Compensation for breach of contract by a franchisor

On 1 August 2005, Zhejiang Xiaer Apparel Company executed a franchising contract with Wu Zhichao. Under the contract, Xiaer appointed Wu to sell Xiaer products in Henan Province, and Wu warranted that he would place orders with Xiaer worth at least RMB3 million (US$439,000) each year. The term of the contract was two years, from August 2005 to the end of July 2007. Furthermore, Xiaer’s franchising handbook stated that the franchisee would enjoy a number of advantages, including exclusive operation within the franchise territory and the sharing of certain benefits. The handbook promised that the franchisee would enjoy a return of at least 65%.

Pursuant to the contract, Wu paid Xiaer a total of RMB160,000, and Xiaer shipped goods to Wu Zhichao worth RMB128,135.

Starting on 14 July 2005, Wu spent approximately RMB1 million on leasing and fitting out premises, participating in exhibitions, soliciting business, publicity, advertising and other items.Xiaer provided Wu with such components as Xiaer apparel labels and signs, and authorized him to affix the labels to, and sell, Xiaer apparel. However, as Xiaer suffered from a shortage of goods, it failed on several occasions to supply goods ordered by Wu on time.

Additionally, Xiaer executed agency contracts with third parties in Zhengzhou and Nanyang during Wu’s franchise term.

On 17 July 2007, Wu instituted legal action requesting termination of the franchise contract and an order that Xiaer pay compensation for direct losses in the amount of RMB1,609,431, loss of indirect benefits in the amount of RMB4,089,540, and relevant court costs.

Trial at first instance

The Zhengzhou Intermediate People’s Court examined the question of whether Xiaer had breached its contract with Wu.

Article 2 of the PRC Product Quality Law states that the term “products” means “items that are sold following processing or manufacture”. Accordingly, the products specified in the contract were finished products sold following their completion through the combination of primary materials and components, not the components of finished products. The provision by Xiaer to Wu of such components as labels and signs, and authorizing him to affix the labels to and sell Xiaer apparel, clearly did not meet the definition of supplying “products”.

The court held that Xiaer’s failure to ship the apparel ordered by Wu after he had paid for it constituted a failure to supply the goods in full and in a timely manner, and thus was a breach of contract.

Furthermore, Xiaer’s development of new agents in Wu’s authorized territory also constituted a breach of contract.

The court also held that a reasonable portion of the direct losses suffered by Wu, after deduction of the normal expenditures arising from engaging in franchise operations, ought to be upheld as his economic losses. His direct losses were assessed as being RMB520,000. The indirect losses he claimed were mainly based on the returns of at least 65% claimed in the Xiaer handbook, but since the handbook was not a part of the contract, this claim was not upheld.

As both Wu and Xiaer were dissatisfied with the judgment at first instance, they appealed to the higher court.

Final instance

The Henan Province Higher People’s Court confirmed that Xiaer had breached the contract, and reaffirmed the direct losses that had been found at first instance.

As to the indirect losses, the court of final instance held that if Xiaer had not breached the contract, Wu, operating normally, should have been able to obtain the anticipated benefits. Xiaer’s breach made the contract unperformable, thus making Wu’s anticipated benefits unrealizable. Accordingly, Xiaer ought to appropriately compensate Wu for his loss of anticipated benefits. The court of final instance determined compensation in the amount of RMB500,000.

Franchisor must not exaggerate

In this case, Wu had been unable to cover the cost of the initial capital investment he had made in order to set up his franchise business. As this was due to the breach of the franchise contract by Xiaer, these costs were deemed to be Wu’s direct losses. The day-to-day expenditures (such as rent, loans, water and electricity costs) made to sustain the franchise activities were deemed to be normal expenditure necessarily arising from engaging in the franchise operations and therefore were not deemed to be direct losses.

The first paragraph of Article 113 of the PRC Contract Law specifies that if a party fails to perform his contractual obligations, thereby causing loss to the other party, the measure of damages shall be “equal to the loss incurred as a result of the breach of contract, including the benefits which could have been obtained after performance of the contract”.

The determination of the court of first instance on the indirect losses claimed by Wu was clearly inconsistent with this provision. Although the franchise handbook provided by Xiaer was not defined as part of the contract, Wu entered into the contract with Xiaer in reliance on Xiaer’s publicity materials. After the objectives of the contract became impossible to achieve due to the breach by Xiaer, claiming loss of anticipated benefits against the party in breach was consistent with Article 113. However, the loss of anticipated benefits claimed should be objective and reasonable.

The contract specified that Wu was required to place orders with Xiaer worth RMB3 million each year, but in fact, Wu only paid RMB130,000. Accordingly, his claim for two years’ loss of anticipated profit calculated on the basis of RMB3 million per year in orders was untenable.

If a franchisor commits a breach of contract, the liability that it can bear will not be limited solely to the direct economic losses incurred by the franchisee, but could also include loss of the franchisee’s anticipated benefits. Accordingly, when a franchisor prepares its franchise handbook, it should do so based on objective and realistic principles.

Exaggeration can only increase the franchisor’s legal risks.

Harry He is a partner of AllBright Law Offices. His main practice areas are foreign direct investment, M&A and labour disputes.