By David Gray and Howard Manis
Discussing bankruptcy in relation to franchising almost seems counterintuitive. After all, franchising is an excellent way for a prospective entrepreneur to prevent those unfortunate circumstances because its business starts with an established brand, trademark and product from day one. Franchisors are also at an advantage because their expenses and responsibilities are distributed amongst a network of franchisees.
However, the practical reality is that bankruptcy is a possibility in any business endeavour. As a prospective franchisee, you need to be aware of this potential obstacle, no matter how unlikely it is. This article will provide an overview of franchisors’ and franchisees’ rights and obligations in an insolvency scenario.
A franchisor can go bankrupt voluntarily by filing an assignment in bankruptcy or involuntarily through a bankruptcy application being made by one of its creditors. When the franchisor has defaulted on an obligation of more than $1,000, any creditor may make a petition to the bankruptcy court to have the franchisor declared bankrupt. For example, an unpaid supplier can make a petition for bankruptcy if it can be demonstrated to the bankruptcy court that the franchisor has generally failed to meet its obligations as they fall due.
Once bankruptcy is declared or ordered, a trustee in bankruptcy is appointed to ‘step into the shoes’ of the franchisor. The trustee’s job is to represent the interests of the unsecured creditors (those who have claims that are not guaranteed by security over the bankrupt party’s property, assets or undertaking), which includes franchisees.
After being appointed, the trustee will attempt to liquidate the franchisor’s assets (e.g. franchise system, trademarks, brand, goodwill, equipment and inventory) and ensure they are distributed amongst entitled government institutions and secured creditors, in accordance with the priority schemes provided for in the Bankruptcy and Insolvency Act. Priority amongst secured creditors, like banks, is determined by the order that each creditor entered into a security agreement with the franchisor and registered such interests under the Personal Property Security Act. The interests of all secured creditors will rank above those of the unsecured creditors, including any franchisees.
Subject to several conditions, unpaid suppliers will have the right to reclaim any goods provided to the franchisor within a 30-day period prior to the franchisor’s bankruptcy. Landlords are also ranked as preferred creditors and will be able to recover arrears in rent before assets are distributed amongst unsecured creditors.
The appointment of a receiver usually takes place concurrently with the bankruptcy but is not a part of the bankruptcy proceedings. Receivership is a remedy secured creditors often use to profit from the debtor’s assets. A receiver can be appointed by court order or privately. The receiver’s job is to represent the interests of the creditors and recover the amounts owed to them.
The receiver acts as an agent for the creditors and is therefore responsible for the liquidation of the debtor’s assets, which may entail running the franchisor’s business to be able to sell it.