Is there an alternative to franchise terminations?

Recent newspaper headlines arising from the acrimonious termination of a franchised food court business, including the involvement of police and the dismantling of the store, provide a rare public insight into a franchise termination.

The termination of the franchise relationship is generally the last resort for frustrated franchisors dealing with franchisees who refuse to comply with the terms and conditions of their franchise agreement, and rarely become a public spectacle.

But it must be asked – can more be done before a franchise is terminated?

After all, the potential consequences of a franchise termination can be quite severe for the franchisee, and unlikely to be desirable for the franchisor either.

Of course there are situations where franchisors must be prepared to terminate a franchise agreement to maintain the integrity of the system and the reputation of the brand, and these are noted in the special circumstances provision of the Franchising Code of Conduct.

Such situations include where the franchisee voluntarily abandons or agrees to the termination of the franchise relationship, becomes bankrupt or insolvent, is convicted of a serious offence, endangers public health or safety, fraudulently operates the franchise, or ceases to hold a required license.

By its very nature, a franchise is a conditional grant. The ongoing performance of the franchise depends on the franchisee complying with the conditions outlined in both the franchise agreement and operations manual.

In previous articles, the importance of understanding these terms and conditions has been underlined, as well as the need to train franchisees on the process and consequences of receiving a breach notice if they do not comply with these conditions.

However, many franchisees fail to understand the seriousness of a breach notice because they mistakenly assume that their franchise agreements cannot be terminated because they have bought the franchise, and like other things they buy, gives them the right to do what they like with these possessions.

The difference is that a franchise is not a possession – it is a license to operate, which like other licenses to operate (such as driver’s licenses), can be revoked if not conducted properly.

The consequences of losing this license to operate is not only the loss of the franchise brand and operating systems, but also invokes other terms of the franchise agreement, such as those restraining the franchisee from operating a similar business in the same location or surrounds for a period of time.

Combining the loss of a license to operate with a restraint on future similar operations can be financially catastrophic to a franchisee (who may have borrowed heavily to establish the franchise) as their remaining asset is generally the stock, plant and equipment of the business at their written-down values. Unable to sell the business as a going concern because it has been terminated, the goodwill value of the business evaporates, and with it usually the franchisee’s capacity to repay the loan they took to buy the business.

As most business loans require real estate security – usually the franchisee’s home – it then follows that if the business loan cannot be repaid after the franchise is terminated, then the lending institution will seek to recover the debt by liquidating the security, and consequently the franchisee can lose their home.

The emotional response by the franchisee and their family to the demise of their business and loss of related assets can further compound the consequences of the franchise termination, and lead to spiteful attempts at recrimination against the franchisor or others believed to be responsible for the franchisee’s situation.

From the franchisor’s perspective, the consequence of termination are also significant, though in proportion to those experienced by a franchisee are much more tenable.

A franchise termination can incur substantial legal and operational cost to a franchisor. The legal cost may only be partially expended up front in preparation of the termination, but is more likely to follow in response to franchisee litigation, or in responding to enforcement agencies if terminated franchisees lodge complaints.

More significantly however, is the cost of resuming the operation of the terminated outlet (where this is possible) and restoring its operations to an acceptable standard. Few business owners can afford to engage staff for the sole purpose of acting as some kind of flying squad to take over the management of a franchise on the off-chance a franchisee is terminated. The cost to and reallocation of resources away from other functions that support the franchise network is a cost that is rarely considered in the discussion of franchise terminations.

Additionally, a terminated franchise often has little resale value, which if sold can negatively impact the market value of other compliant franchises in the same group.

However the point remains that the overall economic consequences of a termination to a franchisee are usually far greater than to the franchisor, so it begs the question, can terminations be approached differently to still achieve the same outcome (ie. a compliant outlet) without causing the complete financial ruin of the terminated franchisee?

In the same vein, what additional solutions for compliance problems should franchisors seek prior to issuing terminations, and without such solutions, can franchisors become too trigger-happy when terminating franchisees?

One potential solution may be to separate the franchisee from the non-compliant franchise, rather than treating the two issues as one.

For example, the franchisee’s right to operate the franchise may be suspended instead of terminated. This could be achieved through the nominated manager provision which exists in most franchise agreements, and which requires an approved individual to be in charge of the daily operations of the franchise.

Nominated managers are necessary where a franchise is owned by a partnership, trust or a company to ensure that the operator of the business undertakes training to a level of proficiency in the operation of the business, holds appropriate licenses, and is a real person accountable for the outlet’s performance. Nominated managers will usually be the majority shareholder or director of a company, or principal beneficiary of the business investment.

By using the nominated manager provision, a non-compliant franchisee could lose their endorsement to operate the business, but not the business itself. This could mean that the franchisee is prohibited from operating their business, and during the interim the franchisor can invoke the power of attorney provisions that exist in many agreements to step in and operate the business to the desired standard, the cost of which is borne by the franchisee.

To come off suspension in the meantime, the franchisee must agree to undertake additional training, counselling or to address whatever issue or issues which triggered the suspension in the first place in order to be reinstated as the nominated manager for their business. If the non-compliant franchisee is rehabilitated to the franchisor’s reasonable satisfaction, they may then resume operation of their business and are obliged to pay costs to the franchisor for the time it was under the franchisor’s management.

This method preserves the value of the franchisee’s investment in a manner that termination does not, and can provide valuable lessons for both franchisees and franchisors in managing future compliance issues.

Of course, a franchisee who must be repeatedly suspended as the nominated manager risks termination, but here again an orderly exit through the sale of the business as a going concern, less the franchisor’s costs in operating it during the franchisee’s suspension, should still provide a better financial outcome for a franchisee compared to the losses that are likely to follow from termination.

Even under a select few of the provisions in the Code which provide grounds for instant termination, could a process of suspension and rehabilitation conceivably apply.

There are practical challenges to consider in suspending, rather than terminating franchisees, one of which is how to prevent the franchisee from interfering with the business while they are still suspended. However, if the concept of suspension can prove to be a viable alternative to termination, both franchisors and franchisees may ultimately benefit.

Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for nearly 20 years at franchisee, franchisor and advisor level.

He advises both potential and existing franchisors and franchisees, and conducts franchise education programs throughout Australia, and publishes Franchise News & Events, a fortnightly email news bulletin on franchising issues and trends.