The COVID-19 pandemic continues to significantly affect the franchise sector, along with many others. In May and July 2020 the German Franchise Association issued a guidance document which provided an overview of the COVID-19 Mitigation Act and the associated legal issues specific to franchising. A few months on, this article examines which issues remain the most relevant for franchising practice.(1)
System participants acting in concert
Little has been said about COVID-19-related internal disputes within franchise systems. There have been some related debates (especially about the payment of franchise fees or goods deliveries), but franchisors and franchisees have often found a reasonable solution quickly, regardless of what the outcome ought to have been on a strictly legal basis. This makes sense because 'ought' is a somewhat flexible concept in light of the COVID-19 Mitigation Act. Not every contractual obligation is being called into question, but the issue of how an exceptional situation such as the COVID-19 pandemic should be dealt with correctly in law often involves uncharted territory, particularly with respect to obligations under the Civil Code, which the courts in particular must deal with. However, it is arguably not the somewhat shaky legal ground which has brought franchisors and franchisees together; rather, it is their desire to manage the current situation as effectively as possible for the benefit of all system participants.
Steps against administrative closure orders
Most franchise system headquarters seem to have focused on helping franchisees to word their communications with customers, suppliers and landlords in order to limit the financial damage to all system participants. Especially in the case of franchise systems such as gyms, which have continuing obligations towards their customers, tactful customer communication was needed in the early days of the pandemic to ensure that customers made at least some payments during lockdown. Without this minimum cash flow, some businesses would have been in even more trouble. In some cases, franchisors also tried, for the benefit of the whole system, to minimise at least some administrative closure orders based on the Infection Control Act, which they consider too far reaching. That was the case with a tutoring services franchise (Baden-Wurttemberg Higher Administrative Court judgment, 13 May 2020, 1 S 1281/20, juris) and a franchise for the sale of ice cream (Schleswig-Holstein Higher Administrative Court judgment, 30 April 2020, 3 MR 12/20, juris). As far as can be seen, such administrative court actions by franchise headquarters succeeded only in exceptional cases (failing in at least the two cases cited). However, it illustrates what most franchisors and franchisees focused on at the height of the lockdown and, for the most part, are focusing on now – namely, pulling together.
This does not mean that every franchise dispute will have automatically ended as a result of the pandemic. Pre-COVID-19 disputes, such as the continuation of a franchise agreement for an economically unviable location, have been accelerated rather than eradicated by the pandemic because the economic (or other) issues that already existed have become even more urgent as a result of the slump in turnover caused by the virus.
Claims for compensation from public authorities
Companies in the franchise sector are among those that have been affected by the official closure orders and requirements – in particular, restaurants and hotels. Companies in these sectors are increasingly seeking compensation from the public authorities for the measures taken under the Infection Control Act. They are basing these claims partly on the act itself or its corresponding (analogous) application, as well as, in some cases, the legal institution of expropriating intervention recognised in public law, which requires the existence of a particular individual sacrifice. Franchise companies are understandably claiming to have made (or to still be making) such a sacrifice.
To date, the courts have tended to oppose such claims for compensation (a recent example is the Hanover Regional Court judgment of 9 July 2020 – 8 O 2/20, juris). The courts' arguments are roughly as follows:
- First, the legislature accepted that there was no entitlement to compensation under infection control laws for closures of establishments in the restaurant sector.
- Second, restaurant operators were not required to make a particular individual sacrifice, but instead a wide range of people were affected by the closure measures.
Further, the courts held that in order to protect the lives and physical integrity of the population, the public interest aspect of safety deserved priority over a restaurant operator's property interests.
However, it is not yet clear whether this view will remain. Even an administrative court has stated as follows:
Whether and, if so, to what extent compensation or damages are to be awarded despite the absence of an express provision in the German Infection Control Act, will have to be decided by the Supreme Court or ultimately by the Federal Constitutional Court (Luneburg Higher Administrative Court judgment, 29 June 2020, 13 MN 244/20, juris para 46).
However, as seen in the media, more than 1,000 restaurants have now joined forces to bring a collective action to get the federal states to pay compensation (see Frankfurter Allgemeine Zeitung, 3 September 2020, p22). This action could lead to a decision by the Supreme Court.
Business interruption insurance
The outbreak of the pandemic in Germany brought business interruption insurance to the attention of many franchise systems, with many realising that they no longer had it. In view of the rapid fall in turnover as a result of the comprehensive COVID-19 measures, many franchisees hoped to make up for their loss of revenue, which was in some cases substantial and often jeopardised their existence. In-house company lawyers had to get involved immediately in the rather unfamiliar subject matter and contact and negotiate with insurers and brokers.
Point of dispute
It quickly became clear that there was no easy solution when the insurance industry collectively rejected claims. At issue was the fact that the existence of insurance cover depends solely on the applicable terms and conditions. A common condition for all variants is the closure of the insured establishment by the 'competent authority'. It was quickly agreed that this condition is met not only in the case of an individual order by the local health office, for example, but also in the case of a municipal general order or a ban on operation for entire sector, such as the restaurant sector, by means of ministerial ordinances. The focus is whether the COVID-19 pandemic triggers insurance cover. Insurers have argued that neither novel coronavirus SARS-CoV-2 nor COVID-19 are listed in their insurance terms and conditions, which generally contain a list of pathogens and diseases that are notifiable under the Infection Control Act. Thus, legal disputes were inevitable.
Case law
The first judgment on this issue was delivered by the Mannheim Regional Court on 29 April 2020 (Case 11 O 66/20). The judgment was given in temporary injunction proceedings and dismissed on procedural grounds a hotel operator's claim that the insurer be ordered to pay. The judgment drew widespread attention because the court accepted, in principle, an obligation on the part of the insurer to provide cover. However, the judgment was hailed by some specialist media outlets as a breakthrough against insurers' supposedly rigid attitude due to the fact that the insurance terms and conditions at issue did not enumerate pathogens and diseases and merely referred to the pathogens and diseases listed in the Infection Control Act. The court viewed this as a "dynamic reference" to the applicable version of the act. On 1 February 2020 – even before the lockdown was implemented in March 2020 – the novel coronavirus was included in the Infection Control Act by statutory ordinance.
Some insurance law commentators argued that in order to protect insureds, if insurance terms and conditions contain an enumeration of agents and diseases, excluding SARS-CoV-2 and COVID-19, but also refer to the Infection Control Act, it must also be assumed that other illnesses are covered. However, cold water was quickly poured on this idea – as reflected in the case law. For example, the Essen Regional Court (16 June 2020 – 18 O 150/20, confirmed by the Hamm Higher Regional Court decision of 15 July 2020, Case 20 W 21/20) and the Bochum Regional Court (15 July 2020, Case 4 O 215/20) ruled against the claimant policyholders. Both procedures were based on insurance terms and conditions which clearly stated that there was cover for "only the diseases and pathogens listed below" (followed by the list). Given this clear and unambiguous wording, the courts considered that there was no room for a different interpretation. According to the Bochum Regional Court, the clause also took the insureds' interests into account because the enumerative list enabled it to understand the scope of the insurance cover. It is also necessary to consider the insurer's interests and risk assessment with regard to premiums, which are generally quite low, in the case of business interruption insurance, described as a 'niche product', which is apparent to the policyholder. A 2 July 2020 notification decision of the Leipzig Regional Court (Case 3 O 1287/20) follows this trend.
Offers from insurers
Early in April 2020, numerous large insurers and industry associations, led by the Bavarian Ministry of Economic Affairs, agreed the so-called 'Bavarian solution', which was originally intended solely for the hotel and restaurant industry, but has now been extended to other sectors. It provides that the participating insurers – including Allianz, Nürnberger, Zurich and AXA – will take on between 10% and 15% of the daily rates agreed for business closures and pay them to the insureds. However, these offers have a catch: they contain comprehensive waiver and settlement clauses to the detriment of insured persons, including for the future. Franchisors should therefore be hesitant about making recommendations to their franchisees. Ultimately, franchisees must examine whether they wish to bring an action against their insurer. If their insurance terms and conditions contain enumerated lists of diseases and pathogens, the aforementioned trend in case law suggests that they should be satisfied with what they get.
In addition to personnel costs, rent payments represent the largest share of costs for franchise systems. Franchisees are either tenants themselves or, in most cases, sub-lessees of their franchisor, which rents the site. During the COVID-19 crisis, one of the most challenging tasks for franchisors has been defending their and their franchisees' interests against landlords in order to obtain pandemic-related reductions or at least deferrals of rent. Over the past few months, there has been little conflict within franchise systems, and franchisees seem to have a high level of trust in and cooperation with their franchisors with respect to negotiations with landlords.
Legal uncertainty
There has been legal uncertainty with respect to rent since the beginning of the COVID-19 crisis. As early as March 2020, franchisors were asking their internal and external lawyers whether they could, in view of the unprecedented drop in turnover as a result of the comprehensive government protective measures, reduce rents accordingly or even withhold rent payments altogether. The expectation was that this would be possible because the pandemic was not franchisors' fault. However, the fact that landlords are also not to blame for the crisis and its severe economic impact was often overlooked.
The legal position in this regard is unclear as there is no precedent regarding the global pandemic. The legal affairs committee of the German Franchise Association debated the topic when writing its guide "Franchise law in the coronavirus crisis". Do public operating bans – such as restaurants, hairdressing salons and gyms – constitute a defect of the rented property, resulting in the elimination of the obligation to pay rent? Or is it a case of impossibility because the rented property can no longer be used for its rental purpose? And what about the right to a contractual adjustment following contract frustration due to force majeure?
Does the COVID-19 Mitigation Act help?
Companies had only just begun to find their way through the legal fog when the legislature adopted the COVID-19 Mitigation Act on 27 March 2020. In the case of continuing obligations entered into before 8 March 2020, this gives micro-enterprises and others the right to refuse payments if, as a result of the pandemic, they cannot make payments without jeopardising the economic foundations of their business. However, franchisees cannot benefit from this rule, as it expressly does not apply to leases. For leases, the COVID-19 Mitigation Act provides only for a ban on termination (applicable until 30 June 2022), under which landlords are prohibited from terminating a lease on account of rent arrears from April, May and June 2020. Many misunderstood the hastily drafted provision as a statutory deferral of rent. In reality, as is clear in the explanatory memorandum, the obligation to pay rent remains in principle.
As a result, negotiations with landlords imply that the law has made it more difficult to achieve rent reductions or deferrals. Thus, many landlords, particularly on receiving legal advice, have insisted that the legislature affirmed their right to continue to demand rent in full by not interfering with the obligation to pay rent and merely limiting their right to terminate a lease because of arrears. The legislature has thus left it up to the parties to a lease to find an appropriate solution. This was arguably the correct approach, as the results so far have been largely satisfactory (eg, partial rent waivers and far-reaching deferrals for the particularly demanding months of April, May and June 2020). However, it is difficult to predict what the situation will be in the future.
Entitlement to rent reduction only for unreasonableness
The extent to which the courts will be called on remains to be seen. To date, only one decision has been handed down in this respect (Heidelberg Regional Court, 30 June 2020, 5 O 66/20). In this case, the applicant landlord demanded unpaid rent from the owner of a retail shop affected by a closure. The court held that there was the leased premises had no material defect and that it was not impossible to use them. Although the court did not rule out the applicability of the statutory rule on frustration of contract (Section 313 of the Civil Code), it did not consider that the stringent conditions had been met. According to the court, the defendant retailer had not shown that it was unreasonable for it to maintain the lease agreement unchanged. This requires a threat to livelihood or a similar economic impairment. It is likely that case law will continue to allow claims for contractual adjustment under Section 313 of the Civil Code only in exceptional cases.
Endnotes
(1) This article considers this question from the perspective of both an in-house lawyer (Tilman Rosse, head of legal Germany, Valora Group) and lawyers advising franchise companies (Tom Billing and Karsten Metzlaff, Noerr LLP).
This article was co-authored by Tilman Rosse, head of legal Germany, Valora Group.
