The University of New South Wales Australian School of Business

The University of New South Wales Australian School of Business Australian School of Business Research Paper No. [2009 BLAT 01]

Square Pegs in Round Holes: Franchisees of Insolvent Franchisors Jenny Buchan

This paper can be downloaded without charge from The Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=1326559

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Business Law International Vol 9 No 2 May 2008

Square Pegs in Round Holes: Franchisees of Insolvent Franchisors Jenny Buchan* Franchising is a globally embraced business model based on contracts between a franchisor and its franchisees. In 2005, the franchising sector contributed an estimated 14 per cent of Australia’s gross domestic product. In 2006, there were approximately 960 business format franchise networks in Australia, with an estimated 62,000 franchisees operating units dependent on these franchisors remaining solvent. Like any other commercial entity, a franchisor might become insolvent. Insolvency may be forced on a franchisor. Or, it may be part of a considered business strategy as acknowledged by US lawyers who state: ‘… bankruptcy is most often an opportunity for a troubled company to solve its operational or financial problems and emerge as a more viable company. Bankruptcy provides a useful business tool for a company to reorganise its operations, deleverage its balance sheet, accomplish a sale of assets, obtain new financing or improve its capital structure. For example, bankruptcy may assist a franchisor in addressing the following challenging business issues; overexpansion in the market and the need to eliminate units, an unworkable equity structure, desire to sell or merge

* Jenny Buchan, LLB (Otago), LLM (Melbourne) is a lecturer in business law at the Australian School of Business at University of New South Wales, Sydney, Australia. She is working towards a PhD at Queensland University of Technology examining franchisor insolvency. She can be contacted by e-mail at [email protected]. She acknowledges research funding provided by CPA Australia and the University of New South Wales, valuable input from Bill Butcher, Michael Murray, Assistant Professor Elizabeth Spencer and Associate Professor Christopher Symes, of Australia; Rupert Barkoff, Michael Hitchcock, Paul Steinberg, Professor William Vincent and Carl Zwisler of the USA; Professor Souicgirou Kozuka of Japan, Albrecht Schulz of Germany and the suggestions made by the referees. 1 Lorelle Frazer, Scott Weaven and Owen Wright, Franchising Australia (Griffith University, 2006), p 9. A dearth of research on the causes of franchisor insolvency means it is not possible to be specific about the proportion of insolvencies that fit either of the two scenarios. In the USA, both personal and corporate insolvency are called bankruptcy.

Electronic copy available at: http://ssrn.com/abstract=1326559

Square Pegs in Round Holes: Franchises of Insolvent Franchisers

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with another entity, threat of franchisee litigation, desire to refinance but the lender has expressed concern about financial or other issues.’ Regardless of what triggers the franchisor’s insolvency, addressing the interests of franchisees whose franchisor becomes insolvent is a challenge for insolvency regimes. As one Australian liquidator observes: ‘When it comes to companies going bust, the insolvency of a franchise is usually about as shambolic as you can get. Of all insolvency matters, the most difficult is the failure of a franchise group … There are always problems with the Franchise Code, always leasing problems and unforeseen third party issues.’ Accommodating a franchisee’s interests within the franchisor’s insolvency is like trying to poke a square peg into a round hole. Figure 1 itemises a franchisee’s investment and which parts of it could be recovered following the insolvency of a franchisor owned by a public company in Australia in 2004. None of the money the franchisee paid on entering the business was recoverable as of right from the liquidator. Figure 1: Retail non-food franchise in Sydney, Australia: franchisor established network in 2000, franchisee signed franchise agreement early 2004, franchisor insolvent mid-2004 Item paid by franchisee

Franchisee’s investment in $Australian

Relevant contract

Franchisee paid to

(1) Initial $60,000 plus Franchise Franchisor in franchise fee additional agreement full before paid to secure $20,000 training. between commence rights for five franchisee and business. years. franchisor signed early 2004.

Outcome for franchisee in insolvency of franchisor

Franchisee no statutory right to claim form administrator. Franchisee will be a creditor for an amount in damages for breach of the franchise agreement. The franchisee may seek leave to bring proceedings against the insolvent

Sarah B Foster and Carolyn Johnsen, The War Of The Worlds: Bankruptcy Versus . . ., unpublished paper presented at American Bar Association, 28th Annual Forum on Franchising, 2005. Franchising Code of Conduct under the Trade Practices (Industry Codes – Franchising) Regulations 1998 made under the Trade Practices Act 1974 (Cth). D Binning, ‘Code Wars – a liquidator’s worst fears’, Australian Financial Review, 29 June 2006. Special Report, at p 13, quoting David Cowling, insolvency partner with law firm Clayton Utz (and Vice-Chair of the IBA’s Section on Insolvency and Creditors’ Rights). The expression ‘square pegs in round holes’ is widely used in colloquial English to refer to any situation where an attempt is being made to fit a concept, person or thing into a ‘space’ that was not designed to accommodate it.


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franchisor in order to quantify its claim.

(2) ‘Sunk’ fit $99,000. Disclosures Franchisor for out costs. document. payment on to independent shop fitter.

Lease (in franchisor’s name) disclaimed by administrator as an onerous contract. Landlord would negotiate with franchisee for a continued tenancy agreement if franchiss gave up value of fit-out. Lost $99,000 sunk cost of fit-out.

(3) $25,000. Franchisor’s fit-out.

Franchise agreement between franchisee and franchisor.

Service fully perfomred by franchisor; franchisee no right to claim. Lost $25,000.

(4) Inventory $45,000. stock.

Supplier Supplier. agreements.

Return, sell depends on terms of supply.

(5) Security Bank guarantee – deposit on three months’ rent franchisor’s = approx $15,000. head lease.

Franchise Provided direct agreement to landlord. between franchisee and franchisor.

Franchisee negotiated with landlord to be released – no loss.

(6) Monthly Approx $4,000pm. premises rental.

Lease between Franchisor for franchisor and forwarding to landlord. landlord. Sublease/ lincense between franchisor and franchisee.

Franchisee debtor of franchisor. Franchisor in breach of lease because of appointment of administrator.

Franchisor as a 25 per cent fee on top of invoiced fit-out.

(7) Training $20,000. Franchise costs. agreement between franchisee and franchisor.

To general Franchisee not creditor of revenue of debtor. No claim possible. franchisor of franchisor related company on day paid.

(8) Other $6,000. costs.

Paid to franchisor up front.

Franchise agreement between franchisee and franchisor.

(9) Options to $60,000. Agreement Paid to open three between franchisor up future and franchisee. front. franchisee - owned stores

Franchisee not creditor of debtor. No claim possible.

Franchisee not a creditor for $60,000 unless could claim frustration of contract or unjust enrichment at common

In Cheque One Pty Ltd v Cheque Exvhange (Australia) Pty Ltd (in liq) [2002] FCA 593 12 applicant franchisees sought leave of the court under s 471B of the corporations Act 2001 to join proceedings commended against the franchisor in 2000.


Square Pegs in Round Holes: Franchises of Insolvent Franchisers @ $20,000 per option.

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law re the $60,000 if court consents to civil proceedings normally prevented under 440D or 471D of the Corporations Act 2001. Unlikely to be recoverable.

Franchisees are arguably under-rewarded and ill prepared for the types and levels of risk they undertake. Because the franchise relationship is documented in a contract, any claims by the franchisee during the insolvency rely on its ability to establish its standing as a creditor. The franchisee’s business will be categorised by the liquidator as an asset or a liability of the franchisor. These are ill-fitting categorisations for a franchisee. They fail fully to acknowledge the roles the franchisee occupies in the franchisor’s business. In the first part of this article, the roles and rights of franchisees are identified. They are compared with the roles and rights of the legal entities that occupy those roles in a non-franchised business. They are also compared to the franchisor’s suppliers. The second part examines the legal rights accorded to franchisees of solvent franchisors in Australia, Japan, the United States and Germany. It illustrates that in diverse jurisdictions where franchising is well established, the relationship between solvent franchisors and their franchisees is recognised as sufficiently different from a simple contractual arrangement to merit specific treatment by the general law. The third part of this article looks at the place of the franchisees in the franchisor’s insolvency. Indicators of impending insolvency and potential avenues of claim for franchisees’ whose franchisor fails are identified. In the fourth part the areas where the present model fails to meet the policy objectives set out in the United Nations draft legislative guide on insolvency law are highlighted. Possible future ways of aligning the franchise model more with insolvency law policy and with franchisees expectations are canvassed. Australia is not alone in its failure, to date, to address franchisor insolvency as a specific policy issue. This article also includes references to examples, cases, commentary and legislation from Canada, Germany, Japan and the United States.

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Roles and rights of franchisees, legal entities in a non-franchised business, and suppliers to the franchisor In legal terms, there is no relationship quite like that between a franchisor and its franchisees. The execution of the franchise agreement triggers a significant commitment from the franchisee in the form of sunk investments in premises, hire of staff and entry into long-term contracts with parties other than the franchisor for finance, premises rental,10 vehicle rental, and stock purchase. The enormous value of granting licences to franchisees as opposed to pursuing organic growth is described by franchisor, Telco Commander Communications: ‘the effect of (moving from a traditional business structure and into) franchising will be an increase in sales, movement of costs from fixed to variable and a reduction in direct labour costs with an increase in commissions.’11 The legal liabilities the franchisee potentially assumes on signing the franchise agreement compare starkly with the rights (many) and liabilities (few) that accrue to parties that perform the equivalent functions to a franchisee in a non-franchised network. ‘The relationship between franchisor and franchisee is akin to a partnership, wider and more complicated in fact than any document could contain.’ 12 Specifically, the franchisees are a source of labour, borrowed and equity finance and a risk-devolving mechanism. In a non-franchised business, the business owner would have to take the responsibility for each of the following areas of the business.

Lorelle Frazer, Scott Weaven and Owen Wright, Franchising Australia (Griffith University, 2006), p 35. The total start-up cost of a new franchised unit (excluding GST) was $78,000 with the range being $2,100 to $960,000 in 2006. 10 Lorelle Frazer, Scott Weaven and Owen Wright, Franchising Australia (Griffith University, 2006), p 30. Where the franchise unit operates from a specific site, the head lease is held by the franchisee in 64 per cent of cases. Twenty-six per cent of franchisors hold the head lease. At the industry level, however, franchisors are more likely to hold the head lease in retail (food and non-food) systems. 11 Jacqui Walker, IT News, ‘Commander to franchise www.smartcompany.com.au’, Tuesday 20 February 2007. 12 American Bar Association Antitrust Section, Monograph No 17, Franchisee Protection: Laws against Termination and Establishment of Additional Franchises 19 (1990) at 55.


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Labour force A non-franchised business sources labour by hiring employees or contractors. Both categories of worker have well-defined legal rights. Employees derive their rights in relation to remuneration, entitlements, leave and work conditions from specific legislation and may be assisted by trade unions representing them in negotiations and disputes with their employers. Contractors, including suppliers, negotiate the terms on which they will perform a job and are remunerated accordingly. Whereas employees enjoy some form of recognition in insolvency and contractors will be creditors in relation to any work done but not paid for, franchisees have no explicit rights and are a creditor in relation to a small sum, if at all. Because of the direction of the money flow in most franchise businesses, most if not all money flows from the franchisee to the franchisor. Thus, the franchisor seldom owes the franchisee money, so the franchisee is not a creditor. Franchisees will be a creditor if a mediation or judgment has provided for them to receive money from the franchisor but this is not an everyday scenario. A franchisee may be categorised as a debtor for small sums in some liquidations. The role the franchisees play as the franchisor’s labour force is acknowledged by the Supreme Court of New South Wales in Majik Markets Pty Ltd v Brake and Service Centre Drummoyne Pty Ltd and ors,13 where Handley JA observed: ‘While the franchisees, if natural persons are working for themselves, they are also in a very real sense working for the franchisor. If the business was not operated by some franchisee, the franchisor would either have to employ staff of its own or sell or lease the site to an independent purchaser or lessee.’ Financier The franchisee supplies capital in the form of the initial franchisee fee, and it funds the establishment of its franchisee business, to help grow the franchisor’s brand. For example, the franchisor of Boost Juice: ‘was able to roll out (a juice bar concept) around Australia at an extraordinary pace and with limited (franchisor) capital by developing a franchise system …We have been able to grow using other people’s capital.’14 13 [1991] 39 IR 169, decision of Kirby P, Mahoney and Handley JJ. 14 Virginia Marsh, ‘Entrepreneur enjoys fruits of fast-expanding juice chain – Janine Allis squeezed her way to success from humble beginnings’, Financial Times, 24 June 2005, p 5 quoting Boost’s chief operating officer, Simon McNamara.

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Traditional suppliers of debt finance such as banks are known as creditors in insolvency and are likely to have had the opportunity to become secured creditors. Traditional suppliers of equity finance – shareholders – have taken the risk of the entity becoming insolvent knowingly and on the basis of information supplied in a prospectus that has met rigorous standards. The most recent case on the subject in Australia, Sons of Gwalia Ltd v Margaretic; ING Investment Management LLC v Margaretic,15 has gone so far as to recognise as unsecured creditors some shareholders who relied on misleading or deceptive information disseminated by the public company they invested in. Risk taking A traditional analysis of a franchisee as a contracting party with the ability to assess risk and then factor it into its contract terms is incomplete because the franchise agreement is both ‘standard form’ and ‘relational’. Whereas a ‘franchisor can manage risk through contract, a franchisee cannot. … the “contract as commodity” approach of the standard form as opposed to a “contract as relationship” approach of the relational … contract creates a conflict where the standard form prevails. A franchisee takes on qualities of consumer of product, rather than an equal party to negotiation of terms.’16 Franchisees shoulder both 100 per cent of their own plus some of the franchisor’s business risk. For a franchisee, the devolving of risk that is achieved by franchisors signing franchisees up may take many forms, for example, franchisee guaranteeing retail leases in the franchisor’s name, as occurred with the franchisee in Figure 1. The franchisee, thus, takes almost all the risk on the premises, while the franchisor retains the full benefit of the site lease being in the franchisor’s name. In the absence of franchisees, all risks associated with conducting the business would be taken directly by the franchisor or indirectly by financiers. The ability to devolve risk is an under-acknowledged, but significant, benefit to the franchisor.

15 [2007] HCA 1. This decision has sparked a plethora of responses from academics and practitioners. Its impact is currently being digested by Australian regulators. 16 Elizabeth Crawford Spencer, The Regulation of the Franchise Relationship in Australia: A Contractual Analysis (PhD dissertation, Bond University, 20 September 2007), p 170.


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Reward sharing Franchisees, while assuming some of the franchisor’s business risk, have no right to receive a corresponding reward, as the venture capital providers or shareholders typically would, if the franchisor entity is sold for a profit. This is acknowledged by franchisors of Australian telecommunications franchise Telcoinabox: ‘The biggest challenge to date for (the franchisor) has been access to capital. None of the banks would lend to them (directors of the franchisor) because they unanimously refused to put their houses on the line. “Banks don’t want to invest in a concept or idea” (the franchisor) says. They were never interested in seeking venture capital because of the hefty chunk of equity demanded in return for the investment. “We did speak to a number of people but they basically want the soul of your first-born son. Equity is the most expensive form of finance you can get,” Mr Kay says. Telcoinabox relied heavily on franchising fees ($50,000 per franchisee) in the first year. (the franchisor) says not being answerable to investors is liberating … .’17 It is suggested that franchisees are, in effect, taking quasi-equity risk in the franchisor, often for returns more typically associated with employment or debt. Suppliers Potentially the most severely affected contracting parties, other than franchisees, are suppliers. In the event of a franchisor’s insolvency, a franchisee is generally exposed to greater loss and is less able to protect against such loss than is a supplier. The entire operation of the franchisee, including its inception, is predicated on and inextricably linked to the franchisee’s relationship with the franchisor. A supplier may have taken significant steps, such as retooling, or committing to grow a particular crop in reliance on its contract with the franchisor but it would normally have done so in the context of an alreadyestablished business. For example, a farmer will negotiate a supply agreement to grow potatoes or a printer will negotiate to print labels to specific standards for a franchisor. A supplier is viewed by the franchisor as a strategic partner that is, effectively, making an investment in the whole network. The supplier 17 Kristen Le Mesurier, ‘Damian, Damien score double hit’, Sydney Morning Herald, 8 February 2008.

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relationship may have begun by the supplier successfully tendering. The franchisor and supplier negotiate and agree the terms of their contract. Although it will contain typical provisions, the supply agreement is relational but is not a standard form contract. Suppliers have their own business that they can adapt to supply other buyers if the business with the franchisor becomes unviable. If a liquidator is appointed to the franchisor, the supplier becomes a creditor or debtor. At that point, the franchisor has breached the agreement and the supplier can access remedies and mitigate losses. Unlike the franchisees, suppliers do not have their businesses reclassified as an ‘asset’ or ‘liability’ following the appointment of a liquidator to the franchisor. While both suppliers and franchisees commit their own capital to the franchisor’s brand, franchisors must then build a business along lines tightly prescribed by the franchisor. They are a party to a contract that is both relational and standard form. Unlike a supplier, the franchisee that sees its franchisor is in trouble has little flexibility to prepare for continuing its business with another partner in the event of the franchisor’s insolvency. The supplier may be able to delay delivery until payment is assured and can try to assure its future by seeking contracts with other parties but the franchisee is seldom free to abandon the franchisor until the term of the agreement ends or the liquidator disclaims the franchise agreement. Both franchisee and supplier to some extent put themselves at the mercy of the franchisor’s ongoing viability but because of the standard form of the franchise agreement, the franchisee does so to a greater extent and with less capacity to protect itself either legally or practically. Solvent franchisors quote their annual profit and turnover in press releases and in submitting their applications for small business awards inclusive of the franchisees’ profit and turnover. A supplier would not be categorised as an asset or a liability of a solvent or insolvent franchisor. The franchisor would not have access to the profit and turnover figures of the supplier and would not include the profit of a supplier in its own annual profit announcements. Suppliers are not ‘owned’ by the franchisor. Is franchisor insolvency significant enough to worry about? To date, relatively little research has been published on the incidence of franchisor failure or its impact on franchisees. ‘Shane suggests heavy failure rates of new franchise systems in the first four years, followed then up to the ten-year period by only modest further losses, as we might expect for conventional small business start-ups. Lafontaine and Shaw, on the other hand, report steady and sustained failure rates from franchise format


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adoption onwards.’18 Lafontaine and Shaw quote UK research by Stanworth, who states: ‘at best, one franchise company in four could be described as an unqualified success story … over a ten-year period … Around half the sample was judged to have failed completely and utterly.’19 Given the global popularity of franchising, the size of the investments made by franchisees and the lack of protection afforded the franchisees’ investments by the franchise contracts, the consequences of franchisor insolvency for franchisees should be of interest to a range of commercial operators. Those especially interested should be third parties that form commercial relationships with franchisees on the assumption that franchisors do not become insolvent; not even for strategic reasons. Legal rights accorded to franchisees of solvent franchisors In recognising the potential vulnerability of franchisees as consumers, many countries have enacted legislation and pre-contractual disclosure obligations to provide some pre-contractual procedural protection for intending franchisees. Although franchising became well established in both France and the United States over 50 years ago, the earliest disclosure law to have been enacted was California’s state disclosure law in 1970. This was followed by the United States federal disclosure law in 1979. France followed ten years later with the Loi Doubin, which was reportedly enacted in response to a number of scandals and abuses within franchising. They prompted the Minister for Commerce and Trade, Mr Doubin, to promote the Loi Doubin to stabilise the sector. Franchising is now a strongly supported business method in France.20 A growing number of jurisdictions provide for pre-contract franchise disclosure. This may take the form of disclosure mandated in legislation, or practices developed through the general law of the jurisdiction or a voluntary code supported by the national franchise association. Countries

18 Francine Lafontaine and Kathryn L Shaw, ‘Franchising Growth and Franchisor Entry and Exit in the US Market: Myth and Reality’ (1998) 13(2) Journal of Business Venturing 95-112. 19 Id, quoting John Stanworth, ‘A European perspective on the success of the franchise relationship’ in D Welsh (ed), 9th Annual Proceedings of the Society of Franchising (Institute for Franchise Management, University of St Thomas, 1995). 20 www.franchise-fff.com/index.php.

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have variously categorised franchisees as business consumers,21 consumers, business entities and entrepreneurs.22 Legislation requiring mandatory pre-contract disclosure has been passed in Australia,23 Belgium,24 Brazil,25 Canada26 (uniform law in addition to specific law for the provinces of Alberta, Ontario and Prince Edward Island), China,27 France,28 Indonesia,29 Italy,30 Japan,31 Kazakhstan,32 Korea,33 Lithuania,34 21 Trade Practices Act 1974 (Cth), s 51AC (Australia). 22 There is extensive academic literature outside the legal field exploring the franchisees’ role as an entrepreneur. For example, Patrick J Kaufmann and John Stanworth, ‘The Decision to Purchase a Franchise: A Study of Prospective Franchisees’ (1995) 33 Journal of Small Business Management. 23 Franchising Code of Conduct 1998, (as amended) prescribed under s 51AE of the Trade Practices Act 1974 (Cth) accessible via www.accc.gov.au/content/index.phtml/ itemId/304806; and Trade Practices (Industry Codes – Oilcode) Regulations (commenced 1 March 2007) www.comlaw.gov.au/ComLaw/Legislation/LegislativeInstrument1.nsf/all/ search/362C19BB44F453C8CA2572260016C00C. 24 Law Relative to Pre-Contractual Information in the Framework of Agreements of Commercial Partnership (2005). 25 Law No 8.955 (1994). 26 The Uniform Law Conference of Canada adopted a Uniform Franchise Act and Regulations in 2005 and recommended that Act to the provinces for enactment. Alberta, Ontario and Prince Edward Island and legislation is proposed for New Brunswick source Canada’s newest franchise statute; Edward (Ned) (Bill 32, the Franchises Act, was introduced into the New Brunswick legislature on 23 February 2007 www1.gnb.ca/legis/bill/editforme.asp?ID=388&legi=55&num=2 ) (last viewed 28 May 2007). 27 China: 2007 Franchise Regulation. The Minister of Commerce will release implementation rules to supplement the Regulation (not released as at 28 May 2007). 28 Franchise Disclosure Law No 89-1008 of 31 December 1989 (‘Loi Doubin’). 29 Government Regulation 16/1997, and Minister of Trade and Industry Decree o.259/MPP/ Kep/7/1997 (‘Franchise Law’) to regulate franchising in Indonesia. 30 Italian Law 129/2004 on rules on the Regulation of Franchising. 31 Medium-Small Retail Business Promotion Act (1973) (Act No 101) and Guidelines on Franchising under the Antimonopoly Act; Ministerial Order Implementing the Mediummall Retail Business Act (1973) (Order No 100) (as amended). 32 Law No 330 of 24 June 2002 concerning the Integrated Business Licence (Franchise). It is not a disclosure law, it deals with the franchise agreement and with the duties of all those identified as involved in franchise relationships: www.unidroit.org/english/guides/ 1998franchising/country/kazakhstan.htm. 33 Act on Fairness in Franchise Transactions (2002) (also referred to as the Fair Franchise Transactions Act); the Presidential Decree to implement the Act on Fairness in Franchise Transactions, Franchisor’s Required Disclosure per Presidential Decree art 4(1) (2002) (as amended); Schedule 1 to the Presidential Decree to Implement the Act on Fairness in Franchise Transactions, Franchisor’s Required Disclosure per Presidential Decree art 4(1) (2002); Notice No 1997-4 of the Fair Trade Commission (12997) prescribed by the Fair Trade Commission, pursuant to para 2 of art 23 (Prohibition of Unfair Trade Acts) of the Monopoly Regulation and Fair Trade Act and paras 1 and 2 of art 36 (Determination of Unfair Trade Acts) of the Enforcement Ordinance of Monopoly Regulation and Fair Trade Act. 34 Civil Code of Lithuania, Chapter XXXVII (2001).


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Malaysia,35 Mexico,36 Romania,37 Russia,38 Spain,39 Sweden,40 Taiwan,41 United States42 (where federal legislation regulates franchising,43 and ‘virtually all states have enacted state versions of the FTC Act or acts modeled on the Uniform Deceptive Trade Practices Act or Uniform Consumer Sales Practices Act which proscribe unfair or deceptive trade practices’44) and Vietnam.45 UNIDROIT settled a Model Franchise Disclosure Law in 2002. Even where specific disclosure laws have not been enacted, many countries have adopted laws to regulate franchising. These include Albania, Barbados, Belarus, Croatia, Estonia, Georgia, Kyrgyzstan, Macau, Moldavia, Saudi Arabia, South Korea, Ukraine and Venezuela.46 In Germany, pre-contract requirements have evolved through court cases. These cases have informed the requirements of the disclosure drafted by the German Franchise Association (the DFV). Under German law, franchisees

35 Franchise Act (1998) (Act 590); Franchise (Forms and Feed) Regulations (1999) prescribed under s 60 of the Franchise Act (1998) (Act 590); Franchise (Compounding of Offences) Regulations (1999) prescribed under s 41 of the Franchise Act (1998) (Act 590). 36 Law on Industrial Property (Franchise Provisions) (1991) (as amended); Regulations Under the Law on Industrial Property (1994). 37 Ordinance Regarding the Legal Status of Franchise (1997) (Government Ordinance 52/1997). 38 Chapter 54 (Commercial Concession) of Part II of the Russian Civil Code (1996). 39 Regulation of Retail Trading (Disclosure/Registration Law) (1996) (art 62 of Act 7/1996); the Regulation of Retail Trading, In Relation to Regulation of the Franchise Regime and The Creation of Register of Franchisors (1998) (Royal Decree No 2485/1998) for the development of art 62 of Act 7/1996; amended by Royal Decree No 419/2006 (enacted 27 April 2006). 40 Law on the Duty of a Franchisor to Provide Information (2006) (Law No 2006: 484). 41 Standards Governing Disclosure of Information by Franchisers released by Taiwan Fair Trade Commission pursuant to the Fair Trade Law, 20 August 2004. 42 Federal Trade Commission Act; States with franchise registration or filing laws include California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, Wisconsin (source: ‘Revised US Franchise Rule – a boon to international franchisors’ by Carl E Zwisler in International Franchising Committee Newsletter, May 2007, IBA). 43 USA: Federal Trade Commission Act (‘FTC Act’). 44 W Michael Garner, Franchise and Distribution Law and Practice 2006 Cumulative Supplement, Vol 2 (Thomson West), para 9:34. 45 Decree making detailed Provisions for implementation of the Commercial Law with respect to Franchising Activities (No 35-2006-ND-CP): www.unidroit.org/english/guides/ 1998franchising/country/vietnam.htm. 46 www.dlapiper.com/ (viewed 28 May 2007).

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are generally categorised as entrepreneurs47 and not consumers.48 However, section 507 of the German Civil Code stipulates that founders of new businesses are to be treated as consumers when a credit or a purchase contract for goods is agreed on for setting up a new business and the amount of credit or the purchase price does not exceed €50,000.00. In such cases, the franchisor must give the franchisee a formal written warning that it is entitled to withdraw from the purchase obligation or from the credit within two weeks of signing the contract. If no formal written warning is given or the written warning is not given in the right form, the franchise may withdraw from the contract at any time during the term of the contract. A formal written warning is not required when the franchisee is an active entrepreneur of a corporation or where the contractual relationship is a pure service franchise. In Germany, guidelines have been developed by the German Franchise Association (DFV) to interpret Article 3.3 of the European Franchise Federation (EFF) Code of Ethics. The guidelines are consistent with German case law and state that a future franchisee ‘will receive prior to the signature of a binding agreement a copy of the valid code of conduct as well as the complete and accurate written disclosure of all information and documents relevant to the franchise relationship’. Guideline (1) states: ‘During the initial phase, when a franchisor starts to explain its franchise opportunity, and during contract negotiations a pre-contractual relationship with fiduciary duties emerges which obliges the parities to disclose whatever information is essential for their future relationship.’ Thus, during the pre-contractual phase, the franchisor and franchisee have a relationship of fiduciaries in countries that adhere to the EFF Code of Ethics. In Japan, franchisees are regarded as a business entity. To Japanese franchisors, the term ‘(business) consumer’ might imply an unacceptable degree of imbalance between the franchisor and franchisee. The fact that the Japanese Medium-Small Retail Business Promotion Act (the MSRBP Act) does not exempt disclosure duty even when the franchisee is a big company could support this proposition. The MSRBP Act applies whenever more than half of the franchisees are small and medium-sized businesses. When, for example, 70 per cent of the franchisees are small and medium-sized, 47 Section 14 of the German Civil Code: ‘(1) An entrepreneur means a natural or legal person or a partnership with legal personality whom or which, when entering into a legal transaction, acts in exercise of his or its trade, business or profession. (2) The partnership with legal personality is a partnership that has the capacity to acquire rights and to incur liabilities.’ 48 Section 13 of the German Civil Code: ‘A consumer means every natural person who enters into a legal transaction for a purpose that is outside his trade, business or profession.’


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the remaining 30 per cent, which are big businesses, also benefit from the disclosure. The MSRPB Act was introduced in order to distinguish franchising from multi-level distributorships. When the Ministry of Economy Trade and Industry (METI) tried to encourage franchising as a way of revitalising the medium-sized and small retail businesses sector, multi-level distributorships were widespread, sometimes describing their activities as ‘franchising’. The disclosure duty was expected to serve as the signal that the franchisor in question was authentic and not a multi-level distributorship. So, the disclosure duty under Japanese law is aimed at ‘ensuring an informed decision’ is made, with an accompanying policy of protecting the more vulnerable contracting party. In the United States, the possible categorisation of a franchisee as a consumer depends on the state and the particular legislation being applied. ‘Some (state) FTC Acts limit relief to consumers, which may be construed to exclude franchisees … For example Kansas, Kentucky and Texas49 may exclude franchisees from being consumers for a range of reasons.’50 A franchisee is a consumer under the Colorado Consumer Protection Act,51 and the statutory definitions of consumer have been held to include franchisees under state laws including the Connecticut Unfair Trade Practices Act and the Illinois Deceptive Practice Act. In all jurisdictions where government regulators seek to provide a level of protection to franchisees, the message needs to be objectively and fully conveyed. In the United States, ‘Implicit in the title of the publication (the FTC publication A Consumer’s Guide to Buying A Franchise) is recognition that the majority view in the United States that franchise purchases are non-consumer transactions is not accurate. Tens of thousands of consumers purchase franchises, and for these non-commercial purchasers, the statements of a government agency are influential’.52 The Australian franchise regulator, the ACCC, is similarly guilty. In its 2007 response to the 2006 Review of the Disclosure Provisions of the Franchising 49 However, in Wheler v Box, 671 S W 2nd 75 (Tex App Dallas, 1984) a franchisee was a consumer under the Texas Deceptive Trade Practices – Consumer Protection Act 1980, which includes purchasers of a business as consumers. See Michelle L Evans, ‘Who is a “consumer” entitled to protection of state deceptive trade practices and consumer protection acts’ (1998) 63 ALR 5th 1. 50 W Michael Garner, Franchise and Distribution Law and Practice, 2006 Cumulative Supplement, Vol 2 (Thomson West), para 9:34 at 9-117. 51 Rocky Mountain Rhino Lining, Inc v Rhino Linings USA Inc, 37 P 3d 458; 2003 WL 122378 (Colo 2003). 52 Paul Steinberg and Gerald Lescatre, ‘Beguiling Heresy: Regulating The Franchise Relationship’ (2004) 109 Penn St L R 105.

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Code of Conduct, the Australian Federal Government agreed in principle to the review’s recommendation ‘that franchisors should be required to provide to future franchisees a risk statement that, together with the ACCC’s educational material, should clearly describe the risks and consequences associated with franchisor failure’.53 The Government rejected the need for the franchisor to supply a risk statement to incoming franchisees in favour of recommending ‘the ACCC address the importance of considering the consequences of franchisor failure in its educational material’.54 The ACCC’s response was to publish a pamphlet called ‘being smart about your new franchise and your retail lease’,55 which does not mention franchisor failure. Great care must be taken by regulators to provide accurate information. While countries categorise franchisees differently, they essentially recognise the same vulnerabilities and provide the same rights to address the vulnerabilities for the franchisee pre-contractually.56 The disclosure is a snapshot of the current status of the franchise network, focusing on the financial and legal fitness of the entity called the franchisor. Even in jurisdictions where the franchisees have a recurrent right to receive updated disclosure documents,57 this will not enable a franchisee to predict the franchisor’s future solvency, or insolvency plans. As comprehensive as the disclosure provisions are, there are situations when it is extremely difficult for prospective franchisees to make a fully informed franchise purchase choice. According to the 2006 Franchising Australia Survey, ‘more than two thirds of franchisors are organised as private (proprietary) companies. Fourteen per cent operate as public companies and a further ten per cent are organised as trusts’.58 A franchisee conducting due diligence to verify information disclosed by the franchisor is potentially confronted with three problems: If the franchise is owned by a public company, there will be very little information that is specific to the wholly owned franchisor subsidiary in the published annual returns of the public company.

53 Australia: Review of the Disclosure Provisions of the Franchising Code of Conduct. Report to the Hon Fran Bailey, MP, October 2006, point 21. 54 Australian Government Response to the Review of the Disclosure Provisions of the Franchising Code of Conduct, February 2007, point 21. 55 www.accc.gov.au/content/index.phtml/itemId/771525 (viewed 11 February 2008). 56 For a comparison of the topics disclosure regimes require to be disclosed see A Terry, ‘A Census of International Franchise Regulation’, presented at International Society of Franchising conference, February 2007. 57 For example Australia and Vietnam. 58 Lorelle Frazer, Scott Weaven and Owen Wright, Franchising Australia (Griffith University, 2006), p 34.


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While it is not difficult to obtain information by conducting a search of a proprietary company,59 franchisors often operate their business through many more than one legal entity. The nature of a trust (ten per cent of Australian franchisors) means that it is impossible to conduct due diligence about it. For example in Australian Competition And Consumer Commission v Chaste Corporation Pty Ltd (In Liquidation) (ACN 089 837 329), Braddon Ralph Webb, Orlawood Pty Ltd (ACN 059 294 334), Peter Clarence Foster, Sean Petrie Allen Cousins, Kevin Anthony Mcmullan, Alan Kenneth Cooper, Stephen D’alton, Lander J in the Federal Court in Queensland observed: ‘Chaste was entirely controlled by the fourth respondent, Mr Foster and the second respondent, Mr Webb, and those two gentlemen, through the entities which they controlled, namely, WMMT and WFDT,60 would receive respectively 75 per cent and 25 per cent of the profits. As far as a bystander was concerned, Chaste was entirely controlled by Mr Webb. No bystander could have known that there were agreements in place between the second and third respondents and the fourth respondent, and an entity controlled by the fourth respondent which gave control of Chaste to Mr Foster.’61 The findings of the court in Chaste contradict the spirit of marketing statements such as: ‘large franchise systems can offer you, the new franchisee, safety and dependability. The risk of getting into a big franchise system is usually lower, because they’ve worked all the bugs out of their systems long ago. This doesn’t mean you’re guaranteed to succeed … .’62 The franchisee, reading statements such as ‘this doesn’t mean you’re guaranteed to succeed’, enters the relationship understanding that we (the franchisor) have our business running smoothly, but there may be something about you (new franchisee) that means you will turn out not to be a good franchisee. It directs the prospective franchisee’s attention away from the possibility that the franchisor may become insolvent. As the prospective franchisee reads to the end of the paragraph above, it finds that it should be reassured about the franchise because there is: 59 Through www.asic.gov.au. 60 Two trusts; in 2006, ten per cent of Australian franchisors were operated by trusts, according to L Frazer, S Weaven and O Wright, 2006 Franchising Australia Survey, 34. 61 Qud 252 of 2001 (22 and 24). 62 Jeff Elgin, ‘Are Bigger Franchises Better? The pros and cons of buying into a big name franchise system’, www.entrepreneur.com/franchises/buyingafranchise/ franchisecolumnistjeffelgin/article177774.html (accessed 28 May 2007).

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‘less uncertainty, due to the wealth of information available about the current system and its operators.’63 In some franchises, this sentence should simultaneously be translated to say ‘into the wealth of information the franchisor wants you to know about ….’. The Australian franchisee, faced with the cost or the impossibility of conducting a thorough investigation for itself, may have little choice but to trust the franchisor’s information on face value, or walk away. On becoming a franchisee Regardless of categorisation as consumer, business consumer, business entity, entrepreneur or investor, in all jurisdictions, franchisor and franchisee are parties to a contract, the franchise agreement, drafted by the stronger of the two parties. For example, the strength of the negotiating position of a well-established franchise is demonstrated by the fact that franchisees of each of the 27,943 Subway restaurants in 87 countries are required to sign the identical or substantially similar franchise agreement that provides for disputes that are not able to be resolved at national level to be resolved by arbitration or in court in the location nominated by the franchisor, Connecticut, United States.64 Having signed the franchise agreement, the franchisee is contractually bound to conduct its business as the franchisor stipulates. ‘A ‘structural inevitability’ of franchising is the fact that the franchisee depends on the franchisor65 not only for materials essential to the business, which the franchisee frequently can only purchase through the franchisor,66 but also for such things as land and financing.67 Furthermore, at least part of the franchisee’s business depends on the continuance of the franchise. 63 See above. 64 ‘Doctor’s Associates Inc, an American corporation, is the owner of proprietary and other rights and interests in various service marks, trade marks, trade names and goodwill used in its business including the trade name and trade mark “Subway”. Subway Systems is the Australian licensee of Doctor’s Associates. … Clauses identical or substantially similar to clause 10 appear in franchise agreements for over 14,000 Subway franchises throughout the world. The reason Subway Systems and Doctor’s Associates require disputes with franchisees to be resolved in accordance with clause 10 is that they want to develop an internationally consistent approach to dispute resolution with franchisees.’ In Timic v Hammock [2001] FCA 74. 65 Doug Fazey, ‘When “good cause” goes bad: Minnesota restricts protection for dealers under HUMEDA – River Valley Truck Ctr, Inc v Interstate Cos 33 WMLR (2007) 711 at 728 quoting ABA Antitrust Section: Monograph No 17, Franchise Protection: Laws Against Termination and the Establishment of Additional Franchises 19 (1990). 66 Id, at 34-35. 67 Id.


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But, despite the degree to which the franchisee depends on the franchisor, the franchisor is generally not bound to respect the reasonable expectation of the franchisee that, in return for its dependence, the franchisee can continue to operate as long as it satisfies its agreement.68 Franchisors (in the United States) owe no fiduciary duty to franchisees,69 and no other duty to honour the franchisee’s expectations is likely to come from the franchise agreement itself70 or from contract law governing it.71 Despite all the words about support and nurturing that have made the franchisee trust the franchisor and purchase the business, the franchisor’s contractual position is typically clearly stated in the wording of the franchise agreement, as is shown in Australian retail chicken shop’s clause 10.1 and vehicle rental franchise’s clause 28.1. Clause 10.1 of the franchise agreement states: ‘The National Franchisor, the Master Franchisee and the Franchisee are each independent contractors. They are not and shall not be considered as joint venturers, partners or agents of each other and no fiduciary relationship shall be deemed to exist between them.’72 The relevant clause in the vehicle rental franchise agreement, clause 28.1, ‘deals with the legal relationship between franchisor and franchisee: that of independent contractors and not agent, fiduciary, partner etc’.73 ‘The franchise agreement, although it does not in my view create a fiduciary relationship, involves a real degree of mutual trust and confidence.’74 Implicit for the franchisee in the decision to buy a franchise is that the franchisee is buying into a proven network. The franchisee signs the franchise agreement and looks forward to operating its business for the duration of the licence.

68 Doug Fazey, n 65 above, quoting David Hess, Comment, ‘The Iowa Franchise Act: Towards Protecting Reasonable Expectations of Franchisees and Franchisors’ (1995) 80 Iowa L Rev 333 at 355. 69 Doug Fazey, n 65 above, quoting Paul Steinberg and Gerald Lescatre, ‘Beguiling Heresy: Regulating the Franchise Relationship’ (2004) 109 Penn St L Rev 105 at 174, and at fn 133. 70 Doug Fazey, n 65 above, quoting Robert W Emerson, ‘Franchising and the Collective Rights of Franchisees’ (1990) 43 Vand L Rev 1503 at 1509, n 21 (noting the franchisor usually drafts the franchise agreement and that most obligations fall on the franchisee). 71 Doug Fazey, n 65 above, 711 at 729. 72 Poulet Frais Pty Ltd v The Silver Fox Company Pty Ltd [2005] FCAFC 131. 73 Bamco Villa Pty Ltd v Montedeen Pty Ltd; Delta Car Rentals Aust Pty Ltd v Bamco Villa Pty Ltd [2001] VSC 192, para 27. 74 Id, para 139.

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Franchisee in the franchisor’s insolvency ‘While franchisees are typically required to meet a number of conditions in their franchise agreements, franchisors do not share the same responsibilities. … a franchisee is usually powerless to correct a poorly managed franchisor, even though the effects may weigh more heavily on the franchisee.’75 The appointment of a liquidator to the franchisor’s business signals a radical change in the franchisee’s legal position. The liquidator necessarily has a different focus to that of the franchisor. On the appointment of the franchisor’s liquidator, the franchisee’s status changes instantly from being a valued part of the franchise network to a component of the franchisor’s business that will be categorised only as an asset or a liability for the purposes of achieving the optimal result for the franchisor’s creditors. Status as an ‘asset’ or a ‘liability’ does not give the franchisee any legal rights. Indicators of impending insolvency In the immediate pre-insolvency phase, the franchisor’s own employees are likely to become aware of the precarious nature of the franchisor’s business before the franchisees do because employees notice irregularities in their wages. ‘The franchisees may be at a significant disadvantage compared with the franchisor’s employees when it comes to detecting early warning signs of the franchisor’s financial woes. Being paid wages fortnightly or monthly, … employees would quickly know if they did not receive wages. For example, Vicky Kay, manager of the franchisor owned store Traveland Bondi Junction, is reported as saying that she resigned on 20 November 2001 as manager after 29 years of working for Traveland, fed up with being paid late. ‘They kept saying the money’s coming.’76 Vicky’s employer, Traveland, was a travel agency with 100 company owned and 270 franchisee owned agencies. It was wholly owned by Australia’s failed Ansett Airlines. Traveland’s franchisees may not have become aware of the franchisor’s position until a supplier changed the terms of trade, or they heard about the franchisor’s demise through the media.’

75 Doug Fazey, n 65 above, quoting David Hess, Comment, ‘The Iowa Franchise Act: Towards Protecting Reasonable Expectations of Franchisees and Franchisors’ (1995) 80 Iowa L Rev 333 at 338–9. 76 Alison Rehn and David Penberthy, Daily Telegraph, 15 March 2002.


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For the franchisee, Canadian insolvency litigator Craig R Coltraine77 states: ‘Poor financial performance, including the accumulation of significant debt when the franchise system is not expanding, growing operating losses, the writing down of assets and re-financings are obvious indications (to the financially literate) that a franchise is in difficulty. … Identifying financial problems in non-publicly traded corporations is more difficult.’ Coltraine’s experience as an insolvency litigator has led him to comment: ‘The financial difficulties of a closely held franchisor may become apparent only when the franchisor’s obligation to provide advertising support, equipment and inventory on a timely basis … is breached.’78 Effects on the franchisee In general terms, ‘the effects of franchisor insolvency on the franchise ecosystem translates into a myriad of interests and competing claims among which the franchisee is the least protected … franchisees have no control over the business when the franchisor fails. Franchisees are subject to the decisions of the external controller.’79 ‘The failure of the franchisor is disastrous for the franchisee. Without the ability to exploit the franchise, the ability of the franchisee to trade profitably is destroyed. Franchise systems, by their nature, involve a complex network of business relations. The effects of franchisor insolvency on the franchise ecosystem translate, on insolvency, into a myriad of interests and competing claims among which the franchisee is the least protected.’80 The formal, legal position for franchisees in Canada whose franchisor becomes insolvent is the same as in Australia. In Canada, ‘Although the franchisees will inevitably have little say in the manner of (the) restructuring (of the franchisor’s business), they can maximise their bargaining power by forming an association to represent their collective interests. … no statutory provision compels either the trustee in bankruptcy or the franchisor engaged in … reorganisation to negotiate with such collective bodies’81. Of Ontario, Canada, Goldman states ‘in very general terms, the purpose of the Arthur Wishart Franchise Disclosure Act 2000 SO 2000 is to protect 77 Birenbaum Steinberg Landau Savin & Coltraine LLP, Toronto, Canada, ‘Franchises: insolvency and restructuring’, unpublished conference paper, June 2002, p 3. 78 Ibid, p 4. 79 Wayne Jenvey, ‘Rocky roads and rollercoasters – turnaround strategies for distressed franchise systems’, paper presented at the legal symposium accompanying the 2006 Franchise Australia Annual conference, p 2. 80 Ibid. 81 Goldman, p 10.

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franchisees by requiring franchisors to make extensive pre-contract disclosure and by imposing a duty on franchisors to act in good faith in their dealings with franchisees. The Act does little to remedy a franchisee’s lack of influence on the course of events following the insolvency of the franchisor’.82 The franchise agreement may be categorised as an ‘asset’, if the franchisee is sufficiently attractive to the liquidator – perhaps because there is a steady revenue stream flowing to the franchisor in exchange for relatively little output on the part of the franchisor. As a ‘liability’, the franchisee may be new to the system and ‘needy’, an average performer that is not an active asset for the liquidator, or may have another unattractive attribute such as being a tenant in a retail shop whose head lease the franchisor has breached by becoming insolvent. Alternatively, the franchisee might be a liability that needs to be eliminated because it is threatening litigation.83 The franchisee is a ‘creditor’ if, for example, the franchise is set up like a commission agency, with the franchisor receiving payment from the franchisees’ customers and then paying ‘commission’ to the franchisee, or if the franchisor owes refunds on faulty goods. The franchisee is seldom in a position of being a secured creditor. A third example of the franchisee as creditor is if the franchisor is a judgment debtor or owes the franchisee money after a concluded mediation or arbitration. The ‘debtor’ franchisee – most franchisees will owe some money to their franchisor in the form of the current royalty payment. They are, thus, likely to be debtor for a sum of money that is relatively small compared to the sunk cost of establishing the franchisee business. In the United States, ‘One of the significant events triggered by the filing of the case is the immediate imposition of an injunction known as the “automatic stay”.84 The automatic stay prevents creditors from proceeding with any action against the debtor such as a foreclosure, collections (including letters and phone calls), perfection of a lien, set-off, lawsuits and contract terminations (including notices of termination).85 The policy behind the automatic stay is that the debtor should be entitled to some 82 Steven H Goldman, ‘Tackling Troublesome Insolvency Issues for Franchisees’, October 2003 unpublished, p 6. Available at www.goldmanrosen.com/pdf/franchiseesinsolvency1. pdf (last accessed 29 April 2007). 83 (See EN 4) Sarah B Foster and Carolyn Johnsen, ‘The War Of The Worlds: Bankruptcy Versus …, unpublished paper presented at American Bar Association, 28th Annual Forum on Franchising, 2005. 84 § 362. The stay arises by virtue of the filing without any action by the court. In re Tom Powell & Son, Inc, 22 BR 657 (Bankr WD Mo 1982). 85 § 362(a).


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“breathing room” while assets are marshaled or while a reorganization plan is being developed.86 Staying franchisee litigation … can save enormous amounts of time and resources.’87 Whatever triggers the franchisor’s insolvency, the franchisee finds itself in an unenviable position. Contractual issues Being both standard form and relational, the franchise agreement delivers specific advantages to franchisors and disadvantages to franchisees. The 960 Australian franchisors require franchisees to accept their standard terms. A disadvantage to the franchisee is that franchise agreements seldom include the right for a franchisee to disavow the relationship if the franchisor becomes insolvent. This is because: The agreements are not made between commercial equals. On entering the contractual relationship the ‘franchisor has power, while a franchisee must rely on trust, reputation and other factors outside the contract. The lack of negotiation of the standard form combined with the flexibility, discretion and vaguely defined obligation required by the relational quality of the franchise contract mean that a franchisor accords flexibility to itself, while at the same time it imposes specific obligations upon franchisees’.88 The small firm Australian legal practitioner typically advising franchisees has no way of benchmarking what constitutes usual or particularly onerous provisions of a franchise agreement as there is no public database of disclosure documents or franchise agreements in Australia. The franchisor’s lawyer, on the other hand, has greater exposure to the breadth of franchise contract norms as he or she will typically work in a larger practice that acts for more than one franchisor. The franchise situation is a classic example of an unresolved treatment of contracts. Executory contracts, of which franchise agreements are an example, are not specifically considered in the UNCITRAL Legislative Guide on Insolvency Law89 (the Guide). The Guide reinforces the significance of the round holes – debtors, assets, creditors – and acknowledges as one of the general features of an insolvency law the ‘manner in which the insolvency 86 In re Seafarer Fiberglass Yachts, 1 CBC 2d 209 (Bankr EDNY, 1979). 87 Sarah B Foster and Carolyn Johnsen, ‘The War Of The Worlds: Bankruptcy Versus …’, unpublished paper presented at American Bar Association, 28th Annual Forum on Franchising, 2005, p 18. 88 Elizabeth Crawford Spencer, ‘The Regulation of the Franchise Relationship in Australia: A Contractual Analysis’, PhD dissertation, Bond University, Australia, 20 September 2007, p 170. 89 United Nations, New York, 2005.

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representative may deal with contracts entered into by the debtor before the commencement of proceedings and in respect of which both the debtor and its counterparty have not fully performed their respective obligations’,90 for example, franchise agreements. ‘unlike all other assets of the insolvent estate, contracts are usually tied to liabilities or claims. They include … leases of land or of personal property; and immensely complicated contracts for franchises.’91 Further, ‘The standard form contract which compels consistency of product and practices is normally franchisor centric and does not anticipate insolvency of the franchisor. This limits the ability of the franchisee to self protect’.92 A fundamental difficulty, identified by Rohrbacher, in developing legal policies around contract based property rights is: ‘For executory contracts in bankruptcy, the debtor’s (here, franchisor/ liquidator) right to performance is treated as property, but the debtor’s obligation to perform is treated as contract.’93 Thus, the franchisee finds the liquidator can at the same time have the right to exercise quasi-ownership rights over the franchisee’s business and to disclaim the franchise agreement as an onerous contract. Because the franchisee is a party to a contract with the franchisor, the franchisor’s liquidator has the right in many jurisdictions94 to disclaim the franchise agreement as an onerous contract. Because of the power and information imbalances between franchisors and franchisees, very few franchisees will have negotiated a right to walk away from the franchise if the franchisor is placed into administration or a liquidator is appointed. Insolvency law: constraints on liquidators A liquidator does not appear to have an obligation to sell assets of the failed franchisor to the purchaser who would be the most suitable from the franchisees’ perspective, or to a purchaser who is well motivated towards the franchisees. Theoretically, in Australia, there is nothing to stop a

90 UNCITRAL Legislative Guide on Insolvency Law, United Nations, New York, 2005, p 17. 91 A Bou, et al, ‘Insolvency in International Franchise Relationships’, conference paper presented at the International Bar Association Conference, San Francisco, 2003, p 16. 92 Wayne Jenvey, ‘Rocky roads and rollercoasters – turnaround strategies for distressed franchise systems’, paper presented at the legal symposium accompanying the 2006 Franchise Australia Annual conference. 93 B Rohrbacher, ‘More equal than others: defending property-contract parity in bankruptcy’ (2005) 114 Yale Law Journal 1099(35). 94 For example in Australia under s 568(1) of the Corporations Act 2001 (Cth).


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liquidator from selling the franchisor’s business to a direct competitor95 of the franchisor. It is unlikely that an acquisition would meet the threshold test of having the effect, or being likely to have the effect of substantially lessening competition in a market,96 that must be met before a merger is closely examined and potentially prevented from occurring. That direct competitor may elect not to buy the franchise agreements but, instead, to simply buy the brand and shelve it. Likewise, the Antimonopoly Act of Japan prohibits various types of consolidation and mergers that would substantially restrain competition in the relevant market.97 Acquisition of a failing company in Japan is subject to looser examination by the Japan Fair Trade Commission under guidelines on merger examination.98 It can thus be concluded that the purchase of a brand from the failed franchisor is unlikely to be found to be substantially restraining competition. In Europe, the purchase of an essential part of, or the entire assets of, a bankrupt franchisor falls under the mergers and acquisitions (M&A) control provisions only where high thresholds of German, French or EC competition law are exceeded. There would be very few franchisors in Europe who seriously qualify for M&A control as the turnover of the independent franchisees in the network is not taken into account when calculating the turnover of the franchisor. The thresholds in most cases would only be reached when the franchisor itself belongs to a major group as, in that case, the turnover of all affiliates has to be taken into account. Even if an acquiring franchisor did fall under merger control when purchasing the remaining assets of the insolvent franchisor, the purchase would probably be authorised since the insolvent franchisor would otherwise disappear from the market and its remaining turnover and market power would probably not greatly enhance the position of the purchaser.99 In the case of franchise agreements where the franchisee has made a large financial investment and adopted a significant part of the franchisor’s business risk it is, arguably, superficial simply to regard the franchise agreement as a contract that may be disclaimed at the liquidators’ election. At the other end of the spectrum, where the franchisee has made a small investment and is significantly controlled by the franchisor, the franchisee 95 Section 50 of the Trade Practices Act 1974 (Cth) prohibits acquisitions that would result in a lessening of competition. 96 Australia: s 50(1) of the Trade Practices Act 1974 (Cth). 97 Japan: articles 15, 150-2, 16 of the Antimonopoly Act accessible via www.jftc.go.jp/e-page/ index.html (last accessed 26 May 2007). 98 Part IV 2 (8) Japanese merger guidelines (accessible via the same link as in n 97 above). 99 The information about the situation in Japan and Germany and France was supplied by Professor Souicgirou Kozuka and Albrecht Schulz.

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may well be an employee in reality,100 and should be accorded the particular status that employees enjoy in the insolvency of their employer. Policy challenges In Australia, once the franchisor is controlled by a liquidator, the consumer protection legislation ceases, for all practical purposes,101 to provide ongoing protection to franchisees. This illustrates an issue that was raised in the UNCITRAL Legislative Guide on Insolvency Law102 – the relationship between insolvency and other law. The Guide recommends that ‘the relationship between insolvency law and other laws should be clear and, where possible, references to the other laws should be included in the insolvency law’. It is suggested that it would also be a good idea if the reverse applied and a reference to the insolvency laws were included in the disclosure and other consumer protection laws regulating franchising. The insolvency model and the franchise model are currently out of step with each other.

100 For example in a case in the Massachusetts Supreme Judicial Court, Coverall North America, Inc v Commissioner of the Division of Unemployment Assistance et al (SJC Docket No 09682) ‘The SJC determined that the claimant was an employee and not an independent contractor for the purposes of unemployment insurance under MGL ch 151A s 2, because the claimant’s business was not actually independent from the franchisor’s business. First, the “franchisee” was required to allow the franchisor to negotiate all contracts and pricing directly with the “franchisee’s” clients. Additionally, the franchisor sent bills and collected payments. Second, although the “franchisee” was entitled to expand her business (although she chose not to), any additional clients would have been clients of the franchisor. The franchisor would have negotiated the contract and pricing, sent bills and collected payments. Third, the claimant’s business ended once the regional manager discharged her. Therefore, the SJC concluded that there was substantial evidence that the claimant’s business was not independent from the franchisor.’ ABA forum on franchising, comment by Michael J Radin, US-based attorney at law, 20 December 2006 and see J Buchan, ‘Is there a Basis for Equating Franchisees with Employees in Priority Ranking on the Insolvency of Franchisors?’ International Society of Franchising (ISoF) conference, 2426 February 2006; and the IBA/IFA joint seminar on 9-10 May 2006, ‘Global Franchising’, ‘Can Franchisees be Treated as Employees?’ Where the issue was addressed in papers by John Chambers, Chambers & Co, United Kingdom; Markus Cohen, Toronto, Canada; Remi Delforge, Donald Manasse & Remi Delforge Avocats Associés, Nice, France; Joyce G Mazero, Haynes and Boone, LLP, Dallas, Texas; Penny Ward, Baker & McKenzie, Sydney, Australia. 101 The decision in Sons of Gwalia Ltd v Margaretic; ING Investment Management LLC v Margaretic [2007] HCA 1 (31 January 2007) provided consumer protection remedies for a shareholder of an insolvent company in relation to his investment in shares, in very limited circumstances. 102 Page 19.


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This will have occurred for a number of reasons, including: • Periodic reviews of insolvency policy have not received submissions from franchise interests. • The economic cost of franchise failure is not counted in studies such as the ‘Economic Impact of Franchised Business’ conducted for the International Franchise Association Educational Foundation,103 and thus it is generally below the regulators’ radar.104 • In each country where franchising is the subject of specific legislation, the focus is firmly on pre-contract disclosure. This ignores that fact that even if the disclosure is perfect, some franchisors will still fail, or will choose insolvency to deliver commercial benefits. At that point, the best disclosure in the world becomes useless to the franchisee who is told that he or she should have conducted better due diligence. • Franchisor insolvency is a little like other uncomfortable issues and is seldom publicly discussed. • There is a dearth of properly funded empirical research of the actual legal effects of franchisor insolvency on all of the franchise stakeholders. Potential solutions for franchisees In the short term, the most appropriate way for prospective franchisees to mitigate against the possible harmful effects of their franchisor becoming insolvent is to ‘attempt to structure his or her affairs to ensure minimum personal liability and flexibility in keeping or restructuring the business in the event the franchise business fails or alternatively the franchisor becomes insolvent’.105 Realistically, the opportunity to do so depends on the franchisor’s willingness to negotiate, the franchisors policies regarding matters such as whose name the premises lease is in, and the franchisee’s ability to negotiate. In the United States, ‘The UST may also appoint additional committees of creditors or equity security holders as the UST “deems appropriate.” (11 USC 1102(a)(1)) This is important in a franchisor bankruptcy if franchisees believe their interests are not adequately represented on the Committee. 103 PricewaterhouseCoopers, 2004. 104 An exception is the exploratory Australian study funded and published by CPA Australia. The resulting report, When the Franchisor Fails, can be accessed at www.cpaaustralia.com. au/. 105 Steven H Goldman, ‘Tackling Troublesome Insolvency Issues for Franchisees’, October 2003, unpublished. Available at www.goldmanrosen.com/pdf/franchiseesinsolvency1. pdf (last viewed 29 April 2007) pp 3–6. Goldman’s paper outlines ten specific strategies franchisees may attempt to put in place.

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Because franchisees may not have an actual liquidated claim against the franchisor at the time of filing, they may not be included on the list of twenty largest creditors and may not be solicited to serve on the Committee. Yet, they have a large stake in the bankruptcy. Franchisees may urge the UST to appoint a separate committee or petition the court to allow the formation of a franchisee committee.’106 Coltraine suggests: ‘Renegotiating the franchise agreements in order to support the franchise and preserve goodwill may be a possibility. Financing the franchisor could be considered if the franchisor’s primary lenders were willing to engage in reorganisations outside formal proceedings.’ 107 The outcome for specific, individual franchisees depends on factors as diverse as: • how individual franchise agreements address franchisor insolvency (usually they are silent on the issue, but do devote clauses to consequences of franchisee failure); • whether the insolvency was forced on the franchisor or was part of a considered business strategy; • decisions the administrator or liquidator takes in relation to disclaiming onerous contracts;108 • whether the liquidator categorises the individual franchise agreement as ‘asset’ or ‘liability’; • whether the ‘franchisor’ that becomes insolvent is the franchisor or is actually a national master franchisor. If the franchisor that fails is a national master, the master franchisee’s insolvency will most likely be an event 106 Sarah B Foster and Carolyn Johnsen, ‘The War Of The Worlds: Bankruptcy Versus …’, unpublished paper presented at American Bar Association, 28th Annual Forum on Franchising, 2005, p 20. Cases in which franchisee committees have been appointed: In re Nutri/System, Inc, 169 BR 854 (Bankr E D Pa 1994); In re First International Services Corp, 25 BR 66 (Bankr D Conn 1982); In re Rusty Jones, Inc, 128 BR 1001 (Bankr ND Ill 1991. 107 Craig Coltraine, ‘Franchises: insolvency and restructuring’, unpublished conference paper delivered in Toronto, Canada, June 2003. 108 Australia: Michael Murray, Keay’s Insolvency – Personal and Corporate Law and Practice (Thomson Lawbook Co, 5th edn, 2005) at 340: ‘In some cases liquidators do not wish to retain property because it is too onerous, worth little or is unsaleable. In such circumstances, liquidators wish to get rid of the property in order to avoid responsibilities and costs in relation to it. In disclaiming, the liquidator gives notice to others that he or she wishes to be rid of any interest in the property. If a person suffers loss as a consequence, those persons to whom notice has been given are required to try to mitigate their loss. They may lodge a proof of debt in the liquidation in respect of the amount of that loss. The liquidator may disclaim property referred to in section 568(1) Corporations Act 2001 (Cth) (including): land burdened with onerous covenants (for example a lease of retail space in the franchisor’s name that is licensed to a franchisee as occupier with no status on the title and no privity of contact with the landlord) contracts (including franchise agreements)’.


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that gives the franchisor the right to terminate the master. This leaves the franchisees’ agreements with the master somewhat meaningless. All lawyers are well schooled on the notion that one can only grant a right that is equal or smaller than the rights one enjoys oneself. Interestingly, in Vietnam, ‘in what may be a unique disclosure requirement, the (25 May 2006 Ministry of Trade) decree (on Franchising) … requires disclosure of certain subjects in the sub franchise agreement, such as … how the sub franchisee will be dealt with in the event of termination of the Master Franchise Agreement’;109 • whether a buyer can be found for the franchise network, and then whether the buyer wants to ‘cherry pick’ or is willing to take over all franchisees; • the suitability of the buyer; ‘sale of the (franchisor’s) business may subject the franchisee to the control of a company unfamiliar in the area and incapable of running the business profitably. The dramatic demise of Traveland (franchise subsidiary of Australia’s former Ansett Airlines) demonstrates the implications of a buying entity that has little experience in the franchisor’s core business area and has insufficient resources sufficiently to support the business’;110 • the physical whereabouts of a franchisee’s business. For example, if the buyer already has an outlet in the same shopping centre it may decline to adopt the franchisee’s franchise agreement as it does not want to cannibalise an existing market; • how the franchise network is structured (configuration of the network, levels and nature of delegation, allocation of risk, ownership of the assets that make up the franchisor); and • the individual franchisee’s resilience and negotiating ability. In civil law countries (for instance Germany), the bankruptcy of one party may constitute a ‘good cause’111 immediately to terminate the ongoing contract unless this is not permitted under the applicable insolvency law. It may also be possible to litigate against the liquidator, claiming the liquidator has been unjustly enriched by the ability to access unearned franchisees’ licences and marketing funds to benefit secured creditors.112

109 David E Holmes, ‘News from around the world – a round-up of developments in franchising’ (2006) quoting Michael Brennan; IBA International Franchising Committee Newsletter, Vol 11 No 1 May 2007, p 12. 110 Wayne Jenvey, ‘Rocky roads and rollercoasters – turnaround strategies for distressed Franchise Systems’, paper presented at the legal symposium accompanying the 2006 Franchise Australia Annual conference, p 9. 111 www.iuscomp.org/gla/statutes/BGB.htm. 112 www.iuscomp.org/gla/statutes/BGBrest.htm#Ungerechtfertigte.

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Possible future ways of aligning the franchise model more with insolvency law policy and with franchisees’ expectations It is arguable that by continuing to address franchisees’ interests on an ad hoc basis insolvency policy objectives articulated in the Guide will not be met. The Guide acknowledges: ‘Since an insolvency regime cannot fully protect the interests of all parties, some of the key policy choices to be made when designing an insolvency law relate to defining the goals of the insolvency law and achieving the desired balance between the (eight key) objectives of (1) maximising the value of assets, (2) striking a balance between reorganisation and liquidation, (3) ensuring equitable treatment of similarly situated creditors, (4) providing for timely, efficient and impartial resolution of insolvency, (5) preventing premature dismemberment of the debtor’s assets, (6) providing for a procedure that is transparent and predictable and contains incentives for gathering and dispensing information, (7) recognising existing creditors rights and establishing clear rules for ranking of priority claims and (8) establishing a framework for cross-border insolvency.’113 In addressing objective number (8), policy advisers should be aware that franchised businesses are destined to travel. ‘Just over one quarter (27 per cent) of Australian based franchisors are currently franchising overseas.’114 For example, Boost Juice originated in Australia in May 2000. By 2006, the franchisor had ‘begun operations in Chile and New Zealand and, as well as the UK, had signed up master franchisers in Kuwait, Singapore and Indonesia’.115 To take another example, ‘Cartridge World is now the world’s largest … cartridge refiller and manufacturer, with more than 1,500 company owned and franchised stores in 46 countries.’116 The United Kingdom also reports that 27 per cent of its franchisors maintain an international presence.117 This pattern of overseas expansion is common among franchisors. If it is accepted that franchisees are uniquely vulnerable in the franchisor’s insolvency, any solutions must be measured enough to permit the value of 113 United Nations Commission on International Trade Law, Draft legislative guide on insolvency law, 16 April 2003, 1-2, 6. 114 Lorelle Frazer, Scott Weaven and Owen Wright, Franchising Australia (Griffith University, 2006), p 66. 115 Virginia Marsh, ‘Entrepreneur enjoys fruits of fast-expanding juice chain – Janine Allis squeezed her way to success from humble beginnings’, Financial Times, 24 June 2005, p 5 quoting Boost’s founder, Janine Allis. 116 Sue Mitchell, ‘Cartridge refiller tops up with $60m’, Australian Financial Review, 2 August 2007, 23. 117 British Franchise Association, NatWest Survey 2006: United Kingdom Franchise Survey, p 17.


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the brand to be retained if possible. Solutions should address the potential for the franchisee to continue in business with or without the brand. The franchisees would be sensible to negotiate with the liquidator as a cohesive group. The liquidator will not be able to register them as priority creditors, but will recognise the value of the franchisees. The franchisees as a group may be able to buy the brand. As the law currently stands, in Australia, every concession secured by franchisees in relation to every contractual commitment will be as a result of their ability as negotiators. If the franchise contracts do not fit the round holes of assets or liabilities, and the franchisee is not a debtor or creditor, there is no room for it in the liquidation. The franchisees’ role as replacement supplier of capital and labour, replacement advertising and marketing arm of the brand, and risk taker, does not secure it status as a stakeholder in insolvency. Turning again to UNCITRAL Legislative Guide on Insolvency Law, it is stated: ‘As to the types of contract to be affected, a common solution is for insolvency laws to provide general rules for all kinds of contract and exceptions for certain special contracts. The ability to reject labour contracts, for example, may need to be limited in view of concerns that insolvency can be used as a means of expressly eliminating the protections that these contracts afford to employees.’118 Once the franchisors motivations for becoming insolvent and the role of the franchisee is fully understood, franchise agreements may be seen to fit this category. Whether the franchisee is categorised as a consumer, a business consumer, an investor, an enterprise, or simply a franchisee, the laws that help inform the purchasing decision, and the laws that provide rights during the time the franchisor is solvent, play no role once the liquidator has been appointed. The liquidator has, necessarily, a different focus. In Australia, the franchisee moves from being a valuable component of the franchisor’s business network, backstopped by rights that are predominantly found in the Trade Practices Act 1974 (Cth) to a contracting party whose business is recategorised as ‘asset’ or ‘liability’ with no particular statutory or common law rights. As franchise networks are destined to travel, it is suggested that it would be appropriate for the consequences of franchisors becoming insolvent to be examined at the time that cross-border harmonisation of insolvency legislation is considered. As the insolvent franchisor is usually part of an

118 Paragraph 113.

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interdependent group of entities,119 it would be appropriate to include a consideration of franchise networks in UNCITRAL’s inquiries into the insolvency of corporate groups. The franchise model will also continue to evolve quickly; to be adapted to an increasingly wide range of goods and services suppliers and to be used as a form of corporate rescue by companies that are not trading strongly. Successful franchise networks are increasingly becoming the target of public company acquisitions. One of the features that attract a company to invest in a franchise network is that it is buying a monopoly. ‘Monopoly power always decreases social welfare unless the harm is offset by innovation, productive efficiency, or network effects. In fact, in a perfect market with the absence of transaction costs and wealth effects, those who are harmed by monopolies would be able to purchase the “right” of monopolies to exist.’120 Future empirical evidence will clarify what number and type of franchisor entities fail, and why the failures occur. This will inform policy-makers about the nature of any protection that might be granted to franchisees. What we do know is that accommodating a franchisee’s true interests within the franchisor’s insolvency is like trying to poke a square peg into a round hole. It is a bad fit. Sir Kenneth Cork once wrote: ‘changes in ... the commercial life of the community since the Nineteenth Century require the law of insolvency to be reviewed and refashioned to meet the needs of our own time.’121 ‘Credit is the lifeblood of the modern industrialized economy. … The employee who is paid at the end of the working week gives credit to his employer.’122 As commercial life continues to change in the 21st century, insolvency laws need to be reviewed and if necessary, refashioned to accommodate franchisees.

119 Usually the franchisor does not own the trademarks, it holds head leases of franchisees’ premises in the names of related entities, yet other entities are created for specific purposes, such as training franchisees, and the franchisor itself may be a wholly owned subsidiary of a listed corporation. It would be very rare for a franchisor to be a single legal entity. 120 Jeffrey L Harrison, ‘An Instrumental Theory Of Market Power And Antitrust Policy’ (2006) 59 SMULR 1673 at 1711. 121 Sir Kenneth Cork, Great Britain Insolvency Law and Practice Report of the Review Committee, June 1982, p 9. 122 Ibid, at p 10.