Moral Hazard, Path Dependency and Failing Franchisors: Mitigating Franchisee Risk Through Participation

Publication Date01 June 2019
AuthorJennifer L L Gant,Jenny Buchan
Date01 June 2019
Moral Hazard, Path Dependency
and Failing Franchisors:
Mitigating Franchisee Risk
Through Participation
Jennifer L L Gant* and Jenny Buchan**
Employment relations are well understood. Business format franchising is a newer and rapidly
evolving business expansion formula, also providing employment. This article compares the fates
of employees and franchisees in their employer/franchisor insolvency. Whereas employees enjoy
protection, franchisees continue to operate in conditions that have been described as Feudal.
We identify the inherence of moral hazard, path dependency and optimism bias as reasons for
the failure of policies and corporations laws, globally, to adapt to the franchise relationship. This
failure comes into sharp focus during a franchisor’s insolvency. We demonstrate that the models
of participation available to employees in the United States, Australia and the United Kingdom
could be used to inf orm a re-balanci ng of the franchise es’ relationsh ip with administr ators and
liquidators during the insolvency of their franchisor, providing franchisees with rights and
restoring their dignity.
Organisations respond to intensive labour needs in several ways: departmentalising, creating
corporate groups with key companies having few employees, engaging contractors and outsour-
cing. These strategies can be used to transfer the obligations typically associated with employee
through a decentralised structure that distances the business management from front-
line operations. Checks and balances for related companies are governed by corporate law. Con-
tractors negotiate and sign supplier agreements that address the risks of all parties, including the
risk of any of the parties’ businesses failing. Business format franchising (‘franchising’) is a form
of outsourcing. In franchising, erstwhile employers of large labour forces become franchisors and
* Jennifer L L Gant BA, LLB (Hons), LLM, MBA, PhD, is a post-doctoral research fellow of the University College Cork in
Ireland. The author can be contacted at
** Jenny Buchan, PhD, LLM, LLB, is a Professor of business law at UNSW Sydney. The authors thank the anonymous
referees for their input and Jennifer L L Gant acknowledges the Tax and Business International Research Fellowship from
the School of Taxation and Business Law, Business School, UNSW Sydney that facilitated the authors’ collaboration. The
author can be contacted at
Federal Law Review
2019, Vol. 47(2) 261–287
ªThe Author(s) 2019
Article reuse guidelines:
DOI: 10.1177/0067205X19831841
outsource branch ownership, management, equity and debt financing, insurance, responsibility for
employees and associated obligations to franchisees. This is achieved through standard form
contracts presented to franchisees on a ‘take it or leave it’ basis. As Veronica Taylor noted as
early as 1997, ‘[f]ranchising is another country...While the form is contractual, the franchise
retains many of the features of the firm’.
But, through this form of outsourcing, corporate law
obligations and scrutiny are avoided.
Given the discrepancies between employment and franchising, our discussion draws on con-
cepts from institutional theory. Institutionalisation refers to the process whereby certain processes,
such as the mechanisms and flexibility of the franchise model, take on a rule-like status.
In the
franchise model, institutional rules developed over time no longer reflect the reality of a mature
franchise market. They are nonetheless embedded in the model. This suits franchisors well. Gillian
Hadfield observed that ‘[u] employment relation ...the franchise relationship is char-
acterised by the fact that franchisees own the bulk of capital assets of the franchise and franchisors
retain the right to determine how franchisees will use those assets’.
Early franchising comprised a
straightforward, albeit skewed, contractual relationship between a franchisor and each of its
franchisees. Possibly because early franchisors were assumed to have tested the business thor-
oughly before offering franchises, the contracts did not provide for the franchisor becoming
insolvent. As the system matures, the franchisor spreads its roles through numerous franchisor-
related companies. When the franchisor expands internationally, sells its role to public sharehold-
ers or private investors, or takes any risky strategic decision like borrowing to acquire an additional
brand, the original franchisor/franchisee relationship is placed at risk. For franchisors, the essential
driver of franchisee profitability can quickly give way to shareholder or venture capitalist focus on
growth of dividends and reduction of costs. Franchisor failure may be the outcome.
Employees regularly benefit from legislative and social protections that can include participa-
tion, consultation, requirement for fair treatment, and alternative employment or payouts when
their jobs are at risk. Corporations law recognises employees as priority creditors in their employ-
er’s insolvency. But there is no specific provision, anywhere in the world, to accommodate
franchisees’ interest as their franchisor fails. We suggest the resistance to recasting franchising
as a form of business requiring adjustment to insolvency rules can be explained by the theories of
path dependency and moral hazard and by franchisees’ own optimism bias. Optimism bias is
explored later under the heading ‘Justifying Franchisee Participation: Moral Hazard’.
Path dependence, ‘paths shaped by a nation’s political and cultural institutions or chaotic
chance events’,
helps explain how the rejection of the Casnot interpretation in Australia
led to
franchising being regulated solely under the national competition and consumer law, rather than
corporations law. This shifted the regulation from the possibility of regulation via the ‘cradle to
grave’ approach of the Corporations Act 2001 (Cth) (‘Corporations Act’) to franchising being
regulated solely under the Competition and Consumer Act 2010 (Cth) that governs competition
and consumer protection. The latter has no role in business failure. It also helps us understand the
difficulty of introducing change in regulatory frameworks. The franchise model, as a relative
newcomer to business, has evolved under the radar of many legislatures, and often without
regulatory constraint.
Franchisors naturally resist regulation that would inhibit the adaptable
character of franchising. They cling to the mantra of growth and success. Such institutional
behaviour shows a path-dependent tendency by placing importance on the status quo of flexi-
bility of the basic franchisor/franchisee relationship remaining in a low regulatory environment.
As the model has matured, it is arguable that franchisors also take advantage of franchisee
262 Federal Law Review 47(2)

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