The ugly side of franchising

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					   franchise review

The ugly side of franchising
The collapse of the Kleins Jewellery chain – and other franchise failures – has thrown the
spotlight on the legal and business status of franchisees when a business goes bust. Specialist
franchising lawyer, Esther Gutnick, outlines the issues that franchisees need to consider.

MIDWAY THROUGH last year, Kleins                  their livelihoods. For the unfortunate Kleins     leases and any sublease, licence or other
retail jewellery chain closed 130 franchised      franchisees, none of these options were           agreement granting occupancy rights to
stores following the insolvency of the            available.                                        franchisees.
franchisor, creating one of Australia’s               What is common to all these scenarios            Interestingly, in the Kleins case, the
largest retail system collapses in recent         is evidence that the fate of franchisees is       franchisor’s underwriting of franchisee
years.                                            inextricably linked to that of their              leases was partly responsible for the
    And Kleins is by no means alone in this       franchisors. Buchan’s study found that 93         franchisor’s     debts     increasing     to
category. A 2006 report by University of          per cent of franchisees involved in a             unmanageable proportions, and was also
New South Wales academic Jenny                    franchisor collapse lost substantial              a key factor in determining the franchisees’
Buchan named at least 40 Australian               amounts of money and were forced to               fate, because the fact that the franchisor
franchisors that “failed” between 1990 and        terminate the employment of their staff           held all the leases was ultimately the
2005. Some of the more significant                irrespective of whether their businesses          reason that all the franchised stores were
examples of franchise system implosions           continued.                                        forced to shut down.
in the retail industry include systems such
                                                  In the face of what is being touted as               Who holds the head lease has long
as the Traveland chain of travel agents (a
                                                  the ‘worst global economic crisis                 been the subject of hot debate in retail
former subsidiary of Ansett which involved
                                                  since the Great Depression’ it is more            franchise circles. The party who holds the
roughly 270 franchisees), Cut Price Deli
                                                  necessary than ever for franchisees to            head lease has control of the premises
(with approximately 150 franchisees), and
                                                  turn their minds to what might happen             which is often critical in retailing, but with
Century 21 Pty Ltd.
                                                  to them if their franchisor does go               that control comes responsibility and
    In each case, different reasons were          under.                                            primary liability to the landlord.
cited for the collapse of the retail chain
                                                                                                       Whether it is best for a franchisor to
including problems peculiar to the                Options for franchisees                           own the franchised premises or to hold the
particular company or the industry sector
                                                  Broadly speaking, when a franchisor               head lease and grant occupancy rights to
in which it operated. However, the real
                                                  ceases to operate, its franchisees have           franchisees by way of sublease or licence,
difference between the collapse of many
                                                  two options – to continue trading or to           or whether it is preferable to have
other franchisors and the Kleins
                                                  cease. Of course, this is not always a            franchisees directly lease premises is not a
experience becomes apparent in the
                                                  decision which is within the franchisees’         question that can be answered globally.
aftermath of the franchisor’s failure and lies
                                                  power to make and depends on a range of           The model that is right for each system will
in the effect that the franchisor’s failure has
                                                  factors.                                          depend on its available resources,
on its franchisees.
                                                      Most franchise agreements do not              priorities and attitude to risk. In fact, some
   Certain brands have continued                                                                    franchisors incorporate a mix of property
                                                  provide for what happens to the
operating long after the franchisor’s                                                               holding options in their system as a way of
                                                  franchisee, its business or the premises in
collapse. Notably, most of the Century 21                                                           hedging their risk and exposure.
                                                  the event of the franchisor’s insolvency.
franchisees have enjoyed prosperity under
                                                  The Franchising Code of Conduct (“Code”)             One thing is clear: if a franchisor holds
new ownership with an ongoing franchise
                                                  is also silent on the issue.                      the head lease for its franchisees’
model. The majority of Traveland
                                                       Certain statutory provisions govern the      premises, it makes it all the more difficult
franchisees were able to continue
                                                  process and relationship of the various           for the franchisees to take control of their
operating independently or by joining
                                                  parties where the franchisor has receivers,       destiny if that franchisor fails.
competitor’s chains when their franchisor
went under. In other cases, groups of             administrators or liquidators appointed to           Where the franchisor holds the head
franchisees    have     formed     buying         it. In the event of liquidation, the liquidator   lease for the franchisees’ premises, in
syndicates to purchase the franchise              has the power to disclaim onerous                 order for the franchisee to continue
system from the stricken franchisor, thus         contracts to which the insolvent franchisor       operating, it must either take an
salvaging the brand, the retail chain and         is a party, including franchise agreements,       assignment of the lease from the

62 | March 09
franchisor (with the landlord’s consent) or      itself from its relationship with the            should not hesitate to ask the franchisor if
negotiate a new lease with the landlord.         franchisor without breaching its obligations     it will agree to the franchisee holding the
The difficulty most franchisees will face in     to the franchisor or the franchisor’s            head lease if this is not their usual
this regard is that landlords are often          administrator/liquidator. The franchisee will    procedure.
unwilling to enter into a lease with a           also be concerned with how to recoup
                                                                                                      If the franchisor insists on holding the
franchisee, preferring the security of having    funds it has outlaid or how to avoid losing
                                                                                                  head lease, franchisees should consider
franchisor tenants who are usually larger,       even more money.
more reputable, and possess greater                                                               building provisions into the franchise and
                                                     A franchisee may find itself in the          occupancy agreements giving them rights
resources than the individual franchisee.
                                                 unfortunate position of a stalemate              of assignment in the event of the
Also, a landlord may be less inclined to
                                                 between the landlord as owner of the             franchisor's failure, or entering into
grant a lease to a franchisee affiliated with
                                                 premises (who wants rental arrears paid or       tripartite re-entry agreements with the
a failing or failed franchisor.
                                                 otherwise wants to terminate the lease and       landlord providing for the assignment of
    Alternatively, the franchisee may be able    re-lease the premises to a new tenant and        the lease to the franchisee in the event of
to terminate its occupancy right at that         who may refuse entry to the premises in          franchisor insolvency.
premises, secure a lease elsewhere, and          the meantime), the franchisor as tenant,
relocate the business to the new premises.       and the bank or other mortgagee (who                 Prior to entering into a franchise
However, this process would inevitably           wants to enter the premises to enforce its       agreement, franchisees should undertake
involve substantial cost, time and effort at     rights over the assets onsite). The              comprehensive due diligence in respect of
a time when the franchisee would be              franchisee must also be mindful of any           the franchisor, the efficiency and
better off concentrating all resources and       liability it has in respect of unpaid rent and   adaptability of its business operations, and
energies on keeping business afloat.             under any make good provisions of the            its current and projected financial viability.
   Assuming a franchisee is able to retain       lease.                                           They should also seek professional advice
rights to the premises and continue                                                               in relation to asset and income protection
                                                     Kleins will not be the first or last large
trading, it must consider whether it should                                                       strategies and potential exit plans in the
                                                 retail franchise chain to crumble in the
do so independently or as part of another                                                         event of a worst case scenario.
                                                 current economic climate. Car servicing
chain. Again, this decision is complicated       company, Midas Australia, and Australia's           Franchisees also need to be prepared
by matters such as the applicability and         largest DVD retail chain and online retailer,    to do deals with any receiver, administrator
enforceability of any restrictive covenant       EzyDVD, were both placed into                    or liquidator which may be appointed to
contained in the franchise agreement, the        administration in December 2008. Just last       the franchisor.
cost of re-branding, and the franchisee's        month saw electronics retailer Strathfield
ability to retain suppliers and customers                                                             If the Kleins collapse has taught us
                                                 Group appoint administrators to the              anything, it has highlighted that nobody is
once no longer affiliated with the franchise
                                                 struggling franchisor.                           immune to failure, and that constant
                                                    There is little that franchisees can do to    vigilance and adequate preparation and
     Whether the franchisee ceases or
                                                 prevent their franchisor from failure,           planning on the part of franchisees are
continues to operate its business, it will be
                                                 however they should do all in their power        imperative to minimise the damage if the
faced with complex issues such as how to
                                                 to implement strategies at the outset in         franchisor should become insolvent.
deal with any stock remaining (especially
                                                 order to best protect themselves in the
where stock has been provided by the
                                                 event of such circumstances arising.              Esther Gutnick is a franchising lawyer with the
franchisor or its associates); how to deal
with any shop fitout or other fixtures and          Franchisees should be aware of the             Melbourne based law firm Mason Sier Turnbull.
fittings (especially where these have been       occupancy rights which they will be               Esther acts for both franchisors and
paid for by the franchisor or are designed       granted and have any occupancy                    franchisees and has a background in
                                                                                                   commercial law. Tel: (03) 8540 0200
in an image specific to the franchise            agreement thoroughly reviewed by a
brand); and how to successfully extricate        lawyer with leasing expertise. Franchisees

                                                Australia’s oldest and best franchise site. See page 42 for details

                                                                                                                                      March 09 | 63

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