granted to the franchisee and, if it wishes, continue operating the business under the head lease. However, where the franchisee has taken out the premises lease directly with the landlord and the franchisor wishes to operate the business at the premises that has been leased, the franchisor will need to negotiate the grant of a fresh lease from the landlord, or an assignment and possibly an extension to the existing lease.

One way to avoid this position is to request that landlords sign a Right of Entry Agreement by which the landlord agrees to allow the franchisor, as the charge-holder, to enter onto the leased premises and run the business using its powers under the charge. By signing this agreement, the landlord essentially agrees not to terminate the lease for default (insolvency by a tenant is a common default event). Even if the franchisor does not intend to operate the franchisee's business, it must as a minimum ensure that it has the right to gain access to the leased premises to remove plant and equipment secured by the charge.

Another issue which needs to be considered by the franchisor is ownership of the franchisee's fixtures and fittings in the leased premises for the purpose of running the business. Where the franchisor wishes to operate the franchisee's business on termination of the franchise, it will invariably need to use the fixtures and fittings. To allow this, an agreement must be reached with the landlord allowing both use, and if necessary, removal of those fixtures and fittings. These matters could be addressed in the head lease with the landlord, or in the Right of Entry Agreement.

Personal Property Securities Act

It is important to be aware that the Personal Property Securities Act 2009 (Cth) (PPSA) will soon be in operation (expected to be February 2012). PPSA will fundamentally change the law in Australia about security interests over personal property, and priorities between competing security interests. The effect of the PPSA is that security interests over personal property will need to be registered on a central computer based register called the PPS Register.

Subject to some exceptions, personal property will include all property (except land and fixtures), tangible property (eg: motor vehicles, plant and equipment, inventory, crops and livestock) and also intangibles (eg: intellectual property, contractual rights and shares). A security interest will be an interest in relation to personal property provided for by a transaction that, in substance, secures payment or performance of an obligation.

Most existing security interests that are registered on existing registers (such as a charges registered with ASIC) will be migrated across to the new PPS Register. However, PPSA is likely to substantially affect the way traditional security interests such as registered charges operate (eg: the concept of crystallisation relevant to floating charges will become redundant).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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