Breach of Franchise Contract according to DCFR

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A franchise has become a new trend of expanding the business. The distribution of goods and services has remarkably developed in recent years. In the past, manufacturers distributed their products by selling them to established wholesale and retail outlets or by using their distribution chains. Now, however, many manufacturers and producers of services frequently license independently to other distributors or dealers to market their products.  They do not face their customers directly. The obligations of the manufacturer and dealer and the allocation of profit, as well as losses between them, is governed by a franchise contract rather than a sales agreement. Franchising has grown steadily in the last 50 years and is estimated to account for more than one-third of the world’s retail sales.[1]

On the basis franchise contract, the manufacturer (franchisor) as an owner of the franchise business grants a license to a dealer (franchisee) as a business operator, allowing the franchisee to run a business in the name of the former. The franchisee is authorised to use and market goods or services under the franchisor’s trademarks, service marks, and trade names, for a particular length of time.[2]

The franchisee runs his own business by using the brand, and by utilising the method and procedures established by the franchisor. The obligation to use the method and system set by the franchisor brings further consequences that a franchise business is an independent business which cannot be combined with other business activities. However, they are not entirely separated; the franchisor still has a relationship based on the agreement. So the relationship within the franchise contract is beneficial to both parties. Because, in the franchise system, a franchisor permits – licenses the franchisee, in exchange for a fee, to exploit the system developed by the franchisor.[3]

Above all, one of the critical parts of almost any franchise agreement is dealing with how, when, and by whom the franchise can be terminated, and what the parties are required to do. This will analyse the requirements for termination of a franchise contract from the view of Draft Common Frame of Reference (‘DCFR’) originating in an initiative of the European legal scholars.

By privity of contract, the standard rule is that the parties may provide for termination on any provisions they want even a minor non-performance of any obligation under the contract will entitle to the other party to terminate the legal relationship. However, the termination rules regarding franchise agreement under DCFR are different.

Article IV.E.–2:304 DCFR concerning termination for non-performance of the commercial agency, franchise and distributorship contract says:

  • (1) Any term of a contract within the scope of this Part whereby a party may terminate the contractual relationship for non-performance which is not fundamental is without effect.
  • (2) The parties may not exclude the application of this Article or derogate from or vary its effects.

So it can be concluded that in the case of non-performance of the obligations under a commercial agency, franchise or distribution contract, or similar marketing relationship contract, the contractual relationship may be terminated for non-performance only when the non-performance is fundamental.[4] The DCFR incorporates rules for commercial agency, franchise or distribution contract, or similar marketing relationship contract in the same scope. It is because they have the same nature i.e. businesses supplying goods or services to consumers.

The background of the Article is merely considerable investments of the parties in long-term relationships, and where they are frequently dependent on the continuity of such a relationship.[5] The freedom of contract principle to stipulate for a right to terminate for any minor non-performance is not compatible to contracts in which parties sometimes make such a relationship. The contract shall not be terminated by one party on account of the other party’s mere nonperformance of an obligation unless the non-performance is fundamental.

Therefore, these long-term commercial relationships may be terminated for non-performance if (i) the non-performance is intentional or reckless and gives the aggrieved party reason to believe that it cannot rely on the other party’s future performance, or (ii) the non-performance substantially deprives the aggrieved party of what it was entitled to expect under the contract.[6]

An illustration regarding fundamental non-performance in DCFR as follows – An international chain of hamburger restaurants provides its franchisees with a book containing hundreds of pages and thousands of very detailed instructions relating to all aspects of hamburger selling. The franchise contract says that strict compliance with each of these directions is of the essence of the contract. During a monthly inspection, the franchisor discovers that hamburgers in one particular restaurant are on average 2% too hot. The franchisor may not terminate the franchise.[7] It is evident that 2 % too hot is not a fundamental non-performance.

As comparison regarding the expired period of the franchise contract, the DCFR divides termination of franchise contract into two types: contract for a definite period[8] and contract for an indefinite period[9]. Regarding contract for a definite period, Article IV.E.–2:301 DCFR states:

A party is free not to renew a contract for a definite period. If a party has given notice in due time that it wishes to renew the contract, the contract will be renewed for an indefinite period unless the other party gives that party notice, not later than a reasonable time before the expiry of the contract period, that it is not to be renewed.

The article mentioned above provides a rule for a detailed situation regarding the end of a contract with a definite period. As a basic rule, the contractual relationship will come to an end on the expiry of the definite period, and parties are restricted to renew a contract for a definite period after the expiry of its duration. If one side gives notification to the other in sufficient time that it requests to renew the contract and if the other party desires not to renew the contract, the other party has to reply not later than a reasonable time before the expiration of the contract period. If other party fails to respond by that time, the contract will be renewed for an indefinite period.

Furthermore, in different condition, when the parties, in fact, continue performing the agreement after the end of contract duration, an agreement that was concluded for a definite term does not stop due to the expiry of the fixed term. As a substitute, the contract becomes a contract for an unfixed duration and depending on the same settings. This is the effect of the general rule in tacit prolongation.[10] Under Article III.–1:111 DCFR any contract providing for continuous or repeated performance of obligations for a definite period may be tacitly prolonged if the obligations continue to be performed by both parties after that period has expired and the circumstances are not inconsistent with the parties’ tacit consent to such prolongation.

On the other hand, there is also contract for an indefinite period, Article IV.E.–2:302 DCFR states:

  • (1) Either party to a contract for an indefinite period may terminate the contractual relationship by giving notice to the other.
  • (2) If the notice provides for termination after a period of reasonable length no damages are payable under IV.E.–2:303 (Damages for termination with inadequate notice). If the notice provides for immediate termination or termination after a period which is not of reasonable length damages are payable under that Article.
  • (3) […]

The article above explains that a contract for an unfixed period occurs when (i) it does not contain any detailed duration or (ii) it explicitly states that it is for an indefinite period. In this case, each party has a right to terminate the agreement because the contractual relationship may be terminated individually by giving notification to another party. If the period of notice is not reasonable, the compensation will be payable. However, by Paragraph 2 of this Article, a reasonable period of notice is not a condition for the effective termination of the agreement.

To sum up, according to DCFR, in the case of non-performance of the obligations under a franchise, the contractual relationship may be terminated for non-performance only when the non-performance is fundamental. Regarding an expiration clause, the DCFR divides the termination of a franchise contract into two types: contract for a definite period and contract for an indefinite period. Relating to the contract for a definite period, the contractual relationship will come to an end on the expiry of the definite period, and parties are restricted to renew a contract for a definite period after the expiry of its duration.  But in the case of the indefinite period, each party has a right to terminate the agreement by giving notification to another party.

Bibliography

[1] (http://www.wipo.int/sme/en/documents/franchising_fulltext.html), last visited (03-10-2016)

[2] See E. Gellhorn, Supra note at 467

[3] (http://www.wipo.int/sme/en/documents/franchising_fulltext.html), last visited (03-10-2016)

[4] The list of definitions in the Annex DCFR provides that A non-performance of a contractual obligation is fundamental if (a) it substantially deprives the creditor of what the creditor was entitled to expect under the contract, as applied to the whole or relevant part of the performance, unless at the time of conclusion of the contract the debtor did not foresee and could not reasonably be expected to have foreseen that result, or (b) it is intentional or reckless and gives the creditor reason to believe that the debtor’s future performance cannot be relied on.

[5] See Von Bar & Clive, supra note 1, at 2331

[6] See Von Bar & Clive, supra note 1, at 2331

[7] Von Bar & Clive, supra note 1, at 2331

[8] Article IV.E.–2:301 DCFR

[9] Article IV.E.–2:302 DCFR

[10] Article III.–1:111 DCFR

 

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