Abstract
Employment relations are well understood. Business format franchising is a newer and rapidly evolving business expansion formula, also providing employment. This article compares the fates of employees and franchisees in their employer/franchisor insolvency. Whereas employees enjoy protection, franchisees continue to operate in conditions that have been described as Feudal. We identify the inherence of moral hazard, path dependency and optimism bias as reasons for the failure of policies and corporations laws, globally, to adapt to the franchise relationship. This failure comes into sharp focus during a franchisor’s insolvency. We demonstrate that the models of participation available to employees in the United States, Australia and the United Kingdom could be used to inform a re-balancing of the franchisees’ relationship with administrators and liquidators during the insolvency of their franchisor, providing franchisees with rights and restoring their dignity.
Introduction
Organisations respond to intensive labour needs in several ways: departmentalising, creating corporate groups with key companies having few employees, engaging contractors and outsourcing. These strategies can be used to transfer the obligations typically associated with employee liabilities 1 through a decentralised structure that distances the business management from front-line operations. Checks and balances for related companies are governed by corporate law. Contractors negotiate and sign supplier agreements that address the risks of all parties, including the risk of any of the parties’ businesses failing. Business format franchising (‘franchising’) is a form of outsourcing. In franchising, erstwhile employers of large labour forces become franchisors and outsource branch ownership, management, equity and debt financing, insurance, responsibility for employees and associated obligations to franchisees. This is achieved through standard form contracts presented to franchisees on a ‘take it or leave it’ basis. As Veronica Taylor noted as early as 1997, ‘[f]ranchising is another country…While the form is contractual, the franchise retains many of the features of the firm’. 2 But, through this form of outsourcing, corporate law obligations and scrutiny are avoided. 3
Given the discrepancies between employment and franchising, our discussion draws on concepts from institutional theory. Institutionalisation refers to the process whereby certain processes, such as the mechanisms and flexibility of the franchise model, take on a rule-like status. 4 In the franchise model, institutional rules developed over time no longer reflect the reality of a mature franchise market. They are nonetheless embedded in the model. This suits franchisors well. Gillian Hadfield observed that ‘[u]nlike…an employment relation…the franchise relationship is characterised by the fact that franchisees own the bulk of capital assets of the franchise and franchisors retain the right to determine how franchisees will use those assets’. 5 Early franchising comprised a straightforward, albeit skewed, contractual relationship between a franchisor and each of its franchisees. Possibly because early franchisors were assumed to have tested the business thoroughly before offering franchises, the contracts did not provide for the franchisor becoming insolvent. As the system matures, the franchisor spreads its roles through numerous franchisor-related companies. When the franchisor expands internationally, sells its role to public shareholders or private investors, or takes any risky strategic decision like borrowing to acquire an additional brand, the original franchisor/franchisee relationship is placed at risk. For franchisors, the essential driver of franchisee profitability can quickly give way to shareholder or venture capitalist focus on growth of dividends and reduction of costs. Franchisor failure may be the outcome.
Employees regularly benefit from legislative and social protections that can include participation, consultation, requirement for fair treatment, and alternative employment or payouts when their jobs are at risk. Corporations law recognises employees as priority creditors in their employer’s insolvency. But there is no specific provision, anywhere in the world, to accommodate franchisees’ interest as their franchisor fails. We suggest the resistance to recasting franchising as a form of business requiring adjustment to insolvency rules can be explained by the theories of path dependency and moral hazard and by franchisees’ own optimism bias. Optimism bias is explored later under the heading ‘Justifying Franchisee Participation: Moral Hazard’.
Path dependence, ‘paths shaped by a nation’s political and cultural institutions or chaotic chance events’, 6 helps explain how the rejection of the Casnot interpretation in Australia 7 led to franchising being regulated solely under the national competition and consumer law, rather than corporations law. This shifted the regulation from the possibility of regulation via the ‘cradle to grave’ approach of the Corporations Act 2001 (Cth) (‘Corporations Act’) to franchising being regulated solely under the Competition and Consumer Act 2010 (Cth) that governs competition and consumer protection. The latter has no role in business failure. It also helps us understand the difficulty of introducing change in regulatory frameworks. The franchise model, as a relative newcomer to business, has evolved under the radar of many legislatures, and often without regulatory constraint. 8 Franchisors naturally resist regulation that would inhibit the adaptable character of franchising. They cling to the mantra of growth and success. Such institutional behaviour shows a path-dependent tendency by placing importance on the status quo of flexibility of the basic franchisor/franchisee relationship remaining in a low regulatory environment. As the model has matured, it is arguable that franchisors also take advantage of franchisee optimism bias, treating franchisees like tools of investment and financial gain, even to the point of delaying inevitable insolvency through capital injection by way of franchise fees. Although franchising has often been likened to a marriage, or a ‘partnership’, these analogies fail when franchise relationships are viewed through a legal lens. They fail spectacularly when we consider that the law provides rules governing the failure of a marriage 9 or a partnership, 10 but not the failure of a franchisor.
Conversely, Australia’s franchise law does provide for the failure of a franchisee. 11 ‘Much of the content of franchising agreements and the supporting ideology seems reminiscent of feudal contractual relationships’. 12 Today, the franchise relationship remains one of subordination of franchisees, who are more akin to employees who have bought their job than independent contractors. While academics have identified that moral hazard can exist on the franchisor’s side, 13 none have examined the moral hazard that exists during franchisor failure. We base our arguments for the implementation of participative procedures and genuine stakeholder rights for franchisees in this area of moral hazard.
When a non-franchised company experiences financial difficulty, employees become a significant burden for administrators, and subsequently for liquidators, but the opposite applies when a franchisor is failing: franchisees become an unpaid labour force during the franchisor’s administration. Administrators may discover that franchise agreements, binding while the administrator tries to sell the franchise, are their most valuable assets. Ultimately, franchise agreements are disclaimed as onerous contracts by liquidators if no buyer is found, leaving franchisees without the support of their franchisor, and potentially losing their businesses. This is the franchisors’ insurance-like payout for the franchisees accepting moral risk.
With significant assets at risk for franchisees, the level of risk transference in the franchise model represents a moral hazard which occurs when franchisors increase their exposure to risk when ‘insured’. The insurers are franchisees who bear the cost and provide ‘insurance’ for the franchisor’s risky decisions. There is no disincentive to risk-shifting by franchisors. While franchisees can choose which brand to invest in: McDonald’s, Hungry Jack’s or Burger King; Hilton Hotels or Quest Serviced Apartments; Flight Centre, Harvey World Travel, itravel or the now insolvent Traveland; once the franchise relationship is established, franchisees lose independence. Their absence of independence is particularly evident when a franchisor fails.
While the franchise model has had a comparatively short existence, it continues to be used globally and, as previously noted, usually without specific regulatory constraint. Where regulations do exist, they make various provisions for registration, precommitment disclosure, mandatory terms and/or dispute resolution processes. Some address franchisee insolvency or bankruptcy through mandatory terms 14 but none address franchisor failure. There is a clear resistance to imposing enforceable regulation that would inhibit the innovative character of franchising. This behaviour shows a path-dependent 15 tendency by placing importance on the status quo of flexibility in a low regulatory environment over time, while ignoring the level of sophistication of 21st century franchise networks. It is difficult to implement change that would interfere with that status quo.
The franchise model also takes advantage of franchisee optimism bias, treating franchisees like tools of costless investment finance and financial gain. Fees generated through sales of new franchises sometimes provide capital injections during times of financial distress of which franchisees will be unaware. 16 Today, the franchise relationship tends towards subordination of franchisees, much like the position of employees. It is in this area of moral hazard in the use of the franchise model that our arguments for the implementation of participative and consultative procedures are derived. It is timely that we break the institutional path protecting the flexibility of the franchise model to acknowledge the moral hazard present in the model and introduce changes to mitigate the risks to which franchisees are all exposed.
The purpose of this article is to explore the legal position of franchisees during franchisor insolvency 17 through the lens of moral hazard with a view to proposing solutions derived from existing employment regulation. There are many similarities between employees and franchisees, including the asymmetry of information available about the overall financial health of the employer/franchisor. While long recognised that these issues can be acute in employment relationships, we argue that franchisees are currently more vulnerable. A compounding factor is the aspect of optimism bias. This tendency of individuals to underestimate risks is strongly present in franchisees. 18
We arrive at recommendations to resolve the moral hazard borne by franchisees by comparing the legal position of employees in collective redundancy arrangements with that of franchisees of insolvent franchisors in three jurisdictions: the United States (US), Australia and the United Kingdom (UK). As Australia has a uniform national regulatory framework for franchises, greater space is given to the Australian franchise environment. In our analysis, we ask whether franchisees should benefit from greater participation during their franchisor’s administration and insolvency, introducing greater equity and diminishing the morally hazardous advantage-taking that the business model currently offers. We then argue for better recognition of the asymmetries and risks affecting franchisees and suggest how franchise laws could adopt solutions from employment law.
Franchisees and Employees in Context
Franchising has been a part of the socio-economic landscape of Western economies for decades. Now, almost every corner of the global retail economy has franchising. In the US, Howard Johnson began franchising restaurants in 1935 and Sanders selling chicken in the 1950s, 19 while the McDonald brothers started selling burgers in 1937. 20 In Australia, each of the 1100 business format franchisors has an average of 60 franchisees; some have hundreds, and some only one. As employers, Australian franchisors and franchisees together provide employment for approximately 472 000 employees. 21
In franchising, a franchisor develops a branded retail business, commits its day-to-day operation to manuals and grants licences to franchisees to replicate the business using the franchisor’s brands and systems. Franchisees themselves have many different starting points. Some are like Aziz Hashim, former Chair of the International Franchise Association, who recalls his inexperience as a first-time franchisee, buying a Kentucky Fried Chicken (KFC) outlet in Atlanta prior to the 1996 Atlanta Olympic Games. Regarding metrics such as Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) or Rate of Return, he admits: ‘I was clueless! I was just happy that KFC gave me a franchise.’
22
Others are like an Australian franchisee whose starting point was to spend her student years as a franchisor’s employee before becoming a multi-unit owner. As a franchisee, she saw a very different face of the brand, writing: Not until I got down on the ground floor did I start to really see the bullying and deceit of the franchisor and their often deliberate demise of some franchisees. Typically the ones who had a voice until it was silenced in fear.
23
Franchise relationships are documented in contracts. Gillian Hadfield observes that ‘[f]ranchising is problematic for contract law’.
24
For her, the heart of the problem [is] the incompleteness of the contracts that structure such a complex relationship, one which requires high levels of commitment to protect [often] large sunk investments against opportunism.
25
The potential for opportunism arises because franchisors and franchisees commit to their relationships by signing standard form executory contracts. These are drafted by franchisors to reflect their interests, mitigate their risks and maintain consistency throughout the franchise system. They place numerous controls and obligations on franchisees while expressing limited franchisor obligations, often in discretionary terms. The non-negotiable nature of the contract is symptomatic of the pervasive asymmetry that permeates franchise relationships. 26
As Hadfield observes of franchising, ‘such an odd-shaped beast tangles in many areas of the law’. 27 Through the process of navigating the tangles franchise law has now evolved as a discrete legal discipline. In jurisdictions that have introduced franchise-specific laws, the need to protect franchisees from exploitation was acknowledged. For example, a professed objective when Australia’s original mandatory Franchising Code of Conduct was enacted in 1998 was to ‘address the imbalance of power’ 28 between the parties prior to and/or during the term of the franchise agreement. This has now been reoriented as regulation ‘to regulate the conduct of participants in franchising towards other participants in franchising’. 29 The asymmetry of power continues into the political sphere. The franchisor voice often has the greater influence on legislation. For example, Division 3 of Australia’s Franchising Code of Conduct (‘Code’) imposes a duty on the parties to act in good faith. But this does not extend to the franchisor’s parent entity. While some consumer protection laws have acknowledged franchising, insolvency law has yet to adapt to the business model.
The American Federal Trade Commission (FTC) Rule is national regulation, supplemented in 24 states 30 by additional regulation. 31 Australia’s franchise sector is regulated by the Competition and Consumer (Industry Codes—Franchising) Regulations 2014 (Cth). The UK relies on general commercial law to regulate franchising. Where specific legislation does exist for franchise relationships, it focuses variously on pre-contract disclosure, cooling off rights, registration of disclosure and franchise agreements or agents, implying terms into agreements and dispute resolution methods. The risk to franchisors of franchisee insolvency has been addressed in some franchise regulations that identify franchisee insolvency as an event triggering the franchisor’s right to ‘terminate without notice’. Franchise agreements provide the same rights. No regulatory, and little academic attention, has been paid to the possibility of franchisees’ rights in franchisors’ insolvency.
The franchisor’s role includes formulating network policy, making strategic decisions, managing the network and negotiating supplier agreements. The franchisees’ role is to create a business following the franchisor’s blueprint and adhere to the terms of the franchise agreement and any system changes introduced periodically through amendments to operations manuals or, in the case of significant amendments, new franchise agreements. Beyond a requirement of good faith in some jurisdictions, franchisors are not required to justify any strategic or operational decisions to their franchisees.
A key distinction between a relationship categorised as employment or as a franchise is that where the employer is a corporation, the conduct of its directors and officers towards employees is measured against standards in corporate law. For franchisors, this additional layer of governance regulation is absent. Franchising is a contract-based relationship. In Australia, even the statutory duty of good faith is diluted by cl 6(6) of the Code, which provides: ‘To avoid doubt, the obligation to act in good faith does not prevent a party to a franchise agreement, or a person who proposes to become such a party, from acting in his, her or its legitimate commercial interests.’ Thus, there is no requirement for a franchisor to consider the impact of strategic decisions on its franchisees if this would be contrary to its legitimate commercial interests.
In the US, ‘[c]orporate lawyers have managed to draft contracts to eliminate the implied covenant of good faith and fair dealing in franchise agreements. They have also lobbied in every state to eliminate the fiduciary duty that franchisors should owe to their franchisees’. 32 However, cases are fact-specific and there remains some state legislation. 33 Similarly, in Australia, it has been argued that franchisors owe no fiduciary duty to their franchisees. 34 A franchisor’s relationship with franchisees attracts no scrutiny under corporate law. This becomes a significant issue in insolvency.
There are some common features. Both employees and franchisees are usually protected by legislation prohibiting misleading or deceptive hiring practices. Employees often have additional protections associated with an employer’s insolvency, including a statutory priority for pay entitlements, 35 national safety net insurance funds, 36 employment protection during business transfers, 37 information and consultation obligations for companies undergoing large-scale redundancies or lay-offs and redundancy pay, 38 and sometimes, government lifelines. 39 No such lifelines or protections exist for franchisees.
Despite the absence of empirical evidence, franchising benefits from the mantra that the business model is more successful than independent small business. Many franchisors start franchising before the franchise businesses are sufficiently established as proven successes. In Australia, 42 per cent of brands began franchising immediately, or within the first year of operation. 40 The evidence does show that both new and long-established franchisors can fail. 41
Franchisee Risks in a Failing Franchise
Employment relationships have long been recognised as having an inherent imbalance owing to the power an employer has in the provision of terms, wages and work to employees. Like employees, franchisees are beset by asymmetries of information, bargaining power, contractual negotiation, process, experience of adviser, premises, finance and regulation. It is in the asymmetries of information that the forces of the competitive marketplace are particularly disrupted, rendering it unequal as between franchisees and franchisors. A perfectly competitive market must not have asymmetries of information, or else market equilibrium will be disrupted in favour of the party with greater information, normally the franchisor in this case. While true that the franchise agreement is predicated on an assumption of some basic informational asymmetries, such as local demand and site of the premises, 42 this does not negate the fundamental economic requirements of a perfectly competitive marketplace requiring no regulation to ensure fairness. When faced with a franchisor’s insolvency, the need for information upon which to base decisions that could save a franchisee’s financial security is more acute. These asymmetries are not a part of the accepted assumptions of the franchise business model. Thus, decisions made by franchisees who are beset by information asymmetries of this nature may not be made in a truly utility or profit-maximising way, 43 leading to a failure in the competitive franchise market insofar as it should benefit a franchisee’s business decisions. Such market failure will often indicate the need for some form of regulation in order to mitigate the imbalance in competition. 44 The recommendations at the end of this article attempt to provide a potential mitigative regulatory framework for this imbalance.
Through franchise agreements franchisees take on significant risks that an employer lacking the opportunity to outsource to franchisees would otherwise bear. These include intangibles, such as market and location risk, as well as concrete costs, like fitting out the business premises, paying for insurance and advertising, carrying stock, hiring employees, accommodating leave entitlements, paying payroll tax and superannuation. Their franchisor’s insolvency will often catch franchisees unawares. Having bought into a ‘proven’ system, neither they nor their transactional advisers normally consider the consequences of the franchisor’s demise. Naivety to the risk of franchisor failure is made more acute by optimism bias and because franchisees are excluded from a role in the franchisor’s insolvency process. As such, franchisee risk persists due to the lack of appropriate regulation. 45
Strategic decision-making input into the franchisor’s business is beyond the role of franchisees. For example, the franchised Sizzler restaurants in Australia were reduced to non-core businesses by parent company Collins Foods to enable Collins to focus on growing its KFC outlets. Consequently, Sizzler was not allocated any growth capital in 2016 following a $37.5 million writedown of the brand. 46 This marginalising of franchisees from input into the franchisor’s strategic decisions is also recognised by Hashim, who observed that unless a franchisee becomes a shareholder, they have no scope for participation in franchisor decision-making. 47
Franchisees in Australia are warned ex ante that a franchisor or franchisee could fail in a range of ways. Both regulator-funded pre-franchise education and Code-mandated pre-contract disclosures warn that some franchisors and franchisees fail. Franchisees are informed that franchises have a lower failure rate than other businesses but acknowledge that franchising is not risk-free and that insolvency could be one of those risks, which ‘may have significant impacts on your business, for instance, you may no longer be able to use the franchise system’s branding’. 48 There is no empirical support for this assertion of a lower failure rate.
Inability to use the franchisor’s branding will be the least of a franchisee’s worries. An administrator owes statutory duties to the franchisors’ creditors, including its employees. If the franchisor is head tenant and the franchisee is a subtenant of the franchisees’ premises, entering administration is a breach of the head lease. The landlord can then terminate the head lease, leaving the subtenant franchisee without premises. The same is true for intellectual property assets that may be sold by an administrator to secure distributions to creditors. If these are sold to a competitor, the franchisees can no longer use them. This would destroy the brand value of the franchised business.
The Franchise Council of Australia (FCA) warns, downplaying the consequences of franchisor failure, that one should not engage in self-employment or franchising if one is not prepared to risk losing the investment made. ‘There are no guarantees of success in any form of small business, and even though franchising is by far the most successful form of small business, it is still a business venture with the many of the same risks inherent to any other business venture.’ 49 Warnings like these should at least serve to alert a prospective franchisee’s transactional advisers to the possibility of franchisor failure. This is, however, predicated on three flawed assumptions. Firstly, transactional advisers are seldom versed in the complexities of insolvency. Secondly, it is widely assumed that franchisors only sell businesses that are proven. In fact, in Australia, as already noted, many franchisors start franchising without having experienced a full 12 months’ trading. 50 Finally, it is assumed that franchisees are business people who should conduct proper due diligence, take professional advice, negotiate better contracts and that, having decided to buy a franchise, must cope with their decision. Franchisees generally do conduct better due diligence than buyers of independent small businesses, 51 but not all do so. The ability to conduct thorough due diligence is hampered by an absence of information on public databases, which in Australia is exacerbated because a master franchisee, such as the 7-Eleven master franchisee for Australia, may be one of the 1500 ‘Exempt Proprietary Companies’ exempt under the Corporations Act from annual filings in the Australian Securities and Investments Commission. 52 This makes conducting due diligence on that company’s finances impossible. In addition, excessive cost, franchisees’ optimism bias, 53 dependence asymmetry 54 and, recalling Hashim’s comments, the franchisee being ‘clueless’, mean that new franchisees don’t know what they don’t know.
Novice franchisees behave more like first-time consumers. Even ‘carefully crafted [legal or accounting] advice does not help when the blood lust is up’. 55 Being psychologically and emotionally committed to becoming a franchisee, the client does not hear advice to the contrary. As Alan Wein noted, ‘an aspiring franchisee’s desire to “buy a job” clouds the willingness to analyse objectively the commercial terms and risks or to make sure that expectations match the contractual reality’. 56 This mirrors the lack of choice that employees have in accepting employment; there really is no choice if there is only one job on offer.
In the UK, there are no franchise-specific regulations, though the British Franchise Association (BFA) has adopted the European Code of Ethics in its BFA Code. The BFA Code only provides guidance on its requirements for compliance and omits warnings of the risks of franchising. It requires a prospective franchisor to pilot the concept before starting to franchise, provides requirements as to the return of preliminary deposits, requires recruitment advertising to be free of ambiguity and requires parties to be fair towards each other. 57 The BFA Code is non-binding and there is no clear sanction for a breach. 58 This does not mitigate the risks undertaken by franchisees entering into a franchise agreement.
In the US, the FTC Rule mandates comprehensive disclosure in the form of the Uniform Franchise Offering Circular that all franchisors must adhere to, but this does not provide the franchisees with standing in their franchisor’s bankruptcy. In addition, many US states have enacted franchise-specific regulation. The US-based International Franchise Association (IFA) Code of Ethics requires mutual respect among franchisees and franchisors, compliance with the law and appropriate conflict resolution in its Mission Statement. As in the UK, the IFA Code is non-binding and there are no required pre-agreement warnings about asymmetries of information or the risk of failure. 59 Thus, UK and US franchisees have similar risks to their Australian counterparts.
Franchisors have continued to advertise for franchisees while insolvent, 60 despite, in Australia, issuing the required pre-contract disclosure containing the solvency statement. 61 According to a survey conducted in 2014, among a sample of eight Australian administrators who had administered failing franchisors, ‘three of the eight said there was evidence that this behaviour was present in the franchises they were administering’. 62 When all other sources of debt finance have dried up or become prohibitively expensive, the opportunity to inject a franchise fee, which ranged from $0 to $150 000 in Australia in 2016, 63 into its revenue can prove irresistible to a failing franchisor.
As franchisors expand their operations beyond their own borders they introduce intermediaries: master franchisees who are responsible for populating a specific territory with franchisees. Franchisees in that territory contract with the master franchisee who, in turn, contracts with the franchisor. At each level of the franchise system, there is a multiplier effect. A franchisor may, for instance, appoint 10 master franchisees in distinct territories. Each of these in turn signs franchise agreements with numerous unit or multi-unit franchisees who establish businesses following the franchisor’s blueprint. ‘The interrelated nature of the franchisor and franchisee’s businesses together with the pattern of contractual relationships that bind the franchise network are strengths that become weaknesses for franchisees if a franchisor fails.’ 64 While the franchise agreement will be the main focus of the insolvency practitioners, there are other contracts that franchisees must execute so they can operate their businesses. These may include, for example, leases, subleases, licences, guarantees, supplier agreements, loan agreements and contracts with employees. The franchisee will remain bound to perform these contracts even after the franchise agreement itself is disclaimed by the franchisor’s liquidator. The failure of one franchisor has a domino effect through to the franchisee-owned businesses. To their further disadvantage, unit franchisees have no privity of contract with the franchisor if there is a master franchisee between them, leaving them without rights as unsecured creditors in the franchisor’s insolvency.
Most franchisors, master franchisees and franchisees need to borrow money to establish their business. In Australia in 2016, unit franchisees’ ‘start-up costs ranged from $2,500 to more than $1.225 million’. 65 Much of this investment is in sunk costs as shown in Table 1.
Actual costs of an Australian franchisee buying into system in 2016, and outcome for those funds in franchisor’s insolvency. 66
Table 1 shows the sums involved in establishing one retail franchise in Australia in 2016, and the participation available to the franchisee in the franchisor’s administration. The borrowed amounts are secured over the franchisee’s assets, including its director’s home. Franchisees also provide personal guarantees for the head lease of their premises, which is often granted to the franchisor/master franchisee.
In contrast to the cost of the failing franchisor’s employees, its franchisees and their employees are a costless source of labour for franchisors’ administrators. Administrators can choose which contracts to either retain or decline to accept personal liability for 68 during an administration in most jurisdictions. 69 If an administrator retains franchise agreements, franchisees will be required to continue operations despite a franchisor’s insolvency as they remain contractually bound to perform under the franchise agreements, unless otherwise provided for in the agreement. Because the costs of running a franchise, including wages, superannuation, insurances and other allowances and benefits, fall on the franchisee, the administrator incurs no additional cost to the franchisor in administration if it continues the franchise agreements and there is no urgency to prioritise the resolution of any issues relating to them. Thus, administrators can benefit from the profit-sharing aspect of the franchise agreements without incurring any of the business costs of the franchise operations.
Unlike employees, who are entitled to be represented in Committees of Creditors, franchisees may not be creditors of the franchisor; most are debtors. 70 Some administrators put franchisees into creditors’ committees ‘for a dollar’, acknowledging that they do have an interest in the outcome of the administration. However, there is no requirement to do so. There is no clear mechanism for ensuring that franchisees are informed or consulted, as evidenced in a 2014 survey of administrators of Australian franchisor firms. 71 By contrast, employees of all three jurisdictions enjoy some form of regulatory protection and/or participation rights when jobs are at risk.
Franchisees in Franchisor Insolvency
As is now clear, ‘[t]he law does not accommodate the franchisees’ interests in a neat or predictable way if its counterparty’s business fails’. 72 For them, the loss of a franchise can represent the loss of not only a large, sunk investment, but also their family’s sole source of income, 73 possibly leading to financial ruin. 74 While true that franchisees have a choice and are required to engage in due diligence, their business experience, or lack thereof, may result in unwise choices influenced by their hopes for success and related optimism bias. Franchisor insolvency may also lead to the loss of franchisees’ employees’ jobs, indicating additional social costs. Where a franchisor is the supplier of goods sold by its franchisees, the loss quickly compounds as set-off against money owed to the franchisor is not available. Franchisee debts must be paid in full, while their credits in franchisor insolvency are unsecured. 75
The bulk of franchisors’ assets are intangible, 76 consisting of intellectual property 77 and use licences, head leases 78 and franchise agreements. As Mark A Kirsch and Lee J Plave note, ‘[f]or many franchise systems, the vast majority (or sometimes all) of the brand outlets are…owned and operated by independent franchisees.…Consequently, the franchise relationships — contractually ratified by the franchise agreements — are usually the most critical assets owned by a franchisor’. 79
Franchisors are in a strong position to monitor the financial viability of their franchisees’ businesses by being head lessee of the franchisee’s premises, possibly suppliers of stock and receiving electronic point of sale reports of franchisees’ takings. This puts the franchisor into a position where they can identify the risk of a franchisee’s financial difficulty early. Their response, to avoid an insolvency procedure, can be to allege the franchisee has committed a breach of the franchise agreement by defaulting on a debt obligation. If the franchisee is unable to remedy the breach, the franchisor terminates the franchise agreement. This deprives the franchisee’s creditors of the opportunity to recover debts through their own insolvency procedure with the franchisee. Franchisees do not have the same access to financial information about their franchisors’ ongoing finances. Rather, ‘[t]he financial difficulties of a…franchisor may become apparent only when the franchisor’s obligation to provide advertising support, equipment and inventory on a timely basis…are breached’. 80
The foregoing demonstrates that franchisors have access to a wealth of information on their franchisees so that they can monitor and control how their business and brand are being used. Franchisees, however, have very little access to information about the franchisor’s business and finances that could help them to come to decisions in their financial best interest. This information asymmetry, acute in a franchisor’s insolvency, is a clear disruption in the competitive franchise market, justifying some form of interference in order to mitigate the unfairness present in the marketplace. 81 The following sections discuss what, if any, protections are present for franchisees in the United States, Australia and the United Kingdom if its franchisor becomes insolvent in order to determine whether further regulation is needed to introduce fairness in the franchise relationship.
Jurisdictional Comparisons of Franchisor Insolvency
The United States
Strategic insolvency ‘arises where the bankruptcy is invoked due to strategic decision-making rather than being a passive response to market forces’. 82 This may be appealing to a franchisor to achieve any one of several possible objectives. US franchise lawyers note that ‘[b]ankruptcy…may assist a franchisor in addressing challenging business issues, such as overexpansion in the market and the need to eliminate units, an unworkable equity structure; desire to sell or merge with another entity; threat of franchisee litigation; desire to refinance but the lender has expressed concern about financial or other issues’. 83 Because franchise agreements are executory contracts, they cannot be terminated by reason of the filing for bankruptcy. 84
Franchisees do not enjoy automatic standing in franchisor bankruptcy. Rather their degree of involvement remains at the discretion of the administrator. ‘[S]ome…administrators convene committees of franchisees. This creates a two-way information conduit and enables the administrators to gauge whether, perhaps, a group of franchisees is interested in buying the franchisor’s business.’ 85
Australia
Challenges confronting Australian franchisees of failing franchisors arise from uncertainty over ongoing rights to use brands and premises; risk of court-sanctioned extended periods of administration; lack of access to creditors’ meetings; refusal of administrators to mediate disputes; having to continue trading because there is no ipso facto clause enabling franchisees to terminate their agreement in the event of insolvency; 86 inability to prosecute as the Corporations Act provides for a stay on proceedings by third parties during administration; and loss of customers who do not want to trade with a business they perceive (by brand association) is failing.
On the insolvency of the franchisor, franchisees may discover that their brand’s intellectual property is owned by another company. 87 As a result, licence fees may be breached or present a liability that the administrator may not decide to adopt, or choose to sell, potentially invalidating the franchisees’ IP licenses. Leases also ‘present [an] area of recurring uncertainty’ 88 to administrators to whom a five-day grace period is granted to deal with such leases. 89 An insolvent franchisor will likely default on the head leases of franchisees’ trading premises, causing its franchisees to forfeit their rental deposits and lose the right to trade from their premises.
Normally the second creditors’ meeting (at which the administrators make a final report with recommendations to creditors) must be held within 21 days of the appointment of the administrator.
90
However, the court has discretion to consent to this meeting being held later. In the REDgroup Case, the administrators appointed on 17 February 2011 were granted additional time to hold the second meeting of creditors. On 14 March 2011, Stone J ordered, [p]ursuant to s 439A(6) of the Corporations Act 2001 (Cth) (Act),…the period within which the Administrators of the second plaintiffs must convene meetings of creditors of REDGroup Retail Pty Ltd and each other company names in the Schedule under s 439A of the Act [is] extended up to and including 18 September 2011.
91
This enabled the administrators to identify and negotiate with potential buyers of parts of the business. The extended time frame placed the franchisees in limbo for 213 days from the administrator’s appointment to the second creditors’ meeting, 192 days (nearly 28 weeks) longer than the usual statutory period. This time frame underscores the complexity of franchisor administration and emphasises the franchisees’ vulnerability. Evidence shows that such extensions are common to maximise the administrator’s opportunity to sell the franchise as a going concern. 92 A consequence of time extensions for franchisees who are not consulted is that they must continue operating their business while dealing with less advantageous supplier terms because they are now being supplied directly without the prior benefit of franchisor-negotiated bulk discounts. They must also juggle the instructions of the administrators, hoping that they will be able to remain in business.
A franchisee is not a creditor for the sunk portion of its investment (see Table 1) unless it can make a claim against the franchisor or liquidator through an equitable action for unjust enrichment. A prerequisite to any such action would be obtaining a court’s consent to the civil proceedings being initiated against the insolvent party. 93
For agreements that fall within the ambit of the Code, franchisors, but not franchisees, are provided with what amounts to a statute-sanctioned ipso facto clause. This enables a franchisor to terminate a franchise agreement if the franchisee becomes bankrupt, insolvent under administration or an externally administered body corporate. 94 This puts the Code in conflict with the Corporations Act and is an example of the disconnect between consumer protection law and corporate law and their respective Australian regulators: the Australian Competition and Consumer Commission and Australian Security Investments Commission. 95 This right to terminate is not extended to franchisees. This is an example of legislation that purports to level the playing field, tilting it even further in favour of the stronger party.
The UK/EU
Administration does not automatically terminate franchise contracts in the UK either. However, when the administrator chooses to continue the business, any expenses accruing under existing contracts will be counted as an expense of the administration. 96 Often, franchise agreements will be the franchisor’s only saleable asset. An administrator will logically adopt them, intending to sell them to swell the pool of funds for distribution.
In a 2007 survey of members of the International Bar Association’s committees on restructuring and franchising, participants were asked how franchisees could potentially be categorised in their franchisor’s insolvency. Responses from Belgium were as a creditor or a debtor; Denmark, as an asset, creditor, debtor, franchisee or other; England, as a creditor or debtor; Finland, as a creditor, debtor or franchisee; France as other; Germany as a liability, creditor, debtor or franchisee; Greece as an asset, liability, creditor or debtor; Ireland as ‘don’t know’; and Spain as a creditor. 97 Only 10 of the 26 jurisdictions surveyed (Canada, Denmark, Finland, Germany, Mexico, the Netherlands, New Zealand, Scotland, Switzerland and Syria) recognised franchisees as a stakeholder in the franchisor’s insolvency. 98 The range of responses suggests there is no settled approach to the categorisation of franchisees in this situation.
Justifying Franchisee Participation in Franchise Decision-Making
In most jurisdictions, the employment relationship can be characterised by the subordination of an employee to the needs of the employer, who will generally have control over hours, workplace, tools and work performance. An inherent imbalance in employment relationships has historically allowed for the exploitation of employees, 99 and the intentional framing of some employees as franchisees in the US, 100 or as independent contractors in Australia. 101 Employment law today equalises the bargaining power in employment relationships through legislation, preventing employers from unfairly exercising their power over employees and protecting employees’ right to continued employment. As indicated, no such mitigation of franchise relationship inequities yet exists, despite the clear moral hazard present in the business model.
Justifying Employee Protection in Insolvency
The argument for protecting employees with some priority in insolvency stems from various justifications. In the US, the purpose of Chapter 11 of the United States Code (the Bankruptcy Code) as a reorganisation procedure indicates the hope that the business will continue. Also, an employee’s wages represent a large part of that person’s wealth; they do not enter the relationship consciously factoring in the risk of their employer’s default like a trade creditor negotiating a contract might. Prioritising employee claims may prevent valuable employees from seeking work elsewhere and taking corporate knowledge with them while a reorganisation is taking place. 102 In Australia, it has been suggested that ‘[e]mployees enjoy priority predominantly because they are involuntary creditors’. 103 Franchisees could arguably claim priority on the same basis.
Historically, it has been argued that social policy and regulations are an illegitimate interference with market relations. 104 While freedom, autonomy, liberty and individualism are central to the needs of free market capitalism and a growing commercial economy, 105 these positive characteristics are not always accessible. It is an inaccurate reflection of the real position of employees in the labour market, and by analogy, franchisees. If markets are truly competitive, information must be perfect to reach a true competitive equilibrium. This presumes that government intervention should not be necessary to maintain market efficiency in an optimally competitive situation. 106 However, labour markets, and by extension the market for franchisees, are imperfectly competitive due to inequality of bargaining power, unequal access to information and resources and unequal rights, as demonstrated.
While employment law often impedes the perceived efficiency of the free market, it is justified to restore balance to an otherwise potentially exploitative and imbalanced relationship that, without control, would be socially inefficient and unjust due to a unilateral reduction of employment rights. 107 One argument in favour of including progressive employment rights as a factor for improving market efficiency is the association of limited employment rights with market failures influenced by informational problems causing an inefficient allocation of resources. 108 It is only necessary to observe the exploitation of workers that does occur in developing countries to realise that such conditions persist. 109 Franchisees are easy contemporary subjects for similar manipulation.
Over the last few decades, information, consultation and participation requirements have been introduced when collective redundancies are envisaged. This is particularly relevant for our discussion about how the franchisee should be considered. Most employment law regimes apart from the US imply a term of ‘mutual trust and confidence’ or ‘good faith’ through either statute or common law into the employment relationship. Any breach can have legal consequences, which is one of several factors that differentiates employees from franchisees. Nevertheless, employees and franchisees have much in common.
Justifying Franchisee Participation: Moral Hazard
There are several reasons why a business owner may choose to franchise, many of which relate to reducing their financial risks. When a business owner is required to hire more employees, increasing employee liabilities, franchising presents an opportunity to defray those costs and increase profitability by outsourcing employees to franchisees. 110 Further, maintaining a centrally organised company with several units separated geographically can be costly for developing effective means of controlling employees and managers. 111
Other factors that favour franchising include low initial investment costs and more repeat customers. 112 Finally, the franchise contract itself is habitually drafted in favour of the franchisor with a view to increasing profit and control, 113 often at the franchisee’s expense. Given the foregoing, one thing is clear: franchisors, whether intentionally or not, mitigate their personal business risks by substituting franchisees as risk bearers. Passing risk freely in this way presents a moral hazard that, during a franchisor’s insolvency, becomes all the more severe. There are many aspects of the franchise relationship and characteristics of franchisees that demonstrate this moral hazard.
Decentralisation
Franchises are highly decentralised organisations whose degree of decentralisation comes into sharp focus during insolvency. The franchise network is designed to divide the globe into territories allocated to master franchisees and unit franchisees. Geographically dispersed franchisees may have no way to contact each other outside franchisor-controlled channels. The risks associated with their franchisor’s insolvency crystallise for franchisees when the administrator is appointed. The situation takes them by surprise. A franchisee who does not know that, for example, having to pay cash on delivery for supplies can indicate their franchisor has not been paying suppliers, will not be alert to signs of impending insolvency. 114 Similarly, if the head lease of the franchisee’s trading premises is held by the franchisor and the franchisee has paid its rent and outgoings on time, it will not know the franchisor has failed to pass those sums to the landlord until the landlord issues an eviction notice.
Franchisees cannot protect themselves ex ante through their standard form franchise agreements, nor through legislated protection. Legislation enacted to provide protection to franchisees operates largely as a form of precommitment information delivery. Some jurisdictions mandate registration on a government database of the franchise disclosure document, and/or franchise advisers, is required. Notably absent are statutory or contractual rights for franchisees if their franchisor enters the insolvency process. They are like the Cheshire Cat — visible and essential when all is going well, then fading as the administration proceeds. 115
Optimism Bias
There is growing evidence that people tend to be stubbornly optimistic, regardless of how well informed they are. Most are overconfident about the future, even when they understand the risks. 116 This is the ‘optimism bias’ referred to previously, which is one justification for introducing protection in the form of information and consultation for franchisees to mitigate the moral hazard presented by the franchise model. Although franchisees are given due diligence information, processing such information is replete with subjective problems. It can be difficult to respond to this information as people depend on their own experiences to judge information. These perceptions (and judgments based on them) may often exhibit overconfidence if a particularly positive outcome is possible. 117 The franchise sector’s pervasive mantra of a successful franchise is one such widespread positive outcome. Optimism bias considers the illogical perceptions that individuals may have of themselves when undertaking certain risks, in this case, the risk of becoming a franchisee.
The extent to which warning franchisees about the risks associated with franchising will affect how rational their decisions are is questionable. Overoptimism is derived from a tendency to reject or downplay information that contradicts more favourable information. 118 Research on franchisees in the US has shown that they are strongly optimistically biased in relation to known and potentially damaging risks to their business. 119 Thus, it is arguable that franchisees are more likely to be positively influenced by the promise of success and profit than by the intangible and perhaps intellectually inaccessible risks associated with engaging in the business model. Individuals prefer to believe that they are intelligent enough not to subject themselves to substantial risk. 120 Thus, optimism bias combined with asymmetries in information and bargaining power in the franchise relationship, the size and nature of the franchisees’ investment, the absence of franchisor duties beyond the contract and the likelihood that franchisees are geographically remote from the franchisor leave franchisees more vulnerable than employees and present a clear moral hazard. As that relationship matures and the spectre of insolvency or restructuring that excludes them looms, franchisees may find themselves without enough information, time or access to suitable advisers to mitigate their risks.
A Fairness Argument
While there is an imbalance in the relationship between franchisors and franchisees, whether there is also a macro-economic argument for providing protection is untested. The ‘change in the way employing organisations work’ 121 in the 21st century by shifting employees off the payroll and turning some of them into franchisees should not free creditors of these organisations or alleviate the responsibility of policymakers from creating a clear set of rights that recognise the stake of franchisees if their franchisor becomes insolvent. Franchisees are not nearly as numerous in the entire labour market as employees but do form a sizeable proportion of the workforce in some sectors.
Franchisors’ strategic decisions may be to invest rashly, embark on distracting and expensive litigation, expand into unprofitable new markets or countries, or even become insolvent. If insolvency results, the franchisor’s employees are protected by priorities in law and through union representation, but franchisees are not; nor are their employees except insofar as national regulations provide. Franchisees are currently subject to the whim of the administrator and the market. If their businesses are unable to continue, they probably also lose the fit-out of their premises, rental deposits, and lay their own staff off. It may be that the best argument in favour of additional protections would be a socially orientated one from the perspective of the franchisee as the weaker party in the franchise relationship. The question, then, is what model such protections should take. We suggest that some form of consultative rights may be adequate to provide an advanced warning mechanism, allowing franchisees time and information to operate collectively to mitigate their individual franchise risks.
It is acknowledged that such change is difficult to implement due to the path-dependent nature of the institutional rules that have developed in the franchise model. However, as the laissez-faire path in the labour market has been well and truly broken by most jurisdictions, it is not too far-fetched to suggest that a similar, if less onerous, protective framework be introduced to mitigate against the moral hazard we have demonstrated is present in the franchise relationship, particularly on the eve of insolvency.
Options and Recommendations
To identify whether some participative procedure may be appropriate for franchisees, it is worthwhile examining what parallel procedures exist for employees who are subject to insolvency procedures in the jurisdictions under study. We may then borrow some elements from these procedures to create a participative framework for franchisees affected by the insolvency procedures of their franchisors.
There are limited participative procedures available to American employees, largely due to adherence to the employment ‘at-will’ doctrine. The only alleviation is the Worker Adjustment and Retraining Notification Act, 122 passed to mitigate social issues surrounding large-scale bankruptcies. Per §§ 2101–2102, the WARN Act does not require consultation, merely 60 days’ notice by employers having over 100 employees. It applies to plant closures resulting in 50 or more dismissals and mass lay-offs of 500 or more employees or 33 per cent of the workforce at a single site. Realistically, the US does not provide participative procedures in the event of an employer’s insolvency outside of what is provided in collective agreements. These vary from employer to employer and lack consistent application.
In Australia, the Fair Work Act 2009 (Cth) (‘FWA’) provides for employee participative procedures. Collective redundancy provisions under the FWA pts 3–6, sub-div 2 are applicable. Employers must consult with employees and their representatives if 15 or more dismissals are proposed for economic, technical or structural reasons by notifying each registered employee association that could represent associated members of proposals and reasons for dismissals, the number of affected employees and the period over which dismissals should occur. Notice is to be given as soon as reasonably practicable after coming to the decision and before dismissal. 123 It has been recommended in Australia that franchisees of franchisors in administration should have the right to put the administrator on notice that if a suitable buyer for the franchise system is not found within a reasonable time, the franchisees should have the right to terminate their contracts. 124 This would impose an obligation on administrators to seek a competent replacement for the franchisor, not just a source of cash for the franchisor’s creditors.
In the UK, participative procedures for collective redundancies have developed through the implementation of the EU Collective Redundancy Directive (‘CRD’). 125 It mandates employee participation through consultation obligations. When the CRD applies, an employer must consult staff representatives. It specifies the points these consultations must cover, the information the employer must provide, and imposes procedural rules. While the implementation has varied across Member States and led to some controversy within EU jurisprudence, the provision presents an interesting model for franchising. It requires that employees are consulted when such redundancies are contemplated 126 and that the consultation should include how collective redundancies can be avoided and how their consequences may be mitigated by considering other social measures, including redeployment and retraining. 127 Employers are required to provide employee representatives with relevant information and notify them in writing of the reasons, numbers and period over which redundancies are envisaged to take place. 128 Of use for our purposes are the requirements of notification and consultation, which would allow franchisees to involve themselves in some decision-making within the franchise and enable them to mitigate the risks posed by the franchisor’s insolvency.
There is currently no requirement for franchisees to be involved in their franchisor’s strategic decisions. Franchisees, however, would benefit from participation in the decisions that could impact on their livelihood. Some European jurisdictions, due to the make-up of their labour market and focus on collectivism and participation, offer far more participative opportunities to employees via works councils, which may provide a valid model for a similar franchisee participation procedure triggered during major events. Given the above, we set out the following general recommendations: Oblige insolvency practitioners to keep franchisees informed; Require franchisors to inform franchisees if a decision may adversely impact the solvency of (a) the franchise network, (b) the individual franchisor or (c) the franchisee; Require that information about decisions that relate to (a) debt restructuring of the franchisor or any entity whose failure would adversely affect it, (b) organisational change or restructuring of the franchise or franchisor and/or (c) the insolvency or imminent insolvency of the franchise or franchisor, be given to the franchisee no longer than 14 days after the decision is made; Provide that in any of the above situations the franchisee can require the franchisor (or the buyer) to buy back the franchisee’s unit(s) if the change results in the franchisee being materially disadvantaged; Adopt a variation of the EU ‘works council’ model and include franchisees on the board of any corporation that owns or operates a franchise network; Expand the corporate franchisor’s directors’ duties to oblige directors to owe to franchisees the same duties as they currently have to their company’s shareholders, employees and creditors; Require that corporate governance includes a duty for directors to take decisions that factor in the well-being of the corporation’s franchisees; Remove Australia’s ‘Exempt Proprietary Company’ exemption under the Corporations Act from any company that is issuing franchise agreements; Amend corporate law to give franchisees the right, during the administration period, to collective representation at committees of creditors. An issue to resolve would be whether to allocate them voting rights ‘for a dollar’ per franchisee or for an amount that more nearly equates to the size of their investment; and Require franchisors to inform the state and/or private institution governing or regulating franchises,
129
in advance if a decision may adversely impact the solvency of (a) the franchise network, (b) the individual franchisor or (c) the franchisee. Such information should be made publicly available to potential franchisees.
Conclusion
Franchisees are a large group of stakeholders who are simultaneously profoundly affected by, and deprived of, the opportunity to respond collectively to opportunities and threats franchisor insolvency presents. Legislated rights would mitigate the moral hazard these circumstances represent.
‘The state has one basic resource which in pure principle is not shared with even the mightiest of its citizens: the power to coerce.’ 130 Observers have noted that the legislative process is skewed in favour of groups with lobbying power, usually special interest groups. 131 The ability to lobby effectively to achieve a break in the institutional path of the franchise model requires numbers and cohesiveness, a characteristic lacking among franchisees in all three jurisdictions.
While it was recognised that the power differential in the employment relationship needed balancing against the needs of business efficacy, franchisees have been left regulation-free in parallel circumstances. While true that franchisees have more choice than employees as to whether they want to take up a franchise, the same has been argued in the past about employees and continues to be argued in the US under the employment-at-will doctrine. Although current discourse on this topic adds that employment is a necessity that limits the choices that individuals can truly make in this regard, the fact remains that the argument is still in play in the US, the largest Western economy. The FTC Rule in America requires franchisors to act fairly, to facilitate informed decisions by prospective franchisees and to prevent deception by requiring franchisors to provide prospective franchisees with extensive information about the franchise prior to the sale. Thus, there is also a justification for the introduction of some form of participative obligations for franchisees as these already exist in some form. The existence of such a rule recognises that there is a risk of abuse. Given the problem of optimism bias in a franchisee’s perspective and that even balancing information asymmetries may not prevent franchisees from entering a poor deal, introducing information and consultation obligations in instances of financial distress or other structural decision-making will help to mitigate the significant risks undertaken by franchisees.
Before the franchise agreement is executed, the market has the appearance of competitiveness. However, numerous asymmetries favouring the franchisor and, in Australia, legislation providing rights to franchisors in the cases of franchisee failure, but not the reverse, demonstrate that it is arguably not as competitive as would be a more easily researched market. Once the agreement has been executed, the franchisee is committed to dealing with the franchisor who arguably becomes a monopolist. 132 The forces of the competitive marketplace have failed franchisees. 133 Without the existence of franchisees, the solvent and failing franchisor would have to provide a significant amount of the operational infrastructure, hire staff and ‘assume a significant…[additional] business risk’. 134 To more equitably position franchisees, we recommend that they should have the right to participate in the franchisor’s insolvency as outlined above. This would not significantly complicate insolvency procedures occurring in decentralised corporate organisations but would be a positive incremental step towards providing a level of participative protection that is currently absent in franchise law.