Overview (May 2001)

Introduction
Legislative Framework
The Civil Code
The Commercial Code
The Standard Contracts Act
The Consumer Credit Act
The Act against Restraints of Competition

Introduction

Franchising is well established in Germany. It is evident in the retail industry (particularly with regard to fashion, shoes, furniture, household appliances, hygiene and health care products, and sports goods) and in certain service industries, such as the dry cleaning, car-rental and travel businesses. It is most prominent in the hotel and restaurant industry.

The importance of franchising in Germany today is very strong and is still growing. Its significance in what was previously West Germany was further strengthened by German unification. In 1990 the emerging East German market encompassed 17 million consumers, but no distribution channels. Thus, many manufacturers and service companies had to build up entirely new distribution systems for the sale of their products in this part of the country. This process still has not come to an end.

Legislative Framework

There is no special statute in Germany governing franchise contracts, the rights and duties of franchisor and franchisee, the requirements for termination of the contract and the compensation to be paid upon termination. Lawyers and courts have been able to deal with all problems afflicting franchising systems on the basis of existing laws, throughout which the relevant provisions are scattered. These include the Commercial Code, the Civil Code, the Standard Contracts Act, the Consumer Credit Act and certain antitrust laws such as the Act against Restraints of Competition.

The Civil Code

An important issue with regard to the preparation of a franchise contract involves the franchisor's duty to ensure that all relevant facts are clearly presented prior to the conclusion of the contract. Although the Civil Code does not explicitly include a corresponding provision, the courts have recognized the underlying principle of liability due to a violation of confidence in the preparation of a contract, and this is an accepted principle of the Civil Code today (known as culpa in contrahendo). In the case of a violation of the franchisor's duty to present all relevant facts, the franchisee is entitled to claim damages. The scope and specifics of this duty depend on the individual case, but the experience and knowledge of the franchisee must always be taken into account. Necessary information for the franchisee might include details relating to cost estimates, to the possible amounts of work and capital involved, and to the local conditions of the new company.

The Commercial Code

Franchising is one of several ways in which the distribution of goods and services through independent third-party intermediaries can be organized. Only one possible form of distribution - commercial agency, whereby the intermediary acts in the name and on behalf of the principal - is comprehensively regulated by statute in Germany. However, courts and authors have recognized that the respective statutory provisions embody legal principles that may generally be applied to franchise contracts by analogy, as long as two conditions are met. First, like an agent, the franchisee must be integrated into the franchisor's distribution system and be subject to the franchisor's instructions. Second, the franchisee must be contractually bound to surrender the customers he has solicited to the franchisor upon termination of the franchise agreement.

General obligations
The franchisee is obliged to make efforts to sell the relevant products or services, to safeguard the franchisor's interests and to provide the franchisor with all necessary business information. In particular, a franchisee must not reveal any business or company secrets, either during or after the contractual relationship.

On the other hand, the franchisor is obliged to provide all necessary documents, and to give the franchisee all business information necessary to commence and maintain operations.

• in the first year, one month;
  
  
• in the second year, two months; and
  
  
• in the third to fifth year, three months.

After five years the minimum notice period is six months. In any event, termination must occur at the end of a calendar month, unless otherwise agreed. In the case of termination for cause, no notice period is necessary.

Compensation upon termination
Upon termination of the franchise agreement the franchisee is entitled to claim compensation for loss of future income that might otherwise have been earned from further business concluded with the customers that have been acquired. This compensation is limited to the franchisee's average annual commission income over a maximum of five years preceding termination. However, compensation will not be paid if the contract was terminated by the franchisee, or because of a breach of its conditions on the part of the franchisee.

The Standard Contracts Act

The purpose of the Standard Contracts Act is to protect the weaker party to an agreement (in many cases the consumer) against abuses by the other party, which will generally be in a stronger bargaining position and will have the time and freedom to draft the standard contract or general terms and conditions in advance. The act applies to "all contractual clauses standardized for a large number of contracts, which one party presents to another in order to conclude a contract". Since practically all franchise agreements are concluded by means of standardized forms drafted by the franchisor, they are generally subject to regulation by the Standard Contracts Act. In particular, the act protects consumers by declaring certain provisions in standard contracts invalid, and by containing a blanket rule under which standard provisions are invalid if they unduly burden the consumer under equity principles. As most franchisees are merchants, it is this blanket rule which applies to the standard agreements into which they have entered. Under the blanket rule the following issues deserve particular attention.

Quality and product guidelines
Guidelines that describe in detail the quality standards which the franchisee must maintain, and the manner in which he must produce goods or provide services, are generally allowed where necessary as a safeguard to maintain the uniform and standardized quality and appearance of the products or services offered. However, guidelines which serve only to protect the unilateral interests of the franchisor will be invalid.

Non-competition clause
A non-competition clause that applies during the term of the franchise agreement will be upheld under the Standard Contracts Act only if the franchise contract, seen in its entirety, enables a full-time franchisee to engage in a full entrepreneurial activity with the potential to earn a living. This is because a full-time franchisee can be expected to devote all his efforts to his particular business and not to engage in any other activity, particularly in a competing business.

Exclusivity
Franchise contracts often provide for exclusivity, whereby the franchisee must purchase all products from the franchisor and may not buy them from third parties. Notwithstanding the Act against Restraints of Competition, such exclusivity agreements are enforceable as long as they are necessary in order to maintain the quality standards typical of the particular product, and provided that this is necessary to protect the brand name.

The Consumer Credit Act

The purpose of the Consumer Credit Act is to protect consumers in the case of loan contracts or brokerage contracts regarding loans, as well as certain types of hire purchase agreement. In particular, the act covers all contracts that oblige the consumer to buy certain goods on a regular basis. The statute protects all natural persons, unless the contents of the agreement concluded by that person show that it was made for an existing business. With respect to the Hire Purchase Act, the predecessor of the Consumer Credit Act, the Federal Supreme Court ruled that a product franchise contract falls under its provisions in cases where the franchisee is required to purchase the franchise products on a regular basis from the franchisor. Even without an explicit obligation to purchase, a corresponding obligation can derive from the franchisor's duty to distribute the product, a breach of which often results in termination of the franchise contract or claims for damages by the franchisor. Therefore, in the case of product (but not service) franchise contracts, the contract must be in writing and a copy of the contract must be given to the franchisee. The franchisee must also be notified of its right to revoke the contract in writing, which exists for two weeks following such notification. If the franchisee does not avail of the right within this period, the contract becomes binding.

The Act against Restraints of Competition

The Act against Restraints of Competition includes further provisions that restrict the parties' freedom in drafting the franchise agreement. Generally, the act distinguishes between horizontal and vertical agreements restricting trade. While horizontal agreements (ie, agreements between competitors) are considered in principle as prohibited cartels, vertical agreements (eg, agreements between buyers and sellers) are prohibited only if they determine the prices and/or terms of trade to which one party must adhere when selling the products or services purchased from the other party. Under franchise contracts the franchisees usually will be subject to stringent control by the franchisor. Therefore, franchise contracts will generally be considered as vertical distribution agreements and the following competition issues will arise.

Price recommendations
Any direct or indirect price fixing in a franchise contract is prohibited. However, the franchisor may provide the franchisee with non-binding price recommendations for the sale of the goods or services as long as:

• the recommendation explicitly appears as unbinding on the products;
  
  
• no other economic pressure is exercised to enforce it; and
  
  
• the recommendation is made with the expectation that the price is that which would be rightfully demanded by the majority of franchisees.

Terms and conditions
As stated above, any provisions in the franchising contract that restrict the franchisee in his freedom to determine how, and under what terms and conditions, he wishes to sell goods or render services to consumers are prohibited. This refers not only to provisions in standard contracts but to all types of contractual provisions relating to contracts with customers.

Exclusivity
Exclusivity, as discussed in connection with the Standard Contracts Act, may be prohibited by the Federal Cartel Office if and to the extent that such a provision unduly restricts the competitiveness of the franchisee in a particular manner, makes it unduly difficult for other enterprises to enter the market, or seriously restricts competition in the market for these or other products or services. Territorial restrictions will be allowed where they are necessary for the establishment and smooth operation of the franchise system.

European Block Exemption

Since June 1 2000 a block exemption on distribution agreements has been in force which creates a wide exemption from the impact of Article 81 of the EC Treaty. EC Regulation 2790/99 replaced the Franchise Block Exemption (EC 4087/88). Under transitional provisions, franchise agreements that were in force by the end of May 2000 and that complied with EC Regulation 4087/88 could benefit from this exemption until the end of December 2001. Under the new regulation an exemption is only available to franchise partners with a market share of less than 30%. Further, franchise agreements may not benefit from the block exemption if the agreement contains restrictions with regard to price maintenance and restrictions on cross supply. Non-competition clauses during the term of the agreement must not be agreed for more than five years, while non-competition clauses after the termination of an agreement may not last for more than one year.

For further information on this topic please contact Karsten Metzlaff or Karl Rauser at Nörr Stiefenhofer Lutz by telephone (+49 30 20 94 20 00) or by fax (+49 30 20 94 20 94) or by e-mail ([email protected] or [email protected]).