Franchising and Insolvency
LG Mönchengladbach, judgement of 25 February 2014 – 3 O 283/12
Occasionally in franchising situations the franchisee can no longer pay some or all of the price of goods purchased from the franchisor, the rent for a shop or the franchise fees. The franchisor is likely initially to talk to the franchisee in order to understand the reasons for the payment difficulties and to find a satisfactory and realistic solution for both parties, irrespective of the legal terms of the franchise agreement or the statutory provisions. Solutions may include deferrals or instalment agreements. However, sometimes the concessions of the franchisor or the efforts of the parties are not adequate and the franchisee falls into insolvency. Then the question is whether the conciliatory action of the franchisor in financially supporting the franchisee by way of deferral is to be rewarded or punished by insolvency law.
The LG Mönchengladbach (judgement of 25 February 2014 – 3 O 283/12) had to deal with a case of a franchisee, whom the franchisor had facilitated with instalment payments, ultimately becoming insolvent.
Since 2002 the debtor was a franchisee of the defendant, running the system headquarters of a bakery chain. The franchise agreement contained, among other things, obligations to purchase goods from the franchisor, payment of rent, a franchise fee and turnover-related fee. From 2007, the franchisee was in payment arrears to the franchisor. The parties initially concluded a number of instalment agreements for accrued debt. Between early 2009 and until the insolvency filing in August 2009, the franchisor received, by direct debit from the franchisee’s bank account, money in return for delivered goods, rent, and franchise fees.
The insolvency administrator (plaintiff) of the former franchisee (debtor) claimed repayment from the former franchisor (defendant) of approximately EUR 282,000 under insolvency (avoidance) law after the insolvency of the franchisee.
3. Reasoning of the Court
The LG Mönchengladbach completely approved the claim of the insolvency estate. The Court held that the payments made by the franchisee were conducted with the intent of placing creditors at a disadvantage. Consequently, the Court ordered the defendant to return the money to the insolvency estate pursuant to §§ 143 para. 1, 133 para. 1 Insolvency Code.
3.1. Legal acts subject to challenge
The relevant legal act of the former franchisee subject to the challenge pursuant to § 133 para. 1 Insolvency Code was the direct debit authorization in accordance with the direct debit rules of its bank.
3.2. Intent to place creditors at a disadvantage
The resulting reduction of debt vis-à-vis the franchisor placed other creditors at an indirect disadvantage by reducing the insolvency dividend for other creditors in the event of insolvency. The Court concurred with the insolvency administrator’s assertion of the franchisee’s inability to pay (i.e. illiquidity) at the time of the relevant legal act. Illiquidity is usually a strong sign of the intent to disadvantage other creditors.
3.3. Imminent illiquidity
Illiquidity is assessed according to § 17 para. 2 Insolvency Code on the basis of whether the debtor is in a position to make payments when due. It is usually assumed when payments are generally discontinued. While the former franchisee also generated income from the franchise business, she was aware that the income she generated was not sufficient to satisfy other matured liabilities within a short time, particularly since her revenue was almost completely exhausted by the direct debits to the defendant. However, since lodgements from cash receipts in the bakery were the only source of income in order to satisfy the creditors, the Court concluded there was a motive for preferential satisfaction of the defendant’s claims in order to maintain the business. The intent of the former franchisee was ultimately based on enabling the defendant to withdraw liquidity as soon as it accrued by means of direct debit, making it unavailable for satisfaction of other creditors’ claims.
3.4. Knowledge of debtor's intent
The party preferred by the debtor’s payment – here the former franchisor – must have knowledge of the debtor’s intent. Such knowledge is also assumed if the preferred party knew that illiquidity of the debtor was imminent and that the act placed other creditors at a disadvantage.
Indications for the defendant’s knowledge of the imminent illiquidity in this case were the many rejected direct debit attempts of the former franchisor and the lack of success of the instalment agreements. Although monthly instalments were agreed and the deferred debt remained interest-free, only a very limited reduction was achieved.
3.5. Overall view
The LG Mönchengladbach concluded that the former franchisor was aware of the imminent illiquidity of the debtor and the detriment to other creditors, since the former franchisor was aware that the debtor could not discharge her liabilities from her own financial payment capacity. In fact, she was dependent on financial support by deferrals and loans granted by the defendant and other creditors. Nevertheless, these efforts did not improve the situation and the defendant was aware of this due to the loan extensions, the direct debit rejections and the non-compliance with the instalment agreements.
Since the former franchisee operated a trading business, the defendant could not ignore that the franchisee was regularly exposed, for various legal reasons, to new liabilities becoming due to other creditors, despite the fact that the illiquidity was now and then temporarily averted by loans and deferrals. Since the capacity of the debtor to pay did not improve at all, it was clear to the defendant that, by the withdrawal of existing liquidity, other liabilities due could not be discharged and the debiting of possible satisfaction payments to other creditors was frustrated or at least rendered more difficult. The former franchisor must have known, because of the failure to achieve any significant debt reduction, that the agreed restructuring concept would not succeed.
Income generated by the debtor from the franchise which enabled the defendant to debit the challenged payments does not justify any doubt as to the knowledge of the defendant of imminent illiquidity. Because of the defendant’s comprehensive knowledge of the debtor’s financial situation the defendant was aware that the franchisee’s only source of income was the franchise operation. Since the continuation of this source of income depended on the defendant itself, it was, as a creditor, in an outstanding position to exercise pressure causing the debtor to aim primarily at satisfying the defendant by maintaining sufficient funds in her bank account. In the Court’s experience, debtors – in order to ensure their financial survival – make preferential payments to major creditors under pressure from them.
A franchisor which grants one or more payment deferrals to its franchisee in an “emergency” arrears situation and concludes agreements accordingly must anticipate that in a later insolvency of the franchisee, it must return all payments received after the deferral of the payments in the event of an insolvency challenge. According to the present draft amendment to § 133 Insolvency Code, while the conclusion of instalment agreements will not in future automatically be an indication of knowledge of the debtor’s intent to disadvantage other creditors, the franchisor is nevertheless well advised to consider whether in such cases it is willing to accept the potential risk of the insolvency of the franchisee. It should also be considered that the period for challenging such prejudicial payments to creditors is ten years.
Any Questions? Please contact: Dr. Karl Rauser or Prof. Dr Karsten Metzlaff
Practice Group: Commerce & Trade