As noted by my colleague Catherine Sedgley in her summary, the Parliamentary Joint Committee on Corporations and Financial Services (“Committee”) recently issued its long-awaited Report on the operation and effectiveness of the Franchising Code of Conduct (the “Code”).
I spend a lot of time advising clients in relation to leasing arrangements – with this often including franchisors and franchisees. As such, I am particularly interested to see the impact that the Committee’s recommendations will have on the world of leasing.
Chapter 20 of the Committee’s Report delves into leasing, and examines the impact of increased rental costs, disclosure of lease arrangements to franchisees, and franchisee rights as sub-lessees or licensees of the franchisor. The process conducted by the franchisor to determine whether a franchisee’s business can afford rental costs has also been considered.
The Committee’s observations with regard to leasing
- The interaction between shopping centre landlords, franchisors and franchisees are both complex and fraught;
- Given the concentration of franchised outlets within shopping centres, the issues arising from retail lease agreements are of essential importance to the franchise industry;
- Franchisors argue that major shopping centre landlords engage in anti-competitive conduct and impose restrictive lease terms, excessive price increases and onerous conditions surrounding lease terminations;
- When franchisors take on the role of head lessor, franchisees can often experience a range of negative impacts; and
- The Committee was concerned about the negotiation strategies used by some landlords, which have required franchisors to negotiate leases for multiple locations simultaneously. This has at times lead to pressure being put on franchisors to accept leases for sub-optimal locations in order to be granted leases for other more preferable locations
The Committee’s recommendations with regard to leasing
- The requirement that a copy of the head lessor disclosure statement and final lease agreement be provided to the franchisee (or prospective franchisee) no less than 14 days prior to the franchisee entering into the franchise agreement;
- That the franchisee be allowed the right to terminate, without penalty, the franchise agreement, as well as any agreement for the sub-lease of a premises by written notice, within six months of the franchisee occupying the premises, if the franchisor does not comply with the obligation to provide a head lessor disclosure statement, or if the head lessor disclosure statement has misinformation or contains false and misleading information where the franchisee is in a substantially worse position than they would have been if the head lessor disclosure document were not subject to these omissions etc.
- The insertion of a new annexure to the Franchising Code of Conduct making reference to how sites are to be occupied for the purpose of the franchise business e.g. Lessee, sub-lessee, licensee and whether the term of the relevant lease or licence aligns with the term or period of the franchise agreement.
- That when the franchisor holds the head lease and the franchisee is the licensee, funds paid by the franchisee to the franchisor for the purpose of paying rent to a landlord must be held in a trust, and may only be used to pay the franchisee’s rental expenses, with franchisors being liable. Further, in the event that the franchisor is wound up, the money held in trust must be used to pay the rent owed to the landlord.
How can lending practices impact the franchising industry?
I also find Clause 19 of particular interest, as it covers the lending practices of banks and other financial intermediaries in the franchising industry. Without capital, the franchisee cannot fund their operations – particularly the fit out of the premises, provision of security, refurbishments during the life of the lease or to make good at the end of the term.
The Committee noted that the failure rate of franchised and non-franchised business is similar. Yet, the funding level of franchising does not adequately connect the franchisor to the financial risks, resulting in the franchisor potentially having little accountability for franchisee failure, and by extension, insufficient incentive to support franchisees in their network or appropriately deal with franchisee underperformance. The Committee concluded that given that financial risk in franchising typically falls on the franchisee in the most part, the role of lenders in the franchise sector and the rules around business lending should receive examination.
The Committee raised questions surrounding whether expenditures required as part of the end of term arrangements for the lease are being adequately accounted for when lenders assess the profitability of the business. The Committee considered it reasonable for lenders to take such expenses (which are significant) into account, alongside start up and operational expenses in more accurately determining the viability of the business, as well as the franchisee’s capacity to repay the loans within the terms of the franchise agreement.
This report is significant and comprehensive, and whilst the areas that I have touched on are just a small part of the Committee’s overall recommendations, they are significant given that the two key areas that drive a franchise are often its occupancy arrangements and ability to obtain and pay for capital. Any changes to the laws surrounding leasing will require a lot of consultation with the States and Territories, due to the fact that the retail leasing regimes and other property related legislation are jurisdictional specific. Therefore, we await eagerly as to what the relevant Governments do to implement the recommendations by the Committee.
If you have a query relating to any of the information in this article, or you would like to speak with a lawyer in Coleman Greig’s Franchising team with regard to your own leasing matter, please don’t hesitate to get in touch.