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13 November 2001
Prior to the conclusion of a franchise agreement, the franchisor must ensure that all the relevant facts have been clearly presented to the potential franchisee. Although the German Civil Code does not explicitly set out a corresponding provision, the German courts have deduced this disclosure requirement from the principle of good faith. In the case of a violation of the franchisor's duty to present the relevant facts, the franchisee has the right to claim damages (so-called 'culpa in contrahendo'). The necessary information which must be provided to the franchisee should include information relating to cost estimates, the possible amount of work and capital involved, and the local conditions of the franchisee's business operations.
In its latest decision relating to franchising law (Aufina, April 24 2001) the Court of Appeal in Munich has developed further criteria on whether a pre-contractual disclosure obligation exists for the franchisor. The court also laid down principles regarding the amount of damages that a franchisee may claim where the franchisor fails to comply with this requirement.
The case concerned a franchise system in the residential property sector designed to promote and support independent property consultants, primarily in the fields of property and client acquisition. The franchisor of a system for property agents had informed a potential franchisee in the course of pre-contractual negotiations that only 3% of its franchisees' operations had collapsed in the past, and that according to its costs and turnover calculations the franchisees had generated twice or three times the turnover of other property agents. The franchisor had also referred to an alliance with a bank and an insurance company which would ensure it sufficient business opportunities in the future.
In light of these statements a franchise agreement was concluded with the franchisee for a five-year term. Approximately one-and-a-half years later the franchisee terminated the franchise agreement and claimed damages because of non-fulfilment of pre-contractual promises. The franchisee submitted to the court 28 letters from "economically unhappy" franchisees. Twenty three of these had closed their business for economic reasons after less than five years. The other five franchisees had operated their property business for five years, but refrained from extending the initial term, again for economic reasons.
The Court of Appeal ruled that the franchisee was entitled to claim damages due to the franchisor's non-fulfilment of existing pre-contractual obligations.
Breach of pre-contractual disclosure obligation
The court stated that damage claims due to non-fulfilment of disclosure requirements may be based on the legal principle of culpa in contrahendo rather than the restrictive existing principles of prospectus liability. These principles cannot be applied to the franchise situation, where the success of the franchisee depends on the franchisee's skills and activities.
The court -as in previous cases - reiterated that parties who enter into pre-contractual negotiations are subject to the principle of good faith, which imposes a particular duty on them to take all due care. Thus, the parties are obliged under the rule of culpa in contrahendo to disclose voluntarily important matters which are recognizably of importance for the other party.
The court explained this general rule as follows. As a general rule, the franchisee is obliged to inform himself of the general market conditions and the impact that these conditions will have on the prospective franchise business. However, an exception to this rule applies if there are particular circumstances (i) of which only the franchisor is aware, and (ii) which are recognizably of importance to the other party's decision to enter the franchise agreement. Thus, the scope of disclosure requirements depends on the franchisee's need for information and on existing possibilities for the franchisee to obtain information. As a result, the franchisor must provide information on the way that the franchise system works and about its prospect of success.
The court took the view that the franchisor had breached its disclosure obligations by providing a misleading quote regarding the number of franchises which collapsed. According to the court, the alleged figure of 3% gave the impression that there were no risks and that the franchise's success was a foregone conclusion. Given that there were at least 28 'economically unhappy' franchisees, this information was false. The franchisor was therefore liable in principle for breaching its pre-contractual disclosure obligations.
No contributory fault of the franchisee
The court held further that there was no contributory fault of the franchisee which could affect or reduce the claim for damages. The franchisee should have requested more detailed information on the system's profitability from the franchisor, but this was a minor fault when compared to that of the franchisor.
Amount of damages
The franchisor was obliged to restore the franchisee to the position that he would have been in if the franchisor had fulfilled its disclosure obligation. The court held that there was a legal presumption that the franchisee would have not entered into the agreement if he had been provided with the correct information. The franchisor was thus ordered to pay all franchise fees back to the franchisee and to reimburse the franchisee for all expenses he had incurred in connection with the franchised business. However, income that the franchisee had obtained through using the franchise business was deducted.
It follows from the court decision that franchisors must refrain from providing misleading information on the success of their franchise and must disclose all risks associated with it in order to avoid subsequent damage claims. Any information which gives the impression that success will be guaranteed may lead to liability on the basis of a breach of pre-contractual disclosure obligations. A defence which argues that the franchisee is to be blamed for negligently relying on the information provided will be successful only in exceptional circumstances.
For further information on this topic please contact Karsten Metzlaff at Nörr Stiefenhofer Lutz by telephone (+49 30 20 94 20 00) or by fax (+49 30 20 94 20 94) or by email (firstname.lastname@example.org).
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