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Bulletin | Covid-19

Beyond COVID-19: Some Issues Specific to Franchising in the Event of a Franchisor's Financial Difficulties

Fasken
Reading Time 9 minute read
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Franchising Bulletin

Our recent Franchise Law bulletin entitled Beyond COVID-19: Five Keys to Better Manage Financial Difficulties within a Franchise Network raised the sensitive and important issue of what is at stake in the event that a franchisor itself experiences serious financial difficulties or foresees a risk of insolvency.

In fact, when franchisees of a network see their revenues decrease drastically or, even more so, when they experience periods of mandatory closure, the franchisor also loses its royalties and advertising contributions on these unrealized sales.

Since royalties are, for most franchisors, their main source of income, such a crisis can, in a few months, jeopardize the financial situation of the franchisor as well as that of its franchisees.

In addition, due to their own financial difficulties, franchisees may not be able to meet their financial obligations to the franchisor, thereby putting additional pressure on the franchisor's liquidity.

Several large retail chains have already filed for protection under insolvency, restructuring or bankruptcy legislation and, unfortunately, it is quite possible that others will do so in the coming weeks and months.

The current or foreseeable insolvency of a business is a very sensitive situation that raises many important, and often complex, challenges, including issues related to transactions carried out in the months (and sometimes even years) preceding a bankruptcy (which could be cancelled or declared unenforceable against creditors or a trustee), payments made in order to benefit certain creditors over others (which could also be cancelled and recovered), securities granted on the company's property, amounts due to government authorities (including for taxes and various forms of government remittances), salaries, indemnities and benefits due to employees, personal guarantees granted by directors and officers, etc.

When a business is faced with financial difficulties that could render it insolvent, it is essential that its executives and its directors quickly call upon the services of accounting, financial and legal experts in insolvency.

There is a whole range of actions that can be taken in compliance with the law to minimize the consequences of a potential insolvency, but the scope and the extent of these possibilities diminish rapidly as we get closer to the time when the business becomes insolvent or places itself under the protection of the law.

This applies to all businesses, not just franchisors.

On the other hand, there are some important issues that are unique to franchisors.

In addition to running its own business, a franchisor also manages a network of several entrepreneurs who have placed in her or him their trust and a significant portion of their future and assets.

Unfortunately, experience has shown that, when it has not been adequately prepared, the insolvency of a franchisor, as well as the cessation of its activities, very often leads to the bankruptcy or the termination of the activities of a good majority of its franchisees.

A franchisor therefore has a responsibility, at least morally, to take the interests of its franchisees into account in its decision-making, including in the event where its own financial situation becomes precarious.

With adequate professional advice, it is possible for a franchisor to reduce the impact of its own financial difficulties on its network and its franchisees.

There is, however, no magic, or unique, recipe for everyone. What can, and what cannot, be done within the law and the franchisor's commitments differs from one franchisor to another. Each situation must therefore be assessed on its own merits with the help of experts in insolvency, intellectual property and franchising.

The following are, however, some of the issues specific to franchising to which a franchisor in financial difficulty (actual or foreseeable) should pay particular attention:

Trademarks and Intellectual Property Rights

A franchisor owns significant assets that are often not reflected in its financial statements: its trademarks, other intellectual property rights, concept, processes and, not the least, its franchise agreements and its franchisees.

In order to maximize the chances that its network (read its franchisees) can continue to operate in the event of the franchisor's insolvency, it is important to consider what can be done to protect both the franchisor's rights in the network's trademarks and other intellectual property rights and the franchisees' right to use them in the operation of their franchised businesses.

In this regard, it is important to understand that the franchisees' right to use the franchisor's trademarks and other intellectual property rights is based on an agreement (the franchise agreement) which may be assigned, terminated or rescinded in the event of the franchisor's insolvency, the exercise by a creditor of a security interest in the trademarks and other intellectual property rights or a transfer of intellectual property to a third party in the context of an insolvency process.

Franchise agreements

As with trademarks and intellectual property rights, the franchisor's rights under its franchise agreements may also be subject to seizure, the exercise of a security interest or vesting in a trustee in the event of bankruptcy.

These franchise agreements may also, by law, be rescinded by a trustee in bankruptcy, which may result in their premature termination.

Furthermore, franchisees may also seek termination of such agreements in the event that the franchisor ceases to meet its obligations under the agreement or its implied obligations as a franchisor, which could be the case, for example, if the franchisor itself loses the right to use the trademarks and other intellectual property rights associated with its franchise network. It should however be noted that the law prohibits a party from terminating a contract for the sole reason that its co-contractor is under the protection of the law.

It is therefore important for both the franchisor and its franchisees to ensure that the franchisor, or any person who acquires its rights as franchisor of its network, (i) continues to have the right to permit franchisees to use the trademarks, intellectual property rights and essential elements of its franchise concept, and (ii) is able to provide franchisees with the services, support and assistance that the franchisees are entitled to expect from their franchisor.

Leases and subleases

A number of franchisors lease the locations of franchised establishments and then sublease them to their franchisees.

In such a scenario, the insolvency of the franchisor may sometimes result in the termination of the head lease between the lessor and the franchisor and, as a result, the franchisees may lose their right to occupy the premises in which they operate their businesses.

Other franchisors who do not themselves lease the premises of their franchised businesses have, however, entered into agreements with lessors whose application in the event of the insolvency of the franchisor could result in the loss of the franchisees' right to occupy the premises of their businesses, particularly in the event of termination of the franchise agreement.

In many of these cases, it is possible, by acting in a timely manner, to enter into or modify agreements to ensure the continuity of franchisees' businesses in the event of the franchisor's insolvency or bankruptcy.

The network's common advertising fund

Another, often forgotten, issue specific to franchising is the amount held by the franchisor in the network's common advertising fund.

This amount, which is the result of advertising contributions made by franchisees under their franchise agreements, often (although not always) legally belongs to the franchisor even though it may be used by the franchisor solely for the purpose of advertising and promoting the franchise network.

In most cases (depending on the terms of the franchise agreement), the amount of the common advertising fund may therefore be seized, be subject to a security interest granted by the franchisor and be vested in a trustee in the event of the bankruptcy of the franchisor.

There are, however, a few ways of preserving a franchise network's common advertising fund.

First of all, it is important for the franchisor to keep the common advertising fund completely separate from its other funds (in particular, in separate bank and accounting accounts) and to be able to clearly identify and distinguish it from its other funds. Indeed, if the franchisor has "commingled" the monies held in the common advertising fund with other monies that may be held from other sources, it will subsequently be impossible to distinguish with the precision required by law the monies actually belonging to the common advertising fund.

Under certain conditions, it may sometimes be possible for the franchisor to use this common advertising fund to pay for advertising and promotional expenses incurred by franchisees in order to ensure that it is properly used for the benefit of the network before it ends up in the hands of third parties who may want to keep it for their sole benefit.

Technology

Franchisees are increasingly dependent on their franchisors for all their technology and communication tools.

In the event of the franchisor's cessation of operations, as well as in the event of bankruptcy, franchisees may therefore find themselves unable (temporarily at best) to operate and manage their businesses since they are deprived of essential tools to do so.

It is often possible for a franchisor to prevent such a situation to a large extent by entering into, or having its franchisees enter into, appropriate agreements directly with suppliers of the technological tools essential to the management and operation of their franchised businesses.

Suppliers and Procurement

The suppliers (of products and services) to the franchise network should also not be forgotten.

When a franchisor stops paying them the money they are owed, many of them will be tempted to stop supplying the network. Others will want to change the prices and terms of supply previously negotiated with the franchisor.

This will raise an even greater risk if the franchisor uses a centralized billing system whereby franchisees pay the price of their supplies to the franchisor, who makes the payments due to suppliers centrally for its entire network. In such a scenario, franchisees have in the past been required to pay twice the price of their supplies when, after paying the price to the franchisor, the franchisor has failed to make payments to suppliers.

Again, by taking timely and appropriate actions, a franchisor can significantly reduce the risk of supply disruption to its network and its franchisees in the event of its inability to meet its financial obligations or in the event of its insolvency.

Generally speaking, these issues (whose list is not exhaustive) mean that, in the event of serious financial difficulties, it is even more important for a franchisor than for any other business to quickly call upon financial and legal experts experienced in financial planning, financial turnaround and restructuring (and, if the situation so requires, insolvency), as well as in intellectual property and, of course, franchising, in order to be able to act proactively to, at the very least, minimize the impact on its franchisees.

As for the relationship, and communications, between a franchisor experiencing financial problems and its franchisees, we refer you to the recommendations provided in our Franchise Law bulletin entitled Beyond COVID-19: Five Keys to Better Manage Financial Difficulties within a Franchise Network, which applies as well, with some adaptations, to the situation of a franchisor experiencing financial difficulties as it does to that of a franchisee experiencing such problems.

Fasken has all the expertise and resources necessary to properly advise and assist you in all aspects of managing your network, including relations with your franchisees, assistance to your franchisees, restructuring and financial turnaround, intellectual property and, of course, franchising, anywhere in the world.

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