Franchisors, as with any other business, are at risk of becoming insolvent. In recent years, some well-known franchise systems have been placed in administration including pastry chain, Pie Face. Franchisees should understand what a franchisor’s insolvency means for the operation of their business, and take steps before entering into a franchise agreement to minimise any potential risks.
What is Insolvency?
Insolvency occurs when a company can no longer pay their debts when they are due. There are three common methods for insolvency procedures:
- Voluntary administration
An administrator, receiver or liquidator will be appointed to represent the franchisor’s interests and may:
- determine whether the company can continue operating; or
- wind up the company and sell the company’s assets to pay back existing creditors (e.g. suppliers, landlords or employees).
How Does Insolvency Affect a Franchisee?
How a franchisor’s insolvency impacts a franchisee will largely depend on the arrangements between each franchisee and franchisor.
A franchisee will likely have an obligation to continue operating the franchise business despite the franchisor’s insolvency. This is because the administrator can continue to operate the franchisor’s business and collect franchise fees, maximising the asset pool to pay back creditors. This will occur unless the franchise agreement includes specific clauses stating your obligations cease if the franchisor is insolvent.
If the administrator continues operating the franchise business, the franchisee must still pay franchise fees to the franchisor, including royalty and marketing fees. as well as any outstanding debts.
The impact on franchisees that operate their franchises from a fixed premises depends on who entered into the lease agreement. If the franchisee holds the lease agreement, their rights to occupy the property don’t depend on the franchisor’s financial situation.
But if the franchisor holds the lease agreement, the franchisee may no longer be able to occupy the premises — especially if the terms of the lease allow the landlord to terminate the lease for insolvency, or the franchisor has failed to make rental payments.
The appointment of an administrator could have terrible consequences for franchisees sub-leasing from their franchisor. We then recommend franchisees secure a lease directly with the landlord at the outset if possible.
Your relationship with a supplier may be affected if a franchisor directly entered into supplier agreements and sold you supplies. This is because the supplier may no longer be committed to fulfilling orders until debts have been paid.
5. Intellectual Property
If the franchisor does not directly own the franchise’s intellectual property (IP), the franchisor’s insolvency may affect their rights to license the IP to other parties, for instance, franchisees. Unless the franchisee obtains the rights to use the IP from the IP owner, the franchisee may no longer be able to operate using the franchise’s business name or logo.
What About the Money Owed to the Franchisee?
The appointed administrator may choose to terminate your franchise agreement. If so, you become an unsecured creditor. This means that a secured creditor will have their debts repaid first.
Can a Franchisee Terminate the Franchise Agreement if the Franchisor is Insolvent?
As mentioned above, unless there is a specific clause the franchise agreement, the franchisee can’t terminate the franchise if the franchisor is insolvent. A franchisee can terminate, however, if it can establish that the franchisor breached the franchise agreement. Although you can argue that the franchisor’s inability to perform their obligations under the franchise agreement constitutes a breach, you should speak with a franchise lawyer first about collecting evidence of the breach.
How Can a Franchisee Protect Their Business?
A franchisee can protect their franchise by following these steps.
1. Due Diligence
You should undertake thorough due diligence of the franchisor to determine whether they are at risk of being solvent or likely to remain solvent throughout the term of the franchise agreement. If the franchisor entity exists within a corporate group, it may also be worthwhile to determine the solvency or the other entities to ensure all aspects of the business are financially stable.
Although it may be difficult to negotiate the terms of the franchise agreement, there are useful clauses that may be inserted to provide franchisees with protection, including:
- A clause that allows the franchisee to terminate the franchise agreement if the franchisor is insolvent.
- A clause requiring the intellectual property owner to take over the rights of the franchisor in the case of insolvency.
- A warranty that the franchisee will continue to have rights to use the intellectual property for the remainder of the term by obtaining the rights through the intellectual property owner.
- A clause allowing the franchisee to de-brand and terminate the franchise agreement if the franchisor entity goes into administration for any reason.
- A clause requiring the franchisor to ensure that they remain solvent.
Franchisees are in a vulnerable position when it comes to the insolvency of the franchisor, and the Franchising Code of Conduct does not provide protections in this regard. To manage your risk, it is important to thoroughly undertake due diligence of the franchisor and negotiate protective clauses in the franchise agreement. If you have any questions or need advice about next steps if your franchisor is insolvent, get in touch with LegalVision’s franchise team on 1300 544 755.
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