[Choi Seok-jin's Law & Biz] The Franchise-Shaking Differential Franchise Fee... The Fate of Pizza Hut's Supreme Court Appeal

Difference in franchise fees. A lawsuit surrounding this unfamiliar cost is shaking the entire franchise industry.

The trigger was last September when the court in the second trial recognized a much larger amount of unjust enrichment repayment liability than the first trial in a lawsuit filed by Pizza Hut franchisees against the headquarters to return the difference in franchise fees.

Since then, from December last year to early February this year, over 1,000 franchisees from five companies including Lotte Super & Lotte Fresh, BHC, Baskin Robbins, Kyochon Chicken, and Puradak Chicken filed lawsuits against their headquarters. Additionally, collective lawsuit movements against other franchise companies such as Goobne Chicken, Cheogajip Yangnyeom Chicken, BBQ, ZicoBA Chicken, Domino's Pizza, Papa John's, and Doojjim have also been detected.

What is the difference in franchise fees?

The difference in franchise fees refers to the difference, or distribution margin, between the appropriate wholesale price and the amount the franchisor charges the franchisee for supplying various goods. For example, if the headquarters purchases ingredients or utensils for making food at 5 million KRW and supplies them to the franchisee at 7 million KRW, the difference of 2 million KRW corresponds to this.

The Enforcement Decree of the Fair Transactions in Franchise Business Act (Franchise Business Act) defines the difference in franchise fees in Appendix 1 as “the amount paid by the franchisee to the franchisor exceeding the appropriate wholesale price for items that the franchisor forces or recommends the franchisee to purchase from the franchisor or a designated party in the course of operating the franchise business.”

Why did it become an issue?

The reason the difference in franchise fees issue escalated into lawsuits is that due to the amendment of the enforcement decree, franchisees who previously could not grasp the difference in franchise fees received by the headquarters could now roughly identify the amount of difference in franchise fees taken by the headquarters annually and the ratio of difference in franchise fees to sales.

According to the law, franchisors must register the “disclosure document” provided to prospective franchisees with the Fair Trade Commission or local government heads when concluding franchise contracts. The contents recorded in the disclosure document are disclosed except for personal information and trade secrets.

However, with the amendment of the Franchise Business Act enforcement decree in April 2018, the “burden on franchisees” that must be recorded in the disclosure document included details about the difference in franchise fees, specifically ▲the average amount of difference in franchise fees paid per franchise in the previous business year and ▲the ratio of difference in franchise fees to sales per franchise in the previous business year.

The amended enforcement decree took effect on January 1, 2019. According to the disclosure documents registered by Pizza Hut headquarters in 2020, Pizza Hut received on average ▲26,669,000 KRW (3.78% of average sales per franchise) in 2019 ▲29,353,000 KRW (4.50%) in 2020 ▲23,680,000 KRW (4.73%) in 2021 ▲25,917,000 KRW (5.27%) in 2022 as difference in franchise fees from franchises. The amount was larger than expected, and the ratio relative to sales increased every year.

First trial court’s judgment

In the Pizza Hut case, the court sided with the franchisees. The Pizza Hut franchisees claimed, “The franchisor received a fixed fee equivalent to 6% of total revenue under the franchise contract but also charged the so-called difference in franchise fees by adding a certain profit margin to the cost of supplied raw materials without any legal or contractual basis, resulting in duplicate payments of franchise fees.” The first trial court accepted this claim.

The headquarters argued, “Difference in franchise fees is a form of franchise fee recognized by law, so there is a legal basis.” However, the court ruled, “Whether an agreement to pay franchise fees in the form of difference in franchise fees is legally recognized and whether such an agreement existed are separate issues,” and “The fact that the law or enforcement decree exemplifies various forms of franchise fees does not automatically justify receiving such fees.” The court also stated, “An agreement is necessary to receive difference in franchise fees.”

The headquarters claimed that the Fair Trade Commission did not consider the failure to record difference in franchise fees in the franchise contract as a violation of the Franchise Business Act and did not impose corrective measures or fines, and that some plaintiff franchisees filed fraud charges against Pizza Hut executives which the police dismissed, arguing “There is no obligation to record difference in franchise fees in the franchise contract.” The court, however, used this as evidence supporting the absence of an agreement on difference in franchise fees between the parties.

However, the first trial court dismissed the plaintiffs’ claims regarding difference in franchise fees for the periods 2016?2018, when information was not disclosed and thus difficult to ascertain, and for 2021.

Second trial court’s judgment

The second trial court, like the first, ruled that ▲an agreement is necessary to receive difference in franchise fees and ▲there was no legal basis or agreement justifying the headquarters’ receipt of difference in franchise fees. Furthermore, the second trial court ruled that the headquarters is liable to return difference in franchise fees for 2016?2018, which the first trial court had not recognized.

The franchisees initially claimed only half of the difference in franchise fees they sought to recover in the first trial. After winning the first trial, they expanded their claim in the second trial to include the remaining half and extended the period for returning difference in franchise fees to 2022. The unjust enrichment repayment amount increased from approximately 7.546 billion KRW in the first trial to 21 billion KRW in the second trial.

In calculating the difference in franchise fees for 2016?2018, which were undisclosed, the second trial court accepted the plaintiffs’ method of retroactively calculating the amount by reducing it by 19% annually, based on the 19% increase in the ratio of difference in franchise fees to sales between 2019 and 2020.

The court based its judgment on ▲the absence of information and data (such as the price the headquarters paid for raw and subsidiary materials) for the plaintiffs ▲the headquarters’ failure to comply with the court’s document submission order (initially claiming no obligation or that the documents were trade secrets, then claiming not to possess the documents after the order, which the court actively considered as contradictory) ▲the plaintiffs’ failure to prove they did not receive difference in franchise fees during the period despite it being seemingly easy to do so ▲and the plaintiffs’ calculation method being unfavorable but not unreasonable.

In the second trial, the headquarters argued, “We notified franchisees of the supply prices of raw and subsidiary materials, franchisees specified the goods, prices, and quantities when ordering, and tax invoices were issued,” implying that a supply contract was established between the parties. They also claimed there was agreement or ratification regarding the difference in franchise fees included in the goods payment.

However, the court rejected this argument based on a clause in the franchise contract stating “Contract terms can only be changed if both parties agree in writing.”

The court also pointed out, “In merchant transactions, including distribution margins in goods prices without informing the counterparty is acceptable because the parties voluntarily choose the transaction subject, counterparty, and price. In contrast, franchisees must purchase raw and subsidiary materials designated by the franchisor under the franchise contract, lacking choice in transaction subject, counterparty, or price, differing from ordinary goods transactions.”

Finally, the court dismissed the headquarters’ argument that returning difference in franchise fees included in goods prices would unjustly allow franchisees to use the headquarters’ costs, time, and value in supplying raw and subsidiary materials without appropriate compensation, which would contradict the fairness and justice principles of unjust enrichment law.

The court stated, “If there is a need to compensate for incurred costs, the franchisor must conclude a franchise contract reflecting this or present cost calculation data to franchisees for consent, following proper procedures to establish grounds.”

Pizza Hut Supreme Court appeal and future lawsuit outlook

The Pizza Hut case appeal was assigned to the Supreme Court’s 3rd Division on November 29 last year. The presiding justice is Justice Lee Heung-gu. After the period for summary dismissal (a system where appeals without significant legal violations are dismissed without substantive review under the Special Act on Appeal Procedures) passed on the 11th, substantive review is underway.

As the first case where franchisees sued the headquarters for difference in franchise fees, the franchise industry is closely watching what conclusion the Supreme Court will reach.

While factual findings in the Supreme Court’s ruling on the Pizza Hut case may not directly apply to other companies’ cases, if the court clarifies legal interpretations regarding difference in franchise fees under the Franchise Business Act and enforcement decree, the necessity of agreement to receive difference in franchise fees, and burden of proof, it will become a leading case applicable to structurally similar cases.

Especially if the second trial ruling is upheld, most domestic franchisors who have received difference in franchise fees during franchise operations will face significant economic losses, making them highly alert.

However, franchisors sued argue that, unlike Pizza Hut which included various other costs besides distribution margin in difference in franchise fees, there are differences in the composition of difference in franchise fees, so the court’s ruling in the Pizza Hut case should not be directly applied to other franchisors.

Experts predict that franchisors will need to find ways to prove that franchisees were aware of the difference in franchise fees received by the headquarters through franchise contracts or other written notices to defend themselves. They also expect that this lawsuit will lead to gradual improvement in existing practices by explicitly stating difference in franchise fees in franchise contracts.

Meanwhile, after losing the second trial, Pizza Hut is undergoing corporate rehabilitation procedures. Most franchisees participating in the lawsuit are included in the creditor list submitted by the headquarters to the court, and some franchisees have individually filed claims. Franchisees who have not yet filed claims must do so by the creditors’ meeting date at the latest to receive repayment as rehabilitation creditors.

Law Firm YK vs Taepyungyang, Kim & Chang

The difference in franchise fees lawsuits against franchisors are led by Law Firm YK (Chief Attorneys Kang Kyung-hoon and Kim Beom-han) Fair Trade Group. The YK Fair Trade Group is headed by CEO attorney Lee In-seok, a former chief judge, with deputy group leader attorney Jin Ho-sik, who served as a Fair Trade Commission officer and prosecutor. The group also includes former Supreme Court Justice Kwon Soon-il, tax law expert CEO attorney Han Man-soo, and fair trade specialist attorney Hyun Min-seok.

After achieving favorable results in the Pizza Hut case second trial, YK is recruiting franchisees to participate as plaintiffs in collective lawsuits against various other franchise companies through its website.

Law Firm Taepyungyang (Chief Attorney Lee Jun-gi), representing Pizza Hut, is reinforcing its existing arguments to overturn the result in the Supreme Court appeal while publicly pointing out logical contradictions in the first and second trial rulings to sway public opinion.

At an emergency forum held on the 25th by the Korea Franchise Industry Association (Chairman Jung Hyun-sik) titled “How to respond to the realized difference in franchise fees crisis?”, attorney Byun Chae-young of Taepyungyang argued, “The regulation requiring difference in franchise fees to be recorded in franchise contracts applies from 2024, so the Seoul High Court ruling that difference in franchise fees must be recorded in the franchise contract to be collected is logically contradictory.”

He also pointed out, “Difference in franchise fees are invested in various costs such as logistics systems and management costs operated by the headquarters, and it is problematic to simply consider them as the headquarters’ actual profit without considering these aspects.”

Meanwhile, Kim & Chang law firm is representing BHC in the case. This lawsuit pits YK, which entered the top 10 law firms in 2023 and grew into the 7th largest by revenue last year, against the largest domestic law firms.

“Industry-wide bankruptcies feared” vs “Existing practices are the problem”

The Korea Franchise Industry Association submitted a petition to the Supreme Court panel hearing the Pizza Hut appeal at the end of last month, urging a ruling that considers industry practices and circumstances.

In the petition, the association stated, “The Korean franchise industry has received difference in franchise fees with explicit or implicit consent from franchisees, and it is a natural principle of commerce for merchants to receive margins during distribution,” adding, “Suddenly judging this as unjust enrichment and ordering repayment would severely undermine legal stability.”

The association also appealed, “Difference in franchise fees are not monopolistic profits of the franchisor but joint funds reinvested in various areas such as raw and subsidiary material processing and logistics costs, franchisee support costs, advertising and marketing expenses, and delivery support costs,” and “If the second trial ruling is upheld by the Supreme Court, the industry is gripped by fear of widespread bankruptcies.”

On the other hand, franchisees argue that it was wrong for the headquarters to unilaterally receive difference in franchise fees without legal or contractual basis and that they are simply recovering money rightfully owed to them.

Attorney Hyun Min-seok of YK, representing the franchisees in the Pizza Hut lawsuit, said, “Before the specific amounts of difference in franchise fees were disclosed through the disclosure document, franchisees had no way of knowing how much margin the headquarters was adding and had no choice but to pay whatever was demanded to maintain the franchise contract,” criticizing, “They earned blind money to fatten themselves and now distort the issue by claiming unfairness and bankruptcy.”

He added, “From the franchisees’ perspective, whether the headquarters adds 100% or 200% margin, they had no choice but to buy or terminate the contract. Where is such an unfair contract? That is why the Franchise Business Act enforcement decree started introducing the concept of difference in franchise fees to guarantee contractual freedom.”

He further emphasized, “Franchisors argue by applying traditional sales law that adding margins is natural, but in a general sales contract, franchisees should be able to choose to purchase from a third party at wholesale price or from the franchisor at retail price, so no separate agreement on margin is needed. However, franchisees have no choice. Fundamentally, franchising is not distribution.”

He concluded, “Franchisees are not saying don’t receive difference in franchise fees, but to reach an agreement. Don’t receive them secretly; agree in advance and specify them in the contract.”