Legal Risk Management in Franchise System Change
As a matter of competitive necessity, franchisors must continually evolve and adapt their products, services and internal operations. However, given the risk of litigation and indeed class actions from franchisees and dealers who may be negatively affected, franchise system change must be managed with special care. In a recent article published in the Ontario Bar Association’s Focus on Franchising, members of McCarthy Tétrault’s Franchise & Distribution Group have reviewed the legal trends that emerge from the franchise system change case law in Canada and distill several risk management strategies. The authors reach three key conclusions in the article:
- Every proposed policy or practice that may economically effect the franchise network as a whole should be identified as carrying class action risk early in the process. This allows for early risk management.
- Franchise agreements should be reviewed and revised at the earliest opportunity to ensure that they provide the widest practical scope of flexibility for potential system changes. However, it is important to recognize the limitations inherent in general reservation of rights clauses.
- Franchisors should consider the benefits of developing good faith compliance programs for any significant system changes, with appropriate consultation with its franchisees and due consideration of their economic interests.
The full article, entitled "Legal Risk Management in Franchise System Change," is provided below.
In business, evolution and adaptability are absolute prerequisites to success.1 Shifting consumer preferences, aggressive competitors, and new technologies require that businesses improve and adapt their products and services, as well as their supply chains and internal operations.2 For businesses that have chosen franchising as their organizational model, the requirement to evolve and adapt gives rise to a legal risk that is unknown to non-franchised businesses: the risk of opposition and litigation from your independent network of franchisees. For franchised businesses seeking to preserve and grow market share in the face of market demands, system change must be managed with special care in light of this unique legal challenge.
Franchise system change is a broad concept that encapsulates the evolution and adaptation of the system’s products, services, internal operations, and supply chains in response to market pressures. Whether a franchise seeks to reduce service delivery costs, to expand its geographical presence, or to offer new products or services, system changes may have significant economic effects on franchisees. As a result of these financial effects on franchisees, system changes by Canada’s franchisors have given rise to a relatively large volume of litigation, beginning in the mid-1990s, often in the form of class actions.3 In these proceedings, franchisees have often raised claims of breach of contract and breach of the duty of good faith, among other causes of action. Similar litigation began to be reported in the U.S. in the late 1980s.4
This article explores the legal trends that emerge from the franchise system change jurisprudence in Canada with an emphasis on risk management strategies. In section one, we propose a broad working definition of franchise system change to assist franchisors as early as possible in the process in identifying system changes that may provoke a response from franchisees. In section two, we discuss some best practices for ensuring that the franchise agreement and ancillary documents best anticipate and accommodate system changes that the franchisor may make during the ensuing term. Finally, we conclude with a discussion of the duty of good faith and the risk management strategies that can be distilled from the recent landmark decision of the Ontario Court of Appeal in Fairview Donut Inc. v. The TDL Group Corp.5
I. A Broad Definition of System Change for Early Identification of Risk
The "franchise system" is an extremely broad concept, encompassing all aspects of the operations, marketing, and branding of the franchised business.6 From the perspective of legal risk, the key aspect of system change is that it generally gives rise to legal issues that are "common" to all franchisees (or to all members of a class of franchisee) and thus may be well suited for certification in class action proceedings.7 Whether the issue is the interpretation of a particular provision of the franchise agreement or system-wide conduct of the franchisor directed at all franchisees, the requirement for "common issues" under provincial class action statutes may easily be met.8 Given this, franchisors should proceed cautiously and with special care whenever a policy or practice is contemplated which could potentially have a financial effect on its entire network of franchisees (or a well-defined class of franchisees). By defining the contours of legal risk from this broad perspective, franchisors can ensure they identify specific risks as early in the process as possible, when the best risk management tools are still available.
In some cases, it will be easy for franchisors to identify the riskier system changes. For example, in Mont-Bleu Ford Inc. v. Ford Motor Co. of Canada,9 the franchisor established a new class of dealer that competed directly with existing franchisees. It was likely not surprising when a class action was commenced by existing franchisees. Similarly, in the landmark case of Fairview Donut Inc. v. The TDL Group Corp.,10 the franchisor introduced two substantial changes to the product offerings in the Tim Hortons system, including the introduction of a new class of product (lunch items) and a major (and arguably expensive) shift in how franchisees baked doughnuts onsite. While these changes were viewed as generally positive by most franchisees, it was almost certainly foreseeable that those franchisees that may not profit from the changes might consider litigation.
However, it will not always be as easy to identify legally risky system changes. Perhaps the best example in this regard is Bertico Inc. c. Dunkin’ Brands Canada Ltd.,11 a case that at first blush may not seem to fit well within the rubric of system change. In Dunkin, the ‘system change’ at issue was the significant and steady decline in market share, changes to the competitive landscape, and the franchisor’s alleged failure to adopt changes to its model in response. Dunkin is an important example of system change occurring from forces "external"12 to the franchisor. The franchisor in Dunkin was alleged to have failed to change the system in the face of the aggressive expansion of a competitor in Quebec and to have abandoned the market in the face of this competitive threat. Despite having a strong brand in the neighbouring U.S., and corresponding resources available to adapt in Quebec, it was the omission to act on the part of the franchisor that gave rise to liability.
Another example of a system change which may be less easily identifiable as presenting legal risk was at issue in 1176560 Ontario Ltd. v. Great Atlantic & Pacific Company of Canada Ltd. In that case, the franchisor changed its policy with respect to identifying the net rebate that was passed along from its suppliers on the invoices provided to its franchisees.13 While a change in invoicing practice may not immediately attract the attention of counsel advising the franchisor, a class action was certified in this case in which the franchisees asserted a right to transparent billing practices and to receipt of the rebates.
II. Anticipate and Accommodate System Change in the Franchise Agreement
In both Canada and the U.S., the most common cause of action asserted in franchise system change cases is breach of contract.14 For these claims, the express terms of the franchise agreement are almost invariably dispositive to the outcome. Indeed, in many system change cases, breach of contract claims have been resolved on the basis of a written record early in the proceedings, without the necessity of viva voce evidence.15 Three broad lessons can be distilled from the case law on system change that relate directly to the express terms of the franchise agreement:
- First, unnecessary lofty language in franchise agreements, as well as ambiguous clauses, should be cleaned up at the first opportunity, as they can impede system change and create legal ‘hooks’ for class actions.
- Second, broad reservations of rights and system modification clauses in franchise agreements are powerful tools to protect the franchisor from breach of contract claims that stem from system changes.
- Third, and related, reliance on general system modification clauses can be risky for a franchisor where the system change at issue is addressed by a more specific clause in the franchise agreement or where the system change causes substantial financial harm to franchisees.
Breach of Contract: Take Every Opportunity to ‘Clean Up’ Your Franchise Agreement
Several system change cases serve as a powerful reminder that ambiguity and lack of precision in franchise agreements increases legal risk and can interfere with good business practice. In the recent case of Spina v. Shoppers Drug Mart,16 the franchise agreement was found to be ambiguous on a critical issue: whether the franchisor had the right to retain a margin on certain services that it provided to franchisees. Since the franchise agreement was reasonably open to more than one interpretation on this issue, the court certified a claim by the franchisees wherein it was alleged that the franchisor had improperly profited from these services. While the franchisor may yet succeed on this issue at trial, express clarity on this issue at the certification stage might have provided the franchisor with an early and cost effective victory.
In Dunkin, unnecessarily lofty language in the franchise agreement was relied upon by the court to impose a duty on the franchisor to "protect the brand". The contractual clause at issue required the franchisor to "make reasonable efforts to disseminate its standards and specifications to potential suppliers of the Franchisee[s] upon the written request of the Franchisee[s]". While this duty appears benign on its face (and had no direct application to the facts of the case), the clause contained additional superfluous language that explained the purpose of this duty as being to "protect and enhance both … [the] reputation and the demand for products of the Dunkin Donuts System" [emphasis added].17 This prefatory language played a central role in the court’s legal analysis when it imposed a freestanding duty on the franchisor to protect the Dunkin brand in Quebec.18 While this case is currently under appeal, it serves as an important example of unnecessary language providing the court with a legal tool to address perceived factual inequities in the case before it. On careful review of the contractual clause as a whole, it is unclear what practical role the phrase "protect the brand" was intended to play in this franchise agreement given the rather modest duty nature of the duty "disseminate" standards and specifications.
Breach of Contract: Reservation of Rights and System Modification Clauses
Robust reservation of rights and system modification clauses are now commonplace in franchise agreements. By expressly authorizing the franchisor to make important changes to the franchise system, these clauses can be powerful tools to reduce the legal risk arising from needed franchise system change.19 Reservation of rights clauses have proven to be dispositive in a number of system change cases in the U.S., with franchisors successfully invoking such clauses at the summary judgment or pleadings stages to defeat unmeritorious claims expeditiously.20 A similar position is reflected in emerging Canadian jurisprudence.
In Fairview Donut, the clear language of the franchise agreement—which expressly permitted the franchisor to make substantive changes to the system through the operating manual—served to effectively bar the franchisees’ breach of contract claims, despite evidence that certain system changes had been unprofitable to a number of the franchisees.21 Similarly, clear contractual language was dispositive of the breach of contract claim in Landsbridge Auto Corp. v. Midas Canada Inc.,22 where the franchisor’s decision to cease manufacturing its own products was alleged to constitute to breach of contract. In Midas, the court dismissed the breach of contract claim at the certification stage, relying on a provision in the franchise agreement under which the franchisor had expressly reserved the right to "discontinue the sale … of any product [if] … the continued sale … becomes unfeasible, unprofitable, or otherwise undesirable".23
Breach of Contract: The Risks of Relying Solely On Reservation of Rights Clauses
Of course, express contractual claims in system change cases are not always so easily resolved by reservation of rights and system modification clauses. In some cases, the system change at issue may relate to an element of the franchise relationship that is governed by a more specific clause in the franchise agreement, which may apply despite a more general system modification clause. In other cases, the magnitude of the proposed system change may be construed to bring it outside the scope of the system modification clause.
In Restaurants Mikes Inc. v. 147564 Canada Inc.,24 the Quebec Court of Appeal held that a franchisor was limited in the types of changes it was permitted to make to the franchise system through a system modification clause. The franchisees alleged that the franchisor’s repeated modifications to a delivery system had disregarded certain elements of their franchise agreement and its addendum. The franchisor attempted to rely on a provision of the franchise agreement, which granted it the right to make unilateral changes to the delivery system. While the court acknowledged the franchisor’s right to make system changes under this provision, it held that the contractual discretion in this regard was constrained: the franchisor did not have the right to make changes that, in effect, resulted in a different contract altogether or which undermined more specific contractual rights that the franchisees held under the agreement.25
A similar analysis was employed by the English Court of Appeal in Fleet Mobile Tyres Ltd. v. Stone.26 The franchisor in Fleet Mobile, relying on a number of clauses which authorized it to provide ongoing instructions to franchisees to modify their business practices, instructed its franchisees to modify their service vehicles, stationary, and advertising to emphasize a different trade name from the one that had historically dominated the franchise system. The English Court of Appeal interpreted the franchisor’s right to provide these instructions as being subject to a limitation "that it would not be exercised so as to impede substantially the exercise of the franchisee's right", which was set out in the agreement, to "operate and promote the Business under the [original] Trade Name and the Trade Marks."27
Similarly, in 887574 Ontario Inc. v. Pizza Pizza Ltd,28 a dispute arose over the franchisor’s significant increase of franchisee contribution rates to rent and advertising pools.29 The franchisor attempted to rely on contractual provisions that allowed it to charge franchises for any deficits in those financial pools, despite more specific provisions which expressly capped franchisee contributions to these funds. In an important early recognition of principles that would later be elaborated in Restaurant Mikes and Fleet Mobile, the Ontario Superior Court, per MacPherson J. (now MacPherson J.A.), imposed a conceptual limit on the franchisor’s general right to pass rental and advertising pool deficits to franchises.30 According to MacPherson J., the issue of rental and advertising contributions by franchisees were "fundamental" issues in the context of the franchise relationship as a whole, and therefore could not be "increase[d] by massive amounts" by the franchisor "acting unilaterally and through the side door of the rental [and advertising] pool deficit provision".31
Two propositions flow from these cases. First, a franchisor’s general contractual right to require its franchisees to comply with system changes cannot override more clear and specific contractual rights of the franchisees to enjoy the benefits of the historical system. Second, general "subsidiary clauses"32 in a franchise agreement cannot be employed so as to substantially impair the "primary" or "fundamental" benefits accorded to the franchisee under the agreement as a whole.
III. Best Practices In Complying with the Duty of Good Faith for Significant System Changes
As noted above, in addition to express breach of contract, the second most common allegation in system change litigation is a breach of the duty of good faith and fair dealing. For these allegations, the express words of the contract will not always accord the franchisor a complete legal defence since the complaint generally focuses on the franchisor’s exercise of discretion or authority under the agreement. As the Ontario Court of Appeal made clear in Shelanu Inc. v. Print Three Franchising Corp.,33 franchisors are under a common law duty to exercise contractual discretion in good faith, a duty that has been codified by statute in Ontario, Alberta, New Brunswick, Manitoba and P.E.I.34 Recent case law has provided an important procedural risk management tool for franchisors: engage franchisees in a meaningful consultation process before implementing any significant system changes. In addition to allowing the franchisor to properly educate franchisees about the issues and to receive non-binding feedback and guidance, consultation can produce an evidentiary record that can be deployed by franchisors in defence of allegations of bad faith in subsequent litigation. Fairview Donut provides three key lessons in this regard.
First, Fairview Donut provides clear guidance to trial courts regarding the level of scrutiny they should bring to bear when analyzing good faith claims in system change cases. Rather than necessarily assessing a given franchise system change for compliance with the familiar standard of simple "reasonableness" as found in the common law of negligence, the Court of Appeal’s decision in Fairview Donut suggests that a more business-oriented and commercial standard of ‘economic rationality’ and ‘legitimate interests’ applies. According to the court, the franchisees’ good faith claims could not succeed in light of the clear evidence that the system changes at issue were "rational business decision[s] made by Tim Hortons for valid economic and strategic reasons, having regard to both its own interests and the interests of [all the system’s] franchisees". 35 This language strongly suggests that Canadian courts, like those in the U.S.,36 will show deference when reviewing the rational exercise of business judgment by a franchisor, similar to the review of the decisions of corporate boards.37 The key to avoiding liability is for the franchisor to illustrate both a rational business purpose and meaningful consideration of the interests of the entire system, including the franchisees as a whole. With these elements made out, we submit that even system changes that turn out in hindsight to be ‘incorrect’ or unprofitable are protected from liability under the duty of good faith.38
Second, Fairview Donut provides a road map for complying with the duty of good faith through a meaningful process of consulting with franchisees. A key element to the franchisor’s successful defence in Fairview Donut was a voluminous record that demonstrated ongoing and transparent consultation with franchisees at various points in the process of developing and rolling out the system changes. The franchisor had a formal system in place for non-binding consultation with its franchisees, which included a franchisee-elected advisory board that was actively engaged and consulted on the proposed changes and encouraged to ask questions.39 In addition, the franchisor also engaged in numerous one-on-one consultations with individual franchisees. The Court of Appeal emphasized in its discussion of good faith the franchisor’s "process for considering [the] franchisees’ position".
Third, Fairview Donut provides a helpful case study on a franchisor’s decision to obtain broad franchisee support for proposed system changes. Both the Superior Court and the Court of Appeal were influenced by the fact that a majority of franchisees apparently supported the impugned system changes.40 Indeed, in assessing the business rationale of the system changes, the Superior Court referred to evidence of a number of franchisees that testified in support of the impugned system changes as well as to supportive comments made by certain franchisees during the consultation process.41 Wide franchisee support for impugned system changes has also been influential in U.S. jurisprudence.42 This raises the question of whether the same outcome in Fairview Donut would have occurred if a more sizeable number of franchisees (or, indeed, a majority) had refused to support the system changes. One suggested best practice, or risk management strategy, is to address franchisee concerns with proposed system changes by making certain modifications to the proposals in order to bring more franchisees onboard.43 In the end, however, armed with express contractual authority to make system changes and a meaningful consultation process, Fairview Donut suggests that franchisors will likely be protected notwithstanding disapproval by franchisees.
Franchise system change cannot be avoided in the modern economy but must be managed with special care. These types of system-level changes represent one of the franchisor’s most clear exposures to class action risk and the greatest risk of multiparty litigation from within its network of franchisees. The Canadian jurisprudence on franchise system change illustrates three risk management devices for franchisors:
- First, every proposed policy or practice that may economically effect your franchisees as a whole should be identified as carrying class action risk early in the process. This allows for early risk management.
- Second, system franchise agreements should be reviewed and revised at the earliest opportunity to ensure that they provide the widest practical scope of flexibility for potential system changes.
- Third, franchisors should develop good faith compliance programs for each of their proposed system changes, with appropriate consultation with its franchisees and due consideration of their economic interests.
1 Edward Dunham & Kimberly Toomey, "The Evolution of the Species: Successfully Managing Franchise System Change", 24 Franchise Law Journal 231 (2004-2005) at p. 231.
2 Ibid. at p. 231; Adam Ship, "Franchise System Change and Managing Legal Risk In-House," Fall 2013, Canadian Corporate Counsel Association Magazine at p. 48; Daniel F. So. "The Ins and Outs of System Modification", Ontario Bar Association 9th Annual Franchise Law Conference: The Whole Nine Yards", October 14, 2009 at p. 3.
3 See e.g., 887574 Ontario Inc. v. Pizza Pizza Ltd., 1995 CanLII 7417 (ON SC) [Pizza Pizza], Rosedale Motors Inc. v. Petro-Canada Inc.,  O.J. No. 5368 (Ont. Div. Ct.); 1176560 Ontario Ltd. v. Great Atlantic & Pacific Company of Canada Ltd.,  CanLII 6199, 62 OR (3d) 535; Mont-Bleu Ford Inc. v. Ford Motor Co. of Canada Ltd., 2004 CanLII 10552 (Ont. Sup. Ct. J.); Landsbridge Auto Corp. v. Midas Canada Inc., 2009 CanLII 13628 (ON SC); 2038724 Ontario Ltd. v. Quizno’s Canada Restaurant Corporation, 2009 CanLII 23374 (Ont. Div. Ct.), Fairview Donut Inc. v. The TDL Group Corp., 2012 ONSC 1252; Trillium Motor World Ltd v. General Motors of Canada Ltd., 2012 ONSC 463.
4 Dunham and Toomey, supra note 1.
5 Fairview Donut Inc. v. The TDL Group Corp., 2012 ONSC 1252 [Fairview Donut (S.C.J.)].
6 See, for example, s. 1 of the Arthur Wishart Act (Franchise Disclosure), 2000, S.O. 2000, c. 3, where the "franchise system" is broadly defined to include the business obligations assigned to the franchisor and franchisee respectively under the franchise agreement; the franchise’s marketing or business plan; its associated goodwill; and its use of trade-marks, logos, or other advertising or commercial symbols.
7 See, e.g., Trillium Motor World Ltd v. General Motors of Canada Ltd., 2011 ONSC 1300 at para. 46; 1176560 Ontario Ltd. v. Great Atlantic & Pacific Company of Canada Ltd. (2002), 62 O.R. (3d) 535 at para. 26; Landsbridge Auto Corp. v. Midas Canada Inc. (2009), 73 C.P.C. (6th) 10 at para. 70.
8 Indeed, in Trillium Motor World Ltd v. General Motors of Canada Ltd., 2011 ONSC 1300 at para. 46, the Court also focused on the inherent vulnerability of franchisees in assessing the preferability requirement under class actions legislation.
9 Mont-Bleu Ford Inc. v. Ford Motor Co. of Canada Ltd., 2004 CanLII 10552 (Ont. Sup.Ct.)
10 Fairview Donut (S.C.J.), supra note 5.
11 Bertico Inc. c. Dunkin’ Brands Canada Ltd., 2012 QCCS 2809 [Dunkin Donuts]. The decision is under appeal.
12 So, supra note 2 at pp. 2-3.
13 1176560 Ontario Ltd. v. Great Atlantic & Pacific Company of Canada Ltd. (2002), 62 O.R. (3d) 535.
14 For the U.S., see Dunham and Toomey, supra note 1 at p. 231. The other main cause of action is breach of the duty of good faith, which is discussed below in Part III. Other possible causes of action can include unjust enrichment, civil conspiracy and breach of disclosure law: see B. Hanuka, "Managing System Changes – A Litigation Perspective", Ontario Bar Association 9th Annual Franchise Law Conference: The Whole Nine Yards", October 14, 2009 at p. 12.
15 See, e.g., Spina v. Shoppers Drug Mart Inc., 2012 ONSC 5563, 2013 ONSC 2559 [Spina]; Landsbridge Auto Corp. v. Midas Canada Inc., 2009 CanLII 13628 (ON SC) [Midas].
16 Spina, ibid.
17 Dunkin Donuts, supra note 11 at para. 15.
18 Ibid. at para. 54.
19 So, supra note 2 at 4.
20 Dunham and Toomey, supra note 1 at p. 234.
21 Fairview Donut (S.C.J.), supra note 5 at para. 423.
22 Midas, supra note 15.
23 Ibid at para. 30.
24 Restaurants Mikes Inc. v. 147564 Canada Inc., 2005 QCCA 551.
25 Ibid at para. 32-33. See also Hanuka, supra note 14 at pp. 5-6
26 Fleet Mobile Tyres Ltd. v. Stone,  EWCA Civ 1209 (Eng. C.A.) [Fleet Mobile].
27 Ibid. at paras. 55-57.
28 Pizza Pizza, supra note.
29 Ibid at para. 24.
30 Ibid at para. 36.
31 Ibid. at paras. 33-34 and 42.
32 Fleet Mobile, supra note 26 at para. 54, citing Esso Petroleum Company Limited v. Addison  EWHC 1730 (Comm).
33 Shelanu Inc. v. Print Three Franchising Corp.,  64 O.R. (3d) (C.A.) at para. 96.
34 Arthur Wishart Act (Franchise Disclosure), 2000, S.O. 2000, c. 3; Franchises Act, R.S.A. 2000, c. F-23; The Franchises Act, C.C.S.M. c. F156; Franchises Act, S.N.B. 2007, c. F-23.5; Franchises Act, R.S.P.E.I. 1988, c. F-14.1.
35 Fairview Donut Inc. v. The TDL Group Corp., 2012 ONCA 867 at para. 6 [Fairview Donut (C.A.)].
36 See Dunham and Toomey, supra note 1 at p. 238 ("[U.S.] Courts recognize that a franchisor's exercise of reasonable business judgment does not make the franchisor liable for breach of contract or the implied covenant of good faith and fair dealing even when that judgment results in financial loss to franchisees …").
37 BCE Inc. v. 1976 Debentureholders, 2008 SCC 69 at para. 40.
38 See also Horkins and Ronde, "Change Before you Have To": Franchise Lessons from Canada’s Donut Wars." May 21, 2013 Mondaq.com ("Franchisors that make calculated decisions to promote the profitability of the system as a whole … are unlikely to attract liability for sweeping, system-wide changes").
39 Fairview Donut (S.C.J.), supra note 5 at para. 30.
40 See, e.g., Fairview Donut (S.C.J.), supra note 5 at para. 675.
41 Ibid. at para. 676.
42 See Dunham and Toomey, supra note 1 at pp. 236 and 239.
43 Ibid. at p. 239.