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FRANCE: Comments on the ruling issued by the Paris Commercial Court against SUBWAY cancelling clauses of the franchise agreement on the ground of significant imbalance.

The case law encompasses all the ingredients of a reflection that the Franchisors and their Counsels usually have when drafting a Franchise contract.

Olivier BINDER - 16.09.21
Country expert

Executive summary

The case law encompasses all the ingredients of a reflection that the Franchisors and their Counsels usually have when drafting a Franchise contract.

The court was severe with regard to SUBWAY, by broadening the scope of Article L. 442-6-I-2 of the French Commercial Code and by adopting often audacious solutions unfavorable to SUBWAY, the franchisor.

The decision of 48 pages is not without criticism and the lessons that can be learned from it have to be qualified, as the defendants (Subway) have already filed an appeal early January 2021. The case is currently pending before the Court of Appel of Paris.

It is nevertheless of particular interest since its substantial rationale guides operators in the drafting of their contracts and, more broadly, in the building of their networks.

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The French and Dutch companies representing the American fast food restaurant company SUBWAY were sued in the Commercial Court of Paris on the basis of (former) Article L. 442-6-I-2 of the French Commercial Code, which prohibits "subjecting or attempting to subject a commercial partner to obligations creating a significant imbalance in the rights and obligations of the parties."

By judgment dated 13 October 2020, the Commercial Court held that several clauses of the Subway franchise agreement on the ground of significant imbalance (former Article L. 442-6-I-2 of the French Commercial Code) were and have been cancelled in whole or in part.

 

Comments on the ruling issued by the Paris Commercial Court against SUBWAY

1. Analysis of the decision issued by the commercial Court of Paris

Within the frame of the proceedings introduced against Subway by several franchisees, the Commercial Court examined (1) the concept of a commercial partner, the main element of the significant imbalance, then (2) analyzed each claim of invalidity relating to eleven clauses of the Subway franchise contract.

1.1 The broadening of the concept of commercial partner

SUBWAY operates its French franchise network through various companies, but only Dutch company SIBV, which enters into contracts directly with French franchisees, and French company SROF, which provides "assistance with the operation and management of the franchise system in France," were sued.

Article L. 442-6-I-2 of the French Commercial Code provides that the significant imbalance can only exist within the context of a commercial partnership.

SUBWAY claimed that the claims against SROF were inadmissible, with SROF having no connection with the franchisees.

SUBWAY noted that the definition traditionally adopted by the Court of Cassation was that a commercial partnership means a "commercial transaction[ ] entered into directly between the parties" and argued that SROF had no contractual or commercial relationship with the franchisees.

The Court rejected the franchisor's argument by referring to its January 21, 2020, decision, according to which:

the economic partnership extends to companies which, without having directly entered into or participated in the contract with the partner - in this case, the franchisee - have personally taken part in restrictive practices, contributed to the damages caused by their partner as a result of these practices by providing the means and ensuring the implementation of the contract that includes clauses that clearly result in an imbalance of power.

As a result, the Court found that SROF was a commercial partner of the franchisees and held the claims against it admissible.

The Court's broadening of the scope of application of Article L. 442-6-I-2 of the French Commercial Code according to the legal persons concerned in the context of a breakup of the franchisor into several companies, calls for several observations:

- The Court's interpretation should be seen in the context of a jurisprudential and legislative trend:

The French High Court (Court of Cassation) recently overturned an appellate decision which had adopted an overly restrictive definition of the commercial partnership and held that "the commercial partner is the party with which the other party enters into or intends to enter into a commercial relationship,"[1] thus aligning itself with new Article L. 442-1 of the French Commercial Code,[2] which merely refers to "the other party."

- The lower court went beyond the French High Court (Court of Cassation)'s position and the new provisions of the French Commercial Code by qualifying SROF as a commercial partner. In fact, since there was no contract between SROF and the franchisees, the lower court could not have understood its actions by abiding with the High Court's assessment.

One would then be tempted to think that the lower court needs not demonstrate a contractual link to find a commercial partnership and that it is now sufficient to simply establish the operator's personal participation in the disputed commercial practices.

However, it is clear from a careful reading of the decision that if a direct contractual relationship is not required, the lower court did not do away with the indirect contractual relationship.

Indeed, in addition to personal participation in commercial practices, the lower court bases its definition on SROF's legal involvement in the franchise network, noting that it is contractually linked to SIBV (the franchisor), making it a "commercial partner of Subway." Yet SIBV contracts directly with the franchisees, thereby maintaining a commercial partnership with the franchisees according to the French High Court (Court of Cassation) and new Article L. 442-1 of the French Commercial Code. Therefore, the three parties are contractually linked, even if indirectly.

A similar rationale had already been applied in the Amazon case, where the lower court held that at a group company (AFS) had participated in the practices, contributed to the injury and that, "while AFS [was] not a party to the contract between the sellers and ASE, it [had] nevertheless entered into an agreement with ASE to provide part of the services relating to these contracts."[3]

If the lower court appears to be concerned with the existence of a contractual relationship between the franchisor's companies when defining the commercial partnership, it is difficult to determine whether it makes it an essential condition. One can then wonder if, absent a contract between SROF and SIBV, the commercial partnership between SROF and the franchisees could have been found.

This desire to broaden the scope of the legal system is found throughout the decision, particularly in the assessment of the subjection or attempted subjection to the franchise contract.

1.2 The analysis of the imbalance in the clauses

The lower court heard claims of invalidity relating to eleven clauses of the Subway franchise agreement.

The lower court stated that it would confine itself to assessing only whether "the clauses constituted an imbalance of power," without considering their effects. This particularly restrictive interpretation of the imbalance was often prejudicially applied by the court with respect to the franchisor.

The court also opined on the possible rebalancing of the powers and justifications for the imbalance of powers in the contract clauses; here again, the court seemed rather hostile to the franchisor's arguments.

First, the court stated that it would need to consider the need to redevelop the know-how and maintain the identity of the network, both inherent to the franchise and likely to justify certain imbalanced clauses.

However, this position, in accordance with the French High Court (Cour de Cassation)'s case law in cases involving anticompetitive practices[4], was immediately qualified by the court, which noted that “Subway, far from contradicting the imbalance of the contract, confirms it by believing that it can protect the franchise industry as a whole from the consequences, if any, of being subjected to the contract." One then understands that the argument will not easily find favor with the court.

Second, while the court appeared to support the rebalancing of the contract by through offsetting in favor of the franchisee, it considered that this rebalancing could "result, in whole or in part, from the sole advantage that the franchisee finds in the consistency of the strategy and the homogeneity of the network, a guarantee of the success of its own financial and human investment" - provided that SUBWAY demonstrated as much.

However, none of the arguments the franchisor submitted were convincing to the court.

The court outlined the significant imbalance:

A clause will be found imbalanced where (i) it favors the franchisor; (ii) it does not provide the franchisee with any consideration, either arising from another clause or implied by its necessity, for the consistency and homogeneity of the network, a guarantee of the success of its own investment; and (iii) it is not offset by an overall rebalancing of the contract.”

1.2.1 The clauses held to be balanced

1.2.1.1 Clauses relating to entry fees and training (Clauses 1 and 5)

Clause 1 of the franchise agreement provided for the payment by the franchisee to the franchisor of an entry fee of €10,000 on signing and before the opening of the point of sale.

Clauses 1 and 5 of the contract specified that this entry fee would not be refunded in several cases specifically referred to in the contract:

- Failure to complete the required training and end-of-training examination; and

- Failure to open the restaurant within two years of signing, the location of which was subject to the franchisor's approval.

Moreover, the reasons for dismissing the candidate franchisee from the training phase were contractually defined and limited in scope: absence from training sessions; inability to respect or assimilate the basic concepts necessary for the operation of the restaurant; non-compliance with the Subway Code of Conduct; sexual harassment; vandalism; theft; alcohol abuse.

The court noted that the grounds for dismissing the candidate franchisee from the training phase listed in the contract are reasonable and this reasonableness is sufficient to disregard the imbalance in the clauses relating to the payment of the entry fee and training.

The court attaches importance to the precise definition of the contract terms, which should be a major issue for franchisors.

1.2.1.2 Clauses relating to the weekly payment of fees, the management of the point of sale and late payment penalties and interest, the advertising royalty (Clauses 2, 5 and 11)

The Subway franchise agreement provided for the weekly payment of two royalties: an 8% royalty based on gross turnover and a 4.5% advertising royalty based on gross turnover.

Late payment penalties accrued as of the first day of the late payment and on any amount due by the franchisee (e.g. "royalties, advertising royalties, miscellaneous invoices, equipment rental or loan program").

In addition, the franchise agreement allowed SUBWAY to review all of the franchisee's accounting documents "at any time" and "without notice" as well as the franchisee's suppliers with respect to purchases.

There was criticism that the combined reading of all of these clauses (weekly payment period, mandatory penalties for delayed payment and access by the franchisor to the franchisees' accounting documents) would result in excessive interference by the franchisor and an imbalance in the parties' obligations. The franchisees also considered that there was no consideration for the advertising royalty.

The court rejected the complaints after a concrete review, and held that:

- The weekly royalty payment is a "management support" rather than a constraint;

- Late payment penalties are legally provided for;

→ "payment terms imposed by Subway can be considered an appropriate warning of a lack of cash flow resulting from a negative operating profitability, which, again, is a support, admittedly disagreeable, but certainly useful for the management of the franchisee"

- Consultation of the franchisees' accounting documents is necessary when the franchisee's default or breach is harmful to the image of the network.

- There is no evidence of the absence of consideration for the advertising royalty.

The court considered that "the apparent imbalance of these clauses is consubstantial with the franchise, since the consideration for the clauses are in the very essence of the franchise." In so considering, the court seems to acknowledge the specificities of the franchise agreement.

1.2.1.3 Liability and recitals (para. I and clauses 5.1, 11(c) and 20)

Among the contentious clauses is the main disputed clause of the recital, which provides:

"You (the franchisee) represent that you are aware of the risks associated with the operation of a SUBWAY restaurant and are able to accept these risks. You understand that the success of the restaurant will depend mainly on the location you choose, your efforts and abilities and those of your employees. The fact we approve the Restaurant's location does not guarantee the Restaurant's success at this location and the Restaurant may lose money or fail … You acknowledge that some SUBWAY restaurants have failed and that others will fail in the future.”

The criticism was that, at the end of the recitals, the franchisee bore all risks and the franchisor bore no liability for the viability of the SUBWAY restaurant/reliability of the franchisee's project.

Rather, the court found that the recitals "were a general notice of non-liability which did not place any undertaking on the part of the franchisee and could not therefore be qualified as an imbalance."

The court therefore ruled that the recitals had no binding force since they were a unilateral representation which has no legal significance "other than to specify the intention of the party making the representation."

The court found that by accepting the recitals, "the franchisee acknowledged that it was an independent contractor fully responsible for its choice within the context imposed by Subway“.

1.2.1.4 Clauses relating to the language applicable to the contract

The SUBWAY franchise agreement was drafted in the English language, translated into French, but in the event of inconsistency, the English language version takes precedence.

The argument was that the drafting of the contract in the English language was such as "to make it difficult for the franchisee to defend its rights."

However, the court considered that the fact only the English version of the agreement took precedence was not sufficient to establish a significant imbalance since "the franchisee could raise a claim of wilful misconduct or bad faith if the translation was intentionally altered or there was negligence."

1.2.2 The clauses found to be imbalanced

1.2.2.1 Insurance clause (Clause 5(c))

The insurance clause in the SUBWAY franchise agreement provided that the franchisee had to purchase insurance with a minimum coverage amount of €1,700,000 and a minimum company car coverage amount of €850,000.

In the event of breach of these provisions, the franchisee was required to reimburse the franchisor the "reasonable costs" incurred in enforcing this clause, including "arbitration costs, legal fees, preparation time, evidence gathering (witness statements) and travel expenses."

The criticism was that this clause was not adapted to the specificities of the franchisee's business.

On the contrary, the court held that "the proposed insurance terms are, taken as a whole, economically sound and even favorable to the franchisee," with the exception of the reimbursement of reasonable costs.

Indeed, the court held invalid the provision that required the reimbursement of costs to the franchisor since "the lack of a cap on the costs incurred by the franchisor was arbitrary."

An obligation is arbitrary if its performance depends solely on the intention of one party.

This solution calls for a practical observation when it comes to drafting franchise agreements: the use of specific terms.

1.2.2.2 Clauses relating to the termination and expiration of the contract (Clause 8)

Clause 8(a) of the agreement allowed the franchisor to automatically terminate the contract in the event of serious breach by the franchisee, and exhaustively lists the breaches: non-payment of royalties; non-payment of all amounts to affiliates - advertising fund - owner of the premises; abandonment of the restaurant; eviction from premises; non-compliance with tax regulations; relocation of the restaurant to an unauthorized location; serious harm to the brand image. The termination would occur within 10 days if the franchisee failed to remedy the breach.

Clause 8(b) provided that, for other breaches, the franchisee would be given 90 days' notice and 60 days to remedy.

Clause 8(c) provided that "after a second notice of breach sent in accordance with Clauses 8(a) and (b), any breach within the next twelve months shall constitute just cause for the termination of the contract" and there would be no option to remedy.

Finally, Clauses 8(d) and (e) provided that on termination of the contract, the franchisee had a reasonable period of time to remove signs, modify the appearance of the restaurant, cancel all permits, licenses and registrations, under penalty for failure of €175 per day.

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The court held that the cumulative effect of Clauses 8(a) and 8(c) was an imbalance of powers since it allowed the franchisor to terminate the contract "following two late payments or two non-payments over the course of one year, even if these amounts were negligible or there were exceptional circumstances, including circumstances that were beyond the control of the franchisee."

The court also found reprehensible the imbalance of powers resulting from the reasons for rescission: "you become insolvent", which the court found too vague. This solution confirms the requirement of the court to be explicit when drafting a franchise agreement.

Similarly, the court found that this penalty clause was imbalanced since performance in full of the franchisee's obligations is, in practice, difficult and that the reasonable period is arbitrary.

Under French law, the penalty clause is a contractual provision providing for applicable penalties when one of the parties fails to perform its obligations towards one or more other parties.

The French court may increase the amount of the penalty clause if it is clearly inadequate or decrease it if clearly excessive.

This decision is problematic since the clause requiring the franchisee to modify the appearance of the restaurant and remove any signs is inherent to the franchise.

1.2.2.3 Clauses relating to the absence of territorial exclusivity and the franchisor's unlimited right to compete (Clause 11.I)

The SUBWAY franchise agreement provided for the unlimited right of the franchisor to compete with the franchisee:

We have the unlimited right with our Affiliates to compete with you and grant licenses to others who may compete with you ... [Y]ou understand and acknowledge that these other stores or distribution methods may compete with the Restaurant and have a negative impact on your turnover.

The criticism was that it promoted the establishment of other franchisees in the same catchment area without consideration for the existing franchisee. This clause constituted a highly imbalanced obligation since the development agents were encouraged to behave in a "predatory manner."

The franchisor indicated that its intention was not to act as a predator of its own network but simply to indicate the absence of territorial exclusivity in awkwardly translated terms.

First, the court noted that:

- SUBWAY's objective is the optimal development of the network and "therefore the development of its reputation and the increase in franchisees' turnover.”

- These competition clauses are "consubstantial, at least consistent with the nature of the franchise network," allow "control of the network of the territory and its development," which ultimately benefits franchisees by allowing them to increase their turnover.

But the court went on to find invalid the non-exclusivity and unlimited competition clauses based on the fact SUBWAY failed to grant the franchisees a right of preemption over new locations available. "SUBWAY could cannibalize two locations, to the detriment of the franchisee, because the second best market location became available at a later stage.

1.2.2.4 Duration clause (Clause 7)

The SUBWAY franchise agreement provided that the contract was entered into for a 20-year period from its signing and automatically renewed for additional 20-year periods.

The contract also provided for an exclusive supply obligation.

The criticism was that the duration was inconsistent with Article L. 330-1 of the French Commercial Code since the exclusive supply obligation had to be limited to 10 years.

SUBWAY argued that a longer term was favorable to the franchisee in that it provided it with "sufficient time to finance its investment and benefit from the return on that investment."

Based on Article 101(1) TFEU, the court admitted that the non-compete clause in a franchise agreement may be for an indefinite period or may last longer than five years provided it did not exceed the duration of the franchise agreement.

Nevertheless, the court ruled on the basis of Article L 330-1 of the French Commercial Code, after implicitly determining that the market share was less than 15% (agreement of minor importance).

Consequently, based on Article L.330-1 of the French Commercial Code, the court found that the duration of exclusivity in a franchise agreement must not exceed 10 years:

"Accordingly, once the franchise agreement provides for exclusivity, it must expire on the same date the contract expires. Since the exclusivity period cannot exceed 10 years, the duration of the franchise agreement cannot exceed ten years, which is violated by the 20-year duration of the Subway franchise agreement.”

In addition, the court stated that the 20-year duration of a franchise agreement is significantly greater than that of retail distribution contracts, based in particular on a duration "ranging from seven to ten years."

In fact, to demonstrate the invalidity of the clause, the court first considers that the combination of the contracts imposes an exclusive supply commitment for a period equal to that of the franchise agreement, which is 20 years. Which, in both European and French law, is illegal and which is why the court successively raises Article 101(1) TFEU and Article L. 330-1 of the French Commercial Code to find that the duration of the exclusivity may not exceed 10 years.

The duration clause was therefore held invalid because it was imbalanced.

1.2.2.5 Clause relating to applicable law and arbitration clause

Clause 10 of the SUBWAY franchise agreement provided that "any and all disputes arising from or in connection with this Agreement shall be submitted exclusively to arbitration ... If either party requests oral proceedings, the parties agree that any arbitration hearing shall be held in New York, New York, in the United States."

In addition, Clause 13 of the SUBWAY contract stated that the applicable law was Dutch law: “This Agreement shall be governed by and construed in accordance with the laws of the State of the Netherlands without reference to its conflicts of laws," while specifying further on in the same clause, "unless local law requires us to use local law.”

According to French contract law, as a principle, the parties are free to (i) choose foreign law applicable and (ii) appoint foreign courts or arbitrators in an international Franchise contract.

In this case, the chosen law was the Choice of law of the drafting party, here the franchisor: Subway

However, in this ruling, the French Court cancelled the foreign governing law and jurisdiction clauses provided for in a Franchise contract holding that the combination of the following constraints for a French franchisee related to English language, the applicable Dutch law and the jurisdiction of the arbitrators ruling in New York constituted a significant imbalance (i.e. French legal mandatory provision).

The Judge has considered that a French franchisee would not have willingly agreed on such provision, in the light of disproportionate litigation or arbitration costs.

With regard to the arbitration clause, the court found that SUBWAY cannot claim that a franchisee, a French retail trader, would voluntarily make use of arbitration proceedings in New York to settle a dispute or would voluntarily enter "into a relationship between equals with their co-contracting party."

The court applied the same reasoning as regards the choice of English language, noting that "the average level of English in France is far from being able to understand a legal text," and as regards the choice of Dutch law, a country which the franchisee "has not visited, whose language and laws it does not even know."

While the applicable law clause is invalid, the arbitration clause is only invalid in that it designates an arbitral tribunal, which sits in a country other than France. As a result, an arbitration clause that designated a national tribunal would therefore be valid.

This case stresses out the need of acceptability by the franchisee and the underlying principle of fairness by making some compromises in order to ensure the efficiency of some clauses disputed.

It is important to take into account the concerns of the franchisee, the sound understanding of the foreign language, the constraints associated to jurisdiction clause (such as the travel costs) and the choice of law in order to avoid having the clauses afterwards.

However, there is a discrepancy between this lower court decision and an earlier decision rendered by the Paris Court of Appeal involving the same franchisor, Subway.

Indeed:

The validity of arbitration clauses giving jurisdiction to arbitrators in New York is not in question since, by decision rendered on June 2, 2020, the Paris Court of Appeal, in a personal action brought by a franchisee against the franchisor SUBWAY, acknowledged the validity of the arbitration clause, noting:[5]

- The independence of the arbitration clause with regard to the contract: the arbitration clause would therefore not be affected by the imbalance resulting from the franchise agreement;

- International arbitration did not deprive the franchisee of the right of access to the court, based in particular on procedural costs of €8,000. The economic argument, avoided in the October 13, 2020, decision, could therefore be argued before the Court of Appeal.

 

[1] Cass. com., Jan. 15, 2020, 18-10.512

[2] Modified by order dated Apr. 24, 2019

[3] TC Paris, Sept. 2, 2019, 2017050625

[4] Cass. com., Dec. 20, 2017, 16-20.501

[5] CA Paris, June 2, 2020, 17/18900

 

Olivier Binder, IDI Country Expert for franchising in France

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