Franchising News

1. What is insolvency?

The Corporations Act 2001 (Cth) (Act) defines a company as insolvent if, and only if, the company is unable to pay all its debts as and when they become due and payable.

 

The insolvency of companies is dealt with exclusively under the Act and can include appointments of administrators, liquidators, receivers and managers, and provisional liquidators. In addition to the appointment of external parties to insolvent companies which can seriously impact on a franchise system or network of franchisees, penalties and personal liability can also be enforced against a director of an insolvent company for allowing a company to trade while insolvent.

 

The procedure known as ‘administration’ under Part 5.3A of the Act was introduced in 1993 to provide in circumstances of insolvency or where a charge has become enforceable for the business, property and affairs of a company to be administered in a way that:

• maximises the chances of the company, or as much as possible of its business, continuing in existence; or
• if it is not possible for the company or its business to continue in existence, results in a better return for the company's creditors and members than would result from an immediate winding up of the company.

An Administrator can be appointed by:

• the company after a resolution has been passed by the directors in accordance with section 436A(1) of the Act;
• a liquidator or provisional liquidator; or
• a chargee entitled to enforce on the whole or substantially the whole of the company’s property, such as a bank, supplier, or other entity granted a charge by the Company.

Some key points about administration are:

• a statutory moratorium period applies from the date of appointment of an Administrator until the end of the administration period preventing creditors commencing action to enforce claims, without the leave of the Court or the Administrator. This permits the Administrator time to assess the situation of the company and report to creditors on the company’s status;
• an Administrator may elect to continue to operate any business run by the company or cease such operation. The Administrator will be liable for debts incurred by the company for any business operation from the date of appointment;
• secured creditors, may elect to enforce their security during an administration, or may choose to be involved with the administration process and be bound by the provisions relating to administration in the Act;
• the Administrator will provide a report to creditors recommending what should happen to the company and creditors will be asked to vote to determine the company’s future;
• Administration can occur in conjunction with other types of external administration such as receivers and managers.

Ultimately, the creditors must decide at a meeting organised by the administrator to:

• return company to control of the Directors;
• accept a Deed of Company Arrangement (which is a proposal put to creditors that usually will result in a larger return to creditors than a liquidator winding up the company and results in the wiping out of the debt of the company to those creditors); or
• put the company into liquidation to wind up the company. If this option is chosen the Administrator will become the Liquidator.

The powers of an Administrator are similar to a Liquidator which is discussed below.

 

A Deed of Company Arrangement (DOCA) will proscribe the conduct of the affairs of the company where it has been under administration and the creditors have resolved to enter into the DOCA rather than wind the company up or return it to the control of the directors. Under a DOCA a Deed Administrator must be appointed and this can be either the incumbent, or a new selection by the creditors.

 

Under the legislation that a DOCA allows for any arrangement which could be contemplated between the company and its creditors, such as:

• a moratorium for existing creditors;
• the release of the company from existing debts;
• indicating the capacity of creditors bound and governing their ranking;
• provision for the company to be run only while a buyer is found, or until the company has fully recovered.

Whatever the terms of the DOCA that are accepted by the creditors, the DOCA itself will binding upon the company, its members, its executives and the Deed Administrator to what ever is agreed upon and executed within the instrument.

 

The purpose of liquidation of an insolvent company is to have an independent and suitably qualified person take control of the company so that its affairs can be wound up in an orderly and fair way for the benefit of all creditors.

 

Under section 532(9) of the Act, the person appointed as liquidator must be a registered liquidator and must consent in writing to act before his appointment.

 

A Liquidator can be appointed by:

Key points about Liquidation:

• a Liquidator may disclaim onerous property such as leases, contracts or other agreements;
• any payments to be made by the Liquidator are governed by a priority list stipulated by the Act which elevates some creditors claims above others;
• reports must be submitted to ASIC by the Liquidator regarding the status of the company and assessed reasons for failure;
• secured creditors may enforce their securities against any secured property of the company which makes it unavailable to unsecured creditors unless there is a surplus after the secured creditor takes out the amount owed to it;
• the powers of the directors are suspended during the liquidation of the company and the company’s books and records are required to be delivered up to the Liquidator;
• a Liquidator can bring, commence or defend any legal proceedings relating to the company including seeking to recover uncommercial transactions, unfair preferences and transfers from the company intended to defeat claims of creditors;
• new proceedings can only be commenced against the company in liquidation by leave of the Court.

The powers of a liquidator are contained in section 477 of the Act. Most powers are exercisable completely at the liquidator's discretion, but some only on resolution of creditors or the approval of the Court. The liquidator's powers include:

• selling all or any part of the company's property in any manner;
• carrying on the business of the company "so far as is necessary for the beneficial disposal or winding-up of that business";
• appointing a solicitor or other agent and obtaining advice or assistance with regard to the conduct of the liquidation; or
• to do all such other things necessary for winding-up the affairs of the company and distributing its property.

Liquidation results in the company no longer being in existence and may take several years to complete.

 

A Provisional Liquidator is the Court appointment of a liquidator to a company for the period between the filing of the application to wind up the company and the Court hearing that application. This can be initiated either:

• voluntarily by the company itself; or
• by a creditor or a member, or ASIC, if necessary against the company’s wishes.

It must be demonstrated to the Court that the appointment is necessary to prevent dissipation of assets or, for other circumstances, to preserve the position of creditors or contributories until the decision as to the winding up order is made.

 

The Provisional Liquidator's powers are akin to those of a Liquidator, except as restricted by statutory provision, court order and generally by the knowledge that a winding up order may eventually be refused.

 

The Provisional Liquidator will have the power to administer company affairs, but is unlikely to be given initially the power to realise assets (except in the ordinary course of business) or to pay dividends.

 

A company goes into receivership when an independent and suitably qualified person, the receiver or receiver and manager, is appointed by a secured creditor or, in special circumstances by the Court, to take control of some or all of the company’s assets.

 

A Receiver or a Receiver and Manager is appointed to realise the security after the company has defaulted in performance of its obligations under an instrument entered into by the company such as a mortgage, charge or other similar document. The Receiver or Receiver and Manager is appointed to enforce the charge by taking control of the charged property.

 

When exercising powers to take control of property, receivers are required to act in the interest of their appointer (that is usually a bank) but also in good faith to the company. This means that when exercising a power to sell the charged property, a receiver must refrain from deliberately or recklessly sacrificing the property (Pendlebury v Colonial Mutual Life Assurance Society Ltd (1912) 13 CLR 676).

 

Receivers have a general power to do all things necessary for the attainment of the objectives for which s/he was appointed (section 420(1) of the Act). Specific powers under section 420(2) of the Act are in addition to any powers conferred by the instrument under which the Receiver or Receiver and Manager was appointed and include:

• entering into possession and taking control of the corporation’s property in accordance with the instrument;
• to sell the property charged;
• borrowing money on the security of the property;
• executing any document, bringing or defending any proceedings on behalf of the corporation;
• appointing a solicitor, accountant or other professionally qualified person to assist the receiver; and
• appointing any agent to do any business.

 

Queensland based franchise Kleenmaid went into voluntary administration in early April 2009 with more than $80 million owing to creditors, of which was revised to $102 million in early May. Deloitte were appointed as the voluntary administrators and the company has since gone into liquidation on 25 May 2009 due to the failure of directors to provide a proposal for a Deed of Company Arrangement. The Liquidators, felt that at the time there was little chance of unsecured creditors receiving a dividend, of whom claimed a total of $27 million.

 

Throughout the period of administration it became apparent through investigations by Administrators that:

• Kleenmaid held the head leases on all stores, including those franchised, which meant a Liquidator could disclaim those leases as onerous, leaving franchisees not only without a product to sell, but without a premises to sell them from.
• under the Kleenmaid Terms and Conditions of sale, a sale transaction was not complete until full payment and delivery had occurred, so those customers who had purchased goods but not yet received them had no chance of ever recovering the purchase price paid.
• potential insolvent trading violations had occurred by the company’s directors. The administration investigations revealed that the company may have been insolvent since 2007, of which the directors were allegedly aware. This makes the annual accounting and franchising code of conduct declarations of solvency made during that period a potential source of evidence for any insolvent trading claims.

Upon entering into liquidation Kleenmaid ceased trading, with the company’s assets all currently being sold.

 

Two of the Kleenmaid’s corporate entities have so far been sold off including the customer solutions division meaning that customers now have someone to fall back on for servicing of products.

 

The liquidation of the remaining stock began on 31 July 2009 through auction based website www.Graysonline.com. However it is still clear that upon complete liquidation many of the company’s unsecured creditors (which may include franchisees depending upon individual circumstances) will go without any dividend.

 

This example highlights the importance of retention of title clauses in contracts for goods and services, security of occupation of retail sites and the accountability that directors may be held to for operation of a franchise system where it is insolvent, if sufficient evidence of such a contravention can be identified.

 

 

Kleins, a 200-store chain Victorian-based jewellery franchise system collapsed with debts of approximately $20-25 million in May 2008. Administrators were appointed over it. The various divisions of the company, both domestic and international, were subject to administration by different groups, including:

• Ferrier Hodgson
• BDO Kendalls
• Ernst & Young
• BDO Spicers

Ferrier Hodgson, who were acting as Administrators for the Klein’s general operations in Australia were actively seeking to sell off the business and as a part of this process and in accordance with their role as Administrators pushed back the date of the second creditors meeting in an effort to effect such a sale.

 

At the conclusion of the first creditor’s meeting 26 interested parties existed which increased to 36 as a total. However, according to Ferrier Hodgson, none of these resulted in an offer to purchase the Kleins network as a whole.

 

It is reported that upon due diligence being performed by interested parties it became readily apparent that Kleins could never be returned to its former glory and was simply a ‘tired’ business. Under the administration it is reported that all employees would be likely to receive their entitlements, under the GEERS (government) scheme, however unsecured creditors should expect nothing.

 

At the end of the Administration period the business instituted a nation wide closing down sale in June 2008 and in the August 2008 publication of the ASIC Gazette 68/09, Kleins Holdings Pty Ltd was listed for deregistration in the two months following the publication of the notice.

 

One of the biggest problems for Kleins was the structural issues with the franchise system. The franchisor entered into the lease arrangements for every franchise premises and in some cases provided income guarantees and rent subsidies to franchisees. This set up combined with challenges such as an increasingly competitive market and a failure of the brand to adapt to changing styles and trends resulted in the ultimate demise of the Kleins franchise.

 

Franchisees have in many cases such as Kleins, lost their right of occupation of their sites being locked out by landlords whose leases were with the Franchisor, who had defaulted despite the franchisees paying to the franchisor the monthly rent payments. Many franchisees after the collapse also still held a significant number of products which were difficult to sell, an inability to obtain more product as this was sourced through the franchisor and shop fit out which cannot be used.

 

This example highlights the significance of leasing arrangements in a franchise relationship. Ideally each party should have arrangements in place to step into the others shoes in the event of default by one party. This could be achieved through a tripartite deed with the landlord, the franchisee and the franchisor. Some systems will not permit this, although others are open to negotiation.

 

 

Under Part 5.7B of the Act, directors are under a duty to prevent insolvent trading by a company if there are reasonable grounds to “suspect” that the company is insolvent. “Civil penalties” apply in addition to the right to recover against the directors personally for any loss suffered, although defences may be available.

 

If the franchisee/or is operating as a company, the directors will be liable in accordance with the standard insolvent trading provisions. Officers of a franchisor or franchisee company may be personally liable for the conduct of their company if the circumstances show they had reasonable grounds to suspect this may be the case. Creditors then have a right of action against the directors personally and seek recovery against any assets a director holds in their own right.

 

 

Commercial leases are often drafted so that an insolvency event is a default by a tenant under the lease. The appointment of any sort of external administrator is typical in an insolvency event.

 

However, the appointment of an Administrator results in a moratorium, and this would include a halt on the landlord’s rights to evict the tenant or recover possession of the premises. This usually means that the landlord cannot terminate the lease or recover possession of the premises without the administrator’s written consent or the leave of the Court.

 

The moratorium does not prevent a landlord continuing certain action for recovery that started before the Administrator was appointed.

 

 

IP usually includes the brand name, franchise system, customer database, trademarks and logos. All of which is critical to the ongoing operation of the franchise system.

 

It is to the franchise or license agreement which a well-advised insolvency administrator will first turn to determine how the franchisor/franchisee rights may be dealt with in the manner which best serves the franchisor/franchisee’s creditors.

 

Assets comprising intellectual property pose problems for external administrators as their intangible nature makes the task of discovery, control and sale generally more difficult than is the case with tangible assets. There is usually some value to be found in selling the IP, even if a sale of the entire system is not possible. Sale of the IP can work both for and against the interests of a franchise system and is an event that the consequences of it occurring should be considered in advance by those with interest in the IP of a franchise system. Some systems permit step-in rights to IP agreements for certain parties. It is highly recommended that any party with an interest clearly understand the consequences of insolvency on the IP of a franchise system.

 

 

Examples include:

• Access to premises;
• Financial auditing rights;
• External Administrator appointment powers (usually receivers and managers);
• Step-in to lease or franchise agreement rights; and
• Secured creditor status (resulting in payment ahead of other unsecured creditors).

It is critical to understand the role, influence and effect of the involvement of a financier in a franchise system as this will often differ between financial institutions, whether the financier is lending to the franchisor or franchisee, or lending and taking security in a combination capacity.

 

With the potential for more companies to enter into external administration in the current financial climate it is important that consideration be given to what will happen both to the company and to their respective franchise agreements upon insolvency.

 

Each of the alternatives available - administration, Deeds of Company Arrangements, liquidation, provisional liquidation, or receivership – will have different consequences, result in different impacts on parties and require a careful review of the impacts and options available if any of these should eventuate.

 

We strongly recommend parties consider, when structuring their businesses or involvement with a franchise system, worst case scenarios, such as insolvency, to fully understand how any agreement will affect their interests and then determine if they want to proceed.

 

Where agreements are already on foot we recommend advice be sought as early as possible if financial trouble is suspected to better consider available options and manage risk as far as possible.

 

Partner

T: 61 7 3100 5103
E: alicia.hill@dibbsbarker.com

 

Partner

T: 61 7 3100 5065
E: derek.sutherland@dibbsbarker.com