- Introduction
In Korean law, franchising refers to "a continuous business relationship in which a franchisor allows its franchisees to use its own trademarks, service marks, trade names, signs, or any other trademarks in selling goods or services in compliance with certain quality standards or business methods, and supports, trains, and controls its franchisees in regards to their management, business activities, etc., and in which franchisees pay required payments to their franchisor in return for the use of trademarks and the support and training provided for their management, business activities, etc."
Franchise agreements can mutually benefit both parties involved, as they allow franchisees to start their own business with limited funds and business experience and franchisors to maximize the use of their trademarks. However, due to the asymmetrical structure of the franchisor and franchisee relationship, there is a high chance for conflict to arise between the two parties due to information imbalance. It is common in the franchising industry for franchisors to prearrange the terms of the agreement and offer the same deal to many prospective franchisees. In such instances, the only choice that prospective franchisees have is whether to buy the license or not. Therefore, it is crucial for prospective franchisees to receive accurate information from the franchisor and thoroughly review the terms of the agreement before entering the contract.
For these reasons, Korea's Fair Transactions in Franchise Business Act (hereinafter referred to as the "Franchise Business Act"') requires franchisors to register an information disclosure statement and provide these documents to their franchisees. The act also prohibits franchisors from providing prospective franchisees with false or exaggerated information and specifically requires information with material effect on the maintenance of the agreement, such as the expected future profits, to be provided in writing.
Out of the franchisor's obligations to provide information, there is a special emphasis on the obligation to provide information on expected future profits. This article will explore the specifics and legal consequences of this violation.
- Franchisor Obligations to Provide Information on Expected Future Profits
2.1 Prohibition on Providing False or Exaggerated Information on Expected Future Profits, Etc.
Article 9(1)1 of Korea's Franchise Business Act prohibits franchisors from providing false or exaggerated information to prospective franchisees or franchisees, supplementing the limitations in the franchisor's obligation to register information disclosure statements and provide information. Thereby, franchisees can hold the franchisor liable for violating this provision if the franchisor registers or provides an information disclosure statement that contains false or exaggerated information.
2.2 Obligation to Provide and Allow Access to Documents about Information on Expected Future Profits, Etc.
According to Article 9(3) of the Franchise Business Act, franchisors must provide franchisees and prospective franchisees with written documents that include information with significant influence on the conclusion of a contract, such as the following: (i) information about the expected future profits of a prospective franchisee, including estimated sales, profits, gross profit, and net income and (ii) information about the past profits or expected future profits of a franchisee, including sales, profits, gross profit, and net income.
Moreover, pursuant to Article 9(5) of the Franchise Business Act and Article 8(2) of its Enforcement Decree, franchisors that are large enterprises must provide prospective franchisees with the range of estimated sales and grounds for the calculation in writing (hereinafter referred to as "estimated sales calculation document"). Franchisors must also keep a paper describing the calculation of estimated sales for five years from the date they enter into a franchise agreement to facilitate ways for prospective franchisees to check if the estimated sales were calculated appropriately.
Article 9(4) of the Franchise Business Act stipulates that the franchisor has an obligation to keep evidentiary materials that serve as a basis for the calculation of estimated sales at its office. In accordance with Article 9(1) of the Enforcement Decree of the Franchise Business Act, such evidentiary materials must include the following: (i) information on a realistic rationale and forecast used for the computation of current profits or estimated profits; (ii) information that forms the basis of computation of current profits or estimated profits; and (iii) the number and percentage of franchisees who make profits at the same level as the current or estimated profits indicated by the franchisor or franchise broker.
- Legal Consequences of the Violation
3.1 Penalties Pursuant to the Franchise Business Act
Pursuant to Article 41(1), franchisors who provide franchisees or prospective franchisees with false, exaggerated, or deceptive information are subject to punishment by imprisonment with labor for not more than five years or by a fine not exceeding KRW 300 million. Furthermore, Article 43(6) stipulates that franchisors who fail to provide franchisees and prospective franchisees with documents containing information about past profits or expected future profits are subject to an administrative fine not exceeding KRW 10 million.
3.2 Liabilities for Damage
A violation of the Franchise Business Act by the franchisor that inflicts injury on a franchisee constitutes a tort pursuant to Article 750 of Korea's Civil Act. However, Article 37-2 of the Franchise Business Act also provides separate regulations for damage liability if a franchisor causes any loss to a franchisee as a consequence of a violation of this act. Accordingly, the injured franchisee can selectively decide whether to claim damages under the Civil Act or the Franchise Business Act. Pursuant to the proviso to Article 37(1) of the Franchise Business Act, the burden of proof is reversed in the Franchise Business Act, and the franchisor must prove there was no intent or negligence for the violation. For the reason above, the Franchise Business Act is more advantageous for franchisees, which is why franchisees commonly prefer to claim damages using the damage liability provisions under the Franchise Business Act.
Meanwhile, Article 37(2) of the Franchise Business Act stipulates that if a franchisor causes any loss to a franchisee by providing false, exaggerated, or deceptive information, the franchisor may be held liable to compensate losses up to three times the amount of loss caused to the franchisee. This can be interpreted as a punitive damages regime that requires franchisors to compensate for damages beyond the actual amount of loss.
- Recent Trends in Korean Court Decisions - Supreme Court Decision 2021Da300791 Decided May 26, 2022, etc., Regarding Compensation for Business Damages to Franchisees Due to the Provision of False or Exaggerated Information
4.1 Overview
In the current law, franchisors have an obligation to provide prospective franchisees with information on estimated profits, etc., and prospective franchisees commonly utilize such information to estimate future profits before deciding whether to buy the franchise. However, because the profit of a franchised store is influenced by various factors beyond the store owner's experience and management capabilities, such as store location, the state of the local economy, and local competitor locations, if the franchisor doesn't provide the franchisee with profit estimates calculated based on appropriate data, franchisees become vulnerable to unexpected business losses. In a recent Supreme Court case where a franchisor provided its franchisees with information about the expected profits when the parties were negotiating the contract, the court recognized the accusation that the provided information about the expected profits was false and exaggerated and ruled that the franchisor had to compensate the franchisees for their startup costs and pay a considerable sum for business losses.
4.2 Case Summary
4.2.1 Facts
In 2015, franchisees, etc., entered into a franchise agreement with a franchisor and were granted the right to operate the franchise business. While discussing the terms and conditions of the agreement, the franchisor provided the franchisees, etc., with documents describing the calculation of estimated sales, which included the range of estimated annual sales at the planned place for their future store. The contract stipulated that the estimated sales were calculated in accordance with the method prescribed in Article 9(4) of the Enforcement Decree of the Franchise Business Act, which is based on the converted sales amount (amount of sales per square meter in the immediately preceding year) of the five-member stores most adjacent to the planned location of the store. However, when calculating the range of estimated sales using the converted sales amount of the five closest stores, the franchisor arbitrarily switched out some of the stores with a low converted sales amount from the immediately preceding year to other stores.
As a result, the minimum estimated sales conversion amount presented to the franchisees, etc., via the document describing the calculation of estimated sales was approximately KRW 3.7 million to KRW 5 million per square meter (amount of sales per square meter in the immediately preceding year) larger than what it would have been if the franchisor had faithfully followed the provisions of Article 9(4) of the Enforcement Decree of the Franchise Business Act. Subsequently, the franchisees, etc., continually experienced business losses to the extent that they could not pay for their operating expenses, such as rent, etc., with their sales profits since the opening of their stores.
Therefore, the franchisees, etc., claimed that the franchisor had exaggerated the estimated future profits and made it appear as if the estimated sales were guaranteed revenue. As this constitutes the illegal act of providing false or exaggerated information pursuant to Article 9(1)1 of the Franchise Business Act, the franchisees, etc., claimed damages, demanding that the franchisor compensate for all incurred expenses, including the startup costs of their stores and business losses. Thus, the franchisees, etc., (plaintiffs) filed a lawsuit against the franchisor (defendant) for damages.
4.2.2 Procedural History and Court Decision
The trial court ruled that the franchisor had provided false or exaggerated information in violation of Article 9(1)1 of the Franchise Business Act and held the franchisor liable for compensating the damages inflicted on the franchisees, etc., including the business startup costs and business losses.
In response, the franchisor filed an appeal to the appellate court, which affirmed that the franchisor was liable for compensating the franchisees, etc., for providing false or exaggerated information. However, the appellate court did not find the franchisor liable for business losses by reason that there are various external factors that influence the profits or losses of a store, such as the franchisees' individual managing capacities, the business itself, or the local market situation. Thereby, the appellate court reasoned that it is difficult to determine whether the business losses of the franchisees were due to the franchisor's illegal action and should be viewed as losses incurred due to special circumstances.
However, the franchisees, etc., appealed this decision, and the Supreme Court not only reaffirmed that the estimated figure of sales provided by the franchisor was false or exaggerated but also ruled that the franchisor must compensate the franchisees, etc., for both the startup costs and business losses, reasoning that "the business losses suffered by the franchisees, etc., are objectively predictable to a considerable extent and falls within the range of ordinary damages in causal relation with the franchisor's illegal act. Thereby, even if such losses are considered damages due to special circumstances, the existence of such circumstances should be considered to be within the foreseeability of the franchisor. Due to the nature of the case, it may be difficult to prove the specific amount of the loss attributable to the franchisor's illegal acts rather than external factors such as the franchisees' business management capacities or the local market situation. However, a reasonable amount of damages must be recognized based on the overall context of the proceedings and the results of the examination of evidence."
4.3 Review
The Supreme Court decision above is meaningful in that it reinforces protection for franchisees and prospective franchisees by clearly stating that business losses should be included in the scope of compensatory damages that the franchisor must pay the franchisee and providing a method for determining the amount of damages. This decision can be said to be reasonable as it considers the legislative intent of the Franchise Business Act, which obligates franchisors to provide franchisees and prospective franchisees with accurate information based on objective and appropriate grounds.
- Conclusion
According to a recent survey announced by the Korea Fair Trade Mediation Agency that analyzed 380 cases where franchisees (including prospective franchisees) applied for dispute resolution to terminate their franchise agreements within a year, the main reasons that franchisees terminated or sought termination of their contracts were the following: (i) the franchisor's violation of its duty to provide information disclosure documents (103 cases, 27.1%); (ii) the franchisor's provision of false or exaggerated information (78 cases, 20.5%); (iii) the franchisor's imposition of unfair compensation obligations (53 cases, 13.9%); and (iv) the franchisor's abuse of its trading position (47 cases, 12.4%).
Considering that a large portion of the disputes between franchisors and franchisees are due to the franchisors' violation of their obligation to provide information, it is imperative for franchisors to faithfully fulfill their duty to provide information to reduce the disputes between franchisors and franchisees.
The franchisors' faithful fulfillment of the obligation to provide information not only protects franchisees but also transfers the risk of business failure to the franchisees, as they cannot claim to have been ignorant about the information provided by the franchisor. Ultimately, the franchisors' compliance with the obligation to provide information benefits both the franchisees and the franchisors, which is why this obligation must be strictly enforced to ensure the sound operation of the franchise business system.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
