Canada: Franchisors: What Are You Doing To Protect Your Brand?

If you are the owner of a franchise system and have recently seen the entry of an aggressive competitor into your market, there are lessons for you in the Québec Superior Court decision Bertico inc. v. Dunkin' Brands Canada Ltd. released on June 21, 2012. Therein, the story of the growth of Tim Hortons in Québec is told through the eyes of its competitor, Dunkin' Brands Canada Ltd., who lost its dominant share of the Québec fast food donuts and coffee market to Tim Hortons beginning in the mid-1990s. In 1998, there were 210 Dunkin Donuts stores in Québec. Today, there are only 13 stores. According to the franchisor, this "stunning fall from grace" is attributable to underperforming, even poor, franchisees. According to 21 Québec Dunkin Donuts franchisees, and subsequently, the Court, the decline was the result of a repeated and continuous failure by the franchisor over a decade to protect and enhance the Dunkin' brand in Québec and was a "case study of how industry leaders can become followers in free market economies."

Summary of the Facts & Legal Findings of the Court

The plaintiffs were 21 Dunkin' Donuts franchisees in Québec operating 32 stores. According to the Court, these franchisees were "amongst the best and most successful in the Québec réseau." Their owners were amongst the most active committee members. Many of them operated several stores and had all been operating for more than 10 years — some as long as 30 years. They had received awards of appreciation for their success. In short, the suggestion made by the franchisor at trial that these franchisees were "poor operators" was, according to the Court, "a defence utterly devoid of substance."

Dunkin Donuts stores had been operating in Québec since 1961 utilizing the Dunkin Donuts System developed by Dunkin Donuts Incorporated and its subsidiary, Dunkin Donuts Canada Ltd. Prior to Tim Hortons' arrival, Dunkin Donuts was the leader in the market, both by total sales and number of stores. At trial, Dunkin Donuts admitted that during its first 30 years in Québec, it had virtually no competition. According to the plaintiffs, during these years of unstructured competition, the franchisor made no substantive changes to its system. In the opinion of their expert, its officers had little appreciation of the Québec market and no coherent plan. Then, according to the plaintiffs, when Tim Hortons arrived in the mid-1990s, the franchisor made the fatal error of underestimating the competition and relied on a system that worked when there was no competition: "It was business as usual in circumstances where 'usual' wasn't nearly good enough."

According to the reasons issued by the Court, shortly after Tim Hortons came into the market, the franchisees alerted the franchisor to the impact Tim Hortons was having on their revenues. According to the franchisees, the franchisor did little, if anything, in response. Again, in 2000, they demanded that the franchisor implement a "recovery plan," which included a plan to address the high level of management turnover, reduction of services offered, deterioration of image, lack of technical support and a requirement that the franchisor reinvest in its banner to maintain its position in the Québec market.

In response, the franchisor proposed the "remodel incentive programme," which was a voluntary programme intended to encourage franchisees to commit to renovations of their stores before the time prescribed in their franchise agreements and which contemplated payments being made by the franchisor towards the overall cost to renovate over the first year following such renovations. The franchisor also committed to contribute 50% of the franchise fees generated by actual incremental sales to the advertisement fund for three years and a financial payment for any remodelled store where Tim Hortons developed a new store nearby within 24 months.

The catch was that at least 75 franchisees had to sign on, and the franchisees who agreed to the programme were required to release the franchisor from any suit or action against it for whatever reason from the "dawn of creation to the day it was signed." According to the Court, this was one of the explanations for poor take up amongst the franchisees: "it was a powerful disincentive to commit to the programme." The Court went so far as to describe the request for a release as "abusive" in the market conditions at the time. The apparent other reason for the programme's failure was that it required a huge investment on the part of the franchisees which, according to experts they had retained at the time, would not bear fruit. Not surprisingly, the programme did not get off the ground. The franchisor's expert attempted to spin this as an example of franchisees' "thwarting" the franchisor's efforts to remain competitive with Tim Hortons by stating that "only a few plaintiff franchisees took the franchisor's advice and incentives to remodel their stores." However, even he had to acknowledge that remodelling alone would not guarantee success. Indeed, those franchisees that had signed on and completed the renovations did not see the promised increases in revenues. The Court went on to note that, concurrently with the implementation of the remodel incentive programme, the franchisor announced that it would invest $40 million to revive the brand in Québec, $20 million of which would come from the franchisees, through contributions to the Advertising fund, and the other $20 million of which was to come out of the pocket of the franchisor. According to the Court, there was no credible evidence that the franchisor ever injected the promised funds.

In 2003, with significant losses mounting, the plaintiffs sought to terminate their leases and Franchise Agreements. The franchisees also claimed an award for damages from their franchisor for a breach of its contractual obligations under their Franchise Agreements. The essence of their case was that the Franchise Agreement, a contract of adhesion, obliged the franchisor to protect and enhance the brand. With little analysis as to the contractual language or indeed, consideration of what is meant by "brand protection" as distinct from operational support, the Court concluded that the allegations had been "substantiated convincingly" from the evidence at trial.

In the Franchise Agreements, the franchisor promised to protect and enhance both its reputation, and the "demand for the products of the Dunkin Donuts System" – in sum, the brand. The Court found that, despite the fact that the franchisor had assigned to itself the principal obligation of protecting and enhancing its brand, it failed over a period of a decade to protect its brand. The Court concluded that brand protection is an ongoing, continuing and "successive" obligation and that franchisees cannot succeed where the franchisor has failed to in this fundamental obligation. According to the Court, the franchisor has a duty to minimize losses and reposition itself in a changing marketplace. Although the Court made mention of the civil duty of good faith and of loyalty owed by franchisors to franchisees, no analysis was undertaken as to what that meant in these circumstances apart from a duty to work "in concert with" the franchisees in such market conditions.

The remaining 20 pages of the decision focus on the calculation of damages. In sum, the Court awarded the plaintiffs a global amount of $16,407,143 on account of lost profits flowing from lost sales in a growing market caused by a franchisor that had failed to protect its brand and the loss of investments made to participate in such a market.

What to Take From the Québec Superior Court's Decision

This case will undoubtedly be unsettling to franchisors. Despite a clear acknowledgement that a franchisor does not guarantee the success of its franchisees, the decision makes a strong case for the relationship between brand success and franchisee success. And, the Court emphatically lays responsibility for brand protection at the feet of franchisors. Unfortunately, there is next to no guidance in the decision as to what, practically speaking, it means to protect the brand. Clearly, a franchisor cannot be content to rest on its past success. It must innovate and rejuvenate. However, beyond that, the decision is quite unhelpful. Similarly, the Court utterly fails to give any insight on how the duty of good faith and loyalty factors into the franchisor's duty to protect the brand from aggressive competitors. In the end, the Court states the obvious: "successful brand is crucial to the maintenance of healthy franchises ... when the brand falls out of bed, collapses, so too do those who rely upon it." This is most unfortunate because one can readily anticipate that brand development, enhancement and protection will be a fertile ground for future litigation between franchisors and franchisees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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