Navigating franchise insolvency: insights for franchisors and franchisees

Navigating franchise insolvency: insights for franchisors and franchisees

ECCTA: Economic crimes

While franchising has typically been a more robust business model than others, it remains susceptible to broader economic and sectoral pressures, as The Body Shop’s recent entry into administration demonstrates.

In the unfortunate event that a franchisor or franchisee becomes insolvent, disruption is inevitable. However, insolvency doesn’t necessarily spell a terminal outcome. In this article we consider some of the key considerations for both franchisors and franchisees.

Handling franchisee insolvency: the franchisor’s approach

When a franchisee faces insolvency, the franchisor’s primary objectives will include:

  • Preserving reputation: Minimizing any negative impact on the brand’s reputation.
  • Business continuity: Ensuring that the franchise business continues operating if feasible.
  • Financial mitigation: Recovering or minimizing financial losses.

To achieve these goals, franchisors must actively monitor franchisees’ financial health. Detecting early warning signs of distress will enable them to take prompt action when necessary.

1. Sale of franchise pre-insolvency process

The insolvency of a franchisee poses a risk to the brand reputation and goodwill of the franchisor. Consequently, where a franchisee is experiencing financial difficulties it is in the franchisor’s best interest to intervene early, before formal insolvency proceedings commence. This intervention may involve providing support to help the franchisee navigate temporary trading challenges, or assistance with finding a buyer to take over the business from the insolvent franchisee.

Typically, the terms of the franchise agreement will give the franchisor substantial control over a sale of the franchise. In most modern franchise agreements, the franchisor’s consent is required in relation to any potential purchaser. A sale, pre-insolvency process, can be advantageous for the franchisor, ensuring that the consideration for the purchase is first used to settle any outstanding debts owed to them by the existing franchisee.

2. Liquidation of the franchisee

Inevitably, there are situations where a solvent outcome is unattainable. For smaller franchisees, the most likely scenario sees the franchisee entering into a creditors’ voluntary liquidation. In this situation, the franchisor will look to terminate the franchise, and ideally they should take pre-emptive steps to do so before the liquidator assumes control. This proactive approach helps avoid the need to navigate statutory restrictions related to the post-insolvency termination of certain contracts. While termination after insolvency remains an option, the franchisor must seek legal advice regarding the grounds for doing so.

In a liquidation scenario, unsecured creditors typically receive only a nominal dividend, if anything at all. The franchisor will therefore need to consider other potential claims related to security, personal guarantees, or set-off in order to recover its debt.

3. Franchisee restructuring

Larger franchisees, who operate both successful and struggling outlets, may explore options for restructuring their operations (either by way of an informal restructuring, or a formal process), rather than entering into a ‘terminal’ insolvency process such as liquidation. Generally, restructuring offers better outcomes for creditors compared to liquidation.

Formal restructuring options include:

  • Administration combined with a “pre-pack” business sale: this approach enables unwanted assets and liabilities to be shed while business operations are continued under a new corporate vehicle.
  • Company voluntary arrangement or restructuring plan: these alternative processes can both be used, for example, to exit non-performing locations and/or compel landlords to enter into a compromise regarding rent..

The franchisor’s support for the business will be pivotal in the post-restructuring phase, and they will therefore likely play a significant role in shaping the final restructuring strategy.

Insolvency of a franchisor – the franchisee’s perspective

While franchisee insolvency is more prevalent, franchisor insolvency does occur. When it does, the outlook for the franchisees is uncertain.

1. Continuation of franchise agreement

A liquidator or administrator overseeing the franchisor’s affairs typically aims to retain valuable franchise agreements, as these can be sold as part of any asset sale. In the short term, the liquidator or administrator may therefore encourage franchisees to continue trading as usual and pay their franchise fees.

Franchisees might be surprised to discover that their franchise agreement does not automatically terminate when the franchisor becomes insolvent. In fact, most franchise agreements lack an express right for franchisees to terminate based on the franchisor’s insolvency, even if the franchisor breaches its obligations under the agreement. While franchisees may still have the option to terminate under common law due to a fundamental breach by the franchisor, this action carries risks. It could potentially place the franchisee itself in breach of the agreement, leading to a claim for damages from the liquidator or administrator.

2. Going solo: franchisee challenges and opportunities

If the liquidator or administrator consents to a termination of the franchise agreement, the franchisee faces the daunting task of sustaining their business independently, outside the franchise framework. Without access to the franchisor’s system, trademarks, or other intellectual property, the franchisee must undergo a complete rebranding process. Additionally, the insolvency practitioner will seek to recover any assets owned by the franchisor (and not fully paid for by the franchisee). The franchisee may also need to renegotiate agreements with suppliers or seek new suppliers if they previously relied solely on the franchisor.

However, there may be a silver lining: a franchisee or a group of franchisees could be strategically positioned to purchase the insolvent franchisor’s assets, including trademarks and system copyrights, at a favourable price. For franchisees in a position to take such action, this challenging situation could become an opportunity.

3. A fresh start: takeover by a new franchisor

Franchise agreements typically grant the franchisor the right to assign the agreement to another party without requiring the franchisee’s consent. Consequently, the franchisee might discover that their business has been sold by the administrator or liquidator, to a new franchisor - sometimes even before the franchisee becomes aware of the original franchisor’s insolvency.

The effect of this transition largely depends on the new franchisor. The impact on the franchisee may encompass:

  • Operational changes: the purchaser may introduce alterations to working practices and fees in an effort to revitalise the business.
  • Rebranding and adaptation: if the buyer is a competitor of the existing business, the franchisee might need to rebrand and adjust to a new operating system.
  • Investment: on the bright side, a new franchisor could infuse fresh energy and investment into the business.

However, if the franchisee prefers not to continue under the new franchisor, terminating the agreement before its original term concludes is likely to be difficult. In such cases, the franchisee will need actively to seek a purchaser for their franchise.

This article was first published in Elite Franchise and can be accessed here

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