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FRANCHISOR AND FRANCHISEE INSOLVENCY

Dr Jenny Buchan, UNSW Business School

Conference1 December 2016

Outline1. Franchise failure

2. How many fail?

3. Indicators and causes of failure

4. An example

5. The law

• Contract

• Competition and Consumer Act 2010 (Cth)

• Code

• Corporations Act 2001 (Cth)

6. What accountants can do

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Franchise failure

• Franchisor failure

• Having a receiver appointed under Ch 5.2

• entering administration under Part 5.3A (‘VA’)

• being wound up under Part 5.4 when insolvent

• under the provisions of the Corporations Act 2001 (Cth)

• Franchisee failure

• The same as for franchisor failure – except:

• Causes may differ

• The impact on the brand and on other franchisees is different

1. Franchise failure

2. How many fail?

3. Indicators and causes of failure

4. An example

5. The law

• Contract

• Competition and Consumer Act 2010 (Cth)

• Code

• Corporations Act 2001 (Cth)

6. What accountants can do

4jm.buchan@unsw.edu.au

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How many franchisors fail?

• 251/347 franchisors in 1999 Australian Franchising Yearbook and Directory (72 %) were no longer franchising 12 years later.

• 2008 → 2010: Of 1,100 franchisors trading in Australia• 56 had ceased operating

• a further 88 ceased franchising. Total 144

• =13 % – more than one franchisor in 5 over 2 years.

• 2010 → 2012: 48 more franchisors had ‘departed’ franchising.

• Not all departures ‘fail’.

• Data difficult to assemble.

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How many franchisees fail?

• Statistics unreliable about:

• how many fail

• whether more likely to fail than independent businesses

• what caused the failure

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• The average proportion of franchisors to franchisees is 1:60

• One franchisor failing potentially has a greater economic impact than one franchisee failing.

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1 Angus & Robertson: 48 franchisees

Franchisor failures

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Traveland: 270 franchisees Pizza Hut buyer considers

Eagle BoysPrivate equity firm Allegro Funds, (owner of the Australian operations of Pizza Hut) is understood to be considering rival chain Eagle Boys, which is currently in administration (2016)

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1. Franchise failure

2. How many fail?

3. Indicators and causes of failure

4. An example

5. The law

• Contract

• Competition and Consumer Act 2010 (Cth)

• Code

• Corporations Act 2001 (Cth)

6. What accountants can do

9jm.buchan@unsw.edu.au

Why businesses fail: 13 general indicators

1. Continuing losses

2. The liquidity ratio being below 1

3. Overdue taxes

4. Poor relationship with banks, inability to borrow further funds

5. No access to alternative finance

6. Inability to raise further equity capital

7. Suppliers insisting on cash on delivery (COD) terms, or otherwise demanding special payments before resuming supply

8. Issuing of post-dated cheques

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Why businesses fail: 13 general indicators

9. The company has dishonoured some of the cheques paid to creditors

10. Special compromise arrangements made with selected creditors

11. Solicitors’ letters of demand, summonses, judgments or warrants

issued against the company

12. Payments to creditors of rounded sums not reconcilable to specific

invoices

13. Inability to produce timely and accurate financial accounts to display

the company’s trading performance and financial position, and to

make reliable forecasts. (list from ASIC v Plymin (2003) 46 ACSR 126)

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Franchisor-specific indicators of possible insolvency

1. Large proportion of the outlets being owned by the franchisor may indicate that some failed franchises have been returned to the franchisor

2. Long history of failures on the part of franchisees in the franchise network

3. Breach of a franchisor’s obligations to provide advertising support, equipment and inventory on a timely basis

4. Evasive answer to the franchisee’s queries when a franchisor default has taken place

5. Landlord’s notice of demand

12jm.buchan@unsw.edu.au

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Franchisor-specific indicators of possible insolvency

5. Large number of court proceedings against the franchisor

6. Restructuring. … the franchisees may see invoices from different companies

7. When the probability of company’s insolvency increases, its operating costs and revenues will be adversely affected. → The flow-on effects of the franchisor receiving less favourable trading terms are noticeable to franchisees who are required to source stock /services through their franchisor

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Franchisor-specific indicators of possible insolvency

8. Information in the franchisor’s balance sheet, the profit and loss statement, or announcements made to the ASX pointing to an accumulation of significant debt when the franchise system is not expanding, or the writing down of assets, or refinancing activities

9. Information from credit reporting services about a franchisor company’s financial health

10. Failure on the part of the franchisor to make timely commission payments

11. Announcement of impending listing followed by failure to list

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Causes of franchisor failure: external factors

• Currency fluctuations

• Increase of import duties

• Withdrawal of an important source of products

• Aggressive and cheaper competitor

• Severe downturn in the economy

• Franchisor’s parent company fails.

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Causes of franchisor failure: internal factors

• Franchisor fraud, greed or blind optimism

• Poor franchisee selection

• Insufficient support of franchisees

• Inexperienced franchisor

• Failure to replace key person

• Persistent conflict

• Intra-system competition - outlets being located too close

• Under capitalization

• Too rapid expansion

• Not responding to changed market conditions

• Poor product or service

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Anticipating the failure

• Franchisees often do not/ can not see the franchisor failure coming

• The franchisor is in a stronger position to know when a franchisee is failing

17jm.buchan@unsw.edu.au

Choosing failure? Via strategic insolvency through the VA process a franchisor may…• Reorganize its operations

• Deleverage its balance sheet

• Sell assets

• Refinance, or improve its capital structure

• Voluntary Administration may assist a franchisor in :• addressing overexpansion in the market• eliminating units • unworkable equity structure • sale or merger of system• threat of franchisee litigation • desire to refinance [hampered because] the lender has

expressed concern about financial or other issues. (Foster & Johnsen)

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Why franchisees fail

• Any of the 13 general indicators of business failure (above) +

• Franchisor has failed and:

• head lease was in franchisor’s name

• franchisor’s IP was sold to another entity

• commission agency model (eg: Kleenmaid, Beach House Group) → cash flow from franchisor dried up

• franchisor-branded/sourced product / service

• Collateral damage:

• franchisor-related company failed (eg: Traveland, because Ansett failed)

• unrelated franchisor failed and franchisee could not be relocated (eg: Gloria Jean’s in Angus & Robertson stores)

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1. Franchise failure

2. How many fail?

3. Indicators and causes of failure

4. An example

5. The law

• Contract

• Competition and Consumer Act 2010 (Cth)

• Code

• Corporations Act 2001 (Cth)

6. What accountants can do

20jm.buchan@unsw.edu.au

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Angus & Robertson: 1886 - 2011

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A&R starts franchising

1886

1946

1977

1990

1993

1995

1996

2001

2004

02/2008

11/2008

2009

08/2009

2010

02/2011

03/2011

06/2011

07/2011

08/2011

A&R starts bookselling

A&R takes license of 6 TMs from Pearson Australia Group P/L

A&R merges with Bookworld

New Zealand book retailer Whitcoulls Group Ltd joins the group

A&R opens an online store

Blue Star Group joins the group

WHSmith PLC purchased A&R and made a significant

investment in its continued development and growth

Venture Capitalist PEP20 acquired A&R and Whitcoulls from

WHSmith

ACCC does not oppose acquisition of Borders Australia

Outstanding loan balance $108m

PEP loaned RED $138m to buy Borders (AU, NZ and

Singapore). Debt cross-collateralised across RED

PEP consolidated booksellers A&R, Whitcoulls and Borders

under RED. RED owed PEP $118m secured over all RED assetsRED has 20% of the Australian Book Market

RED identified as a float candidate in 2010, disclosed full year

loss of $43m, breached financial covenants →received a waver

from its lenders

Borders USA into Chapter 11

Voluntary Administrator appointed to RED by secured creditor

PEP

A&R has 185 bookstores (124 franchisor owned and 61

franchisee owned) + No new gift cards are issued

No evidence of insolvent trading prior to today

1998

Administrators under no obligation to repay franchisees who

honour gift cards.

1st creditors meeting

Administrators closed 48 franchisor owned A&R stores

19 company owned A&R stores remain

Administrator guaranteed all employee entitlements for RED

employees would be paid in full

2nd creditors meeting

Gift card holders to receive final dividend in October 2011

ACCC assessed proposed sale of Borders and A&R online book

retailing business to Pearson Australia Group and found it not to

be in breach of merger guidelines

Deed Administrators appointed to 10 Australian and 5 New

Zealand companies pursuant to S444A Corporations Act 2001

…

Franchising Code of Conduct became mandatory in Australia

Rise and fall of Angus & Robertson

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REDgroup Retail Pty Limited

Supanews

Holdings Pty

Ltd

Spine Holdco

Pty Ltd

REDgroup

Online Pty Ltd

A&R Australia

Holdings Pty

Ltd

REDgroup

Retail

Administrative

Services Pty

Ltd

A & R

Bookworld

Cal. Club Pty

Ltd

Whitcoulls

Group

Holdings Pty

Ltd

Supanews

Retail Pty Ltd

Spine Newco

Pty Ltd

Borders Pty

Ltd

Borders

Australia Pty

Ltd

Angus &

Robertson Pty

Ltd

WGL Retail

Holdings Ltd

Calendar Club

New Zealand

Ltd

REDgroup

Online Ltd

Whitcoulls

Group Ltd

Borders New

Zealand Ltd= Franchisor

= Australian Company

= Singapore Company

= New Zealand Company

= In Voluntary Administration (AU)

= In Voluntary Administration (NZ)

= New Zealand Member of Deed of

Cross Guarantee effective 29/08/2009

= Australian Member of Deed of Cross

Guarantee effective 29/08/2009

Angus &

Robertson Pty

Ltd

Pearson

Australia

Group Pty

Ltd

Franchisor

operated

Franchisee

owned

6 Trademark

licenses

185 Stores

61 Stores124 Stores

RED Group at time of failure

Disclose this

entity

A & R franchisees

• A $380,000 investment

• Term 5+5

• Franchisee ‘had done a tour of the office [the same day the

administrator was appointed], [the REDgroup] had welcomed

us, the CEO had been in to talk to us the day before,” ... “call

me naive, but I can't believe that any of the staff in that

building on that day knew’. (Good staff and family support see stores

write another chapter. Light at end of the tunnel, 13 September 2011,

Sunshine Coast Daily, 20.)

• Required to continue trading throughout administration to sell warehouse stock → funded full payment of franchisor's employees’ entitlements

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1. Franchise failure

2. How many fail?

3. Indicators and causes of failure

4. An example

5. The law

• Contract

• Competition and Consumer Act 2010 (Cth)

• Code

• Corporations Act 2001 (Cth)

6. What accountants can do

25jm.buchan@unsw.edu.au

Contract and consumer protection vs insolvency

Solvent and

Trading

Trading under

Administration

Insolvent and

winding up

Consumer Protection legislation

Insolvency legislation

Problem: Embargo on commencing litigation against the party in administration

Theory: Franchisees can seek mediation or sue for misleading conduct

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Contract law issues

• Franchise agreements contain ipso facto clauses for franchisor use

• Agreements can not be disclaimed by administrators but they can chose not to honour them

• Franchisees remain bound

• Agreements can be disclaimed by liquidators (s 568 CA)

27jm.buchan@unsw.edu.au

Why don’t franchisees sue insolvent franchisors?

1: The franchisor has probably not breached the franchise agreement by becoming insolvent

2: An award of damages for breach of contract is ineffective against a party with no assets

3: Administrators’ and liquidators’ powers under the Corporations Act trump contract law rights

4: Insolvency of the franchisor will not free franchisees from contracts entered into between franchisees and other parties

5: Only a liquidator can initiate proceedings against a party in administration without the consent of the court

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Competition and Consumer Act 2010 (Cth)

• Misleading and deceptive conduct? In Moss v Lowe Hunt & Partners [2010] FCA 1181, Katzmann J held it was misleading or deceptive [under s 52 TPA] to describe a business as “successful” when, without the continued support of its parent, it would be insolvent.

• Unconscionable conduct• Is it unconscionable to advertise franchises for sale

when the franchisor is insolvent?• Is it unconscionable for banks to offer franchisee finance

when their franchisor client is showing signs of insolvency?

• Bar lowered for merger applications by administrator or liquidator

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Trade Practices (Industry Codes — Franchising) Regulations 2014 (‘The Code’)

• Requires disclosure of limited ‘associates’ (Cl 4 Code)

• Supports ipso facto clause for franchisors29 Termination—special circumstances

(1) … a franchisor may terminate a franchise agreement without [notice] if the agreement gives the franchisor the right to terminate the agreement should the franchisee:

(b) become bankrupt, insolvent under administration or an externally-administered body corporate;

• Applies to administrators but not to liquidators.

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Pre purchase due diligence?

Code prescribes disclosure requirements → then it is up to franchisee to conduct pre-purchase due diligence

FCA identified the main causes of franchisee failure to undertake effective due diligence as being:

• costs of professional advice

• lack of understanding as to the value of professional advice

• a belief that they do not need assistance

• ignorance of the Code requirement.

(Final Report, Franchises, Sixty-Fifth Report of the Economic and Finance Committee, Parliament of South Australia, 6 May 2008, 25)

31jm.buchan@unsw.edu.au

The Code: Cl 21 of Disclosure requires …

• Problem: Some franchisors sign the solvency declaration despite being insolvent:• Kleenmaid ‘hopelessly insolvent’ for past 14 months

• Beach House Group

• Kleins sold franchises while it was in ‘financial trouble’

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21.1A statement of the franchisor’s solvency that:

(a) reflects the franchisor’s position:

(i) at the end of the last financial year; or

(ii) if the franchisor did not exist at the end of the last

financial year—at the date of the statement; and

(b) is signed by at least one director of the franchisor; and

(c) gives the directors’ opinion as to whether there are

reasonable grounds to believe that the franchisor will be able

to pay its debts as and when they fall due.

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Snapshot or crystal ball?

Due diligence may not be capable of revealing insolvency risks

‘many franchisees entering franchises are not in a position

to anticipate the difficulties they may face as a result of the

failure of their franchisor. … The provision of … information

[about consequences of franchisor failure on a generic level

is] insufficient to address the current regulatory gap’.

(Final Report, Franchises, Sixty-Fifth Report of the Economic and Finance Committee, Parliament of South Australia, 6 May 2008, 37-38).

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Corporations Act 2001: Insolvency Process

• Purpose: to move a company in financial stress → resolution.

• Administration, an administrator is appointed to determine whether the company can be:

• (1) returned intact to the control of the directors, or

• (2) restructured and returned to the control of the directors, or

• (3) put into liquidation.

• If option (3) is chosen the administrator becomes the liquidatorand winds the company up.

• The liquidator’s role is to dispose of the failed company’s assets and pay its creditors. (http://www.asic.gov.au/asic/ASIC.NSF/byHeadline/Resources#4)

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Administrator appointed to franchisor

• Franchisees must continue to :

• adhere to the franchise agreement

• meet upstream and downstream contractual obligations

• Administrator owes no statutory duty to franchisees under CA except where they are creditors

• 21 day time between 1st and 2nd creditors meeting can be extended with consent of court eg: A & R nearly 28 weeks

• Stay of all proceedings against franchisor except administrator initiated / court approved ss 440D, 471(2) CA.

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Leases and administrators

• Division 9 Corporations Act : Administrator’s liability and indemnity for debts of administration.

• Administrator has 5 business days to make decisions before incurring personal liability for rent under pre-appointment leases. S. 443B(2) CA

• During the 5 days the administrator can give the lessors notice that the franchisor head tenant does not propose to exercise rights in respect of the property s 443B(3)CA.

• A notice served on a landlord under s 443B(3) does not terminate the lease. Silvia v Fea Carbon Pty Ltd (ACN 009 505 195) (Administrators Appointed) (Receivers and managers Appointed) [2010] FCA 515.

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Gift card dilemma for franchisees

Sell voucher

Pay royalties to franchisor on

value of voucher sale

Administrator appointed

Instructs franchisees no

reimbursement for vouchers

in the future

Franchisee continues to

accept vouchers from

customers

• Defy administrator’s

instructions

• Pay royalties as value included

in gross turnover

• Effectively, give book away

• Retain customer loyalty

• Comply with administrator’s

instructions

• Pay no royalties

• Keep stock

• Lose customer now and in

future

AC

CE

PT

RE

FU

SE

Liquidator

• Job is to wind company up and pay the creditors according to statutory priorities in s 556 CA

• Can disclaim onerous contracts under s 568 CA

• Franchise agreements, leases, supply agreements are assets or liabilities

• Can deal with IP if owned by franchisor, but difficult if IP in a separate entity

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1. Franchise failure

2. How many fail?

3. Indicators and causes of failure

4. An example

5. The law

• Contract

• Competition and Consumer Act 2010 (Cth)

• Code

• Corporations Act 2001 (Cth)

6. What accountants can do to help franchise clients

39jm.buchan@unsw.edu.au

… for franchisors of failing franchisees?

• If franchisee is trading precariously franchisor may decide to terminate the grant before the administrator is appointed

• Franchisor thus may be able to avoid dealing with the administrator

• Franchisor can then re-sell the former franchisee’s business and may avoid the risk of having it clawed back into the insolvency as a voidable preference

• If franchisor leaves it too late it may have to buy the franchisee's business from the administrator

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Variables affecting franchisee survivability

• Structure of franchisor group

• All insolvent or some still solvent?

• What franchisees sell

• Leases

• IP

• Direction of money flows?

• Location of franchisee's businesses

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Accountants up front role …• Investigate the franchisor's accounting methods to determine whether

or not the company is using generally accepted procedures.*

• Look for signs of the franchisor's reduced liquidity and profitability. Various ratios, especially the current ratio and the asset-test ratio, should be accessed, provided that the franchisor is obliged, by agreement or by public listing procedures, to make them available.

• Leverage of the franchisor? Is it, heavily in debt.

• Analysis of these ratios and debts of the franchisor entity may assist the franchisee to identify possible financial problems for the future or identify a trend earlier than would otherwise be possible.

* See Cheng & Kregor, 1973 Cheng, P. C., & Kregor, J. J. (1973). Some guidelines to the potential franchisee. Journal of Small Business Management, 11 (April), 35–40.)

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What can accountants do for franchisee clients?

• Before entering contract

• Is the sector viable in the medium term, and is it already saturated• Google the franchisor and sector with the key words "earnings"

and/or "financial" and "competitors"

• Word search on blogs such as www.Bluemaumau.Org

• Negotiate an ipso facto clause into franchise agreement

• Quarantine franchisee's personal assets

• Make all franchisee's consequential/ collateral contracts conditional on franchisor remaining solvent

• Require franchisors directors to provide personal guarantee if franchisee is remunerated via commission

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Acting for franchisee clients during administration

Once franchisors administrator appointed:

• Franchisees have difficulty achieving standing in their franchisor’s insolvency - “creditors”?

• Understand timing constraints of process

• All franchisees should

• Work together, and quickly,

• Get each other’s private contact details

• Decide whether want to buy the brand

• Communicate early with the administrator, seek representation in creditors committee

• Communicate with landlords and suppliers

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Remember

• Regulation … is never able to shield small businesses from errors in decision-making and the negative consequences of commercial risk taking. Regulation … cannot remove the possibility of failure or guarantee success. (SA Review 2008)

• No high level governance duties owed by franchisors to franchisees

• Once insolvency in progress:

• Contract law provides few viable avenues

• Code ineffective

• Insolvency law trumps and alters contract ‘rights’

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