We would like to ensure that you are still receiving content that you find useful – please confirm that you would like to continue to receive ILO newsletters.
08 March 2016
Sometimes a franchisee can no longer pay some or all of the price of goods purchased from the franchisor, the rent for the premises or the franchise fees. Irrespective of the legal possibilities provided by the franchise agreement or statutory provisions, the franchisor is likely to talk initially to the franchisee in order to understand the reasons for the payment difficulties and to find a satisfactory and realistic solution for both parties. Deferrals or instalment agreements may be among such solutions. Nevertheless, the concessions of the franchisor or the efforts of the parties may be inadequate and the franchisee may fall into insolvency. The question then is whether the conciliatory action of the franchisor in financially supporting the franchisee by way of deferral is rewarded or punished by insolvency law.
The Monchengladbach Regional Court (February 25 2014 – 3 O 283/12) had to deal with a case of a franchisee – who the franchisor had facilitated with instalment payments – ultimately becoming insolvent.
Since 2002 the debtor had been a franchisee of the defendant (the system headquarters of a bakery chain). The franchise agreement contained, among other things, provisions on the obligation to purchase goods from the franchisor, the payment of rent, a franchise fee and turnover-related fee. From 2007 the franchisee was in payment arrears to the franchisor. The parties initially concluded a number of instalment agreements for the debts accrued. From the beginning of 2009 and up to the filing of the insolvency application in August 2009, the franchisor received by direct debit from the account of the franchisee high amounts for goods, rent and franchise fees.
The insolvency administrator (plaintiff) of the former franchisee (debtor) claimed repayment from the former franchisor (defendant) of approximately €282,000 under insolvency law following the franchisee's insolvency.
The court granted the claim of the insolvency administrator. It held that the payments made by the franchisee constituted legal acts open to challenge undertaken with the intent of prejudicing creditors, so that the payments made should be returned to the insolvency estate according to Sections 143(1) and 133(1) of the Insolvency Code.
Legal acts subject to challenge
According to Section 133(1), the former franchisee's legal acts subject to challenge existed in the debiting of her account, as she had issued direct debit authority in accordance with her bank's procedure.
Intent to prejudice creditors
The resulting reduction of a debt prejudiced the other creditors – at least indirectly – by leaving only a lower dividend for the other creditors in the event of insolvency. The inability to pay (illiquidity) is usually a strong indication of the intent to prejudice creditors.
In spite of threatened illiquidity
Illiquidity is assessed according to Section 17(2) of the Insolvency Code on the basis of whether the debtor is not in a position to meet payments as they fall due, this being usually assumed when payments have been discontinued. While the former franchisee also generated income from the franchise business – which was almost completely exhausted by the debits activated by the defendant and so left nothing for the repayment of other liabilities – she was aware that the income she generated was inadequate to satisfy other liabilities due a short time from the debits activated by the defendant. However, since lodgements from cash receipts in the bakery were the only source of income to satisfy the creditors, the court concluded a motive of preferential satisfaction of the defendant in order to maintain her business. The intent of the former franchisee was ultimately based on enabling the former franchisor, by means of a direct debit issued by her, to reduce the liquidity as soon as it accrued and which was therefore no longer available to satisfy the other creditors.
Knowledge of debtor's intent
The party favoured by the payment of the debtor (in this case, the former franchisor) must have knowledge of the debtor's intent, which is also assumed if the preferred party knew that illiquidity of the debtor was threatened and that the act prejudiced other creditors.
Indications that the defendant had knowledge of the threatened illiquidity existed in the present case from the number of rejected debits in the debiting procedure in relation to the former franchisor. The unsuccessful instalment agreements made within the franchise indicated the same since, although monthly instalments were arranged in the instalment agreements, the deferred debt remaining interest free, only a limited reduction was achieved.
Overall, the court concluded that the former franchisor was aware of the threatened illiquidity of the debtor and prejudiced to other creditors, since the former franchisor was aware that the debtor could not discharge her liabilities from her own financial payment capacity. In fact, she was dependent on financial support by the deferral and loans of the defendant and other creditors. Nevertheless, these efforts did not improve the situation, as the defendant was aware of the extension of the loan, the rejection of direct debits and non-compliance with the instalment agreements.
Since the former franchisee operated a trading business, the defendant was not entitled to ignore that – even to the extent that illiquidity had been averted by loans and deferrals – the franchisee was regularly exposed, for various legal reasons, to new liabilities due to other creditors. Since the financial payment capacity of the debtor did not improve, it was clear to the defendant that by withdrawing existing liquidity, other liabilities due could not be discharged and the debiting of possible satisfaction payments to other creditors was frustrated or at least rendered more difficult. The granting of loans and the conclusion of instalment agreements by the defendant could not give the impression that they constituted a restructuring measure with prospects of success. The former franchisor must have known that because of the failure to achieve any significant reduction in the debt, such a restructuring concept would not succeed.
Income generated by the debtor from the franchise, which enabled the defendant to debit the challenged payments, did not justify any doubt as to the defendant's knowledge of threatened illiquidity. Because of the defendant's comprehensive knowledge of the debtor's financial situation, it was aware that the franchisee's only source of income was the franchise operation. Since the continuation of this income source depended on the defendant itself, it was, as creditor, in an outstanding position to exercise pressure, causing the debtor to aim primarily at satisfying the defendant from adequate account funds. According to the court, in order to ensure their financial survival, debtors prefer payments to a major creditor under pressure from that creditor in order to induce silence.
A franchisor which grants one or more payment deferrals to its franchisee in emergency arrears and concludes agreements accordingly must, as a worst-case scenario, anticipate that in a subsequent insolvency of the franchisee, it must return all payments received after the deferral of the payments – whether in the form of deferral or instalment agreements – in case of an insolvency challenge. According to the present draft amendment to Section 133 of the Insolvency Code, while the conclusion of instalment agreements will not in future automatically be an indication of knowledge of the intention to prejudice other creditors, the franchisor is nevertheless well advised to consider whether in such cases it is willing to accept the potential risk of the franchisee's insolvency. It should also be considered that the period for challenging such prejudicial payments to creditors is 10 years.
For further information on this topic please contact Karsten Metzlaff at Noerr LLP's Berlin office by telephone (+49 30 20 94 20 00) or email (email@example.com). Alternatively, contact Karl Rauser at Noerr's Munich office by telephone (+49 89 28 62 80) or email (firstname.lastname@example.org).The Noerr LLP website can be accessed at www.noerr.com.
The materials contained on this website are for general information purposes only and are subject to the disclaimer.
ILO is a premium online legal update service for major companies and law firms worldwide. In-house corporate counsel and other users of legal services, as well as law firm partners, qualify for a free subscription.