Pre-contractual franchisor disclosure obligations

Background
Facts
Decision
Comment

Background

In principle, each contractual party is responsible for informing itself of the general market conditions and resulting risks associated with a contract. A franchisee, as an economically independent businessperson, is obliged to bear the financial risks associated with concluding a franchise agreement. In order to facilitate a realistic assessment of these risks, before the agreement is concluded, the franchisor must disclose to the potential franchisee circumstances which are known only to the franchisor and which it knows or must know could influence the potential franchisee's decision to conclude the agreement. The franchisor is under a statutory obligation in this respect, since - even on the commencement of negotiations about the agreement - a pre-contractual relationship of trust with mutual obligations of protection arises (Sections 311(2) and 241(2) of the Civil Code).

The significance of pre-contractual disclosure obligations should not be underestimated. If the franchisor does not fully disclose circumstances that are relevant to the conclusion of the agreement, and the franchisee would not have concluded the agreement had there been due disclosure, the franchisee can claim for damages. In the worst-case scenario, the entire franchise agreement may be set aside and reversed. The franchisee is also entitled to compensation for breach of trust, and must must be restored to the position in which he or she would have been without the defective disclosure. This means that the entrance fee and ongoing franchise fees, as well as all costs and expenses (less any profits achieved by the franchisee) will be refunded.

However, the law does not specify the actual extent of pre-contractual disclosure obligations, which presents considerable difficulties in practical implementation. Judgments of the higher regional courts primarily provide indications of the extent of these obligations. In recent years, there has been a noticeable tendency to intensify the requirements in this regard. This trend was commenced by the Hamm Higher Regional Court in a December 22 2011 judgment (file 19 U 35/10). The court considered the form and extent of a franchisor's obligation to disclose the profitability of its franchise system.

Facts

The franchisor operated a franchise system for grind schools and computer schools for adults and children. When the franchisee became aware of the franchise system through an advertisement and requested information, she received from the franchisor, among other things, a brochure stating the investment costs and turnover possibilities, as well as profitability projections for the first few years of the business. The franchisee and the franchisor concluded a total of five franchise agreements. Subsequently, disagreements arose over, among other things, the disproportionate relationship between the franchisee fees payable and the turnover achieved. The franchisee was of the opinion that the franchisor had breached its disclosure obligations because the figures stated in the profitability projections were incorrect and unachievable. The franchisee therefore stopped paying the franchise fees. The franchisor's claim was dismissed by the Bielefeld Regional Court (January 28 2010, file 9 O 385/04). On appeal, the Hamm Higher Regional Court considered whether the franchisor had satisfied the pre-contractual disclosure obligations by the presentation of profitability projections.

Decision

The Hamm Higher Regional Court rejected the appeal. The court opined that the franchisor had no right to payment of the franchise fees. It had breached its duties of disclosure in the contractual negotiations, so that the agreements were reversed by way of damages. The court found that the franchisor was obliged to inform the franchisee before the conclusion of the franchise agreement about the profitability of the system, because this was of particular significance to the franchisee's decision. For this purpose, a franchisor is obliged to provide correct information about achievable turnover. The data used must be:

• based on careful examination of the market;
• directed at the actual locations; and
• not merely an estimate.

If only an estimate is provided, it must be clearly stated. The franchisee must, on the basis of the material provided, be in a position to undertake a meaningful economic review. In addition, the profitability projections and turnover figures provided must be based on a real reference system, in the form of model accounts based on reliable factors which permit a comparison of the intended location with other locations. These circumstances (ie, the accuracy of the figures) must be provable by the franchisor in court. In this case, the franchisee failed to do so; therefore, the court held, in view of the fact that the franchisee was able to achieve less than half of the projected turnover, that the profitability projections were based on inaccurate figures.

Comment

The Hamm Higher Regional Court established strict criteria for the production of the figures on which, for example, profitability projections are based. In comparison, the professional independence of the franchisee and its economic risk was given substantially more weight in previous decisions of other higher regional courts. In future, a franchisor must therefore accept that much higher standards for pre-contractual disclosure will be set. If there is doubt about the accuracy of the figures or if the manner in which those figures were ascertained cannot be reliably presented and proved, the franchisor must be strongly advised to state clearly that the figures are only an estimate. For the purpose of evidence, this statement should be made in writing. Otherwise, the franchisor will be exposed to successful claims for damages from its franchisees.

For further information on this topic please contact Karl Rauser or Karsten Metzlaff at Noerr LLP by telephone (+49 30 20 94 20 00), fax (+49 30 20 94 20 94) or email (karl.rauser@noerr.com or karsten.metzlaff@noerr.com). The Noerr LLP website can be accessed at www.noerr.com.