Why the franchise system is broken (and how to fix it)

The franchise system places franchisees between a rock and a hard place when it comes to legal and financial responsibilities – but new research has found that there is a simple fix for the problem

Franchising is a significant sector of Australian business, contributing around 9 per cent of gross domestic product – equivalent to $170 billion a year – and employing more than 470,000 people.

Despite its success and growth, the franchise sector continues to suffer from an ongoing power imbalance between franchisors and franchisees.

Jenny Buchan, a professor in the school of taxation and business law at UNSW Business School, describes the sector as “feudal” in the way that it operates.

In particular, Buchan calls out the relationship between the franchisor and franchisee as one which still, after 17 enquiries in Australia across three decades, resists fundamental reform.

The current franchise model, she says, embeds institutional rules developed over time which no longer reflect the reality of a mature franchise market, but which remain nonetheless.

Franchisees, for example, have no input in overall strategy and can find themselves on the wrong side of change.

This occurred in Australia in 2016, when franchised Sizzler restaurants were reduced to non-core businesses and deprived of growth capital by parent company Collins Foods, which decided to focus on its KFC outlets.

The power imbalance can also surface in cases of franchisor insolvency.

With her colleague Jennifer L. L. Grant, a post-doctoral research fellow at University College Cork in Ireland, Buchan recently published Moral Hazard, Path Dependency and Failing Franchisors: Mitigating Franchisee Risk Through Participation, which looks specifically at this issue and proposes solutions drawn from alternative legislative models for collective redundancies in the US, the UK and Australia.

An unfair deal?
While, in the event of franchisor failure employees still enjoy protection, franchisees across these jurisdictions have few rights or legal recourse and can – in some circumstances – find themselves responsible for costs that can culminate in their financial ruin. This can happen even if their own franchisee businesses are viable.

“The system allows franchisees to make very significant investments in their business, and yet provides them with no support in the event of franchisor failure,” says Buchan.

“And the response, as it is now, is to say that franchisees didn’t do their due diligence, even though the pre-contract information they receive from franchisors is tightly managed and often doesn’t give a true picture.”

A fundamental problem, says Buchan, is that the franchisor/franchisee relationship is dealt with under competition and consumer legislation and not under the Corporations Act, which she thinks would be more appropriate.

“We have a sophisticated set of obligations and rights for shareholders and employees under corporations law,” she says.

“Franchisees in effect replace these people in the relationship with franchisors, but we don’t have a set of rights to mirror this, so this means that franchisors are on a free ride once they get the franchisees to sign on the dotted line.”

While there are rights for the franchisor, under the existing Franchising Code, if franchisees fail there are no reciprocal rights.

In the event of franchisor failure, administrators and liquidators have to act in the interests of the franchisor’s creditors while franchisees are excluded from the process and have no seat at the table. The franchisor’s employees, in this event, are recognised as priority creditors.

Administrators may negotiate restructuring agreements of the franchisor’s business without any consultation with franchisees, while franchisees who are considered to be underperforming can have their businesses taken over.

If the process moves from administration to liquidation, the liquidator has even more power.

Between a rock and a hard place
A worst-case scenario can occur if the franchisee is operating successfully and the franchisor company fails.

“The administrator will be coming after you because, as a successful operator, you are a source of income and royalty stream for the administrator to pay the franchisor’s creditors,” says Buchan.

“Unless you as franchisee have negotiated an exit right, you have no exit right until your contract is disclaimed as onerous, and that is unlikely to occur quickly because your business provides a lucrative income stream.”

For franchisees who sublease premises from the franchisor as the head lessee, the situation can be even bleaker.

If the franchisor has the head lease and the company then fails, it is possible that rent and outgoings will have gone unpaid to the landlord even if the franchisee has been diligently paying them to the franchisor each month.

“In that case, you might find you have signed a rental guarantee and that means you can lose your shop and your investment,” Buchan says.

“You may find that the rent you have been paying to the franchisor, expecting them to pay the landlord, has been used to pay other creditors.”

The simple fix for franchise arrangements
If the reverse situation occurs, and the franchisee's business fails, the Franchising Code allows the franchisor to terminate the agreement if the franchisee is bankrupt or goes into administration.

The recently enacted laws making ipso facto clauses in most contracts unenforceable do not exempt franchise agreements, but are yet to be tested in court.

“In reality, the franchisor has the opportunity to terminate the franchisee before any administrator is called,” says Buchan.

“The franchisor sees all of the franchisee’s books and knows how badly the franchisee is trading. In many systems every time the franchisee’s till rings there is information sent through to the franchisor’s head office.”

Buchan believes that the “simple fix” to the imbalance in legislative rights would be to bring franchise arrangements under the Corporations Act in Australia, and in that process define the rights and responsibilities of both parties.

The alternative is standalone legislation. But, most countries in the world that do have standalone franchise laws largely address issues around pre-contract disclosure and registration of aspects of the franchisor’s offering. They are limited in terms of protection for franchisees once the ink is dry on the franchise agreement.

“The imbalance of power began when we deviated from the Corporations Act model, and so franchisees came to be looked upon as consumers rather than investors,” says Buchan.

“I believe it is an egregious situation, which should be urgently addressed.”