In February this year, the press in the UK took a break from Brexit for a few days and led with a story about KFC's supply chain crisis, which saw almost two thirds of its 900 + stores in the UK close due to a lack of chickens.
The majority of these stores are franchised and the resulting loss of revenue and negative PR could not have come at a worse time given the current pressures that all businesses in this sector are facing.
The story helps shine a light on the importance of supply chain management and also how the different parties which rely on it need to protect themselves from a contractual and legal point of view.
Who "fowled" up?
The root cause of the closures appears to have been operational issues under a new chicken supply contract between KFC and DHL.
In November 2016, Yum Brands-owned KFC revamped its supply chain in the UK by ending its relationship with delivery company Bidvest and entering into a three-way partnership with DHL and Quick Service Logistics (QSL).
Whilst it is not thought that trying to stuff chickens into brown jiffy bags was the issue(!), it has been reported that DHL only uses a single depot from which to deliver all of the KFC ingredients to its stores across the UK, and deliveries were compromised by a new and malfunctioning IT system. Poor planning and risk/contingency mitigation also exacerbated the problems.
What can franchisors learn from this?
In most franchise supply chains, the franchisor or its nominated supplier will supply certain key products to the franchise network. Where the franchisor is the supplier, the terms of supply will often be set out either in the franchise agreement itself or in the Manual or in a separate set of standard supply terms. In our opinion, the third option is the best for the franchisor as it enables a franchisor to update supply terms from time to time and ensures that the network is supplied on uniform terms. In an international context, franchisors and its developers or master franchisees may enter into a supply agreement for that particular market.
It is not clear in the KFC example whether KFC is the de facto supplier to its franchisees, or DHL and QSL enter into their own supply terms with each franchisee. For the purposes of this article we have assumed that KFC is the contractual supplier to its franchise network.
Managing Supplier Liability
Where the fulfilment of the supply is outsourced to a third party, a franchisor should ensure that it has in place a robust agreement covering the following key aspects:
- A clear set of service levels with sanctions for failure to meet them.
- Clear guidelines and a clear process on what happens when something goes wrong and time is of the essence. This should cover issues like defective products, product recalls and failure to supply.
- Warranties which set clear expectations in respect of the goods and services provided.
- Indemnities to ensure the appropriate allocation of risk under a contract. An indemnity is a promise to pay money on the happening of a specified event. If drafted with care and precision, they can have a number of advantages over a simple claim for damages for breach of contract; indemnities are not necessarily subject to a duty to mitigate loss, they do not need to be limited by causation or the remoteness of the losses, they can require payment without proof of loss and they are useful if the loss continues over a period of time. In the context of KFC, indemnities for the failure to supply, reputational damages and any "downstream" liability from the franchise network would have been advisable.
- Penalties – Following the Supreme Court joint judgment in the cases of Cavendish Square Holding BV v Talal El Makdessi and ParkingEye Ltd v Beavis, there is now more flexibility for a party to impose contractual penalties where they are protecting a "legitimate interest". Financial penalties may therefore form part of the approach to risk allocation.
- Limitations and exclusions of liability - it is not uncommon for a supplier to limit or exclude their liability for certain losses. It is therefore important to check these clauses carefully to ensure that they do not neutralise other aspects of the agreement, such as indemnities or breach of warranty.
- Insurance and guarantees – the overall allocation of risk and financial liability of the parties is not worth the paper it is written on if the defaulting party is unable to meet those liabilities. The party looking to enforce its rights should ensure from the outset that adequate insurance cover is in place and it may also be worth exploring whether it is possible to secure some form of fiscal guarantee, such as a bank guarantee, letter of credit or parent company guarantor.
Due Diligence, Contingency Planning and Managing Reputational Damage
Clearly, putting all of its eggs on one basket with a new supplier operating from a centralised warehouse was a gamble KFC would not take with the benefit of hindsight. Using a "hub and spoke" warehousing and distribution model would have mitigated the impact.
Franchisors should also ensure that they have in place contingency plans and protocols for when something as potentially serious as a failure to supply occurs. KFC turned to Stowga, a warehouse on-demand start-up service (think Airbnb for warehouses). KFC's property consultants contacted Stowga who bid for and secured 8 warehouse spaces within minutes and within days these sites were operational. This flexible model could be the future for a number of businesses, and not just as a contingency measure.
Contingency plans should also include clear guidance for how franchisees can best mitigate their losses, as well as a public relations strategy to minimise damage to the brand and customer goodwill. KFC did respond to this crisis with an advert that has been hailed a "masterclass" in PR crisis management. The full-page image on the back cover of London's Metro newspaper showed an empty bargain bucket with the company's logo rearranged to read "FCK", with an apology to customers and thanks to its staff and franchises.
Managing Franchisee Liability
Franchisors should keep under regular review review their template franchise agreement, the Manual and any separate terms of supply. Franchisors should consider the following points:
- Are there any supply terms and if so, are they comprehensive enough and do they reflect actual practice?
- If the supply terms are not contained within the franchise agreement, are they validly incorporated into the transactional process?
- Do they expose the franchisor to any onerous commitments or liabilities which the franchisor is not covered for, either by its own insurance cover and/or by appropriate indemnities in its upstream agreements?
- How regularly are the supply terms reviewed and updated to take account of legal developments (such as modern slavery reporting) and best practice? How are the updates communicated to the franchise network?
- Do they strike an appropriate balance between, on one hand, the need for the franchisor to operate an efficient supply chain across the network and on the other hand, the need for a franchisee to have a degree of certainty over its ability to respond to a crisis?
Ultimately, supply chain management is a significant but often neglected aspect of a franchisor's business. If a franchisor mismanages the types of risks highlighted by the KFC crisis or other issues such as franchisee credit, it may very quickly be faced with an existential crisis.
What can franchisees learn from this?
Given the standardised nature of most franchise agreements and any related supply terms, franchisees may not have much recourse against their franchisor for failure to provide products. Nevertheless, franchisees should consider the following points:
- What, if anything, do the supply terms say about the obligation to deliver products and what happens if delivery is delayed for any reason?
- Is a franchise entitled to source products from alternative suppliers when there is a temporary interruption to supply?
- How are risks allocated under the contract, and what does it say in respect of limitations and exclusions of liability? For standard form contracts, franchisees may be able to challenge particularly onerous clauses as unreasonable and therefore enforceable under the Unfair Contract Terms Act 1977.
- What does the franchise agreement say in relation to supply and consequent allocation of risk and liability? In the event of a failure to supply, a franchisee may have some form of claim for breach of contract and depending on the gravity and effect on their business, there may also be grounds for claiming a repudiatory breach of contract, which would also entitle a franchisee to terminate the franchise agreement and claim damages.
- Does the Manual include any guidance on supply and contingency plans? In any event, franchisees should ensure that they are able to mitigate their own losses, particularly in relation to the management of their employees during periods of forced closures or limited operations.
Finally, whilst a single franchisee (unless it is a substantial operator with multiple units) is unlikely to be able to influence changes to the supply chain and the terms which govern it, if the franchise system has a franchise council, this would be the appropriate forum for engaging with the franchisor to ensure that when these types of events occur, their interests are adequately protected.
They say that out of every crisis comes an opportunity. The opportunity for franchise businesses is to look again at the management and procurement of their supply chains and the terms which govern the upstream relationships with third party manufacturers and suppliers and the downstream relationships with franchisees.
The obvious starting point is to carry out a risk analysis of the template franchise agreement, the Manual and any separate terms of supply and associated policies and procedures.
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.