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What happens when the franchisor wants to implement a change to the franchise system, yet the franchise agreement does not contain some system modification clause, the changes are unclear, or the effect on the franchisee has not been agreed on or disclosed at the outset?
A system change may amount to a breach of the franchise agreement if it is in violation of a provision in a franchise agreement, or if it is not authorized by the agreement.
1. Key issues and the duty of good faith
There are few Canadian court decisions dealing with the implications of system changes on the rights and obligations of parties to a franchise agreement.
In my opinion, the common thread running through the decisions relating to system changes involves an examination of the scope and nature of the change that the franchisor has implemented, and the manner or extent to which the system change affects the franchisee’s rights under the franchise agreement.
The typical language in the modern standard franchise agreement purports to give the franchisor the power to impose or implement any changes to the system as it deems appropriate.
The legal implications of a system change on the parties’ rights in this context require an analysis of whether the system change is to be imposed without an agreement between the parties, be it by contract or conduct.
Another element of the analysis if whether the change is so fundamental that it affects the franchisee’s rights and reasonable expectations under the agreement in a way that was not reasonably anticipated at the time of entering into the contract.
The Ontario courts have typically analyzed the parties’ rights and obligations arising out of system changes through the terms of the contract and the parties’ duty to carry out their obligations in good faith and through fair dealing. This obligation is found in the common law and codified in section 3 of Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000.
A franchisor will likely be required to implement a system change in a commercially reasonable manner where the right to implement the change is provided for in a franchise agreement but the provision does not contain sufficient parameters as to the scope of the change. The scope and extent of the change therefore must be commercially reasonable.
A franchisee pursuing redress arising out of unlawful system changes will be required to demonstrate what is commercially reasonable in the circumstances of the proposed system change.
Factors such as the cost of the change, the monetary impact of the change on the franchisee’s business, the overall value of the franchised business, and market customs and trends, are among the various factors to be considered.
A franchisee will claim damages as the most likely remedy in relation to a change to the system. These damages will be typically calculated on the basis of lost profits incurred as a result of the system change. Other cases have awarded damages on the basis of royalties and rents paid by a franchisee.
2. Some common types of system changes
a. New products/services, alternate sources of products and services
A franchisor may impose a requirement that the franchisee purchase a certain key product from a new supplier, or that the product itself be upgraded in quality or other characteristic.
Any of these could have the effect of significantly raising the cost of the product to the franchisee.
While a franchise agreement will typically contain a clause generally providing a franchisor with the right to impose new requirements relating to product purchases, it is possible that the franchise agreement does not provide in clear language that such a change may result in significant added costs to the franchisee.
To what extent, then, may a franchisee have recourse in connection with the added cost of the product?
At what point does the franchisee have a right to claim that the effect of the change has a significant effect on its overall profits and that therefore the change should not be imposed or damages should be awarded as a result?
The change that a franchisor seeks to impose in this regard must fall within the parameters of commercial reasonableness.
Depending on the circumstances, these parameters may include changing consumer demands, market changes and competitiveness, operational issues perceived by the franchisor with the old product, overall sales revenues and profitability of the franchisee, or an upgrade to the franchise system’s product line or quality across the board.
b. Leasehold/physical premises
A franchise agreement may require a franchisee to undergo significant renovations to the premises of the franchised business as a condition of renewing the franchise or transferring it to a new franchisee. Such renovations may be required if the premises are deficient. Renovations may also be required to bring the premises to the franchise system’s current standards.
Even if the premises are generally in good physical condition, the design, layout or other distinguishing elements of the premises may be outdated. The current standards of a franchise system may be significantly different, particularly if the existing premises were constructed long before the event that triggered the renovation requirement.
Another common trigger of the renovation requirement is a shopping centre head lease. Under some shopping centre head leases, the premises may be required to be renovated as a condition of renewing the head lease. This may also coincide with the renewal of the franchise term.
A requirement of this nature by a landlord, even if not originating with the franchisor and not based on a direct requirement under the franchise agreement, may nonetheless involve the franchisor in a variety of ways.
Under a sublease between a franchisee and franchisor, head lease obligations of the franchisor that are imposed by the landlord are typically passed on to the franchisee.
Even where the franchisee leases the premises directly from the landlord, the franchise agreement may contain a requirement that the franchisee maintain the head lease in good standing at all times.
The extent of the renovation requirement may not be readily clear in the absence of clear guidelines in the franchise or lease agreement.
In some cases, a franchisor or landlord may require expensive renovations equal to a significant portion of the market value of the entire franchised business.
Where there are no clear guidelines in the governing agreement, good faith and commercial reasonableness standards will play a greater in the analysis.
If the cost of renovations is significant, is it commercially reasonable for a franchisor to require that the franchisee invest $100,000 or $200,000 in renovations as a condition of renewing a franchised business that is not worth more than $500,000?
Should the franchisee be able to negotiate the extent of renovations, and, if so, on the basis of what factors?
Without clear and specific language in the franchise agreement, a franchisee will claim that the value of the overall business should be taken into consideration when determining whether the extent of required renovations is reasonable.
A franchise agreement may allow the franchisor to change the size of the franchisee’s exclusive territory at various intervals during the course of the franchise agreement or at the time of renewal or transfer.
As indicated earlier, in the absence of clear language in the franchise agreement setting out how and to what extent such change is to be made, the doctrine of commercial reasonableness applies to provide the parameters of this scope and extent.
Depending on the circumstances, these factors may include significant increases in population in the territory or even a change in consumer demand or other marketplace change that may support similar sales revenues in a smaller protected territory.
d. Marked-based terminations/market withdrawal
Franchisees of a franchise system which has not met with success in a particular market, or at all, may find themselves operating in a diminishing system.
Some franchisees in the system may gradually leave the system, either by closing down early or not renewing their franchise.
The franchisor may start limiting its operations in the marketplace while providing less support and activity in the market.
Typically in these situations, the franchisee will have no recourse. The franchise agreement will likely not impose an obligation on the franchisor to maintain a certain size of the franchise system or a minimum number of franchisees in the market.
A franchisor will likely be required to provide ongoing support to a franchisee, yet that has generally been held to a low standard.
e. New concepts; mixture of concepts in a territory/vicinity
In some cases, although not frequently observed, a franchisor may attempt to roll out a modified and competing concept under the same trademark of the original franchise system by planting in the marketplace new franchisees under the new concept. The new concept may include any combination of the following: different layout of retail premises, modified menu or product list, different retail sales methods (delivery, onsite, etc.), and different product qualities or grades.
When a franchisee operating a new concept is in close proximity to a location or even a territory of another franchisee operating under an older concept, issues may arise.
Consumers may prefer one concept or version over another. This may result in significant lost sales revenues to the franchisee operating the franchised business under the older concept.
f. Mergers with, or acquisition of, competing systems
A franchisor that merges with, or acquires, a competing system creates a combined franchise system where franchisees suddenly find themselves competing with other franchisees on a variety of possible levels: within an exclusive territory or offering products made or produced from materials with different cost bases.
Some of these may result in a breach of the franchisor’s contractual obligations to a franchisee; others may require an analysis of commercial reasonableness.
3. Other causes of action
a. Unjust enrichment
The three requirements for unjust enrichment claims for the grant of a restitutionary remedy are as follows:
1. The defendant (typically in this context the franchisor) had been enriched;
2. The plaintiff (typically a franchisee) had suffered a corresponding deprivation; and
3. There was no juristic reason for the enrichment.
A franchisor’s system change may be grounds for a claim of unjust enrichment. However, a franchisee will be required to prove a direct causal relationship between the unlawful system change and the alleged benefit to the franchisor.
b. Lack of disclosure
An important and often overlooked element of material fact disclosure in a disclosure document is disclosure of the types and extent of system changes that a franchisor may implement in the course of the franchise agreement, or as a condition of renewal or transfer.
It may not be sufficient to merely repeat in the disclosure document the broad language of the franchise agreement that purports to allow a franchisor to implement any system changes.
A material fact is generally defined under the Wishart Act to mean any information about the franchise system that may reasonably affect a prospective franchisee’s decision to purchase the franchise or the price that the prospective franchisee is willing to pay for the franchise.
The concept of material fact disclosure may require disclosure of the possible types of future system changes, their scope and extent, and the impact they may have, if any, on the franchisee’s business. If this information is reasonably within the knowledge of the franchisor, it ought to be disclosed.
In order to avoid legal liability, a franchisor should take steps to provide sufficient information in its system modification clause in the franchise agreement and in its disclosure document.
The elements on which to focus are the nature and extent of all system changes that may be reasonably contemplated throughout the term of the franchise agreement.
If at the time of implementing the system changes, a dispute arises with franchisees and there is a real question whether the above contractual and disclosure obligations have been complied with, a franchisor should aim to negotiate the terms of the system changes with its affected franchisees.