The Duty of Good Faith in Franchise Agreements in European Civil Law

The German Approach

In Germany, the concept of good faith is extremely sophisticated and far reaching. It has “been used as a convenient legislative peg on which to place a whole raft of developments by German courts to deal with perceived problems either technical or social '. It remains a 'general principle' of German contract law ' but its effects have been worked out and elaborately classified into particular categories (known as Fallgrupen).” Whittaker, The Draft Common Frame of Reference: An Assessment, Commissioned by the Ministry of Justice, Appendix II, p. 138 (available at ). Each category takes a markedly different approach. In order to understand how these various interpretations of the duty of good faith work together, one commentator has broken them down into three different approaches: 1) collateral; 2) restrictive; and 3) adaptive. Kroppholler, Studienkommentar BGB, 10th Edition 2007, '242 Rn. 1. This categorization is subjective. More often than not, a particular provision contains elements of two or three different approaches. A black and white categorization is usually not possible.

Most jurisdictions follow the “restrictive approach” to a certain extent, whereas the “collateral approach” is primarily confined to pre-contractual disclosure and most heavily used in countries that have a long-standing tradition of protecting the weaker party.

An “adaptive approach” is the least common and tends to be used in the circumstances in which the English law concept of frustration of contract would be applied. There is an important distinction between “Treu und Glauben” (objective good faith) and “gutter Glaube” (subjective good faith), which has to do with knowledge. Treu und Glauben has become an “open” norm and although it is not a legal rule with specific requirements it takes shape in the way it is applied.

The Collateral Approach

Article 311 BGB (German Civil Code) takes a collateral approach. It imposes totally new obligations on the parties to the agreement and in doing so can reduce the risks to which both the franchisor and franchisee are exposed. In Germany, the franchisor has certain continuing implied obligations, which include advising, instructing and supervising the franchisee. The franchisor also has a fiduciary duty to refrain from interfering in the franchisee's business, especially if the franchisor is active himself in the same market area. Thus, encroachment and the adequacy of support are dealt with.

The franchisee's main duty of good faith and fair dealing is to pay the royalty and other fees to the franchisor. In return, it receives access to the franchisor's know-how, trademarks, equipment and so forth. Usually, the franchisee will be obliged to purchase certain kinds of products from the franchisor. Even without a non-compete clause, the business secrets of the franchisor will be protected by the franchisee's fiduciary duties to the franchisor. Accordingly, the risks to which the franchisor is exposed are reduced.

The Restrictive Approach

The duty of Treu und Glauben takes a restrictive approach to the concept of good faith. It requires that a franchisor is bound to perform its obligations according to the requirements of good faith, ordinary usage being taken into consideration. It seeks to restrict the ability of parties to the agreement to exercise their agreed contractual rights in an unreasonable manner.

This means that the franchisor must exercise its discretion reasonably in order for it to be considered valid by the German courts. It can be a substantial fetter on the ability of the franchisor to act in the best interests of the franchise network as a whole rather than an individual franchisee. What may seem to be reasonable in the context of a bilateral relationship between the franchisor and a particular franchisee may be totally unreasonable in the context of a multilateral relationship between the franchisor and all of its franchisees. Article 138 BGB provides that a legal transaction that offends good morals (contra bonas mores) is void. It seeks to adjust the terms agreed by the parties to the agreement to new and unforeseen circumstances that arise; so if the franchisor exploits the predicament, inexperience, lack of judgment or considerable (economic) weakness of the franchisee or gains a financial benefit that is clearly disproportionate to its performance, the agreement will be void. Agreements that breach the duty of Treu und Glauben in Article 242 of the German Civil Code are therefore void under Article 138. This is clearly far from the English concept of caveat emptor (“let the buyer beware”), and the freedom of the parties to negotiate the contractual terms of their relationship is thus limited.

The German courts have ruled that the following did not comply with the principle of good faith and fair dealing: lack of consideration; if the franchisor's obligations are merely discretionary; if the franchise system is based on pyramid selling or multilevel marketing systems; if the franchisee is obliged to buy overpriced goods or an excessive amount of them; or provisions providing the franchisor's access to the franchisee's accounts twice a month (on the basis that this unduly restricts the franchisee's entrepreneurial freedom).

The Adaptive Approach

The prime example of the adaptive approach is Section 313 BGB, which stipulates that if circumstances upon which a contract was based change substantially after the conclusion of the contract, and if the parties would not have concluded the contract or would have done so on different terms if they had foreseen the change, adaptation of the contract can be claimed if a party cannot reasonably be expected to continue to be bound by the contract in its unaltered form. German courts will only make very limited use of the adaptive powers under this provision, in situations in which the English courts might apply the concept of “frustration of purpose.” It is used to save a contractual relationship rather than to invoke termination from the beginning.

Conclusion

The German concept of good faith has a substantial impact upon the franchisor/franchisee relationship and, as is evident from the above, reduces the risks to which both franchisor and franchisee are exposed and re-enforces the economic drivers that attract franchisees to franchising and reduce the consequential risks. In the second part of this article, we will discuss the French approach to good faith, as it applies to franchising agreements.

Dr. Mark Abell, a member of our Board of Editors, is a partner at Bird & Bird LLP, London.

The duty of good faith seeks to deliver a degree of equilibrium to the inherent tension within the franchise relationship between the desire of both parties to obtain the best commercial deal for themselves and a need to have a good ongoing commercial relationship based upon a modicum of mutual trust. It is currently a topic of considerable interest in the United States as a number of states consider enacting legislation imposing a duty of good faith. This is the first in a series of three articles that consider how the concept of good faith impacts upon franchising. This first is a two-part article that considers how it impacts franchising in the civil law jurisdictions of the European Union. The second will consider the current U.S. position. The third article will compare and contrast the U.S. and European approaches to good faith and seek to identify lessons for U.S. legislators to consider if they seek to legislate for a duty of good faith.

The European Approach

There are generally considered to be two main “families” of civil law in Europe ' German and French (both civil law jurisdictions). Each takes a different approach to the concept of good faith, and so both laws can be usefully considered in this regard.

The German Approach

In Germany, the concept of good faith is extremely sophisticated and far reaching. It has “been used as a convenient legislative peg on which to place a whole raft of developments by German courts to deal with perceived problems either technical or social '. It remains a 'general principle' of German contract law ' but its effects have been worked out and elaborately classified into particular categories (known as Fallgrupen).” Whittaker, The Draft Common Frame of Reference: An Assessment, Commissioned by the Ministry of Justice, Appendix II, p. 138 (available at ). Each category takes a markedly different approach. In order to understand how these various interpretations of the duty of good faith work together, one commentator has broken them down into three different approaches: 1) collateral; 2) restrictive; and 3) adaptive. Kroppholler, Studienkommentar BGB, 10th Edition 2007, '242 Rn. 1. This categorization is subjective. More often than not, a particular provision contains elements of two or three different approaches. A black and white categorization is usually not possible.

Most jurisdictions follow the “restrictive approach” to a certain extent, whereas the “collateral approach” is primarily confined to pre-contractual disclosure and most heavily used in countries that have a long-standing tradition of protecting the weaker party.

An “adaptive approach” is the least common and tends to be used in the circumstances in which the English law concept of frustration of contract would be applied. There is an important distinction between “Treu und Glauben” (objective good faith) and “gutter Glaube” (subjective good faith), which has to do with knowledge. Treu und Glauben has become an “open” norm and although it is not a legal rule with specific requirements it takes shape in the way it is applied.

The Collateral Approach

Article 311 BGB (German Civil Code) takes a collateral approach. It imposes totally new obligations on the parties to the agreement and in doing so can reduce the risks to which both the franchisor and franchisee are exposed. In Germany, the franchisor has certain continuing implied obligations, which include advising, instructing and supervising the franchisee. The franchisor also has a fiduciary duty to refrain from interfering in the franchisee's business, especially if the franchisor is active himself in the same market area. Thus, encroachment and the adequacy of support are dealt with.

The franchisee's main duty of good faith and fair dealing is to pay the royalty and other fees to the franchisor. In return, it receives access to the franchisor's know-how, trademarks, equipment and so forth. Usually, the franchisee will be obliged to purchase certain kinds of products from the franchisor. Even without a non-compete clause, the business secrets of the franchisor will be protected by the franchisee's fiduciary duties to the franchisor. Accordingly, the risks to which the franchisor is exposed are reduced.

The Restrictive Approach

The duty of Treu und Glauben takes a restrictive approach to the concept of good faith. It requires that a franchisor is bound to perform its obligations according to the requirements of good faith, ordinary usage being taken into consideration. It seeks to restrict the ability of parties to the agreement to exercise their agreed contractual rights in an unreasonable manner.

This means that the franchisor must exercise its discretion reasonably in order for it to be considered valid by the German courts. It can be a substantial fetter on the ability of the franchisor to act in the best interests of the franchise network as a whole rather than an individual franchisee. What may seem to be reasonable in the context of a bilateral relationship between the franchisor and a particular franchisee may be totally unreasonable in the context of a multilateral relationship between the franchisor and all of its franchisees. Article 138 BGB provides that a legal transaction that offends good morals (contra bonas mores) is void. It seeks to adjust the terms agreed by the parties to the agreement to new and unforeseen circumstances that arise; so if the franchisor exploits the predicament, inexperience, lack of judgment or considerable (economic) weakness of the franchisee or gains a financial benefit that is clearly disproportionate to its performance, the agreement will be void. Agreements that breach the duty of Treu und Glauben in Article 242 of the German Civil Code are therefore void under Article 138. This is clearly far from the English concept of caveat emptor (“let the buyer beware”), and the freedom of the parties to negotiate the contractual terms of their relationship is thus limited.

The German courts have ruled that the following did not comply with the principle of good faith and fair dealing: lack of consideration; if the franchisor's obligations are merely discretionary; if the franchise system is based on pyramid selling or multilevel marketing systems; if the franchisee is obliged to buy overpriced goods or an excessive amount of them; or provisions providing the franchisor's access to the franchisee's accounts twice a month (on the basis that this unduly restricts the franchisee's entrepreneurial freedom).

The Adaptive Approach

The prime example of the adaptive approach is Section 313 BGB, which stipulates that if circumstances upon which a contract was based change substantially after the conclusion of the contract, and if the parties would not have concluded the contract or would have done so on different terms if they had foreseen the change, adaptation of the contract can be claimed if a party cannot reasonably be expected to continue to be bound by the contract in its unaltered form. German courts will only make very limited use of the adaptive powers under this provision, in situations in which the English courts might apply the concept of “frustration of purpose.” It is used to save a contractual relationship rather than to invoke termination from the beginning.

Conclusion

The German concept of good faith has a substantial impact upon the franchisor/franchisee relationship and, as is evident from the above, reduces the risks to which both franchisor and franchisee are exposed and re-enforces the economic drivers that attract franchisees to franchising and reduce the consequential risks. In the second part of this article, we will discuss the French approach to good faith, as it applies to franchising agreements.

Dr. Mark Abell, a member of our Board of Editors, is a partner at Bird & Bird LLP, London.