As if the events of the past three financial quarters weren’t enough, two recent developments may have provided franchisors with more cause for concern about the financial health of their franchisees.
As if the events of the past three financial quarters weren’t enough, two recent developments may have provided franchisors with more cause for concern about the financial health of their franchisees. The first was news that all parts of the United Kingdom are entering into new lockdowns. The second was the publication by the Office for National Statistics of its latest Business Impact of Coronavirus Survey, which found that 64% of businesses across all industries were at some risk of insolvency, with 43% of companies running on less than six months’ cash reserves.
If tradition is anything to go by, the number of potential insolvencies in the year ahead is likely to be greater among franchisees than with franchisors. With that prospect in mind, this article looks at how franchisors can mitigate against the risk of failure amongst their franchisees.
Keep your friends close
Many franchisors will already have taken steps to put in place a strategy for managing their franchise during the pandemic. For the best prepared, this may have included the establishment of a dedicated coronavirus task force with responsibility for managing how franchisees deal with the virus (covering employees, supply chains, marketing and financial planning). Franchisors should be monitoring franchisee performance carefully, staying alert to any late payment of franchise fees, failure to provide information or any increase in customer complaints or staff redundancies – these are all potentially signs of distress. Keeping an eye out for new filings at Companies House by a franchisee (such as director changes, new security or statutory account updates) can enable franchisors to spot signs of trouble before they get out of hand.
Reduce operating costs
Franchisors should be encouraging franchisees to explore all available options to reduce their overheads. This includes taking advantage of any available government support, such as the Coronavirus Job Retention Scheme (recently extended until December) and business rates relief.
Rent will be one of the largest costs for many businesses. Franchisors will often sub-let business premises to a franchisee, with the franchisor named as tenant under a head lease. This exposes the franchisor to risk where the franchisee becomes insolvent, as the franchisor may become responsible for any rent arrears. Whilst currently commercial landlords are unable to exercise their forfeiture rights for non-payment of rent until 31 December this year, once this suspension is lifted commercial tenants who are behind on their rents will be in the spotlight.
Franchisees who have difficulty paying rent may consider seeking rent concessions from their landlords. A popular option right now is to move away from contractual towards turnover-based rent. Where landlords are not amenable to such changes, or the business operates from an extensive portfolio of premises making it difficult to co-ordinate such concessions, it might be necessary to compromise rents via a company voluntary arrangement (CVA). Pizza Hut (U.K.) Limited is one example of a franchisee that has gone down the CVA route already this year.
Franchisors should also re-visit their supply arrangements. In the context of new lockdowns, there may be scope to invoke force majeure provisions in supply contracts to cancel outstanding orders or to negotiate extended credit terms with suppliers. It has been a thorny issue with many insurers throughout the pandemic, but claiming under business disruption insurance policies might also be possible.
Take a bath
Not the warm, soapy kind but the less attractive financial hit. This is of course easier said than done but Subway is reported to be one example of a franchisor that has gone down this path by reducing royalty payments and offering advertising fund relief to counter the effects of falling sales.
Whilst instinctively a waiver of outstanding or reduction in future franchise fees might sound like a non-starter, franchisors shouldn’t necessarily dismiss the opportunity to grant such a concession as part of a wider re-alignment of franchise terms. In return for any such agreement, a franchisor might, for example, seek to curtail force majeure rights which entitle a franchisee to avoid paying fees or walk away from the franchise altogether, enhance termination rights and/or introduce step-in rights which reserve the ability for the franchisor to take over the premises and acquire assets upon certain events. It might also be possible to set conditions aimed at ensuring the franchisee takes steps to retain sufficient liquidity, or to oblige the franchisee to explore new distribution channels, such as encouraging take-out and home deliveries where in-restaurant sales are going south.
Dealing with franchisee insolvency
Franchisees who fear they may be unable to continue trading may have a little bit of breathing space yet. Whilst the UK’s wrongful trading laws continue, there are currently restrictions in place which prevent creditors from petitioning to wind-up a company based on an outstanding statutory demand served between 1 March and 31 December this year. There is also now scope to seek a standalone moratorium on various creditor enforcement actions outside of administration under a new regime introduced by the Corporate Insolvency and Governance Act 2020.
Assuming however that a franchisee files for liquidation, there are a few points for franchisors to note. The first is that liquidation comes in a number of different guises. A solvent (or members voluntary) liquidation typically results in all creditors being paid out in full. By contract, an insolvent (either creditors voluntary or compulsory) liquidation is likely to result in creditors suffering a shortfall. There is also the risk with an insolvent liquidation that a liquidator may seek to disclaim a franchise agreement as an onerous contract. This would mean terminating the franchise agreement and treating the franchisor’s outstanding claims as unsecured debts in the franchisee’s liquidation.
As an alternative to liquidation, a franchisee may file for administration instead. This will typically be viable where there are willing purchasers ready to make an offer for the franchisee’s business which delivers a better return for its creditors overall than would be achieved via a liquidation. Administration may be a more attractive scenario for a franchisor, as it may offer an opportunity to extract a more favourable return (such as being paid out ahead of other creditors if the administrator wants to sell the business with the benefit of the franchise agreement).
Administration may also offer the opportunity for the franchisor to purchase the franchisee’s business itself to preserve the goodwill in their brand in the relevant territory. However administration is not without its risks. Firstly, there is the possibility that one might be outbid by a competing offer. Secondly, section 216 of the Insolvency Act 1986 restricts a director of an insolvent company from being involved in a company with the same or similar name. As such, if there are common directors of the purchasing and selling company, it may be necessary to take steps (such as seeking court permission) to ensure the directors of the purchaser can manage the acquired business.
Know when to quit
Sadly, there will inevitably be some businesses who find that they are unable to turn a corner. Where a franchisor decides to cut ties with a franchisee, they need to tread carefully to exercise any termination rights in accordance with the franchise agreement and as permitted by applicable law. In particular, among new laws introduced under the Corporate Insolvency and Governance Act 2020 are rules which prevent suppliers from exercising termination rights under a supply contract where the counterparty enters a relevant insolvency procedure (such as administration, liquidation or a CVA). Where these new rules apply, franchisors will need to be quick off the mark if they wish to terminate a franchise agreement otherwise they potentially risk finding themselves stuck in the relationship for longer than anticipated.
The events of the last year have been felt very differently from one sector to another. Some are forecasting a long-term drop in demand, whilst for others it is perhaps still too early to say whether any decline in customer demand is something temporary or more permanent. Whatever the sector, part of the solution will be for all franchisors to have an open dialogue and work closely with franchisees to preserve their relationship to avoid the worst of the outcomes touched on above.