Can you lose your option to purchase or your right to use assets of the franchise granted in a franchise agreement?

19 Dec 2018

By Benjamin Caddaye, Law Clerk and Alicia Hill, Principal, MST Lawyers

A client recently approached MST Lawyers with this very question. The Franchisor had:

  1. an option to purchase the assets of the franchise within six months of the expiry or termination of the franchise agreement; and
  2. a right to use those assets freely within the six months allowed for the exercise of the option.

The Franchisee entered into liquidation, and the liquidator claimed both the option to purchase and the right to use were extinguished under section 267 of the Personal Property Securities Act (PPSA) as they were unregistered security interests.

 After conducting a review of Australian, New Zealand and Canadian case law, MST Lawyers concluded that an option to purchase the assets of a business, in the form that was presented by our client, was not capable of forming a security interest. The option to purchase was not extinguished even though it was not registered on the Personal Property Securities Register (PPSR).

However, the conclusion in respect of the right to use was less clear.  This article sets out MST Lawyers’ view on the arguments raised by the liquidators and suggests Franchisors consider registering on the PPSR where they may wish to enforce rights to use franchise assets after termination of a franchise.

What Is The PPSA And Why Is It Relevant To The Liquidator Denying The Franchisor The Option To Purchase Or The Right To Use The Franchise Assets?

In 2009, the Commonwealth Government passed the Personal Property Securities Act (PPSA) into law.

The Act attempted to create a single regulatory framework for the recognition of a security interest in personal property through the process of registration on the Personal Property Securities Register (PPSR).

This regime was created by modelling our system on the New Zealand, Canadian and US legislation as well as incorporating the perspective of the United Nations Commission on International Trade Law.

Operation Of The System

A ‘security interest’ is defined in the PPSA to mean an interest in ‘personal property’ that secures payment, or the performance of an obligation.

‘Personal property’ is defined in the PPSA broadly to include an interest in property, other than an interest in land, a right, entitlement or authority from the Commonwealth or a State Government, or a fixture in land.

 This definition flows from the distinction in law between real property, being land, and chattels which are tangible items such as plant and equipment, or intangible items like legal rights.

The PPSR cannot be used to register a security interest in land, such as a mortgage, as there is a separate system known which allows for registration of those interests.

Generally, the first security interest registered on the PPSR will have priority and first rights to seek recovery of the amounts owed to it from the secured interest. A common example of a security interest that would be registerable on the PPSR would be where a Franchisor provides finance to a franchisee to purchase a franchise.In order to secure the repayment of the loan, the Franchisor can register its security interest against the franchisee on the PPSR.

The effect of such a registration is that the person holding the registered security interest has a preferential entitlement to the personal property over other creditors.If the franchisee were to default under his/ her loan agreement, the Franchisor would be entitled under the PPSA to enforce its security in order to satisfy the debt owed under the loan agreement.

Importance Of Registration

An important aspect of the PPSR is the distinction between ‘perfected’ and ‘unperfected’ security interests. Generally, a ‘perfected’ security interest is one that under the PPSA is attached to the property, is enforceable against third parties and is either registered on the PPSR or the security interest holder has possession of the property. If these requirements are not satisfied, then the interest is ‘unperfected’.

The rights that attach to a perfected security interest are great. It allows for control of the personal property by the holder of the interest, placing them in a better commercial position than other creditors to sell property to satisfy the debt.

Under the priority rules, a perfected security interest will take preference over an unperfected security interest. In the case of two or more perfected security interests, the priority will be given to the earliest security interest.These priority rules indicate how important the registration of a security interest can be; as the earlier they are registered, the better placed the creditor will be.

Extinguishing Interests

It is also important to understand the operation of section 267 of the PPSA. This section applies where a party which has granted a security interest (the grantor) either goes into liquidation to wind up, appoints administrators, enters a deed of company arrangement or becomes bankrupt.

If such an event occurs, and the party who received the security interest (the grantee)has not ‘perfected’ the interest on the PPSR, the interest vests with the grantor and is extinguished.

Therefore, the questions of what is a security interest for the purpose of the PPSA is of great importance.  

If a right of a party is not a security interest, then it does not come under the operation of the PPSA and does not extinguish under section 267 of the PPSA.

The Challenge By The Liquidator To The Exercise Of The Rights In The Franchise Agreement

Most franchises running businesses where specific plant and equipment (assets) are required to operate the business contain a clause which permits, on termination of the franchise, the Franchisor to:

1.        buy the assets used in the franchise; or

2.        use the assets for a specified period of time subject to final disposal of them to either the Franchisee or the Franchisor.

Liquidators have been challenging the right of Franchisors to:

1.        exercise the option to purchase; and

2.        utilise the assets payment to specified periods contoured in the franchise agreement.

Liquidators have been asserting that due to lack of registration on the PPSR of the Franchisor’s rights that when they are appointed, section 267 of the PPSA Act to vest the assets solely in the Liquidator without the Franchisor being able to exercise these rights.

After conducting a thorough review of Australian, New Zealand and Canadian case law, MST Lawyers concluded that an option to purchase the assets of a business, in the form that was presented by our client, was not capable of forming a security interest. Furthermore, the option to purchase was not extinguished despite the fact that it was not registered on the PPSR.

This option was merely a personal right of the Franchisor that was capable of enforcement through an order for specific performance. Importantly, it did not secure any payments or the performance of any obligation.

However, the conclusion in respect of the right to use was less clear.

The right to purchase and the right to use fall with the definition of ‘Personal Property’ in section 10 of the PPSA.

If the rights are also security interests, then they will be captured by the operation of the PPSA.  There is no decided case in Australia exactly on point to our knowledge at the time of writing.

In New Zealand:

  • the option to purchase a luxury car did not constitute a security interest (Asset Traders Ltd v Favas Sportscar WorldLtd) (Unrep NZ High Court Judgement);
  • the option to purchase consignment stock did not constitute a security interest (Triumph Motorcycles (NZ) Ltd v Keogh)(2010) DCR 824.

In Canada:

  • the option to purchase 589 cows did not constitute a security interest.

The common reasoning for these decisions was that the right created did not in substance ‘secure payment on the performance of an obligation’.  As such the PPSA regime does not apply to the effective operation of these rights.

In contrast in a New Zealand case a right under a construction contract for a person on the builders insolvency to step in and use the builder’s equipment to complete construction and then sell the equipment to recover amounts owing to that person has been held to constitute a security interest (McCloy v Mongkau Institute of Technology [2013] 3 NZLR 390). 

So in circumstances where a franchise agreement clause is simply a right /option to purchase our view is that such a clause does not “secure payment or performance of an obligation” and is not captured by the operation of the PPSA as it does not fall within the definition of a ‘security interest’ despite clearly being ‘personal property’.

However, where a franchise agreement clause grants the Franchisor the right to use the assets for a period post-termination before sale/purchase arguably this right is granted to ‘secure payment or performance of an obligation and is captured by the operation of the PPSA as it will constitute a security interest.

Ultimately this would result in a loss of the ability to rely on and exercise these clauses where the Franchisor had not registered a security interest on the PPSR, and a Liquidator was appointed, and the unregistered/or improperly registered security interests vest in the Liquidator.

Lessons For Franchisors And Liquidators

Given the low cost to the PPSR registrations compared with the losses likely suffered if the clause was unable to be utilised we recommend Franchisor:

  1. ensure they have identified what security interests exist within their Franchise Agreements; and
  2. assess the cost/benefit for registering those security interests on the PPSR and register where they believe it is important to presume the ability to utilise their right to use the assets and then sell/buy clause.

The important legal questions for insolvency practitioners are whether an interest in property constitutes a security interest and whether the holder of that interest has a perfected or unperfected interest.

The answer to these will determine the rights of the secured creditor, and affect the pool of assets available to distribution to unsecured creditors. While the PPSA regime has drastically reduced the compliance costs for those with security interests and made the task of determining whether a security interest exists as simple as searching the register,uncertainty still remains.

It is important that if any doubt arises concerning these two questions you contact your legal practitioners for professional advice.

If you have any questions by the matters raised by this article, please feel free to contact Alicia Hill by email or call +61 3 8540 0292.