In Civil-Law Jurisdictions, Risk of Liability Begins with Negotiation

Vol. 17 No. 1

By

Gilles Menguy, Avocat and Solicitor

Ted P. Pearce, Nexsen Pruet, PLLC

Franchise systems that rely on international master or development agreements to export their business concepts must expect to negotiate terms in almost every facet of the relationship, including territory, development schedule, royalty splits, choice of law, venue, and means of dispute resolution. What they may not expect, however, is that when they negotiate with parties in countries grounded in the civil law, they may be charged with a duty of good faith not only in the final contract, but in the contract negotiations themselves.

Consider this scenario: A franchisor from a country relying on the common law is engaged in negotiations with a prospective master franchisee from a county with a civil law system. After significant discussions fail to produce a definitive master franchise agreement, the franchisor terminates the negotiations, suddenly and without explanation. The franchisor may believe it has no obligations to the prospective master franchisee — and under a common law system, it may be correct. But if a franchisor finds itself in a civil law jurisdiction, it may face a claim in contract or tort.

In the common law tradition, parties can negotiate in relative freedom. The doctrine of caveat emptor governs. Few, if any, disclosures are required. The buyer is expected to have conducted sufficient due diligence in the seller and the business concept before consummating a contract. Unless there is a definitive written agreement, parties are free to negotiate and back out of negotiations with little fear of risk of liability. See E. Allan Farnsworth, Pre-contractual Liability and Preliminary Agreements: Fair Dealing and Failed Negotiations, 87 Colum L. Rev. 217, 221 (1987). Under this “aleatory” view of contract negotiations, a party that enters into negotiations in the hope of benefit must also bear the risk of loss if the negotiations fall through. Id. Even under Sections 1-209 (19), 1-203, and 2-103(1)(b) of the Uniform Commercial Code (UCC) and Section 90 of the Restatement of Contracts Second, the covenant of good faith and fair dealing implied in contracts has not been found to apply to contract negotiations.

In the civil law tradition, on the other hand, negotiations must be serious and purposeful. If they fail, then the party that broke off the negotiations may be subject to liability under a doctrine known as culpa contrahendo, or fault in contracting, which holds that parties in pre-contractual negotiations have a duty of good faith, fair dealing, and loyalty to each other.

The civil law theory focuses on the relationship of the parties, while the common law theory focuses on the bargain or contract formation. Under the civil law, damages can be recoverable against the “blameworthy” party whose conduct prevented the consummation of the contract to the detriment of the “innocent” party. Depending on the timing of the negotiations and the country where a transaction is deemed to occur, liability can be either in contract or tort. The concept of culpa contrahendo challenges all of the assumptions of franchise practitioners who negotiate under the common law tradition.

The civil law concept of liability in contract negotiations varies from one country to the next. France, for example, recognizes the concept of freedom of contract, unless there is good cause for nullification based on proof of a legitimate error, a deceitful attitude, or some coercion or abuse by the other party during the negotiations.

French law of pre-contractual liability is based in tort as defined by Article 1382 of the French Civil Code. Liability can arise when one party enters into negotiations without having any intent to contract, yet creates a reasonable expectation in the other party that a contract will be forthcoming, causing the other party to incur substantial pre-contractual expenses. In addition, liability can be found if contract negotiations are well advanced and one party arbitrarily breaks off the negotiations.

The most common claims relating to preliminary negotiations under French law are:

  • Unjustified and abusive breaking off of negotiations;
  • Negotiation without a serious intent to contract;
  • Failure to cooperate;
  • Misuse of information gained in confidence;
  • Entry into negotiations with the goal of preventing the other party from negotiating with a third party;
  • Conduct of parallel negotiations in bad faith; and
  • Failure to disclose essential and material facts.

Paula Giliker, Pre-Contractual Liability in English and French Law 132 (Kluwer 2002).

In addition, France’s Loi Doubin requires a party offering a business opportunity to provide a disclosure document (a “DIP” or “Document d’information précontractuelle”) to prospective investors. Since this law was enacted, numerous decisions have protected a franchisee’s pre-contractual rights. And several recent decisions by the French Supreme Court have created a presumption of pre-contractual liability of a franchisor if the financial estimates provided by the franchisor do not match the returns of the franchisee.

Civil-law jurisdictions generally restrict a damage recovery to reliance damages intended to restore an injured party to the position it had before the negotiations started. Lost profits usually are not recoverable. But French law has a doctrine known as loss of chance to conclude the contract, which allows for a party to be awarded a portion of the anticipated benefit of the contract. See Giliker, supra at 130, note 12.

In cases involving aborted contract negotiations, whether the claim is characterized as a contract or tort may determine, under a conflict-of-law analysis, which country’s law will apply. As for other civil-law countries, in Italy, the Italian Civil Code, Article 1337, expressly establishes a duty of good faith in contract negotiations. In Switzerland, contract negotiations create between the parties a legal “pre-contractual relationship.” See International Chamber of Commerce, Formation of Contracts and Pre-contractual Liability 69 (1990).

Liability Rarely Found in U.S. Courts

Even U.S. courts have found pre-contractual liability in certain situations. The three most popular theories of liability are: restitution, based on unjust enrichment; misrepresentation, involving false or misleading information given during the negotiations regarding the intention to come to terms on a contract; and promissory estoppel, where one party relied to its detriment on a promise made by the other party to induce it to negotiate. Under each of these theories, a successful plaintiff may recover reliance damages but not expectation damages, which are premised on the parties’ having reached an agreement.

A leading case in this area is Hofmann v. Red Owl Store, 133 N.W.2d 267 (Wis. Sup. Ct. 1965). There, a supermarket chain promised to sell claimant a franchise, after advising him to sell his bakery, move to another town, open a smaller grocery store as a way to gain experience, and buy a lot the chain had selected for the potential franchised location. The franchisor then told the claimant to sell his grocery store, which was operating at a profit, only to break off negotiations for the franchise shortly thereafter. The court held that the claimant was entitled to reliance damages because the franchisor’s conduct induced him to act to his detriment.

Despite these theories of recovery, U.S. courts typically reject plaintiffs’ claims that they were wrongfully cut off from negotiations if there is no preliminary agreement in place. A study of cases alleging reliance damages based on broken pre-contractual negotiations found that courts in 87% of the cases denied liability, whether premised on promissory estoppel, quantum meruit, or negligent misrepresentation. See Alan Schwartz and Robert S. Scott, Precontracual Liability and Preliminary Agreements, 120 Harv. L. Rev. No. 3, 661-707 (2007). The common law view prevalent in U.S. courts is that a party to pre-contractual negotiations may break off the negotiations at any time for any reason or for no reason at all, without facing liability.

Negotiating in Civil-Law Jurisdictions

When negotiating international master agreements with parties in civil-law jurisdictions, franchisors must be mindful of the laws and culture of those jurisdictions. They should not assume that the common law principle of caveat emptor will insulate them from liability if contract negotiations fail. Instead, they should discuss this possibility up front and address questions such as:

  • What law will govern the parties’ contract negotiations and the contract itself?
  • Will the parties enter into a preliminary agreement? If so, will it be legally binding or merely an agreement to negotiate?
  • Will either party be granted any exclusivity in the contract negotiations, as protection against the possibility that the other party might engage in parallel negotiations?

An example of this proactive approach can be seen in the recent negotiation of a master franchise relationship between Burger King and a leading French business group, Groupe Bertrand, to develop and operate Burger King restaurants in France. In negotiating that relationship, the parties addressed early on the law that should be invoked if a pre-contractual dispute should arise, adding greater predictability to the negotiations. (Author Gilles Menguy participated in this negotiation on behalf of the master franchisee.)

No negotiation is risk-free. But parties can minimize their risk of legal liability in negotiations by making sure they know, even before the negotiations begin, what laws and customs will apply and what duties those laws may impose.

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