Can you really terminate a franchisee who goes bust?

 

Franchisors have traditionally operated with the comfort of being able to cut loose a franchisee who enters administration or insolvency. After all, this is a right conferred by the Franchising Code of Conduct (“Code”).

 

What does it mean to ‘go bust’?

 

No franchisor likes to see a franchisee go bust. Unfortunately, circumstances can arise where a franchisee is unable to pay their debts and the business cannot be salvaged. That can be detrimental to the reputation and goodwill of a franchise system. Franchisors will often prefer to get that franchisee out of the system, and sometimes operate that business as a corporate franchise until a more permanent solution can be found.

 

The term ‘goes bust’ can refer to bankruptcy, insolvency, entry into administration (whether voluntary or external) or appointment of a liquidator.

 

In basic terms, administration is stage one. An administrator is appointed to a company and tasked with evaluating whether the business can be salvaged by helping the company repay debts and escape insolvency. Many companies can successfully work through the administration and get back on their feet.

 

Liquidation is stage two, when it is determined that the company cannot be salvaged. A liquidator is appointed and tasked with selling the assets to pay creditors, and then dissolving the company.

 

The Code

 

Section 29 of the Code entitles a franchisor to immediately terminate a franchise agreement if a franchisee becomes bankrupt, insolvent under administration or a Chapter 5 body corporate (as that term is defined under the Corporations Act 2001). For a franchisor to rely on this, the franchise agreement must include a clause which says that the franchisor can immediately terminate on those grounds.

 

The Ipso Facto Regime

 

On 1 July 2018, the ‘ipso-facto’ regime of laws was introduced. The regime applies to certain types of contracts entered into on or after 1 July 2018 and certain types of insolvency events. It restricts a party to those contracts from terminating the contract if the reason for termination is because the other party is experiencing an insolvency event or restructuring procedure. Any attempt to terminate the contract will be ‘stayed’, meaning the termination is essentially suspended until a Court decides otherwise.

 

The purpose of ipso facto is to give struggling companies a lifeline, with the ability and flexibility to continue to trade while the company attempts to recover from the insolvency event. If the company can’t recover and enters formal liquidation, then the ipso facto regime generally ceases to apply, lifting the block on the ability to terminate the contract because of the insolvency event.

 

This is only a very basic and general overview of the ipso facto regime. The regime contains a very detailed process for determining whether or not it will apply. It will depend on the type of contract and the type of insolvency event.

 

The Code vs Ipso Facto

 

What we are now left with is a clash between the laws. Whether ipso facto will apply depends on whether the franchise agreement was entered into, renewed or varied on or after 1 July 2018. If the regime does apply, then the Code must be read subject to ipso facto, meaning that where there is a clash, then ipso facto takes priority. That means that despite the Code saying a franchisor can immediately terminate a franchise agreement for certain insolvency events, the franchisor can only exercise that right when ipso facto permits.

 

For our first example, let’s use the appointment of an external administrator to a franchisee’s company.

 

The Code says this entitles a franchisor to immediately terminate the franchise agreement. If the franchisor wanted to terminate, they would need to assess whether ipso facto prevented them from doing that. If ipso facto prevented it, then the franchisor cannot use that appointment of an external administrator as a reason to terminate during the administration event. However, if the administration eventually leads to the company being placed into liquidation, the franchisor must then assess again.

 

Most types of liquidation are generally not covered by the ipso facto regime, meaning ipso facto is unlikely to prevent the franchisor from terminating because of the liquidation.

 

For our second example, let’s use a franchisee’s company going straight into liquidation. Again, the Code says liquidation entitles a franchisor to immediately terminate the franchise agreement. The franchisor must still assess whether ipso facto would stand in the way because the regime will apply to some types of liquidation. If that type of liquidation wasn’t covered by ipso facto, then ipso facto wouldn’t prevent the franchisor from terminating because of the liquidation.

 

How to tackle a franchisee going bust

 

What is important to remember is that ipso facto prevents termination of a contract when the insolvency event is used as the reason for termination. It does not prevent a franchisor from terminating a franchise agreement if there are other valid grounds to do so (provided the franchisor does not rely on the insolvency event as well).

 

Section 29 of the Code gives franchisors the right to immediately terminate in circumstances other than insolvency events, such as abandonment and fraud. Again, for a franchisor to rely on this, the franchise agreement must include a clause which says that the franchisor can immediately terminate on those grounds. That means ipso facto is unlikely to stand in the way of the franchisor terminating in reliance on abandonment or fraud.

 

Section 28 of the Code also entitles a franchisor to terminate a franchise agreement if they have served a breach notice on the franchisee and the franchisee has failed to take the action required to remedy the breach within the required time.

 

Let’s use another example of a franchisee breaching their franchise agreement by falling behind in paying royalties, and also having an administrator appointed. Because the franchisee has failed to comply with their obligation to pay royalties on time, the franchisor is entitled to issue a breach notice and give a reasonable time to pay the arrears. If the fees then weren’t paid within the time given, then ipso facto is unlikely to prevent the franchisor terminating for failure to remedy the breach.

 

Takeaways

 

Franchisors must be very cautious about how they treat a franchisee who has gone bust or is on the track there. Perhaps once the ipso facto regime is tested further by the Courts, there will be better guidance on how the regime will interplay with the rights to terminate under the Code.

 

Care must be taken when terminating a franchise agreement in any situation, especially when a franchisee is experiencing an insolvency event. We cannot stress enough the importance of obtaining legal advice before terminating a franchise agreement. Failure to do so correctly can invalidate the termination and expose the franchisor to a claim by the franchisee.

 

The team at Stone Group Lawyers are experienced in acting for both franchisors and franchisees in all aspects of franchising law. Contact our office on 1300 088 440 to arrange a free 30 minute consultation with our franchise team.

 

 

This article is only meant to give you general information and should not be relied on as legal advice. Speak to one of our lawyers for more information.

 

Stone Group Lawyers welcomes Mia Behlau to the Team

We are excited to welcome Mia Behlau to Stone Group Lawyers as Special Counsel. Mia is a skilled commercial litigator who has worked exclusively in Commercial Litigation and Insolvency. Mia is skilled in Competition and Consumer Law, Breach of Contract, Construction Law, Estate Litigation and Franchising disputes.

Mia is known for her professionalism and ability to respond to complex disputes in a measured and meaningful way. She has a natural rapport with her clients which has resulted in a loyal client base for many years.

Mia has been a Gold Coast based lawyer and has therefore gained extensive experience in the local market making her have a deep understanding of the commercial needs of her clients. Whilst Mia is a serious and strong litigator, she prides herself on focusing on resolving complex litigation and commercial disputes in a cost effective and time efficient manner with a view to achieving the right outcome for her clients.

Mia is an industry leader in her field, and she is recognised by her colleagues and the profession to be one of the top in her field. In addition to assisting clients, Mia is also President of the District Court Law Association and a regular presenter for continuing legal education with the Queensland Law Society. Mia prides herself as being an advocate for Gold Coast Legal Practitioners and a mentor to junior lawyers.

Stone Group welcomes Mia to the Team.

Luke is a skilled commercial lawyer who specialises in franchising, business and property law. He will strive to be an essential part of your business’ team.

 

Luke has spent a number of years acting for a diverse range of multinational franchisors. His experience includes advising franchisors on day-to-day operational issues and regulatory compliance, drafting/updating franchise agreements and disclosure documents, and acting on new grants/renewals/resales. From the setting up of new franchise systems, to working closely with established franchisors, Luke assists his clients maintain that careful balance of a healthy franchisor/franchisee relationship.

 

Acting for franchisors is only just part of his experience. He has helped franchisees of many different franchise systems achieve that exciting goal of becoming a business owner. After giving advice to determine the best business structure, Luke carries out a comprehensive review of franchise agreements, gives plain-English advice on the key terms and considerations to cut through the legal jargon, and then negotiates changes. He’s then just a phone call away to answer any questions once the business is up and running.

 

Luke has also assisted many franchisees and franchisors resolve their differences in times of dispute, helping his clients navigate the process of issuing and/or responding to breach notices.

 

Luke isn’t just about franchising though. His days involve providing advice on a wide variety of commercial issues that arise in operating small to medium businesses, where he assists clients who are growing their business or wanting to protect what they’ve established. This includes acting on business sale and purchase transactions, to reviewing and negotiating retail and commercial leases for tenants. He is also experienced in acting for landlords.

 

In his spare time, Luke is an active member of both the Queensland Law Society Franchising Law Committee and the Franchise Council of Australia Legal Committee. These committees allow him to keep on the forefront of the latest developments in laws affecting franchising, and to contribute towards government submissions on topical issues facing the franchising industry.

 

The ACCC has successfully prosecuted former hand car wash and detailing franchisor Geowash in the Federal Court for acting unconscionably, making false or misleading representations and breaching the Franchising Code of Conduct by failing to act in good faith in its dealings with franchisees.

 

A lengthy ACCC investigation and resulting court proceedings determined Geowash had made false or misleading representations on its website about the revenue and gross profit prospective franchisees could expect to receive, and that Geowash had commercial relationships with numerous major corporate entities (which in fact it didn’t).

 

Geowash was found to have acted unconscionably towards a number of its prospective franchisees about the methods of charging for establishment and fitout costs of franchised sites. Some franchisees were told that the initial fees payable to Geowash were reflective of the actual setup costs for a site, but in actual fact, a large portion was paid to Geowash’s director and franchising manager as commissions. The surplus was then expended to setup costs, and many franchisees billed extra when budgets were exceeded. These costs were often initially marketed as a fixed or capped cost. After signing their franchise agreements, franchisees later learned the actual costs they were expected to pay often far exceeded the initial figure stated by Geowash. Many franchisees were then left with inferior car wash sites, and some never even received their car wash.

 

The decision is a timely reminder that franchisors must be extremely careful about the statements, promises and representations made to prospective franchisees in the negotiations before entering a franchise agreement. If something said about a future matter is relied upon by a franchisee, then turns out to be untrue or misleading, and causes the franchisee financial detriment, a franchisor can land in hot water.

 

Whilst the ACCC unsuccessfully tried to hold Geowash’s director and franchising manager personally liable, the decision nonetheless shows that had the circumstances been different, there is a real risk that individuals involved in such conduct may be held personally liable.

 

Franchisors should take careful note of the key takeaways from the Geowash decision:

  1. Don’t advertise franchises in a way that gives an impression that a franchisee can achieve a certain profit or turnover. Franchisees should always be made aware that the success of their business will be dependent on their own business efforts.

 

  1. If you tell a prospective franchisee that a fee will be calculated a certain way using a certain method, then don’t deviate from that. Geowash told franchisees that their initial fees were calculated based on actual costs to be incurred for establishing a site, but in actual fact, the fees were first determined based on the franchisee’s spending capacity, and a large portion then allocated towards undisclosed commissions. If you collect a fee for a particular purpose, then you must expend it towards that purpose.

 

  1. Don’t market something as a fixed or capped cost, and then attempt to introduce additional costs not previously disclosed.

 

  1. If fees disclosed to prospective franchisees are only estimates and based on variables, then make that very clear. Disclose the factors that determine whether the final fee will fit into the lower or higher end of the estimate.

 

  1. Only charge franchisees in accordance with your rights under the franchise agreement and disclosure document. If you want the right to collect installment payments or change charging methods, ensure your documents allow this. Don’t expect to collect a fee that you don’t have a contractual right to charge.

 

  1. Ensure consistency between the information and documents given to prospective franchisees.

 

  1. Don’t claim to have experience or commercial relationships that you don’t actually have.

 

  1. Don’t claim to use a certain site selection criteria or process, when in fact you don’t.

 

  1. Keep detailed records in support of every promise, statement or representation you make, especially about future matters. The onus is on you to prove that you had a reasonable basis to make it. If you can’t support your statement, then don’t make it. Avoid stating personal opinions, and train your staff on what they can and cannot say.

 

  1. Select your franchisees carefully. Ensure their level of experience is appropriate for the franchised business. Take extra care with migrant franchisees. If you know they aren’t cut out for the franchise, don’t offer it to them.

 

  1. If you know the prospective franchisee doesn’t have the financial means to enter or run the franchise, don’t offer it to them.

 

  1. Encourage your prospective franchisees to obtain their own independent legal, accounting and business advice.

 

  1. Finally, don’t promise something you can’t offer!

 

 

By Luke McKavanagh

Luke McKavanagh is a regular contributor to online and print media for Inside Franchise Business. This article which was previously published on the Inside Franchise Business website can be viewed at www.franchisebusiness.com.au