What steps should a franchisor be taking when dealing with an insolvent franchisee?

September 18, 2012

This article was originally written for and featured in Fresh Business Thinking.

Recent figures released by Deloittes showed a 64% increase in the number of High Street firms failing in the first quarter of 2012, resulting in nearly 10,000 job losses. Although household names such as Blacks, Game and La Senza have grabbed the headlines, it is usually the failure of smaller franchisee-operated businesses which result in empty stores on Britain's High Streets.

Franchisors can find themselves in uncomfortable positions. Their contractual rights (usually set out in a franchise agreement), are often usurped by insolvency law.

What action can a franchisor take when faced with an insolvent franchisee?

1. Act early

Franchisors should be well placed to spot a franchisee in trouble. Late payments of franchise fees; failing to keep up with administration required by the franchise agreement and increased customer complaints are all obvious signs of financial and/or operation problems.

Franchisors can also use the Companies House “monitoring service” to keep a watchful eye on their corporate franchisees.

By registering your contact and franchisee details, you will be notified if:

  • there is any change in management;
  • any additional security is granted; and
  • when the accounts and annual return are filed.

If problems are spotted at an early stage, it gives the franchisor greater flexibility over the action it can take. For example, some franchise agreements have “step in rights” which allow a franchisor, as the name implies, to step in and take control of the franchisee's business (or any sub-franchisee arrangements). The enforcement of such rights may be prohibited further down the line. If a franchisee goes into administration, there is a moratorium on creditors taking such enforcement action (explained below at point 3).

2. Appreciate the difference

A quick review of the UK financial tabloids reveals that many business journalists do not understand the differences between various insolvency procedures. For example, only individuals (not companies) can enter bankruptcy in the UK.

For UK companies, one of the main insolvency procedures is liquidation. However there are three methods of liquidating a company (all of which are very different):

  1. Members’ Voluntary Liquidation (MVL);
  2. Creditors’ Voluntary Liquidation (CVL); and
  3. Compulsory Liquidation.

It is important to take advice as each procedure will result in different consequences for the franchisor. For example, if a franchisee is subject to a MVL, this means that the company is solvent and that the franchisor will be repaid in full.

However an insolvent liquidation (either by CVL or compulsory liquidation procedure), as opposed to an administration, means the liquidator has the right to disclaim onerous contracts.

A liquidator’s main functions are to realise the company’s assets and to quantify its liabilities. As such, he may take the view that the franchise agreement represents a liability, rather than an asset, and take steps to terminate the same. This can apply even if there is no express termination right for the franchisee in the contract. In such circumstances, a franchisor will have an unsecured claim in the liquidation.

What happens if an alternative measure to liquidation is used? If the franchisee is, for example, subject to a Company Voluntary Arrangement (a rescue mechanism proposed by the directors), the franchisor will have the right to vote for or against the proposal.


3. Understanding the concept of a moratorium

If a franchisee goes into administration, the law provides breathing space in the form of a statutory moratorium. This is akin to the defensive shield– no creditor (including franchisors) can pursue the franchisee without consent of the administrator or relevant court.

It is important to note that this would not prevent a franchisor from terminating the franchise agreement. However the moratorium would prevent the franchisor from taking positive enforcement steps, such as entering a shop to repossess stock.

Similarly, a franchisor can not instigate an action against a franchisee in administration demanding that it ceases using any IPR rights. However, a franchisor could be well-advised to threaten the administrator with an action for breach of IPR rights. This would only be an appropriate course of action if the administrator continued to trade in the face of a terminated franchise and/or IPR licence.

In practice, an administrator will usually be keen to enter into a dialogue with a franchisor if there is perceived value in the franchise. Administration often ends in the sale or hive down of the business to a third party, and it will usually be easier to achieve this with a live franchise agreement.

Administrators are commercial creatures and will be able to agree individual deals with creditors if they can demonstrate that the overall outcome will benefit the creditor base as a whole.

As such, a franchisor may be able to extract favourable terms e.g. being paid ahead of other creditors in order to grant consent to any sale including a transfer of the franchise agreement.

4. Termination

In some cases, a franchisor may be grateful for an opportunity to terminate a franchise agreement in order to generate further income by re-issuing the territorial franchise to another third party franchisee.

It is therefore imperative to possess a well drafted franchise agreement with extensive termination rights. These should apply, not only on the commencement of a formal insolvency procedure, but also if the franchisor has reasonable grounds to believe that the franchisee cannot meet its debts as they fall due.

5. Property

Sometimes franchisors will own the property where the franchisee’s business is traded, or alternatively hold the head lease (with the franchisee in occupation under a sub-lease). In such circumstances, administration would prevent the franchisor from taking possession without consent of the court.

Recent cases have established that if the franchisee does stay in occupation, the administrator would be obliged to pay rent as an administration expense. The administrator should also look to vacate or conclude a deal no later than a few months after the administration order has been granted.

Where a lease is in the franchisee’s name directly, the franchisor should consider asking for a right of first refusal. This means that the lease could be assigned to the franchisor in the event of the franchisee defaulting under the terms of the lease.

Ideally, the length of the lease should also coincide with the term of the franchise agreement.

6. Consequence of termination

Even though insolvency may result in a moratorium, a well drafted franchise agreement can help to protect a franchisor’s position through extensive termination and consequences of termination clauses. These could include obligations on the franchisee to:

  • cease using all intellectual property rights;
  • pay all sums then due under the franchise agreement within a specified period;
  • offer the franchisor the lease, goodwill, stock and all other necessary business assets to take over the business;
  • return all materials and information supplied by the franchisor such as manuals and promotional material; and 
  • pay the employees all outstanding wages and remuneration. If the franchisor takes over the business, UK law may deem the employees are automatically transferred to the franchisor.

Summary

A franchisor should be in a better position if it has taken the following steps:

  1. set up a Companies House “monitoring service” on each of its franchisees;
  2. check the trading of each franchisee to spot early warnings signs; 
  3. include extensive termination rights in its franchise agreement; 
  4. read up on the various UK insolvency procedures in order to be prepared for the consequences of insolvency on the franchise arrangements; 
  5. be prepared to be flexible and negotiate with insolvency officials; 
  6. be on the lookout for opportunities (for example, if an administrator is keen to include the franchise agreement in the sale, then insist on all outstanding monies being settled); and 
  7. take legal advice to understand the strength and weaknesses of your position.

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