Canada: "Change Before You Have To": Franchise Lessons From Canada’s "Donut Wars"*

Last Updated: May 21 2013
Article by Christopher Horkins and Derek Ronde

Canada's two most significant franchise law decisions of 2012 demonstrate the fierce competitiveness of the quick-service restaurant (QSR) industry in Canada and the need for franchisors to adapt to changing market conditions by enacting well-thought-out system-wide changes or potentially face the economic and legal repercussions of failing to keep up.

The Ontario Superior Court of Justice decision in Fairview Donut Inc. v. TDL Group Corp. ("Tim Hortons"), which was recently upheld by the Ontario Court of Appeal, tells the story of a successful franchisor whose system-wide changes were upheld by the court over the objections of some disgruntled franchisees.1 In contrast, the Quebec Superior Court's decision in Bertico c. Dunkin' Brands Canada Ltd. ("Dunkin' Donuts") concerns a once-dominant franchise system that was, despite its best efforts, unable to keep up with a competitor – which, somewhat ironically, happened to be Tim Hortons – that was making inroads into its established territory in the province of Quebec.2 While Tim Hortons' sweeping changes were found to be a valid action within the bounds of its franchise agreements, Dunkin Donuts' alleged failure to stave off competition and prevent the franchise system's decline was found to be a breach of the franchisor's obligation to its franchisees to protect and develop the brand.

While these two cases may, at first blush, seem at odds, they share the common thread that franchisors are not only within their rights in enacting broad changes to stay relevant in the market, but (and to the dismay of franchisors) the court may ultimately focus on the result of those changes.

Tim Hortons

The Tim Hortons case was a proposed class action under Ontario's Class Proceedings Act, launched by a number of franchisees of the iconic Canadian coffee and donut franchisor Tim Hortons. The franchisees' claim arose from the franchisor's introduction of a new lunch menu and the switch from baking donuts and pastries from scratch on-site to a "par-baking" system known as the "Always Fresh conversion". Where franchisees were formerly required to hire bakers to make baked goods from scratch at each individual store, the new par-baking system involved partially baking donuts and pastries at a central facility, then flash-freezing and shipping them to stores where they were finished in specialized ovens. This eliminated the need to employ professional bakers at all franchise locations and ensured consistency across the franchise system. The franchisees alleged the new lunch menu and "Always Fresh" conversion required them to buy ingredients and supplies at above-market prices and sell certain menu items at break-even or a loss, which they alleged was a breach of their franchise agreements with Tim Hortons.

The plaintiff franchisees, proposing to represent a class spanning 500-800 franchisees operating approximately 2400 stores across Canada, claimed that the prices of certain ingredients they were required to buy from Tim Hortons became commercially unreasonable, eroding their ability to make a profit. They alleged several causes of action including breach of contract, misrepresentation, unjust enrichment, price maintenance and breach of the statutory duty of good faith under Ontario's Arthur Wishart Act (Franchise Disclosure)and similar franchise legislation in other provinces.

In the Ontario Superior Court of Justice decision, the court gave extensive reasons granting summary judgment to Tim Hortons and dismissing the franchisees' action. In granting summary judgment, the court acknowledged that, despite the voluminous record before the court, the case was not complex and essentially boiled down to the interpretation of the applicable legislation and franchise agreements.3

The court found no basis for the plaintiffs' claim that Tim Hortons was obligated to offer franchisees the lowest available prices in the marketplace for products and supplies, writing:


What matters, at the end of the day, is whether the franchisee makes sufficient profit overall to justify his or her investment and to remain in the business. The suggestion by the plaintiffs that the franchisor has an obligation to price every menu item so that they can make a profit on that particular item is not supported by the contract, by the law or by common sense. It is simply not the responsibility of the court to step in to recalibrate the financial terms of the agreement made by the parties.4

The court found that the franchise agreements did not confer a right for the franchisees to sell every menu item at a profit. If franchisees were losing money on lunch menu items, they were likely making up the difference through increased sales of higher-margin items such as coffee. The court similarly found that the Always Fresh conversion, in particular, was a net benefit to franchisees, as it effectively outsourced a baking process that was "time consuming, aggravating and wasteful."5 Despite the increased unit cost to franchisees for baked good products under the Always Fresh system, avoiding the rising costs of labour and ingredients related to the former scratch-baking process validated the franchisor's wisdom in requiring franchisees to abide by the system-wide change.

The introduction of the lunch menu and the Always Fresh conversion were both found to be within the bounds of Tim Hortons' contractual powers under the franchise agreements and, further, both were found to be perfectly rational business decisions made with regards to the interests of Tim Hortons as well as its franchisees. Tim Hortons had no obligation to prefer the interests of franchisees to its own in enacting such changes, especially when the evidence demonstrated that the franchisees were in fact earning a substantial return on their investment in their franchises.

The plaintiffs appealed the motion's court decision to the Ontario Court of Appeal, the highest appellate court in the province, only with regards to the dismissal of the breach of contract and statutory duty of good faith claims. Upon the conclusion of two days of argument, the three-judge panel dismissed the franchisees' appeal from the bench.

The Court of Appeal was emphatic in their endorsement of the motion court's decision, stating they agreed completely with his conclusions on the breach of contract and duty of good faith claims. On the breach of contract claim, the Court of Appeal made particular note of the motion court judge's conclusion that, when enacting system-wide changes, "the franchisor is entitled to consider the profitability and prosperity of the system as a whole".6 Turning to the good faith claim, the Court praised the motion's judge for having "carefully and comprehensively reviewed the record on this issue which strongly documented the extent and fairness of Tim Hortons' process for considering their franchisees' position with respect to the transition to a new donut production system".7

An application for leave to appeal of the Court of Appeal's decision to the Supreme Court of Canada was filed in February, 2013.8 Leave, however, is unlikely to be granted given the Court of Appeal's strong endorsement of the motion court's reasons. Tim Hortons will likely remain a landmark decision for the duty of good faith, and franchise class actions in Canada.

Dunkin' Donuts

Not long after the decision in Tim Hortons was released, a judge of the Superior Court of Quebec ruled in favour of a group of 21 former Dunkin' Donuts franchisees in that province, finding the franchisor, Dunkin' Brands Canada Ltd. ("Dunkin"), liable for having failed to "protect and enhance the Dunkin' Donuts brand in Quebec" in accordance with its obligations under the franchise agreements and ordered Dunkin to pay nearly $16.5 million in damages to the former franchisees who had lost their businesses.9

The franchisees' claim arose from Dunkin's alleged failure between 1995 and 2005 to protect and enhance the brand in Quebec, which they allege resulted in the collapse of the Quebec franchise system and the loss of their franchised businesses. Dunkin was, for many years, a dominant presence in Quebec. It enjoyed a market-leading share of the quick service coffee and donut market. In the face of stiff competition from Tim Hortons, however, Dunkin's presence in the Quebec market declined sharply. In the mid 1990s, Dunkin led the Quebec coffee and donut market, in terms of both total sales and number of stores. Over the course of the 2000s, however, Dunkin suffered what the court referred to as "a stunning fall from grace" in the province, losing nearly all of its Quebec franchise locations.10 Dunkin's total number of Quebec franchises decreased from 210 stores in 1998, to 115 in 2003, 41 in 2008, 25 in 2011 and just 13 remaining open in June 2012 when the court released its decision.

While the franchisees alleged that this collapse of Dunkin's Quebec franchise system was the result of their franchisor's failure to meet its contractual obligation to protect and enhance the brand in Quebec, Dunkin argued it was attributable to factors outside its control, namely, the underperformance of franchisees and what came to be known as the "Tim Hortons phenomenon". Beginning in 1996, Tim Hortons, whose dominant presence in English Canada had never translated into a similar presence in Quebec, began an aggressive plan of expansion into the Quebec market. Tim Hortons' success in expanding into Quebec mirrored Dunkin's decline. As the court noted, Tim Hortons' stores multiplied five times from 60 to 308 stores between 1995 and 2005, while Dunkin's market share in Quebec plummeted from 12.5% to 4.6% over a similar time period.11

Dunkin contended that it had made numerous attempts to combat the "Tim Hortons phenomenon" and had provided ample support to its Quebec franchisees. This support included conducting research and development in new products, menu changes designed to increase profitability, financial assistance programs for struggling franchisees, investments in Quebec-focused marketing campaigns and a remodeling incentive program to encourage franchisees to renovate their stores, especially those in close proximity to newly opened Tim Hortons locations. Many of these initiatives were met with resistance by reluctant franchisees. The remodeling program, in particular, suffered from poor take-up among franchisees and ultimately did not accomplish its intended goal. Despite the evidence put forward that Dunkin had invested considerable resources in supporting the Quebec market, as much or more in fact than it did for many other regions, the court was unconvinced by Dunkin's arguments that its actions were an adequate response to the increased competition from Tim Hortons, finding the franchise system's decline to be proof positive that Dunkin's measures were "too little way too late".12

Instead, the court accepted the franchisees' argument that the preamble of Dunkin's franchise agreements created a primary obligation for the franchisor to protect and enhance the Dunkin Donuts brand in Quebec. The failure to do so amounted to a breach of that obligation:

But the greatest failing of all was [Dunkin's] failure to protect its brand in the Quebec market. No doubt the host of failings chronicled by the Franchisees contributed to the collapse of the Dunkin Donuts' brand in Quebec. A successful brand is crucial to the maintenance of healthy franchises. However, when the brand falls out of bed, collapses, so too do those who rely upon it. And this is precisely what has happened in this case.
[Dunkin] had assigned to itself the principal obligation of protecting and enhancing its brand. It failed to do so, thereby breaching the most important obligation it had assumed in its contracts. It must accept the consequences of such a failure. As noted above, Franchisees cannot succeed where the System has failed. After sustaining several years of stagnant sales, narrowing profit margins and then losses, the Franchisees have all had to close their stores. Their losses follow hard upon the heels of [Dunkin's] failures as night follows day.13

In finding that the preamble imposed this obligation on Dunkin, the Quebec court appeared to disregard that the financial success of the franchisees was expressly disclaimed in the body of the agreement. It is unclear from the court's decision how the vague and broadly conceived positive obligation to "protect and enhance the brand" is reconciled with the express disclaimer elsewhere in the contract.

The court awarded the full amount of damages claimed by the franchisees for losses sustained beginning in 1996, the first instance where franchisees formally warned Dunkin of the "fox looking to enter the hen-house", finding that Dunkin's failure to adequately heed these warnings about Tim Hortons was a breach of its contractual obligation to protect the brand.14 The court accepted the franchisees' unorthodox method of damages calculation using the "comparable sales" of Tim Hortons franchises in Quebec to calculate the amount of lost profits the Dunkin franchisees had suffered due to the franchisor's breach of contract. In essence, the court endorsed a damages calculation that based the plaintiffs' losses on the operating results of their competitors from Tim Hortons on the purely speculative assumption that the plaintiffs would have enjoyed similar successes but for Dunkin's breach of the obligation to protect and enhance the brand. This method of calculating damages is both unorthodox and unprecedented.

The Dunkin' Donuts decision was met with a significant degree of surprise and concern by the Franchise bar. The decision is currently under appeal to the Quebec Court of Appeal. It is likely that key aspects of the appeal will deal with the overriding interpretation that the trial judge placed upon the franchise agreement regarding the "duty to protect and enhance the brand", the failure to adequately consider the evidence put forward by Dunkin regarding the many actions it did take to support its Quebec franchise system and stave off competition from Tim Hortons, and the excessive damage calculations.

Until the appeal is heard, it is unclear what impact Dunkin' Donuts will have on Canadian franchise law. First, it was decided under Civil Law principles which do not apply in the rest of Canada outside of Quebec, where common law principles govern. Second, it ostensibly casts upon franchisors an obligation to effectively guarantee the financial success of their franchisees in the face of legitimate competition. This would stretch commercial law principles beyond their breaking point from the perspective of many commentators, and make franchisors de facto insurers of their franchisees' success. While traditionally franchisors have been found to have an "obligation of means" – in that they must proactively support and assist their franchisees – the Quebec court in Dunkin' Donuts imposed a new and unintended "obligation of result" with dire consequences if that result, namely financial success, is not delivered. The obligation to "protect and enhance the brand" appears to require not only that a franchisor take action to stave off competition, but that that action be successful – notwithstanding the ease with which a court may stand with the benefit of 20/20 hindsight and judge what the appropriate business decision in the moment might have been. Ultimately, this challenges not only the longstanding "business judgment" rule, namely that Canadian courts will afford deference to reasonable business decisions made in good faith regardless of result, but also the underlying principle of franchising that success is a common objective shared by both franchisor and franchisee, and not a legal obligation resting solely with one party to the franchise relationship.15

If upheld on appeal, Dunkin' Donuts will be a daunting precedent for Canadian franchisors due to its controversial and expansive take on franchisors' contractual obligations.

The Take Away: Change is Good

Tim Hortons and Dunkin' Donuts are similar in that they both touch on the franchisor's legal responsibility and financial imperative to remain relevant in a dynamic and competitive industry by carefully considering and taking action to promote and enhance the viability of the franchise system. Franchisors that make calculated decisions to promote the profitability of the system as a whole, like Tim Hortons, are unlikely to attract liability for sweeping, system-wide changes. On the other hand, if Dunkin' Donuts is upheld on appeal, franchisors like Dunkin, whose efforts to adapt and remain relevant do not result in financial success for franchisees may face significant liability for failing to live up to any perceived contractual obligation to protect and enhance the brand.

It is important to remember that both of these decisions were ostensibly grounded in the law of contract and ultimately turned on the interpretation of provisions in the respective parties' franchise agreements which may not be similar to the provisions in other franchise agreements at issue in future cases. However, the terms of the franchise agreements at issue and the disputes in both cases are common enough that it is possible to draw broader conclusions applicable to all franchise systems. Franchisors will always have an economic incentive to adapt and protect their brand. Tim Hortons confirms that enacting broad, system-wide changes to adapt and protect their brand is within the franchisor's power.

A key factor underlying both decisions is economic success. In Dunkin' Donuts the court found that the collapse of Dunkin's franchise system in Quebec at the hands of competition from Tim Hortons was tied to Dunkin's failure to adequately respond to the warnings of franchisees about the "Tim Hortons phenomenon". The decline of Dunkin's Quebec franchise system was held up by the Quebec court as proof that its efforts to combat the "Tim Hortons phenomenon" and support its franchisees were not sufficient to meet their contractual obligations. In Tim Hortons, the franchisees' complaints about being forced to sell certain menu items at a loss or being required to purchase new products at above-market prices were offset by evidence that the system and the individual franchisees remained profitable and economically viable. As the court in Tim Hortons noted, the franchisees' "real complaint is not that they don't make a reasonable profit ... but rather that they don't make more profit."16 The court ultimately held that the franchisor's obligations did not extend so far as to require that the franchisees earn as much profit as possible on every item sold.

What remains to be seen is what result would occur in a case where, like in Tim Hortons, the franchisor made a calculated decision to enact system-wide changes to maintain the health and viability of the franchise system, but, like in Dunkin' Donuts, the system suffered a decline in the face of competition from other brands. What if, despite the wealth of evidence in Tim Hortons supporting the well-intentioned decision making behind "Always Fresh", and the finding that Tim Hortons was within the confines of the franchise agreements, the move had not produced the intended result of increasing franchisee profitability and success? Would a court taking a similar view to that of the Quebec court in Dunkin' Donuts find the franchisor's actions to be valid regardless of the outcome? Or would the court find the franchisor had not acted quickly or decisively enough to remain relevant and competitive in the QSR market? The curious logic of Dunkin' Donuts certainly raises the question of how far the court will step in to decide exactly what the franchisor's obligation to "protect and enhance" the brand requires. How close will the court come to second-guessing the business judgment of franchisors when well-intentioned changes go awry or fail to live up to expectations? As always, future cases will be determined on the unique facts of each case and the terms of the agreements at issue, but for now the "Donut Wars" gives us at least one important lesson – in a dynamic and competitive QSR market, franchisors must certainly strive to adapt to change.

* Orginally published in the May 2013 (Vol 17, No 1) edition of International Franchising, the International Bar Association's franchising newsletter.

Footnotes

1. Fairview Donut Ltd. v. TDL Group Corp. Ltd., 2012 ONSC 1252 [Tim Hortons OSCJ]; aff'd by 2012 ONCA 867 [Tim Hortons ONCA].

2. Bertico Inc. c. Dunkin' Brands Canada Ltd., 2012 QCCS 2809 [Dunkin' Donuts].

3. The court did certify the action as a class proceeding, but that certification was rendered moot as a result of the summary judgment decision.

4. Tim Hortons OSCJ, supra at para. 679.

5 Tim Hortons OSCJ, supra at para. 428.

6. Tim Hortons ONCA, supra at para. 5.

7. Tim Hortons ONCA, supra at para. 6.

8 Fairview Donut Inc. v. TDL Group Corp. Ltd., 2013 CarswellOnt 1782 (SCC).

9. Dunkin Donuts, supra at paras, 1, 128.

10. Dunkin Donuts, supra at para. 30.

11. Dunkin Donuts, supra at para. 38.

12. Dunkin Donuts, supra at para. 71.

13. Dunkin Donuts, supra at paras 57-58.

14. Dunkin Donuts, supra at para. 96.

15. For discussion of the "Business Judgment Rule" in Canadian law see BCE Inc. v. 1976 Debenture Holders, 2008 SCC 69; see also Peoples Department Stores Inc. (Trustee of) v. Wise, 2004 SCC 68.

16 Tim Hortons OSCJ, supra at para. 41.

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