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The Parliamentary Inquiry into the Franchising Code of Conduct was released in early 2019. It provided insight into the large number of franchisees who are caught in difficult financial troubles with no way out. It discussed the possibility of changing the law to give franchisees termination rights in certain circumstances, particularly when the franchisee’s business is making a significant loss. This article will discuss: 

  • the current lack of termination laws for franchisees;
  • what suggestions have been made to change this; and 
  • the possible implications for franchisors if these suggestions become law.

 What Is the Current State of Affairs? 

It is currently rare to come across a franchise agreement which provides a franchisee with an express and written right to terminate their contract.

Without an express right to terminate, a franchisee has limited options. Often, the only options available to franchisees are to sell their franchise on the market or negotiate a mutual termination.

The current legal framework favours franchisors. This is because it helps ensure that the franchisor’s training and onboarding a new franchisee does not go to waste. It also reduces the risk of a franchisee ending the franchise arrangement early and competing against the franchisor.

However, the Inquiry Report indicates that this can also leave franchisees in a vulnerable position. An independent small business owner is able to close up shop and liquidate to avoid trading in a bankrupt state. On the other hand, the provisions of the franchise agreements effectively prevents franchisees from doing so.

If a franchisee has an obligation to keep the business running, they could lose money or be put at risk of trading in a bankrupt state.

This has led many franchisees sending submissions to the parliamentary committee asking to terminate the Franchise Code.

What Is the Committee Suggesting?

The committee noted that exit arrangements do not provide a way for franchisees to exit an ‘impracticable’ franchise in a way that is fair to both parties and minimises financial losses. As a result, the Report recommends that the Code introduce three different exit arrangements. These exit arrangements would allow a franchisee to initiate an exit from their franchise agreement before the end of the term.

The Report highlights three franchisee business performance metrics that the Code could use to decide whether to terminate an agreement. These are:

  1. Franchisee Net Profit after Tax (NPAT);
  2. Franchisee Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA); and
  3. Franchisor Net Profit after Tax (NPAT) for that business.

Depending on the state of these metrics, termination could be triggered under the exit scenarios outlined below.

 

Exit Scenario

Description

Proposed Termination Right   

‘Hardship’

 

Franchisee NPAT < 0

Franchisee EBITDA > 0

Franchisor NPAT > 0

In this scenario, the franchisee business is making a profit, but the franchisee is facing hardship because either the business is over-worked or the franchisee is unable to operate the business in usual fashion.

  • A franchisee can trigger early exit with ‘protection’ against exploitation in a buyback process (however, the Report does not detail what these protections would look like).
  • As a result of early exit, a franchisor is allowed to claim damages. In this case, the franchisor may only claim six months or the remaining balance of the term of  the franchise agreement, whichever is less.

‘Exploitation’

 

Franchisee NPAT < 0

Franchisee EBITDA < 0

Franchisor NPAT > 0

If the franchisee’s NPAT and EBITDA are negative, but the franchisor’s NPAT is positive, this indicates franchisor exploitation. This is because the franchisor can be making a profit from the store, either by ongoing royalties or rebates, while the franchisee is making a loss.

  • A franchisee can initiate termination in this scenario after nine  months of the business falling into this scenario.
  • A franchisor will be liable for the costs of breaking the lease.
  • A franchisor will pay the franchisee’s portion of upfront fees paid back to them (corresponding to the portion of the term that has passed at the time  of termination).

‘Business Failure’

 

Franchisee NPAT < 0

Franchisee EBITDA < 0

Franchisor NPAT < 0

In this scenario, all metrics are negative, indicating a business failure. Here, both parties are making a loss relating to the franchisee store/business. It does not benefit either side to continue operating.

  • A franchisee can trigger termination with notice of no more than 90 days.
  • A franchisor is prevented from seeking a balance of fees for the remainder of the franchise agreement term.
  • The franchisee is not required to continue to perform the franchise agreement.

Should a ‘Special Circumstances’ Right of Termination Be Given to Franchisees?

There is a ‘special circumstances’ right of termination given to a franchisor. This means that if a franchisee acts fraudulently or otherwise, the franchisor is able to end the agreement. The Report recommends that this right should also be given to franchisees. This is so that a franchisee would be able to terminate the franchise agreement if the franchisor were facing liquidation. 

For example, a franchisor may become bankrupt or acts fraudulently in connection with the franchised business. In this case, the franchisee would be able to end the franchise agreement. 

What Are the Implications for Franchisors?

Any changes to the law of this kind will have significant implications for franchisors, including:

  • a loss of security over income through ongoing royalties; 
  • less certain site control; and 
  • weakened leverage in settlement discussions.

Importantly, lawmakers have not made any laws to allow the committee’s proposal to be legally enforceable. Nevertheless, as a franchisor, you should consider the impact that laws of this kind could have on your system. For example, you may wish to:

  • avoid sites where the franchisee is unlikely to succeed (the exploitation scenario is the most troubling. In this case, franchisors should avoid moving forward with franchise agreements simply because they will make a profit from franchise fees and rebates);
  • apply the model to your franchise system (use your franchisee reports to determine where each franchise falls within your system. This will provide a good indication of the changes needed to avoid the fallout from the possible changes to the law); and
  • make sensible expenses changes (if several franchises in your system fall within one of the three scenarios set out above, consider what expenses could be minimised to push more stores or businesses into NPAT and EBITDA positive).

Key Takeaways

The Parliamentary Inquiry into the Franchising Code of Conduct has suggested three different exit arrangements. These would provide franchisees with rights to exit their franchise agreement. Although they are not legally binding, it is important for all franchisors to consider the impact of the law on franchised businesses. If you have any questions about termination rights for franchisees, contact LegalVision’s franchise lawyers on 1300 544 755 or fill out the form on this page.

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