Personal Property Securities Act and Franchisee Financial Failure

THE PERSONAL PROPERTY SECURITIES ACT AND FRANCHISEE FINANCIAL FAILURE. 

Sarah Pilcher, Partner, MacDonald Pilcher Partnership, November 2006.

 

Introduction

The following summary and comments are intended to provide an introduction to a relatively new and sometimes confusing area of business law.  I hope to raise some issues that business owners (in particular franchisors) might need to be aware of if they have not utilised the PPSA system or, if they have, but are still not quite sure what it is all about. 

 

This is based on my own experience in advising franchisors and writing commercial agreements and my observations of practical situations which will be no doubt be different to other perceptions and interpretations. In other words as a lawyer writing an article in a hurry I am saying please be interested in what I am saying, but don’t rely on it to make business decisions without getting specific advice on your own situation!

 

In practical terms the PPSA is probably most interesting and relevant to a franchisor when it defines who has the right to possession, ownership or both of the assets of a franchisee that are liable to be seized by a creditor (e.g. supplier or landlord) or are the subject of a receivership or bankruptcy where the business of the franchisee has financially failed.

 

The PPSA System

The Personal Property Securities Act 1999 (PPSA) came in to effect in New Zealand in May 2002.

 

Many lawyers and accountants pretended or wished it had not. It represented a total rework of the laws and procedures in place for creditors to secure debtors’ obligations against the debtors’ assets and property known legally as “personal property”. (This is different to “real property” which means land and attached buildings which can have their own title registration system and are not covered by the PPSA).

 

Prior to introduction of the PPSA, most people in business would have been familiar with the company debenture which was a registered charge over the assets of a company, normally placed by a lender to secure repayments of a loan.

 

There was also contractual retention of title by which suppliers and vendors would state in their contract of sale that if goods were not paid at the time of receipt, then the legal ownership remained with the vendor or creditor, until paid off. Examples of this are any sale of goods on credit, hire purchase arrangements or vendor finance where on the sale of a business the vendor leaves money in as a loan to the purchaser. Contractual retention of title gave the creditor rights over any other person claiming an interest in the debtor’s property. The item was simply kept outside the pool of property owned by the debtor as long as the creditor turned up to claim it with proof of its status. While the contractual clause may still be around, it will not provide any protection to the supplier unless they have followed it up with filing a charge on the PPSA register. This web based Personal Property Securities Register (PPSR) is where all charges under the Act must be filed to be valid.

 

Other systems in place were the motor vehicle and chattels registers where creditors like car financiers and hire purchase companies could register a charge against the item that had been bought on credit. 

 

All of those systems were replaced by the PPSA system, which allows any person (which includes a company or other entity) to file a charge on a public web based register against the assets or personal property of any other person or entity where the second person owes something to the first, and has agreed to allow the charge to be placed. 

 

Even thought the debtor (borrower or credit purchaser) is required to have given the charge to the creditor this agreement to file the charge on the PPSA register, this “grant of security” is often not truly voluntary. In many situations a purchaser or borrower does not have much choice in granting a charge secured over their property if they are not in a strong negotiating position and most standard terms of trade in lending and credit supplies will have this requirement as a non-negotiable term. 

 

In PPSA language, the lender or supplier is referred to as the “secured party”, and the borrower / purchaser as the “debtor”. There are two broad types of charge.

 

The first is known as a General Security (or a GSA) which is given when the lending or obligation is not attached to the acquisition of a specific asset, for example a bank term loan or overdraft to a franchisee used for general funding and set up or working capital. This type of charge more or less replaces the company debenture system. The first creditor to file their charge usually has priority over all other creditors. The assets have to be described and most will be “all present and future acquired property of the debtor” or similar. In other words “everything you own now or acquire is mine until I am repaid”. 

 

The second type of charge is a Purchase Security (sometimes referred to as a PMSI) which is given where the money or value given by the secured party is tied to particular  assets. Typical examples of this include a hire purchase agreement where money is loaned to buy a vehicle or equipment then the charge is registered against the same vehicle or equipment. Also all credit sales of product or supplies. A creditor with a Purchase Security will have priority over all other creditors who claim an interest in the particular asset including anyone that has a General Security over all property. 

 

A Purchase Security also replaces retention of title although legally they are quite different. Previously a supplier or lender would declare that the purchaser or possessor of an item did not legally own that thing until it was paid for in full. Under the Act, if you sell on credit, you no longer actually retain ownership – you just become the first creditor in the queue with an interest in the item, but only if you register a Purchase Security within a certain strict time frame. This rule also applies to leased items for a term of more than one year, for example car or equipment leases. If the leasing or finance company did not file a Purchase Security and the hirer of the item went in to bankruptcy or liquidation, the owner would have no right to step in and take back the asset, even if it was very clear in a written contract that it was only leased it would fall in to the hirers pool of assets. This could affect franchisors which lease or lend out specialised equipment to franchisees for the term of a franchise agreement.

 

The most important thing to know about the different types of security are that the holder of the first filed General Security over all present and future property effectively owns all the assets of the debtor except where any of those assets have a Purchase Security charge. The strongest General Security holder will usually be the bank. Purchase Security usually relates to suppliers and hire purchase or finance leases.

 

What This Means to Your Franchise System

Knowing and using the PPSA system in advance is the only way it will work for a franchisor. It can not be called upon as a remedy or solution if things go wrong unless you have completed the right documents and registrations at the right times, and thought about whether it is a tool you need in your franchise system, and if so, how it will be utilised.

 

Consider the ‘average’ franchisee in New Zealand today. Most likely a single business unit owner with a fairly low net worth.   Such franchisees will be relying on a high level of bank or other lender financing both to enter (purchase and set up) the franchise and for working capital and other short term financial accommodations.   Similarly most franchise businesses will be dependent on supplies and product purchases through various credit arrangements, and in many cases the franchisor may also be a key supplier.

 

For this franchisee, a bank or other major lender will not lend without security. If this is not available against the franchisee’s house or land under a mortgage, the bank will be looking for a first ranking General Security against the franchisee business and assets. The bank will want their General Security to be at the front of the priority line, not second to a franchisor.

 

During the normal course of trade, suppliers of any significance will expect a Purchase Security to be granted against the goods or equipment before supplying on credit. Often this will be in their standard credit application or terms of trade which the franchisee will have signed or at least accepted by continuing to make the purchases.

 

Most franchisees will at some time owe their franchisor money under the franchise agreement. This may be accrued royalties or fees, purchase of supplies / equipment or delayed payment of initial franchise fee. Some franchisors require all franchisees grant a GSA security interest in the assets of their business to the franchisor.  

 

Therefore, franchisees are likely to get financing from some external source, and they are likely to be selling or using products purchased on credit, and may be leasing equipment or vehicles, so there could be quite a few charges registered against the franchisee. (Many franchise agreements actually prohibit the franchisee from assigning or mortgaging the franchise business or assets without specific franchisor consent, however in reality if a franchisee cannot obtain finance or supplies, the business will fail).

 

What Happens if a Franchisee Business Fails

It does need to be noted at this point that once a business goes into receivership or liquidation, or a person is bankrupted there is a whole other area of law, rules and procedures that come into play, and sometimes they will clash with what the PPSA tries to do. It is a very specialised area, and not covered here. To follow are some practical suggestions of how a franchisor might work within the PPSA structure to be in a strong position if a franchisee does fall into financial failure which results in control or winding up of the franchisee business being in someone else’s hands.

 

If a franchisor is collecting royalties and other fees in a timely manner, and is not a credit supplier or hirer of products or equipment to franchisees then there is probably little direct financial exposure if a franchisee business goes into liquidation, receivership or bankruptcy. It may seem that the PPSA would not add much value. 

 

If a franchisor does have more direct financial exposure with the franchisees and is registering on the PPSA register against franchisee business assets, it is possible the franchisor will be second in line to a bank or other major creditor. The franchisor will also be behind any security charges against stock and equipment for credit purchases or hires.

 

If any dissatisfied creditor of the franchise business used the PPSA procedure to call in a loan and seize assets to satisfy it, or to put the business into receivership or bankruptcy, once the suppliers had taken back their unpaid for goods, and the lease and hire purchase items were removed, there might not be much left for a franchisor even though they have taken the step of securing a charge.

 

In this situation, the franchisor might wonder what value there was in registering in the first place.

 

Whether there are PPSA registrations or not, hopefully the franchise agreement will clearly give the franchisor the right to terminate the franchise as soon as the franchisee gets into such a situation, and possibly beforehand. The franchisor can collect regular financial reports and accounts and have a fair idea of when a franchisee is in trouble. If the problems cannot be worked through and termination is the only option (due to financial failure of the business) then the franchise agreement needs to be formally terminated as soon as possible.

 

Termination will have the result of the franchisee no longer being able to trade using the franchise system and if premise based and the franchisor wants to retain that location, hopefully the franchise agreement and lease documents will have provided for the franchisor to have the right to move into those premises and take over operation of the business.

 

In practice however a worst case scenario might mean that waving your franchise agreement or sublease at an unsympathetic creditor or their representative who has put chains on the door and taken possession of essential equipment, paperwork and stock might not be enough to scare them away – and it could turn in to an expensive exercise to prove your rights. 

 

Even if the franchisor decided not to carry on the business at that location, there will be a procedure following termination that needs to take place, such as getting back all confidential information and intellectual property, i.e. the manuals, recipes, software, etc; having signage removed from premises and vehicles, uniforms returned; products and supplies returned, unique or proprietary equipment returned and so on. Again, if a third party is in control and more interested in paying out secured creditors, they may not see that your rights as a franchisor are all that important. After all, your rights are based on a contract between you and a now absent or powerless franchisee. This third party is acting under a different set of rules and depending on their attitude may not have a lot of respect for your franchise agreement. This is a highly unsatisfactory situation for a well run franchise. It will take up time and energy of your staff, and means you are not in control of valuable and confidential items and information. It means tidying up and moving on could be a long time coming.

 

This outcome for a franchise system seems harsh and commercially unattractive. But it is quite possible that it could happen. 

 

A practical way for franchisors to avoid this is to ensure that they have the first perfected security interest in the franchisee’s business and all components of the franchise grant and system. This could be done by filing a financing statement on the PPSR immediately a franchisee applies for a franchise, and require that franchisee to incorporate a new company against which the franchisor charge would be registered on the PPSR immediately. This is not going to be so useful with existing franchise agreements, but could be built in as part of conditions of renewal.

 

If the franchisor is the first to file, it would then at least be able to negotiate with the bank by agreeing to allow the bank priority over all general assets excluding any franchise related property, or, getting the bank to enter an agreement with the franchisor that it will not exercise its rights over the business without giving the franchisor notice, and the option to take over the debt and business.

 

Another approach could be for the franchisor to file a purchase security (which gives super priority) against specific assets of the franchisee business that are unique, proprietary or essential to the franchise system. This could be done on the basis that those items are never really owned by the franchisee but only loaned or licensed for the duration of the franchise agreement and the franchisor always has the right to take back possession at the end of the franchise term. 

 

At the end of the day it might come down to who has the biggest truck, the burliest repossession man and the fastest reaction to the situation. And these suggestions are untested in New Zealand because the system is so new, the PPSA Act itself is confusing and there have been very few court cases. But while we wait for the law to catch up and provide us with some guidelines of how to use this system, business people owe it to themselves and their system to take good practical steps in advance and have plans in place to deal with those big problem areas which always seem to occur when you have the least time and resource to deal with them.