DISCLOSURE IN FRANCHISE AGREEMENTS*
 
 

Prof. Avv. Aldo Frignani

(prepared for a conference in Bruxelles on October 31, 1995)


 







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DISCLOSURE IN FRANCHISE AGREEMENTS


 








Nature of Disclosure: Required by Codes of Ethics

In the past five years various franchise associations have either established or revised their Codes of Ethics, most noteably provisions dealing with franchisor’s pre-contractual disclosure requirements. Much of this activity was prompted by the European Franchise Federation’s revision of its European Code of Ethics for Franchising (ECEF) in 1991, which was a response to the European Commmunity’s Block Exemption Regulation. The ECEF now requires its members to give prospective franchisees, " . . . full and accurate written disclosure of all information material to the franchise relationship, within a reasonable time prior to the execution of [the] binding documents." Because many European franchise associations use this as a model for their codes of ethics, these associations have also revised their codes.

The French Franchising Federation (FFF) uses the ECEF (which is based, to some extent, on the original FFF Code of Ethics) and therefore, it is binding on members of the FFF and parties who agree to be bound by the Code in their franchise agreements. The ECEF has been interpreted by French courts to require members of the FFF to act in good faith and specifically, with regard to disclosure, statements made to attract potential franchisees ". . . should be free of ambiguous or misleading information [and] information on provisional financial earnings should be objective and verifiable." Also, French Courts may refer to the code ". . . to define acceptable practices in terms of loyalty and honesty for the entire franchising industry." Similarly, the regulations of the Italian Franchise Association (Assofranchising or AIF) are mandatory for members and must be kept in accordance with the ECEF. Finally, Chapter 4 of the British Franchise Association’s, "The Ethics of Franchising", deals with "Recruitment and Disclosure Under the Code", which elaborates the ECEF requirements for disclosure.

The Code of Principles and Standards of Conduct of the International Franchise Association (IFA), the largest franchise association in the United States, was revised in 1994 to present a clearer understanding of its intended use. The section on Franchise Sales and Disclosure, like the ECEF, requires written disclosure of "[a]ll matters material to the granting of a franchise . . ." and that "[o]ffering circulars [are] complete, accurate and not misleading." The code further requires that franchisors advise all potential franchisees to seek legal counsel. Finally, all members must conform their policies and practices to the code.

In Australia the Franchise Code of Conduct, created in 1993 to deal with, inter alia, the problem of nondisclosure by franchisors, was reviewed in March 1995. Presently, registration with the FCAC is voluntary, which of course makes compliance with the code voluntary; however, franchisors who register (i.e. over half of all franchisors in Australia) are bound by the code. It is important to note that, because of the recent review of the Code, compliance may be made "mandatory" by requiring all franchisors to either register with the board in charge of oversight, (i.e. the Franchising Code Administration Council (FCAC) or undergo a very costly process of registration with the Australian Securities Commission. Also important, in achieving this end, are recommendations regarding an increase in franchise regulation by increasing the power of the FCAC.

It must be stressed that the abovementioned codes are promulgated and administered by independent franchise associations and therefore do not have the force of law. Also, membership in such associations is not mandatory and so, if a franchisor chooses not to become a member, there is virtually no oversight of its activities.
 
 

Nature of Disclosure: Required by Statutory Laws

The majority of States have not yet enacted specific legislation to regulate the franchise relationship and instead use established principles of contract law, commercial law and tort law to regulate franchising.

In Germany, section 242 of the Civil Code (B & B) requires all agreements to be negotiated and conducted according to the good faith principle. This, coupled with the Law to Regulate General Terms of Trade of 1977 (Gesetz zur Regelung des Rechts der Allgemeinen Geschä ftsbedingungen, AGBG), section 9, which voids any disproportionately disadventageous contract provision between contracting parties, has been interpreted to mean that the franchisor would be well advised to "fully disclose [its] business and financial schemes." Applying these laws, German courts have required the franchisor "to give full advice to the franchisee and . . . to protect him from business mistakes." If the franchisor fails to fully disclose such information, he may be held liable for damages. Similarly, in Portugal, the general good faith requirement for the negotiation of contracts, including a duty to disclose all information necessary to carry out contract obligations, is applied to the franchise relationship. Also, there are no franchise laws in the UK, therefore, general commercial laws apply. This means, in the area of disclosure, a franchisor may be held liable in tort for negligent advice, applying standard principles of commercial and tort law. As a final example, the principle of good faith in negotiating a contract is also a pillar of the Italian law, where art. 1337 of the Civil Code states, "[t]he parties, in the conduct of negotiations and the fromation of the contract, shall conduct themselves according to good faith . . . ."

The reasons for such lack of specific regulation are found in the desire to foster and promote the franchise relationship and not to hinder commercial activity. For example, in Australia, a recent call for legislation in this area was rejected because of the lack of flexibility and the likelihood that the legislation would inhibit rather than foster the development of franchising.

To my knowledge, Brazil, France and the United States are the only jurisdictions which specifically regulate the franchise relationship, including pre-contractual disclosure requirements.

In Brazil, franchise agreements are regulated by Law No. 8955 of December 15, 1994. It, like legislation in France and the U.S., requires franchisors to provide a "Franchise Offer Circular" to all prospective franchisees, which must be in writing, with a copy of the standard or preliminary contract.

In France, the Doubin Law covers the franchisor’s obligations in the pre-contract phase, specifically disclosure, therefore, in this area the law supercedes the code. The law was enacted to protect franchisees in the pre-contract phase, becasue, it was felt, that they are the weaker party and this is the most crucial phase, as it defines the rights and obligations of each party.

The Doubin Law (Article 1 of Law No. 89-1008 of December 31, 1989), is applicable only to franchise agreements seeking exclusivity or quasi-exclusivity, and requires franchisors, among others, to give prospective franchisees ". . . a document [which provides] accurate information enabling the other party to commit itself with full knowledge of the relevant facts." The law states in general terms what must be disclosed. The Decree of Implementing Regulations (Decree No. 91-337) specifies what must be included in the disclosure document and sanctions for failure to deliver such document. This law also applies to the subfranchisor/subfranchisee relationship (specifically to deal with the issue of confidentiality between master franchisor and subfranchisor). In light of these regulations, franchisors are advised to ". . . include a clause in the franchise agreement containing an acknowledgement by the franchisee that all the requirements of the Law have been met and to attach copies of the information disclosed to the agreement itself."

Finally, in the United States, the Uniform Franchise Offering Circular Guidelines (Guidelines) are approved by the U.S. Federal Trade Commission (FTC) and are adopted and amended by states to regulate pre-contract disclosure in accordance with each states view of commercial law. The FTC regulates franchisor/franchisee disclosure on the federal level, while states have their own agencies in charge of oversight. It is difficult to evaluate the specific requirements of each state in the context of this paper, as such requirements vary from state to state. Therefore, it is necessary when conducting a franchise agreement in a state, to perform a thorough examination of the state requirements, as well as the Guidelines.
 
 

What to Disclose

The majority of disclosure regulations, either from Codes of Ethics or statutes, require franchisors to provide all necessary information in a written document, sometimes called an "offering circular". Below is a brief description of the information required by each of the following States. For more detailed descriptions, please see the attached information.
 
 

Australia

The Code requires production of a Prior Disclosure Document (updated each year and given to all franchisees and potential franchisees), which must include: Experience of franchisor; financial status; detailed projection statements regarding future financial performance and undertakings; ". . . details of any material legal proceedings concerning the franchisor or its principals; a summary of the main particulars of the franchise system and agreements; a break-up of the franchise price; the number of existing franchises and company outlets; if the franchisor has not been in the franchise business for a period of more than two years, details of financial performance of any relevant business operations; and details of the prior history of the territory if it has been previously franchised." Franchisees must acknowledge, in writing, receipt of this document.

Additionally, it was recently recommended that "disclosure documents include details of any payment or commission paid by a franchisor to [an] advisor or consultant in relation to the sale of a franchise" (to deal with premature entry into the market by franchisors on the advise of franchise brokers or consultants) and increase the scope of disclosure to include information on companies which are related to the operation of the franchise.
 
 

Italy

Article 5 of the AIF Regulation requires franchisors to disclose the following: A copy of the franchise agreement; franchisor’s balance sheet for the previous three years (only if requested by the franchisee); addresses and telephone numbers of franchisees in franchise system; information on the number of franchisees for each of the previous three years; summary of any legal proceedings against franchisor with regard to franchise system in last three years (at the request of the franchisee); franchisee’s projected budget; and a copy of the Regulations and the ECEF.
 
 

Brazil

The Circular must "contain the background, balance sheets, financial statements, list of network franchisees, list of any pending court suits involving the franchisor, a detailed description of the franchise, the business and activities to be carried out by the franchisee, the specifications in the operating territory, the relationship with network suppliers, if applicable, as well as the status of the franchisor’s trademarks at the Brazilian Industrial Property Institute (INPI), the profile of the ideal franchisee, the degree of involvement in the business, the investment need, and anything else relevant to the undertaking. . . . The Circular should also indicate exactly what the franchisor is offering the franchisee, as well as any consequences of termination of the contract for the franchisee."
 
 

France

As specified by the Implementing Regulations of the Doubin law, franchisors must disclose the following: Address of the principle place of business with a description of the corporate form and names of management; company and trademark registration numbers; locations of five principle banks; five year history of business to explain business or management experience, including general description and prospective development of the market; financial statements for previous two years; complete description of other licensees; terms of the franchise agreement; and franchisees expenses for use of the trademark. Moreover, the full text of the draft contract must be given to the franchisee at least 20 days before signing the final contract.
 
 

United States

Disclosure requirements in the United States are particularly dense and complex. The Guidelines were recently revised in an attempt to cut down on the use of legal language, to make offering circulars more easily understandable and to avoid a mere restatement of the franchise agreement. These new Guidelines, however, have not yet been adopted, and so the following is a list of general headings or categories of the necessary information: The franchisor, its predecessors and affiliates; business experience; litigation; bankruptcy; initial franchise fee; other fees; initial investment; restrictions on sources of products and services; franchisee’s obligations; financing; franchisor’s obligations; territory; trademarks; patents, copyrights and proprietary information; obligation to participate in the actual operation of the franchise business; restrictions on what the franchisee may sell; renewal, termination, transfer and dispute resolution; public figures; earnings claims; list of outlets; financial statements; and contracts.
 
 

Defenses for Non-Disclosure: Information that the Franchisor Does Not Possess or Information Commonly Available or Easily Accessible

Keeping in mind the time honored saying, (which is borne out by many American football games) that the best defense is a good offense, it is suggested that the franchisor include an integration clause in all franchise agreements and require written confirmation from the franchisee of receipt of all necessary pre-contractual disclosure information. In the U.S., integration clauses have been used to protect the franchisor from liability for statements made during negotiations which were contrary to contract provisions. However, it is questionable whether such a clause would stand up to gross negligence or fraud on the part of the franchisor. This being the case, it is necessary to examine other ways to protect the franchisor from liability.

In France, franchisors are held strictly liable for failure to comply with the Doubin law and criminal penalties may be imposed. However, at the discretion of the judge, a franchisor may completely or partially protect itself from liability if it shows that it acted in good faith. Additionally, if a franchisor is charged with fraud it must be shown that it acted intentionally, therefore a valid defense may be that the franchisor acted negligently, but without intent.

To protect itself from civil damages the franchisor must either show that it acted without negligence or that the harm was caused by the franchisee’s negligence (i.e. shift fault to the franchisee). To protect itself from cancellation of the contract the franchisor must show that the error was not the basis or "material in the franchisee’s decision to undertake the business involved."

In Italy, the AIF Regulations do not provide specific defenses. Since the provisions of the regulations and code of ethics must be strictly adhered to by members, it is assumed that the only defenses available would be a showing that the franchisor did in fact comply with the regulations. However, because it is up to the AIF to monitor the activities of the members and impose sanctions for violations, the AIF may take into consideration the fact that the information the franchisor failed to disclose was either not in its possession or else was readily available through other sources.
 
 

Time of Disclosure: Early Enough to Allow Franchisee to Make Decisions with Full Knowledge

The main issue presented by the various time periods is whether they provide enough time for the franchisee to thoroughly examine all disclosure information. The number of days to review the information after negotiations end but before the franchise agreement is signed (i.e. the examination period) ranges from 7 days in Australia, to 10 days in Brazil, to 15 days in Italy, to 20 days in France. In the U.S., such time periods vary from state to state, but all states must provide a reasonable time to review the information.
 
 

Sanctions for Lack of Disclosure: Penal Sanction (loi Doubin in France)

The Doubin Law provides for penal sanctions if a franchisor does not strictly comply with the provisions of the law (i.e. either fails to deliver the disclosure document and proposed agreement or does not disclose the required information). The fine may be ". . . from FF 3,000 to FF 6,000 and/or imprisonment from ten days to one month. In the case of repeat offenses, the fine may range from FF 6,000 to FF 12,000 and imprisonment can be from one to two months." If , however, the franchisor intentionally discloses false information, it will be liable under the criminial fraud provison of the French Penal Code.

Additionally, in the United States, penal sanctions may be imposed under various state laws.
 
 

Sanctions for Lack of Disclosure: Civil Remedies: Precontractual liability; annulment; damages

In Brazil courts will ". . . render the franchisor/franchisee relationship null and void, and the franchisee will be entitled to obtain from the franchisor or its appointees a refund of any payments already made by way of membership fee or royalties, duly adjusted for inflation."

There is no provision for civil damages in the Doubin Law. Generally, franchisees seek either damages or annulment/cancellation of the agreement. In the case of annulment/cancellation, the franchisee must produce a signed agreement and show that the franchisor failed to deliver the required documents within the stated time period. A franchisee may obtain damages by proving that the disclosure document contained false information and that the franchisor acted negligently.

In the U.S., Washington State has dealt with the issue of whether there must be a connection between the disclosure violation and the harm suffered or whether the violation is sufficient to impose liability. It found that there must be a connection. However, some courts have held franchisors strictly liable for disclosure violations, basing such findings on the special nature of the franchisor/franchisee relationship. Franchisors may be liable in some states for treble damages, in addition to "actual damages, injunctive relief, costs and attorney fees" for violation of franchise laws, specifically if such violation rises to the level of an independent tort.
 
 

*******Updating is fixed at October 1995