Managing supply chain risk in a franchise system – proposed changes to the UK insolvency regime
Failures rates within franchising are typically much lower than non-franchised start-ups. However, the latest BFA/NatWest survey of the UK franchising sector cites franchisee underperformance as one of the three key concerns of franchisors, and franchise businesses are of course not immune from the economic headwinds and technological changes, which are affecting various sectors.
Against the backdrop of a number of high profile business failures in the UK retail sector, the UK Government has issued a report on the insolvency regime, which will affect the operation of termination rights in supply agreements.
This article considers the proposals and provides a best practice recommendation for recovering goods in the possession of a franchisee once they have entered some form of insolvency protection.
1. Terminating the right to terminate – UK Government announces measures to protect distressed businesses
The number of Company Voluntary Arrangements ("CVAs") is on the rise, driven by a number of factors, including increased costs and fierce competition from online sales. However, CVAs themselves are often not enough to save a failing business and this has led to the UK Government deciding to step in and take action. One of the proposed measures to support companies through a business rescue is the introduction of new rules to prevent suppliers terminating contracts solely by virtue of a company entering an insolvency process. This is relevant to franchisors, as most franchisors will also be the franchisee's principal supplier.
These measures are part of the Government’s wider response to its consultation on proposals to improve the corporate governance of companies that are in or are approaching insolvency.
Franchisors should take note of the following points contained in the Government's response:
- The Government will legislate to prohibit the enforcement of ‘termination clauses’ by a supplier in contracts for the supply of goods and services where the clause allows a contract to be terminated on the grounds of a party entering formal insolvency (such as administration, liquidation or a CVA).
- The supplier will need to seek permission from the court in order to terminate supplies. In rare cases where a supplier will be significantly and adversely affected by not being able to rely on a contractual termination clause, the supplier will be allowed to exercise such a right on the grounds of undue financial hardship. Only if a supplier's own solvency is threatened will the right be granted.
- Personal guarantees will not be required (whether from a director or insolvency office holder) where a supplier continues to supply due to not being able to rely on insolvency-related termination clauses. Such suppliers will have "super priority" for supplies made during a pre-insolvency moratorium period in the event of a subsequent insolvency (meaning that they are unlikely not to be paid for any supplies they provide).
However, franchisors will retain the ability to terminate contracts on any other ground permitted by the contract such as:
- non-payment of liabilities (e.g. invoices) incurred following entry into a moratorium, restructuring plan, or insolvency procedure;
- giving notice in accordance with other terms of the contract (e.g. a right to terminate upon giving fixed notice); or
- any other ground that gives rise to termination, save for those connected with the financial position of the debtor company, or it entering into a moratorium, restructuring plan, or insolvency procedure.
It will be a few years before the measures become law (not least because of the distraction of Brexit). However, this development is relevant to any business entering into long term supply agreements as it is likely that the new laws, when passed, will apply to existing agreements.
These changes highlight the need for franchisors to assess their supply terms and ensure that the rights for termination are sufficiently detailed, clear and broad to enable the franchisor to take the necessary action when it is faced with an insolvent buyer.
2. Retention of title and insolvency – best practice tips on how to protect your position
Franchisors should ensure that they have comprehensive and robust terms of supply (ideally in a separate document from the franchise agreement) which have effective "retention of title" clauses so they can take action to recover goods in an insolvency situation. However, in our experience, franchisors often overlook terms of supply and do not give them enough attention.
Retention of title claims are a regular feature of claims made against insolvent businesses. Many suppliers of goods need to have an all monies retention of title clause enabling them to recover the goods held by the retailer when they go into insolvency or alternatively payment for those goods in full to the value of the goods held at the date of the appointment of the insolvency practitioner.
It is well established in English Law that a buyer of goods has the right to sell goods once they are in possession, notwithstanding the supplier having retention of title and ownership in the goods. By selling the goods to a third party, title effectively passes, thereby negating the benefit of the retention of title clause. Recovering the proceeds of sale of any goods supplied is impossible unless the supplier has obtained a legal charge over the assets of the company to the value of the goods, which is unusual in normal supply relationships.
In addition, credit insurers usually insist on their insured clients having an automatic termination of the licence to sell in the event of an insolvency of the buyer.
This type of clause will give a supplier a contractual right to insist that the buyer and the insolvency practitioner shall stop selling the supplier's goods immediately upon the practitioner's appointment. To back this up, we recommend writing immediately upon their appointment revoking the licence to sell and demanding an inventory showing the value of the goods held at the time of their appointment so that the value of the retention of title claim can be calculated as it crystallises at that point.
If the buyer continues selling the goods after receipt of such a letter then the supplier is entitled to claim the value of all goods sold following termination of the licence to sell, together with any goods that are retained by the buyer. This enables the full valuation of the retention of title claim to be pursued and hopefully payment made in full if the business carries on trading.
In most cases, the administrator will resolve the retention of title claim by paying the full value of the goods held once the inventory is agreed. Stock controls systems are usually available to provide a printout from the retailer's IT system showing the amount of goods held and their value. This is essential in deciding whether or not to pursue a retention of title claim.
If this clause is not contained in the terms and conditions then a letter should be sent immediately to the administrator, terminating the licence to sell in any event. If no such letter is sent or if there is no such clause in the terms and conditions, then the value of the retention of title claim will diminish with each day of continued trading as the stock is depleted and sold.
It is therefore essential to terminate the licence to sell and preferably incorporate such a clause into the applicable terms and conditions to avoid these problems arising.
3. In conclusion…
Most franchisors will act as suppliers of goods and services. As a franchise network grows, so does the systemic risk to the franchisor of franchisee-default and failure. It is therefore important that franchisors invest in proper legal advice and legal contracts to ensure that they have the contractual rights to act quickly and effectively if the need arises.
We recommend that franchisors review the inter-relationship between the franchise agreement and the standard terms of supply, paying close attention to termination rights and developing a clear process for dealing with franchisees who are in financial distress.