Franchising in Germany: Indemnity Claims on Expiry of Contracts for Commercial Agents - Also Mandatory on Franchisees?

01 May 2006

Albrecht Schulz, CMS Hasche Sigle, Stuttgart

This provision was based on similar provisions already in existence in Austria and Switzerland. It, in turn, then served as a model for the alternative ‘indemnity’ in article 17 paragraph 2 of the EC Commercial Agents Directive No. 86/63/EEC; the other alternative ‘compensation for damage’ in article 17 paragraph 3 of the Directive was modelled on the existing case law practice in France. All of 25 EU Member States have implemented the Commercial Agents Directive into national law, whereby the large majority of them have chosen the German indemnity model for their respective law. Although the statutory mandatory indemnity for commercial agents has existed in Germany for more than 50 years, there are few other economically significant statutory provisions on which there are so many individual case laws. 

The courts, above all the Federal Court of Justice, then began from 1958 onwards to apply section 89(b) of the German Commercial Code to distribution (dealer) agreements by analogy, and also to grant the dealer an indemnity claim, as a matter of principle, subject to fulfilment of certain preconditions. These preconditions are the following, pursuant to what is now established case law: The dealer must be integrated into the sales organisation of the company in such a way that the legal relationship between the parties is not merely a purchaser-vendor relationship but that the dealer, from an economic point of view, has tasks to fulfil which are, to a considerable extent, comparable with those of a commercial agent. 

The dealer must be under a contractual obligation to transfer its clientele to the entrepreneur (at the latest) at the end of the contractual relationship in a manner which enables the entrepreneur to make immediate use of the clientele. 

Application of Section 89(b) of the German Commercial Code to Franchisees by Analogy? 

As early as the late 1980s discussion had begun in German legal literature about whether section 89(b) must not also apply by analogy to franchise agreements which are not covered by statute, since a franchisee fulfils similar distribution functions to a dealer. Over the course of the years the prevailing opinion has emerged in legal literature, however not always with very convincing arguments, that section 89(b) must also, in principle, apply to franchisees if the two preconditions for application which have emerged for dealers are fulfilled. 

The Federal Court of Justice has not yet expressly confirmed the application of section 89(b) to franchise agreements by analogy, which is generally considered appropriate in German legal literature. However, it did make comments in two decisions of 23 July 1997 (Benetton I and Benetton II) which suggest that, if presented with a suitable case, it would award an indemnity after the end of a franchise agreement by way of application of section 89(b) by analogy. In that case, namely, it did not state that application of section 89(b) by analogy could not be considered for legal reasons. Rather, it decided against application because the above-mentioned analogous preconditions required for the dealer agreement were not fulfilled. In doing so, with respect to the second precondition, it even expressly questioned whether in the case of franchising as in the case of dealer agreements, a contractual obligation to transfer the clientele is necessary or whether it is sufficient that the customers simply remain with the franchisor. 

After this decision it had to be assumed that the courts would, sooner or later, grant an indemnity claim at the end of the contract to a franchisee applying section 89(b) by analogy, which then happened in the decisions of the Frankfurt Regional Court of 19 November 1999 (which only became known in 2003) and of the Hanau Regional Court of 28 May 2002. The decisions were naturally not greeted with open arms in the franchise community. In light of the prevailing opinion in legal literature and the implied opinion of the Federal Court of Justice in the decisions of 1997 it can, however, hardly be expected that the application of section 89(b) by analogy to franchise agreements, which has now also been established by the courts, will disappear again in the future. It should not be overlooked in this regard that as early as the year 1991, in Austria, the Highest Court of Justice considered application by analogy of the corresponding Austrian provision (then section 25 of the HVG) appropriate for franchise contracts. Since this landmark decision, it is generally assumed in Austria that franchisees also have a compensation claim at the end of contracts, although no detailed decisions from lower courts have come to light since. 

The question now raised is whether or not these decisions will have dramatic consequences for franchising. It should not be overlooked that there is only an indemnity claim in the individual case subject to a whole series of complex preconditions and then only if, in turn, there are no reasons for exclusion. 

As already explained above, section 89(b) does not apply to franchise agreements under all circumstances but only if the two preconditions for its analogous application are fulfilled: Integration into the distribution network and obligation to transfer the clientele. What does this mean exactly? 

The franchisee must be integrated into the sales organisation of the entrepreneur (franchisor) in the same way that a commercial agent is integrated into the sales organisation of the principal. This can only be evaluated on the basis of the structure of the contract and the circumstances of the individual case. However, this first condition will usually be fulfilled in the case of a typical franchise relationship where the franchisor has extensive rights to control and the franchisee has extensive obligations with respect to the use of the franchise system, whereby the latter has to observe interests in favour of the network and prohibitions on competition. Nevertheless, there may be individual franchise networks which do not contain suf- ficient elements permitting the classification of a franchisee in a similar position to that of a commercial agent. 

The second and more important characteristic is the contractual obligation to transfer the clientele. The franchisee appears on the market as an independent businessman and concludes its own and direct agreements with its customers. These and their data are usually, especially in ‘over the counter’ bulk business, not available to the franchisor without further measures. Not knowing the franchisee’s customers, the franchisor cannot therefore in most cases fall back on these after the end of the contract. It was therefore obvious to recommend to the franchisors not to include any provisions in the franchise agreements which seemed to create some sort of obligation for the franchisee to transfer the customer data to the franchisor during or after the end of the contract. The belief that this had eliminated most risks seemed to be confirmed by recent case law of the Federal Court of Justice on distribution agreements, in which the signifi- cance of a contractual obligation to transfer customer data was emphasised on several occasions. However, this position with respect to the franchise agreements became questionable after the comments of the Federal Court of Justice in the above-mentioned ‘Benetton’ decisions, from which it had to be assumed that actual transfer or assumption of the clientele (without any contractual obligation) could be sufficient. Certainty that a great risk lies herein was obtained through the above-mentioned decision of the Frankfurt Regional Court of 19 November 1999. In the case in question, there was no contractual obligation of the franchisee to transfer the clientele. Nevertheless, the court considered this precondition fulfilled because the sales point of a bakery chain was transferred directly from the retiring party to another franchisee, and the customers were therefore seamlessly transferred to the new franchisee and thus remained with the franchisor’s network. Whether or not this wide-reaching view will become generally accepted remains to be seen. However, in the appeal proceedings the Frankfurt Higher Regional Court made it clear that it shares the view taken by the Regional Court, which is why the parties terminated the proceedings with a settlement. 

It can therefore only be recommended that all franchisors avoid, wherever possible, contractual and factual situations in their franchise systems and franchise agreements which can be regarded by the courts as an actual transfer of the clientele or a transfer of the clientele as the result of a contractual obligation. All types of customer card systems can be an example of such customer transfer. One possibility of providing customers with advertising could be to make the addresses of the customers available only to the advertising company responsible for the customers, so that they cannot be passed on to the franchisor and must be returned to the franchisee at the end of the contract. 

Even if the actual risks were increased by the Frankfurt Regional Court’s decision, the second precondition for application of section 89(b) by analogy will, however, not exist in many franchise systems. The situation in favour of the franchisor can be improved in that notification and transfer of the customer data to the franchisor be expressly excluded in the franchise agreement. 

It must be emphasised that the German commercial agency law pursuant to the German Commercial Code, unlike the EC Commercial Agents Directive and the majority of the national laws in the other EU States, does not only apply to goods agents but also to agents working in service sectors. Application of section 89(b) of the German Commercial Code by analogy therefore does not only concern agreements in the area of products franchising but all areas of service franchising. 

It will not be possible to avoid application of section 89(b) by analogy to franchise agreements by referring to the attraction of the mark. Even if the mark and the franchise system thereunder are the main success factors (which will not be the case in all franchise systems) they always represent only co-factors for economic success. No success is conceivable without the franchisee undertaking activity on site, and if it does not work well, even a well-known mark will barely guarantee success. The attraction of the mark is, however, taken into account from the point of view of the ‘equitableness’ of granting a compensation claim (see below). 

Preconditions and Calculation of an Indemnity Claim in Detail 

Recognising that there is, in principle, a possibility for franchisees to have indemnity claims at the end of contracts, however, does not say anything about whether there is an indemnity claim in the individual case, and, if so, the amount thereof. All actual preconditions and exclusion possibilities must be reviewed on the basis of section 89(b) in the same way as in the case of indemnity claims of commercial agents. This will reveal that the franchisee’s belief that it is definitely entitled to a substantial claim is often illusiory. These preconditions and exclusion possibilities are set out in detail in the following. 

The end of the franchise agreement is the first precondition pursuant to section 89(b)(1) sentence 1 of the German Commercial Code. The contract can end as a result of expiry of the agreed contractual term, dissolution by mutual consent, death of a contractual party or termination by one party (the termination situations in which the claim is excluded shall be discussed below). 

The franchisor must gain considerable advantages after the end of the contract from the new customers acquired by the franchisee or from old customer relationships intensified by the franchisee. 

Loose business relationships with occasional customers are not sufficient for this. “Business relationships” within the meaning of section 89(b)(1), sentence 1, No. 1 of the German Commercial Code are only those with regular customers, or with such first customers of whom it can be expected that they will make repeat purchases within a foreseeable period of time. In the case of assumed existing customer relationships, the volume of business must have been considerably increased, which is generally considered to be the case where the turnover is increased by 100 per cent. In the case of restaurants or other shops in motorway service stations or railway stations it will hardly be possible to record regular customers or turnover increases with specific customers. 

The customers must be acquired by the franchisee, ie, the customer relationship must be caused by its activities, whereby co-causality is sufficient. Whether merely keeping a shop open in a favourable location is sufficient can be doubted. The existence of regular customer relationships normally has something to do with the quality of the service by the individual franchisee. 

The franchisor must have considerable advantages after the end of the contract as a result of business relationships newly acquired or significantly expanded by the franchisee; this is determined at the end of the contract by way of a prognosis for future development of the business relationships. This depends on the prognosis for the business chances which exist at the end of the contract and not on the turnover actually generated later. A considerable advantage for the franchisor is, however, excluded or reduced if it closes a business itself in whole or in part or no longer maintains any franchise businesses in a country or area in which the franchisee was active. Future business advantages are also excluded if the franchisee continues the business alone or in the framework of another franchise system and the customers remain loyal to it or also if, at the end of the contract, it has been ascertained that certain long-standing customers have broken off the business relationships and have gone out of business. 

The prognosis for the future business development is based on the actual turnover generated in the last 12 months before the end of the contract and is established for a “foreseeable period”. This depends on the individual sector and the purchasing habits there. A period of two to five years is the rule, possibly longer periods in the case of long-term economic goods. Here the respective ‘churn rate’ of the customers will need to be taken into account, which should be actually ascertained in the individual case. The churn rate at the franchisor should be valued in a similar way to that at the franchisee (see below). 

In a dispute between the franchisor and the franchisee, each party must set out and prove the facts which it brings forward in its own favour or to the detriment of the other party. The franchisee must therefore state and prove its turnover for the last 12 months and the extent to which it is based on newly acquired or expanded business relationships with regular customers. However, case law grants it a certain relief with respect to the burden of proof, eg, for the likelihood of the continuation of customer relationships of the franchisor with regular customers acquired by it. 

A further precondition for an indemnity claim of the franchisee is that it suffers losses as a result of the end of the contract – as a counterweight to the advantages of the franchisor – within the meaning of section 89(b)(1), sentence 1, No. 2 of the German Commercial Code. The statutory provision is based on the ‘commission losses’ of the commercial agent which are relatively easy to ascertain since the commission is usually set out in the contract as percentage of the turnover. The franchisee, like the dealer, does not generate commission paid out to it by the principal but margins between its purchase prices and other costs and the sales prices set by itself. However, only those losses can be subject to indemnity which the franchisee incurs by way of loss of the remuneration components that correspond to the remuneration for the activity of a commercial agent. 

Legal literature and case law include complex considerations as to how losses of remuneration similar to those of a commercial agent are to be ascertained. This is made even more complicated by the fact that in many franchise systems not only goods are handled but goods are purchased from third-party suppliers, products are self-manufactured or processed and to a large extent services are provided for which the goods (of the franchisor or a third party) only have an insignificant value. 

The loss corresponding to a commercial agent’s remuneration must therefore be ascertained for each individual case and for each individual type of franchise. In the case of pure goods sales this is simple, since by comparison the usual commercial agent commission to similar products can be applied. In other cases all the remuneration components that are not ‘typical of commercial agents’ but ‘typical of franchisees’ will have to be excluded from the gross profit of a franchisee which is being ascertained. All remuneration components generated for the manufacturing of goods or services or other activities which are not typical of the salesman’s activity of the commercial agent must be eliminated since, subject to application of section 89(b) by analogy, a franchisee (like a commercial agent) may not achieve better indemnity than a commercial agent. It would go beyond the scope of this article to set out the individual possible calculation elements. At the end of the day and in practice the quota is always one which corresponds to the usual commercial agent commission in comparable sectors. This may be around 5 to 10 per cent, rarely more. 

A forecast must also be drawn up for the ‘losses’ of the franchisee suffered by the end of the contract; it is based on the turnover it has achieved in the last 12 months. Here, in turn, only the turnover generated with regular customers or potential repeat customers must be taken into account and, in individual cases, respective determinable churn rates. Where these cannot be precisely determined in the respective case, a churn rate of 20 to 25 per cent per year is normally applied. As already set out above, the franchisee must also demonstrate and prove its ‘losses’, whereby it again enjoys relief from the burden of proof. If it plausibly sets out the losses incurred to it, it is up to the franchisor to set out and prove that higher deductions are reasonable. 

The indemnity claim asserted by the franchisee must correspond to the ‘equitableness’ pursuant to section 89(b)(1), sentence 1, No. 3 of the German Commercial Code. The equitableness yardstick is a further precondition for a claim. 

When reviewing this, all circumstances must be taken into account which refer to the contractual relationship. Equitableness can lead to a reduction of the calculated claim or an increase, but the latter is unusual. Overall considerations of equitableness do not play a large part in practice, except with respect to the ‘attraction of the mark’. For a long time, the Federal Court of Justice has been considering, in its case law on distribution agreements, the extent to which the ‘attraction of the mark’ has contributed towards their business success, which is of particular importance in automobile trading. This point will also have to be taken into account when reviewing the equitableness of a claim with respect to the application of section 89(b) by analogy to franchise agreements. An argument against this would be that from the beginning of the agreement, and then during the whole term of the agreement, the franchisee has paid fees to be granted rights in the system, the know-how and the mark and that it is therefore not reasonable to make it pay again at the end of the contract in the form of a deduction. This must apply all the more the higher the fees are, in light of the reputation and level of recognition of the mark and system. It is impossible to say whether this argument will one day convince the Federal Court of Justice. The decisions of the Frankfurt Regional Court and the Hanau Regional Court quoted above varied considerably in their views hereon. The Frankfurt Regional Court considered a considerable deduction (of 25 per cent) reasonable, the Hanau Regional Court did not consider a large deduction for the attraction of the mark justifiable since the franchisee had paid a considerable entry fee. It will therefore have to be assumed for the time being that only marks which are already well-known in the respective area of activity of the franchisee can appeal to effects of an “attraction of the mark”. 

It is conceivable that in the framework of the review of equitableness the protection which a franchisee may need or not need could have a role to play which can then, where appropriate, lead to an increase or to a reduction of the claim. However, great signifi- cance need not be attributed to this element. With respect to the burden of proof it is the case here, in turn, that the party which appeals to considerations of equitableness in its favour must prove the facts on which these are based. 

A franchisee is not entitled to an indemnity claim in every case of contractual termination even if the analogous preconditions are fulfilled. The grounds for exclusion set out in section 89(b)(3) of the German Commercial Code also apply here, of course, by analogy. 

The franchisee loses a claim to indemnity if it terminates the contract unless the franchisor’s conduct gave justifiable cause herefor (section 89(b)(3) No. 2 of the German Commercial Code). The franchisee equally loses its claim to indemnity if the franchisor has terminated the franchise agreement for good cause owing to culpable conduct of the franchisee (section 89(b)(3) No. 2 of the German Commercial Code). Since termination without notice for good cause is often seen by an entrepreneur as a chance to get rid of its commercial agents, dealers or now also franchisees without having to pay indemnity, such an attempt is, of course, often undertaken. However, it must be emphasised that this is not easy. In particular, it is often not suffi- cient to simply refer to one of the numerous so-called ‘good causes’ in franchise agreements. Courts thoroughly review their worth and in particular the culpable conduct of the franchisee, which is always a requirement. With respect to section 314 which has now been included in the German Civil Code (Bürgerliches Gesetzbuch) termination without notice must normally be preceded by an official warning which gives the franchisee an opportunity to change the misconduct of which it is being accused. 

A rather impractical further exclusion is contained in section 89(b)(3) No. 3 of the German Commercial Code. Pursuant hereto, a franchisee loses its indemnity claim if a third party enters in its place into the contractual relationship after the end of the contract owing to an agreement between it and the franchisor. After the end of the contract there is no longer a contractual relationship into which a third party could enter by way of an agreement. Such agreements are therefore really conceivable only if they are concluded at the same time as a dissolution of the contract, which is permissible under the case law of the Federal Court of Justice. 

Pursuant to section 89(b)(2) of the German Commercial Code, a commercial agent’s indemnity claim, irrespective of the results of the calculation methods outlined above, is restricted to the average of the annual commissions during the last five years (or, where appropriate, the shorter contractual period). The same ‘cap’ must naturally also apply to franchisees by analogy; however, a difficulty exists here, since there is no average commission which can be easily calculated. The remuneration taken as a yardstick must therefore be calculated in accordance with the above rules for five years, so that a mathematical cap can be ascertained. In light of the practical difficulties it ought to be self-evident that claims of a franchisee arising from section 89(b) will rarely be fought out in court.

For the assertion of an indemnity claim there is a deadline of one year from the end of the contract, under section 89(b)(4), sentence 2. However, an informal assertion is sufficient, and the amount has not to be stated. The limitation period for assertion of the claim in court is four years pursuant to section 88 of the German Commercial Code whereby the period begins to run at the end of the calendar year in which the claim becomes due. 

The final question is whether or to what extent the application of section 89(b) by analogy to franchise agreements is mandatory. Pursuant to section 89(b)(4), sentence 1 of the German Commercial Code, the indemnity claim for commercial agents may “not be excluded in advance”. 

For distribution agreements the Federal Court of Justice decided in a decision of 06 February 1985 that prior exclusion of the indemnity claim is always ruled out also for such contracts if the other preconditions for application by analogy of section 89(b)(1) of the German Commercial Code are fulfilled. It is not implausible to assume that the Federal Court of Justice, when it will finally have to decide on the application by analogy of section 89(b) to franchise agreements, will also come to the conclusion here, as in the case of distributor agreements, that the compensation claim may not be excluded in advance. However, by all legal means, even constitutional arguments are conceivable as to why an exceptional provision like that of section 89(b) is not mandatory and in particular not fully applicable to a commercial partnership that has not been considered particularly worthy of protection by the legislator. In particular, there must be a differentiation between a full “exclusion” and contractual restrictions, eg, practical and reasonable calculation measures that could at the end of the day represent certain restrictions. It is therefore too early to make a conclusive statement on this issue. 

A different question is whether the application of section 89(b) is also mandatory if the franchisee works in Germany but the franchisor has its domicile in another country (possibly not in the EU), which recognises neither by statute or by case law a (mandatory) indemnity claim for franchisees, and if the franchise agreement is subject to the laws of the franchisor’s country. Pursuant to a judgment of the European Court of Justice of 9 November 2000, the commercial agent indemnity or compensation claim pursuant to the respective national law which has implemented the Commercial Agents Directive No. 86/63 of 1986, is always mandatory for a commercial agent active in a member state even if the agreement is subject to a non-European jurisdiction that does not recognise this sort of protection of the commercial agent. Does this mean that application by analogy to franchisees is mandatory? It is not possible to appeal to the case law of the European Court of Justice with respect to franchise agreements since this judgment only applies to national laws which are based on the EC Commercial Agents Directive. National franchise law, however, is not based on the Commercial Agents Directive and this cannot be used as a mandatory interpretation standard for legal areas for which it was not intended. It is therefore justified to argue that an indemnity claim for franchisees is not mandatory if the franchise agreement is subject to the laws of a country that does not recognise this sort of mandatory legal concept. This must be all the more so for service franchise agreements since the Commercial Agents Directive only applies to goods agents. It cannot therefore be used as a mandatory standard for distribution relationships which do not include goods distribution. Until further notice it is therefore possible to recommend to all non-German franchisors not to subject cross-border franchise agreements with German franchise partners, to the extent that this is justifiable, to German law. In this way they keep at least a chance of not having to pay an indemnity at the end of a franchise agreement.

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