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Legal v. Ethical – What should a near-bankrupt Franchisor disclose?

Australian franchisees have similar gripes to U.S.A. franchisees – disclosure issues and the renewal rights in agreements for franchisees.

It has not always been so crystal clear when a franchise chain collapses and there is an urgent need to clarify the legal rights, obligations and ranking of franchisees in a liquidation or sale of the business by receivers.           

The article brings up an interesting ethical question:  Is it legal or ethical for Franchisors that are at the brink of collapse to recruit new franchisees to their stricken businesses even as they face the very real prospect of bankruptcy?   

In my opinion, the legal and ethical answers are similar.  The franchisor must not lie or mislead in the sales process and it must disclose risks accurately, but within those boundaries it should do what is necessary to survive. 

Does a cash starved franchisor have tell a prospective franchisee – “We need to sell 10 more franchises this year or we will go bankrupt and you will lose your license” ? No, I do not believe that is or should be a requirement because many businesses live on the edge of financial survival.  But, if the franchisor knows that bankruptcy or winding down the business is a 100% certainty, I do believe the franchisor should ethically stop selling franchises, inform the franchisees of the situation, and work out a sale of the assets in the best interests of all stakeholders.  Franchisors who sell a few more franchises just to pay off some bills or salaries as they wind down the business are indeed unethical.

Being a franchisee in a larger system does have advantages if the franchisor goes bankrupt.  The likelihood is very high that some group will acquire the assets and enable the franchisees to continue operating.  Or, worst case, the franchisees themselves could come together and buy the franchisor’s assets out of bankruptcy.   Small bankrupt franchisors have such little book and IP value that there typically scant interest from investors.

How is a franchisee to know if the franchisor is near its end? The only sure way to know is to analyze at the franchisor’s financial statements such as it’s cash flow and balance sheet. If you don’t know how to do that, HIRE AN ATTORNEY OR ACCOUNTANT/FINANCIAL ANALYST TO GUIDE YOU!

Ontario attorney Michael Webster blogged on this franchisor bankruptcy issue last year. 

About Ryan Knoll

Attorney and advisor with an interest in franchising. Feel free to email me comments and questions on the "Contact Us" page.

5 comments

  1. The leading authority on Australian franchisor bankruptcy is Prof. Jenny Buchan at the Univ. of New South Wales ( jm.buchan@unsw.edu.au ), she wrote her doctoral dissertation on the topic.

    Ryan’s points are valid, although we should bear in mind that just as many franchisees delude themselves with rose-colored glasses, so too many franchisors will continue to sell franchises in the (erroneous) delusion that they can sell enough franchises to survive long enough that some miracle will enable them to save the company.

    • Is this the same Paul W. Steinberg who failed to pay the taxes on his franchise operations to the extent of over $33,000 with the result that NY State had to go to the expenses of issuing a series of Tax Warrants against him. Go to: http://appsext8.dos.state.ny.us/stwarrants_public/st_search, enter “Steinberg” for the taxpayer name, leave “City” blank, enter “New York” for the county, “Base word” for the search type, and “All.”

  2. [quote comment=”405784″]The leading authority on Australian franchisor bankruptcy is Prof. Jenny Buchan at the Univ. of New South Wales ( jm.buchan@unsw.edu.au ), she wrote her doctoral dissertation on the topic.

    Ryan’s points are valid, although we should bear in mind that just as many franchisees delude themselves with rose-colored glasses, so too many franchisors will continue to sell franchises in the (erroneous) delusion that they can sell enough franchises to survive long enough that some miracle will enable them to save the company.[/quote]
    Thanks for the info on Prof. Buchan, Paul. There is enough going on in U.S. franchise law to keep one busy full time, but I always find it interesting to see the good and bad regulations in other countries.

  3. Ryan, I agree with your observations. But prospective franchisees have to do more work for themselves. The financial failure of their franchisor indicates that there is no real business model that is working – for either the franchisee or franchisor. Franchising is simply a method of distribution, if the franchisor is not making any money or is insolvent, then there is simply no business.

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