Common Law and Civil Law on Franchising Issues

This article is an extract from GTDT Practice Guide Franchise 2023. Click here for the full guide.

Introduction

The civil law approach to franchising was, for a considerable period, largely ignored within franchising because franchising was developed in the United States. Canada was the most obvious and easiest export market for US franchisors and the United Kingdom was the country of choice for US franchisors contemplating international expansion outside North America. At the time, other geographical markets had not developed as possible areas for expansion. Franchise conferences generally took place in the United States and, of course, English was, even then, the language of commerce. All this combined to focus attention on common law jurisdictions rather than the civil law approach to franchising.

However, the CIA World Factbook² lists 150 civil law jurisdictions, as opposed to 80 common law jurisdictions – the latter essentially being ex-British colonies or countries with a very close connection to the United Kingdom. This means the civil law approach to franchising simply cannot be ignored.

Differences between the two systems

Academic articles tend to focus on historical and theoretical differences between the two systems by emphasising that in common law systems the law is generally uncodified, statutes and other legislation play a less significant role than court decisions and the system is adversarial. In civil law countries, the laws are codified and there is no binding precedent that judges have to follow. Instead, judges simply establish the facts and apply them to the law as set out in the relevant code. Proceedings are not adversarial.

In practical terms, the differences from a franchising perspective are that:

• civil law franchise agreements tend to be shorter than common law agreements;
• the civil law concept of good faith plays a significantly greater role in contract interpretation;
• civil law courts are much more willing to apply principles to franchising that, on the face of it, only seem relevant to other types of contract;
• litigation in civil law countries, because of the limited requirement for oral hearings, tends to be much shorter and less expensive; and
• civil law does not require a litigant to disclose documents that are unhelpful to that party’s case or helpful to the other party.

The differences summarised above are significant, but:

• both civil and common law countries, even those with a close shared tradition and geography, may adopt different solutions to the same problem. It is not the case that there is a homogeneous common law or, indeed, civil law approach;
• common law jurisdictions may achieve the same result as the civil law applying principles of good faith but using different methods and routes from civil law countries and, in particular, making less use of overarching legal principles; and
• with the increase in international trade, different legal systems are having an influence on each other so that, for instance, in civil law jurisdictions franchise agreements are becoming more detailed and looking more like their common law counterparts. Civil law franchise agreements are now often modelled on common law agreements. Equally, within Europe, only the United Kingdom and Ireland have common law systems. All the other jurisdictions adopt a civil law approach. This does mean that European Union legislation tends to reflect a civil law approach that UK and Irish judges have to apply and, as a result, those judges are more open to civil law principles.

Applying the high-level comments set out above to franchising highlights the differences between the two systems but also makes their similarities apparent. The next sections review the major differences insofar as they relate to franchising.

Disclosure

In common law countries, there is generally no obligation on a party negotiating a contract to disclose information. There are minor exceptions to that general rule. An English court in a case involving the female pop group the Spice Girls concluded that the members of the Spice Girls knew that one member was planning to leave the group when they agreed a promotional contract that required the involvement of all the women in the group. The judge found that by allowing all the group members to participate in a photo shoot envisaged by the contract with the third-party promoter, there had been a representation by conduct that there would be no change in the membership of the group and, in the absence of the other party being able to discover the true position, there was a continuing representation and nothing was done to discharge the duty to correct it. That is an unusual and very limited departure from the common law approach of ‘let the buyer beware’.

As a result of the general common law rule that parties negotiating a contract are under no obligation to disclose facts relevant to the other party’s decision to enter into the contract, limitations on franchisors’ freedom to disclose whatever information they want are imposed in common law countries, either by law, as is the case in the United States and most provinces of Canada and Australia, or as a result of membership of a national franchise association that imposes disclosure requirements on its members. Generally, in civil law countries, no specific legislation is required (although a number of civil law jurisdictions such as France and Belgium have introduced laws requiring disclosure) because of a general civil code obligation to negotiate contracts in good faith.

Germany is probably the most ardent exponent of an obligation to negotiate in good faith and thereby provide pre-contractual information, but precisely what has to be disclosed in Germany is unclear. The starting point is that disclosure has to be made of all matters that would be required to comply with the principles of good faith set out in section 242 of the German Civil Code. Nevertheless, the approach in recent court cases³ is to focus on the obligation to provide information on profitability, which must be based on a careful study of the market and requires an assessment by the franchisor of the specific site location or area to be franchised. Profit projections cannot be based simply on an estimate unless this is clearly set out.

It has been suggested by one German franchise lawyer⁴ that the following information, in addition to the disclosure obligations imposed on members of the German Franchise Association, must be provided to comply with the German Civil Code:

• information showing the success of the franchisor’s marketing activities;
• accurate figures concerning comparable franchise businesses (whether currently in existence or terminated);
• details of the franchisor’s IP rights;
• the training to be provided to franchisees;
• current turnover figures for the three most recently appointed franchisees;
• information about the franchisor’s own experience in operating company-owned or pilot operations; and
• the initial costs to be incurred by a franchisee.

In addition, the pre-contractual disclosure obligation continues throughout the term of the franchise agreement so that any changes to the information that has been provided should be furnished to franchisees.

In other civil law countries, a much less far-reaching approach to obligations based on general civil code principles is applied in respect of pre-contractual disclosure to franchisees, which, as highlighted above, has led to the enactment in some countries of specific laws requiring franchisors to provide pre-contractual disclosures.

Non-compete covenants

Generally, in common law countries, post-termination non-compete covenants are enforceable only to the extent that they are reasonable. The courts have adopted their own approach to calculating what is or is not reasonable. The English courts, for instance, have traditionally drawn a distinction between post-termination non-compete covenants in business sale agreements and those in employment contracts. In the latter case, imposing any significant non-compete obligations is unlikely to satisfy the test of reasonableness. In the former, lengthy periods of three to five years have been upheld if necessary to protect the goodwill acquired by a purchaser of a business. Post-termination non-compete covenants in franchise agreements were treated similarly to those in business sale agreements rather than those in employment contracts, although with a shorter period and a more restricted geographical scope, so that, in practice, post-termination non-compete covenants in UK franchise agreements have generally been drafted to apply only for 12 months and only within a franchisee’s territory. It appears that approach will have to be modified following the Court of Appeal’s Drain Doctor decision.⁵ The courts need to take a more flexible approach to assessing the reasonableness of post-termination non-compete clauses and to take into account factors such as the parties’ respective bargaining powers – which, of course, in a franchising context, will make it harder for franchisors to enforce their non-compete covenants against franchisees.

A different but inconsistent approach is adopted in civil law jurisdictions in Europe. While most jurisdictions permit post-termination non-compete covenants provided they comply with article 5(3) of the vertical restraints block exemption,⁶ in some countries, such as Germany, compensation is payable to franchisees who are subject to these non-compete covenants even though the franchise agreement contains no requirement to pay compensation.

Termination compensation

In common law countries, unless the franchise agreement contains a specific obligation to compensate a franchisee on termination of the franchise agreement – which would be very unusual in view of the fact that franchisors and their legal teams prepare the franchise agreement – no compensation is awarded to franchisees on termination, although, of course, if the termination was unlawful, then damages would be payable to the innocent party.

In a number of European civil law jurisdictions, compensation is payable based on the compensation and indemnity provisions in the Commercial Agents Regulations.⁷ To common law lawyers, the approach of the courts in those civil law jurisdictions where the indemnity provisions applied in commercial agency agreements are applied ‘by analogy’ to franchise agreements is puzzling. The two agreements are entirely different in terms of the relationship created, and it is clear from the express language of the Regulations that they only apply to commercial agency agreements. Nevertheless, a number of countries, including Austria and Germany, apply the provisions of the Commercial Agents Regulations to franchise agreements, so as to entitle franchisees to claim compensation on termination of their franchise agreement, provided that the franchisee acquired new customers or substantially increased the scope of an existing business – which will almost always be the case – and as a result the franchisor receives material benefits after termination of the franchise agreement. Nevertheless, franchisees are not entitled to claim compensation if the franchise agreement is terminated by virtue of the franchisee’s breach of contract or the franchisee transfers the franchise agreement or business to a third party approved by the franchisor.

In Austria, the maximum amount of compensation cannot exceed one year’s profit generated by the franchised business based on average profits earned over the previous five years and, furthermore, the franchisee is required to notify the franchisor of a claim within one year of termination of the franchise agreement.

Good faith

The area most frequently discussed in the context of the difference between common law and civil law in a franchising context is good faith. All civil law systems have a concept of good faith. As from 1 October 2016, the French Civil Code, for instance, introduced a new article 1.1.4, which provides that ‘[a]ll contracts must be negotiated, created and performed in good faith. This obligation is a matter of public order.’

That, of course, is a very different concept from the good faith obligations that, at least in some common law jurisdictions, are accepted by the courts. The civil law good faith requirement applies to the negotiation and formation of a contract as well as to its performance. Further, because in civil law jurisdictions it is a matter of public policy, the obligation cannot be excluded.

The civil law approach to good faith should be contrasted with the common law approach. The Uniform Commercial Code in the United States provides that ‘every contract . . . imposes an obligation of good faith in its performance or enforcement’. Similarly, the US Statement (Second) of Contracts says in paragraph 205, ‘every contract imposes upon each party a duty of good faith and fair dealing in its performance and in its enforcement’.

The common law obligation of good faith requires the existence of a contract in which the obligation can be applied. The purpose of the provisions set out above is to give effect to the intentions of the contracting parties and ensure that the contract is performed as the parties intended. This is quite different from the civil law notion that the freedom to negotiate, enter into and perform a contract is limited by the broader public policy that parties should deal with each other fairly.

Even within common law jurisdictions, there are substantial differences in approach. For instance, until 2015 Canada did not embrace a unified and clear concept of good faith. The Supreme Court in the decision of Bhasin v Hrynew⁸ held that there was a general organisational principle of good faith that underpins many facets of contract law and that as a manifestation of that general principle, there was a specific duty of honesty in the performance of contractual obligations.

In Australia, the New South Wales Court of Appeal decided in the Renard Construction (ME) Pty case, which was subsequently followed in a franchising case – Burger King Corp v Hungry Jacks Pty Limited⁹ – that the concept of good faith had to be accepted on the basis that it represented the current ‘expected standard’.

The only common law country that appears to set itself against the concept of good faith is England. As recently as 2016, a judge of the English Court of Appeal held that, ‘there is in my view a real danger that if a general principle of good faith were established it would be invoked as often to undermine as to support the terms in which the parties have reached agreement’.¹⁰ That appears to be the prevailing view in some English courts, even though Mr Justice Leggatt in the well-known Yam Seng decision¹¹ indicated that in relational contracts, which would include franchise agreements, an obligation of good faith should be introduced. Since then, that judge has been promoted to the Supreme Court, but the position concerning good faith remains relatively uncertain. It is perhaps possible to assert that a good-faith obligation will be implied into relational contracts that do not contain any express good-faith obligations, but precisely what such a good-faith obligation will mean is unclear.

Termination of franchise agreements

Previous sections of this chapter have highlighted the differences between the common law and civil law, as well as highlighting differences in the approach taken in both civil law and common law jurisdictions. In this section, we set out an in-depth review of the different approach of the two systems in relation to the termination of franchise agreements. This section is based on an article co-authored by the author of this chapter and the late Professor Aldo Frignani of Italy,¹² and compares the position under Italian and English common law.

Franchise agreements can terminate in a number of ways:

• expiry of a fixed term with no right to renew;
• termination by notice of a franchise agreement granted for an indefinite period;
• by mutual consent;
• unilateral withdrawal;
• non-renewal of a contract (whether by a party exercising, by notice, a right not to extend or renew, or by a party not requesting or not allowing renewal); or
• termination for breach.

The two countries under consideration, Italy and England, are quite different. Italy is a civil law country with a specific franchise law. England, on the other hand, is a common law country with no specific laws relating to franchising. You might expect there to be substantial differences in the approach of the two jurisdictions but, in fact, the similarity is striking. While the process of reaching the answer may be different, the answer is largely the same or at least similar.

Expiry of fixed-term contract

Unlike in some US states where the law requires ‘good cause’ for the non-renewal of a franchise agreement, in Italy no such requirement exists and no action is required by either party to bring a fixed-term contract to an end. Here the principle of freedom of contract, which is fundamental in the common law systems, applies in Italy in the sense that parties have the freedom not to enter into the fixed-term contract, but if they do, they are bound by its terms.

In England and Wales, a similar position prevails. The rights and duties of parties on expiry of a franchise agreement are governed by the terms of the franchise agreement itself. If one of the parties, notwithstanding the expiry of the fixed-term contract, continues to operate the business, then the other party may notify the party treating the contract as continuing that it is also treating the contract as continuing or may notify that party that the contract is at an end. This decision needs to be taken quickly by the party making the notification because, otherwise, the parties will be treated as ‘holding over’ under the terms of the expired agreement and that holding over can be brought to an end by the giving of reasonable notice.

Termination of a contract for an indefinite period

In both Italy and England, contracts for an indefinite period are uncommon in a franchising context. In Italy, as in the United Kingdom, both parties can terminate the indefinite-term agreement by the giving of reasonable notice provided that the minimum term of three years of the indefinite-term contract has expired.¹³ Article 1569 of the Civil Code concerning indefinite-term supply contracts, which is generally considered applicable to franchising, provides:

If the duration of supply obligations is not established, each party may withdraw from the contract, by giving notice within the agreed period or the period established by custom and practice, or in default by an adequate period of notice having regard to the nature of the supply obligations.

In England and Wales, the courts approach the situation differently from those in Italy but come up with the same answer. Assuming that a contract does not have a fixed term and there are no provisions for the serving of notice, then the English courts would approach the issue by seeking to ascertain, in light of all the admissible evidence and what the parties have or have not agreed in the agreement, what was the common intention of the parties concerning termination at the time they entered into the franchise agreement. It is likely that the court would conclude that the parties intended that either party could give reasonable notice because, in a commercial context, the English courts would struggle to accept that parties had intended to bind themselves forever.

Termination by mutual consent

In all European civil law jurisdictions and in common law jurisdictions, a franchise contract can be terminated by mutual consent without an express contractual provision to that effect. In Italy, article 1372 paragraph 1 of the first part of the Italian Civil Code provides that a ‘contract has force of law between the parties and cannot be terminated except by mutual consent’. Similarly, in the United Kingdom, the parties to a contract can mutually agree to bring the contract to an end on the basis of the principle of freedom of contract, which also entitles parties to mutually agree to change what they had previously agreed.

Termination by unilateral withdrawal

In Italian law, by virtue of article 1373 of the Italian Civil Code, if a contract provides that one party can withdraw from the contract, that right has to be exercised before the contract or any element of the contract has been performed. Nevertheless, withdrawal can take place thereafter if some form of compensation is paid to the other party, subject to an overriding requirement for the party withdrawing to comply with the principle of good faith. Further, the withdrawing party is required to give notice of withdrawal and that notice must be adequate to comply with good faith obligations. In practice, if the right to withdrawal is given to only one party, then the notice period required is likely to be longer than if both parties had a similar right.

In England and Wales, in the absence of an express contractual provision, neither party can withdraw from a contract, except when exercising the right to terminate during a holding-over period when withdrawal can take place on the giving of reasonable notice. In practice, this is likely to be between three and 12 months, with a six-month period being the most likely.

Non-renewal

In the absence of an express obligation for a party to renew, the non-renewal of a franchise agreement is not, in civil law jurisdictions, considered to be an ‘abuse of economic power’ unless, in very limited situations, a franchisor is deemed to have dominant power over a franchisee or, for the purposes of competition law, a dominant position in the relevant market.

English courts will always uphold the terms of a contractual renewal clause. In the Apollo Window Blinds Ltd v McNeil¹⁴ decision, which was an injunction application by a franchisor, the court allowed a franchisor to refuse a renewal because the franchisee had failed to serve a request for renewal within the contractual period. Even though the franchisor had never previously required franchisees to comply with these periods, it knew that the franchisee wanted to renew and left it to the last day before expiry to notify the franchisee that it had lost the right to renew.

Termination for breach

In Italy, termination as a result of breach of the franchise agreement is regulated, in the absence of specific contractual provisions, by article 1453 of the Italian Civil Code, which provides, ‘[i]n contracts providing for mutual counter-performance, when one of the parties fails to perform its obligations, the other party can choose to demand either performance or dissolution of the contract’.¹⁵

There is no exact equivalent to the common law concept of ‘fundamental breach’, but a franchisor can terminate a franchise agreement whenever a breach by a franchisee is ‘important’ to the franchisor.¹⁶

Failure to make a significant payment to the franchisor has been treated as an important breach of the franchise agreement, but a delay in making a single payment of an insignificant amount would be unlikely to justify the termination of the agreement.

Other examples of important breaches include:

• failure by the franchisor to transfer and update the know-how, which represents a key element of a franchise; and
• the sale by a distributor of competing products, because of the damage caused to the commercial image of the supplier.

Article 1456 of the Italian Civil Code also applies when the parties insert a clause in their agreement specifying those obligations that they deem to be of such importance that their breach will give the innocent party the right to terminate the contract with immediate effect simply by notifying the other party.¹⁷

If no such clause exists, the innocent party must, in the case of a breach, provide written notice to the party in breach. Such notice must provide adequate time to remedy, which cannot, in the absence of a contractual provision saying otherwise, be less than 15 days. Ultimately, the court will determine whether the breach was important or not.

In England and Wales, franchise agreements will almost invariably contain express contractual provisions setting out those franchisee breaches that give rise to the right to terminate. In practice, it is much less likely that franchisees will also have a contractual right to terminate. The courts will not seek to amend the termination provisions agreed by the parties except in very exceptional situations, which, in practice, are most unlikely to arise in a franchising context. In addition, whatever the contract provides, both parties have a right to terminate at common law for repudiatory or fundamental breach by the other party. English law categorises the terms of a contract as being either a condition, a warranty or an intermediate term. The classification is primarily significant for the effect it has on the remedies available to the innocent party for breach of contract. A condition is a term that, if breached, gives the innocent party the right to either treat the breach as a repudiation and terminate the contract or affirm the contract.

In either case, the innocent party can also claim damages. Curiously, a breach of any condition entitles the innocent party to terminate, even if the consequences of the breach on the innocent party are minor.¹⁸

In the franchise case of Peart Stevenson Associates Ltd v Holland,¹⁹ the court concluded that even the failure to make a payment of a relatively minor sum of £129.84 constituted a breach of a condition, which entitled the franchisor to terminate, although it should be noted that the franchise agreement contained a ‘time of the essence’ clause in relation to payments, which has the effect of enabling a franchisor to terminate for any failure to make payment on the due date for payment.