Risks to franchisors when franchisees are in serious financial difficulties

Introduction
Common claims made by distressed franchisees
What a franchisor should avoid doing
Pending case

Introduction

Difficult economic conditions in France have led to a surge of insolvency proceedings in the last three years. In this context, franchisors should be aware of the extent of their potential liability if the financial difficulties of one or several franchisees are serious and may lead to insolvency.

This update outlines the various risks incurred by franchisors – both to franchisees and to shareholders, creditors and third parties – in light of the most recent and pending court cases in France. International franchisors with franchisees located in France should watch these cases carefully, as most concern the application of rules which are mandatory by nature and apply regardless of the governing law in the franchise agreement.

Common claims made by distressed franchisees

If a franchisee is on the verge of bankruptcy or is already insolvent, the typical arguments it will use to sue its franchisor and seek compensation are as follows:

• It was misled by the franchisor, which failed to provide it with accurate information on the real prospects of the franchise prior to entering into the agreement; or
• The franchisor did not fulfil its contractual obligations in terms of technical and commercial assistance.

In many cases these two legal grounds are used in conjunction with one another.

Pre-contractual disclosure in franchise agreements is the subject of extensive and recurring case law in France, in circumstances where the franchisee's business turns out to be unsuccessful and the franchisee alleges that it was misled by the franchisor on the financial prospects of the business. According to Article L330-3 of the Commercial Code, the franchisor must provide to the prospective franchisee, at least 20 days prior to execution of the contract, a document setting out accurate information allowing the candidate to make an informed commitment. The information that must be provided includes a presentation on the state and development prospects of the relevant market. Where a franchisee complains about the lack of forecast figures, the French courts tend to hold that the law does not require the franchisor to provide a local market survey and forecast income statement to the franchisee; but where this is provided to allow the franchisee to build its business plan, the information must be fair and accurate.

Where a court considers that the lack (or inaccuracy) of information has deceived the franchisee (which is often the case where the actual turnover is materially below the forecast figures – for example, by more than 30%), it may hold the franchise agreement null and void and in some cases find the franchisor liable for damages, if the latter has committed misrepresentation. If the franchisor's misrepresentation or the franchisee's error cannot be demonstrated, the court may nonetheless grant damages to the franchisee for the loss suffered (covering the costs and investments incurred by the franchisee, but not the profit it was expecting to make on the basis of the figures provided by the franchisor). This will be the case in particular where the franchisee has become bankrupt due to a structurally loss-making business. However, even in the case of a bankrupt franchisee, the provision of flawed or inaccurate information will not automatically give rise to damages: to reject the franchisee's claims on this ground, the court will often consider the extent of the knowledge which the franchisee could have obtained by itself (through due diligence or otherwise) and the time it had to make its own enquiries.

In most cases distressed franchisees allege that in addition to providing inaccurate figures, the franchisor failed to provide them with the requisite technical and commercial assistance, which caused them to incur serious financial difficulties. When the franchisor becomes aware that a franchisee is in dire straits, it is faced with the risk of doing either too little or too much. If the franchisor takes no initiative or pretends to ignore the situation, its liability may well be at risk if this results in losses to the company and its creditors further down the line. If, on the other hand, it takes action, it must be careful not to interfere in the affairs of the franchisee at the risk of being found the de facto manager of the franchisee if such action is considered improper and prejudicial to the creditors' interests. In such case the franchisor may also be held liable and may be sentenced to cover the debts of the bankrupt company.

In such cases the courts will consider the scope of the franchisor's assistance obligation in light of the terms of the franchise agreement itself, the nature of the business and the actions taken by the franchisor in controlling its network. Moreover, the French Supreme Court has reiterated the principle that the franchisee is and must remain an independent operator, running its business at its own risk and peril and assuming the commercial risks of its decisions. Even if the rationale of franchising is to limit the risk of the franchisees through the use of developed concepts and methods offered by the franchisor, this does not eliminate any risk related to the conduct of business. The assistance to be granted by the franchisor is on a best-efforts basis only; there is no guarantee that the assistance and advice provided will give rise to the franchisee's success.

Therefore, recent Supreme Court decisions tend to stick to a strict application of the contractual provisions and avoid imposing on the franchisor additional obligations on the ground of a more general duty of good faith. For instance, it was held that the franchisor's assistance obligation does not go as far as redefining a new business plan for a distressed franchisee or recommending the franchisee to redirect its activities.

In a January 7 2014 decision the Supreme Court confirmed that assisting the franchisee does not mean covering its financial losses, where the franchisee has taken over the operation of an unprofitable business. If the contract does not include a hardship clause, it must be performed in accordance with its terms and the franchisor has no duty to renegotiate them. In this case the franchisee also complained against the commercial policy of the franchisor targeted at key accounts at a national level, which resulted in a reduction in the number of the car rental outlets operating under the franchisor's brand. However, the court rejected such arguments on the grounds that a franchise network develops over time and the franchisor has no obligation to existing franchisees to maintain or extend the network.

What a franchisor should avoid doing

A franchisor is unlikely to find itself on the hook if it strictly complies with its contractual obligations, even if the business model leads to low profitability for franchisees. However, certain types of behaviour should be avoided, including the following.

Terminating the franchise agreement
Although an indefinite-term agreement may be terminated at any time by either party, this is subject to providing reasonable notice to the franchisee and termination must not be abusive. In difficult circumstances where the franchisee is experiencing cash problems, franchisors may be tempted to change the terms of payment for the supply of goods, for instance. In such case termination without a proper notice period on the ground of the franchisee's failure to comply with such new payment terms may be considered sudden and give rise to damages by the franchisor. The same applies if the franchisor terminates the agreement shortly after it has requested significant advertising investments and budgets from the franchisee. Furthermore, if and when the franchisee is declared insolvent, the franchisor is not entitled to terminate the agreement unilaterally: the franchisor must rather make a formal notice to the judicially appointed receiver of the franchisee. Upon receipt of this notice, the receiver has one month to decide whether the franchise agreement should be continued. If the receiver decides to terminate the agreement or does not respond within one month (which may be extended by the judge in charge of supervising the insolvency proceedings for a duration not exceeding two months), the agreement is automatically terminated. If the receiver decides to continue the agreement, the franchisor will have to continue performing its obligations under the agreement notwithstanding the franchisee's failure to pay the sums due prior to the judgment opening the insolvency proceedings. However, such mandatory continuation is subject to the receiver having the necessary funding to continue enforcement of the agreement.

Interfering in the affairs of the franchisee
In any event, the franchisor should avoid taking control of the franchisee's business to the extent of substituting for the franchisee in the conduct of its activities. Typical indicators of such de facto management include:

• the establishment of banking, accounting, administrative and tax documents in lieu of the franchisee;
• the creation and use of payment means on behalf of the company;
• the recruitment and control of the franchisee's staff; and
• the management of the franchisee's procurement policies (in relation to products which are not specific to the franchise).

Prior to finding the franchisor liable, the court needs to ascertain whether the actions committed by the franchisor actually constitute mismanagement (eg, continuing to deliver products to a franchisee which is totally unable to pay for them, thereby causing the ruin of the franchisee and its creditors). In accordance with general principles of civil liability, if such acts of mismanagement have caused the company to become bankrupt, the franchisor will have to pay all or part of the franchisee's debts.

Abusive financial support
It has been held on several occasions that if the franchisor is aware of the financial difficulties of its franchisee (in particular, cash shortage) and allows the situation to deteriorate by granting the franchisee increasing supplier credit terms, this creates a misleading appearance with regard to creditors and the franchisor should be held liable for the insufficiency of assets upon the bankruptcy of the franchisee. Allowing the franchisee to continue operating a loss-making business and benefit from fictitious cash for the purpose of using the franchisee's sales force for as long as possible may therefore give rise to heavy sanctions. However, the risk of franchisors being held liable for abusive financial support is now more limited following the enactment of the Law on the Safeguard of Undertakings (July 26 2005). This law provides that the liability of credit providers (including franchisors) may be incurred in the event of insolvency of the franchisee only if the credit was wrongful and the franchisor:

• committed fraud;
• interfered in the management of the franchisee; or
• obtained disproportionate guarantees to secure the credit.

Recent case law shows that these conditions are construed restrictively, so the risk of franchisors being held liable on this ground is now more remote.

Pending case

The financial difficulties of franchisees may trigger court actions not only by the franchisees themselves or their liquidators (on behalf of the creditors), but also by third parties on the ground of unfair competition. This is illustrated by the ongoing 'pizza war' in France, which has pitted dominant player Domino's Pizza against its main competitors (Speed Rabbit Pizza and Pizza Hut). Domino's Pizza is facing numerous court proceedings on various legal grounds. Some current and former franchisees have filed suit against the pizza company, arguing that they were deceived by the franchisor in relation to the prospects of the business and have been crippled by debts that they owe to Domino's Pizza.

However, the most interesting aspect of this saga is the line of argument taken by the competitors (Speed Rabbit Pizza being the most aggressive in the legal battle). They allege that Domino's Pizza abused the dire financial straits of some of its franchisees by granting them extremely long payment terms (far beyond those provided for in the law) and letting them accumulate considerable levels of debt owed to it (eg, royalties, raw material prices), with the aim of squeezing competitors out of the market. In their view, the artificial distortion of the franchisees' working capital enabled them to charge unsustainable prices, below variable costs, and offer recurring promotions (eg, three pizzas for the price of one). They claim that the consequence of this strategy has been the closure of many Speed Rabbit and Pizza Hut shops in France, which can no longer survive.

It is true that the number of pizza outlets operating under the Domino's Pizza brand has more than doubled in about five years in France, while those of its competitors have shrunk. However, it remains to be seen whether the tribunals considering such claims will attribute such developments to the actions of Domino's Pizza.

For further information on this topic please contact Raphael Mellerio at Aramis Law Firm by telephone (+33 1 53 30 7700), fax (+33 1 53 30 7701) or email (mellerio@aramis-law.com). The Aramis Law Firm website can be accessed at www.aramis-law.com.