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Sales Forecast is no Guarantee: once more the “legal error torpedo” of franchisees recently missed its target

Quite frequently franchise organizations hire an external market research firm to have them carry out a local market survey (VPO), when the opportunity of a new outlet location presents itself. Local circumstances may substantially vary and are often unknown. That is why it is logical to first properly map any competition in the area of the intended location and to estimate the purchase flows inter alia, to get a feel of the market potential and sales prospects. This information may assist a franchisor (as direct or indirect lessor) in choosing a new outlet location, but also may give insight whether it seems legitimate to have a future franchisee invest in and operate at such a business location.

Prospective  franchisees are deterred by the high cost of such a VPO. In order to avoid double work, VPOs are frequently made available  by franchisors to franchisees or their financial advisers  to allow them  to make their own financial forecasts and/or for the purposes of obtaining funding. Sharing an external VPO may seem like a win-win and practical solution. However,  in reality this is very often not the case, as it is often used by franchisees as a a key reason for a premature contract exit and a legal basis for damages claimed in numerous court actions brought by dissatisfied franchisees against their franchisors.

So where does the problem lie? The disappointment of a franchisee if the actual sales performance in the first year of operation is lower than estimated in the VPO will often lead to frictions in the relationship with the franchisor. Any disappointing sales results may have numerous internal and external causes, for instance the outbreak of a (Corona) virus, stronger than expected competition, higher retail outlet vacancies in the area, poorly performaning staff or personal circumstances on the side of the franchisee. This often will result in franchisees giving up midway their contract term and, with the VPO in hand, will present the franchisor with the bill claiming that  ”…if I had known in advance that sales would be this much lower than projected in the VPO I would never have entered into the contract and therefore I quit..”. In more legal terms: the franchisee invokes the argument as legal error, annuls the franchise agreement and lease with a simple letter and claims back from the franchisor all the investments and payments made”. This is what I call the proverbial error torpedo, fired by franchisees at franchise organizations.

Settled Case Law on Sales Forecasts

In court the error torpedo misses its target in a large number of cases. Despite well-defined case law, there is still a misperception among franchisees that a VPO is a guarantee for a profitable franchise business.  Settled case law on franchisor’s liability in case of disappointing sales compared with forecasts can be briefly summarized as follows: no duty rests upon a franchisor to provide a sales or profit forecast to the future franchisee before entering into the franchise agreement. The mere circumstance that in the negotiations prior to entering into the franchise agreement the franchisor provided a report on the projected sales and profit to the franchisee does not alter this. However, a franchisor could be blamed for acting unlawfully in specific circumstances, i.e. if the franchisor provides the franchisee a report that contains clear mistakes and he did not warn the franchisee against this and if negligence of the franchisor (or the persons he is legally responsible for) resulted into the mistakes in the report. As a rule, a franchisor is allowed to rely on correctness of a VPO drawn up by a third party ¹.

Recent court decisions – Again no Error or Tort allowed

Subsequently,  invoking legal error does not make for a clear-cut case. In two recent court cases,  we succeeded once more in firing back the error torpedo for a large nationally operating franchise organization. In both proceedings the court ruled that the mere fact that a forecast is not realised, does not imply that the franchise agreement is voidable. A forecast is in itself nothing but an expectation of future results. The mere fact that a forecast is not realised does not mean that the franchisor is liable at all time. After all, the sales are to a large extent also the result of business decisions made by the franchisee and external factors.

A unilateral decision by the franchisee to cease operations will increase his liability risk.  One of the litigating franchisees not only ended up losing the case but also  had to pay the franchisor’s damages. The franchisee had annulled his lease and franchise agreement through a unilateral letter while invoking legal error.  He closed his business halfway the contract period, handed over the keys and left his inventory behind. The franchisor had no choice but to pick up the pieces. As lessee, the franchisor had to deal with an outlet that remained closed for two years, resulting in significant financial damage. The court held the franchisee liable: the franchisee was ordered to pay compensation for the damage incurred by the franchisor (e.g. lost franchise fees and lease income) up to a sum of over EUR 100,000.

The result: after years of litigation of the franchisee (as in many cases, through his insurance company) the consequences were unfortunate for all the parties involved: high litigation cost, an award for damages and legal costs incurred by the franchisor and a significant loss of valuable time and effort, as well as loss of income. (Read court decision: Vonnis Rechtbank Midden-Nederland – kantonrechter – 22 januari 2020 and Vonnis Zeeland-West-Brabant 20 mei 2020).

New Franchise Act

Will the new act bring some change to the current litigation practice?

The bill involves more specific and detailed rules regarding the franchisor’s duty to inform and provide available data on the intended franchise outlet location. The duty to inform applies both to the franchisee and to the franchisor. Under the bill the franchisee himself will have to take the necessary measures within the limits of reasonableness and fairness, which will avoid him to enter into the franchise agreement under incorrect information and/or assumptions. The bill also obliges the franchisor to provide more specific information to allow the franchisee to better assess the investment case. For example, the franchisor will have to provide financial data regarding the intended outlet location, however only to the extent that such information is readily available, such as historical sales figures previously generated under the formula at said outlet. In case the franchisor does not have access to this information he will have to provide financial data of one or more other similar franchised outlets, unless none of these outlets can be considered similar.

The explanatory memorandum of the new franchise act reads that it is in line with settled case law and that there will not be any duty for the franchisor to provide sales forecasts. At the moment, it seems not intended that the new franchise act will put an end to the present well-defined case law of the Supreme Court and lower courts. However, the new franchise act will hopefully lead to a decrease in court cases, so that that the legal error torpedo will not be fired unnecessarily anymore.

 

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¹ I.a. S.C. 25 January 2002, ECLI:NL:HR:2002 AD7329 (Paalman v. Lampenier), SC 24 February 2017 , ECLI:NL:HR:2017:311 (Street-One), SC 21 September 2018, ECLI:NL:HR:2018:1696 (Albert Heijn Franchising)