Québec Court Of Appeal Upholds Finding Of Franchisor’s Obligation To Maintain Brand Strength - Franchising

Bertico Inc. et al v. Dunkin' Brands Canada Ltd. (Allied Domecq Retailing International (Canada) Ltd.)

In a highly anticipated decision released on April 15, 2015, the Québec Court of Appeal upheld the findings of Justice Tingley of the Québec Superior Court that the Dunkin' Donuts franchisor in Québec breached its franchise agreements with its Québec franchisees by failing to adequately support them in the face of the "Tim Hortons phenomenon" in that province. With the exception of certain aspects of Justice Tingley's assessment of damages, the Court of Appeal upheld his decision in full. Read more about the Québec Superior Court decision in our June 28, 2012 Osler Update.

This decision has been long awaited by the franchise bars in both Canada and the United States because of the potential impact on franchisors of Justice Tingley's reasoning regarding "implicit obligations" flowing "from the general nature of franchise agreements," including an implied obligation incumbent on all franchisors "to protect, improve and enhance the brand," and an "underlying assumption of all franchise agreements [to the effect] that the brand will support a viable commerce." As we reviewed in our May 23, 2013 Osler Update, given the perceived importance of the matters at issue in the case to North American franchisors, the Canadian Franchise Association had in fact moved for leave to intervene as a third party on the appeal, but was denied by the Court of Appeal.

While the breadth of the precedential effect of the decision remains to be seen – the decision is made pursuant to the Civil Code of Québec and based on extensive trial evidence and unusual specific contractual terms – it affirms a franchisor's obligation to take reasonable measures to maintain brand strength generally and especially in the face of market changes.

Background

This case was a group action brought against Allied Domecq Retailing International (Canada) Ltd. (Dunkin' Donuts) by 21 plaintiff Dunkin' Donuts franchisees that collectively operated 32 Dunkin' Donuts franchises in Québec. Dunkin' Donuts was historically a strong brand in Québec with 210 stores in its heyday in 1998. However, its market share had been slipping in Québec, with a wave of Tim Hortons franchises flooding the province through the late 1990s and early 2000s. Under what Justice Tingley named the "Tim Hortons phenomenon," Tim Hortons stores had multiplied five times from 60 stores in 1995 to 308 by 2005, and in turn Dunkin' Donuts' market share plummeted from 12.5% in 1995 to 4.6% in 2003. The plaintiffs claimed that while they had voiced concerns to Dunkin' Donuts about rejuvenating the Dunkin' Donuts brand and business strategy in Québec as early as 1996, they found Dunkin' Donuts to be unsupportive and unresponsive to their concerns.

The plaintiffs brought an action against Dunkin' Donuts for the formal termination of their leases and franchise agreements together with damages totalling $16.4 million. The claim alleged a repeated and continuous failure by Dunkin' Donuts between 1995 and 2005 to fulfill its explicit contractual obligations to "protect and enhance" the Dunkin' Donuts brand in Québec. The plaintiffs' action was based on breach of contract, namely the franchise agreements between each plaintiff and Dunkin' Donuts.

The plaintiffs' claim succeeded in full and the franchisor appealed Justice Tingley's decision on several grounds. With the exception of the quantification of damages awarded to the plaintiff franchisees, the Court of Appeal upheld Justice Tingley's decision and reasoning, finding that counsel to the franchisor had failed to show an error of law in Justice Tingley's analysis of the obligational content of the franchise agreement, or any palpable and overriding error of fact regarding the franchisor's breach of this obligational content and the causality between this breach and losses sustained by the franchisees.

The Decision of the Québec Court of Appeal

As noted by the Court of Appeal, Dunkin' Donuts "radically" abandoned on appeal its wholly unsuccessful trial strategy of attempting to attribute blame to the failure of the brand in Québec to the performance and behaviour of its franchisees. Instead, Dunkin' Donuts chose to base its argument on Justice Tingley's alleged misapprehension of the evidence surrounding Dunkin' Donuts' efforts in favour of the brand, and his allegedly incorrect interpretation of both the explicit and implicit terms of the franchise agreements between the franchisor and the plaintiff franchisees.

In its decision, the Court of Appeal rejected the franchisor's arguments, finding, among other things, that Justice Tingley had

properly interpreted the obligational content of the franchise agreements, both in his analysis of, and reliance on, their explicit and implicit terms including the implied obligation of good faith [49-96]
acted appropriately by not applying the business judgment rule, as this rule is not to be used as a shield against civil liability of corporations arising from the breach of their contractual obligations [97-102]
properly considered the evidence of Dunkin' Donuts' efforts and initiatives to address franchisee concerns, support the brand and avoid franchisee losses, and had a basis for finding that in the circumstances these efforts nonetheless fell short of the "reasonable efforts to protect the brand" required by the franchise agreements and the duties inherent in the relationship [103-122]
properly adduced that there was a causal link between Dunkin' Donuts' conduct with respect to the network of franchisees as a whole, and the individual losses suffered by each individual plaintiff franchisee

The one instance in which the Court of Appeal respectfully disagreed with Justice Tingley was on his assessment of damages finding that he had erred in his failure to

apply the right limitation period to the calculation of damages (and was therefore over-inclusive by a period of three months) [172-174]
set-off against the damages award unpaid royalties owed by the plaintiff franchisees to the franchisor [175-178]
take into greater account competition that the plaintiff franchisees would have experienced from Tim Hortons in any event had the brand survived in the Québec market (which was the most significant error from a quantum perspective) [180-192]

The Court of Appeal therefore reduced the damages awarded at trial by approximately $5.5 million.

Key Points of Interest

Implied Contractual Obligations

A number of the Court of Appeal's findings relate to the provisions of the Civil Code of Québec (article 1434) providing for implied terms in agreements, including franchise agreements. Franchisees may take a broader interpretation of certain points made by the Court as grounds for expanding the scope of a franchisor's implicit obligations to a franchisee. It is important to keep in mind, however, that the implied obligations found by the Court of Appeal that are central to its decision and summarized below, arise out of the express language of the franchise agreements and the intent of the parties.

The Court of Appeal's main findings on implicit obligations in the franchise agreements and implied obligations of good faith included:

"Implicit obligations formed a part of a long-term collaborative relationship between the franchisor and each individual franchisee, within an established network in which service and quality of experience were imagined as nearly identical from restaurant to restaurant." [63]
"Given the role the franchisor assigned to itself in overseeing the on-going operation of the network and the uniform system of standards, it is fair to characterize the obligation of means to protect and enhance the brand as a "complement necessaire" of the contracts due to their nature. It was thus appropriate in my view, for the judge to infer that the Franchisor had implicitly agreed to undertake reasonable measures to help the franchisees, over the life of the arrangement, to support the brand. This included a duty to assist them in staving off competition in order to promote the on-going prosperity of the network as an inherent feature of the relational franchise contract." [64]
"In characterizing the essential obligation of the Franchisor as a duty to protect and enhance the brand, the judge did not assign a new and unintended obligation on the Franchisor, but he drew on the explicit terms, supplemented by implicit obligations flowing from the nature of the agreement that in both cases, reflected the intention of the parties." [65]
"This implied obligation of good faith requires a franchisor, by reason of superior know-how and expertise upon which the franchisees rely, to support individual franchisees and the whole of the network through its on-going assistance and cooperation." [70]
"[T]he franchisees were entitled to rely on the franchisor, as a matter of contractual fairness and as a reflection of their own presumed intentions, to take reasonable measures to protect them from the market challenge presented by Tim Hortons." [72]
"[I]t was in the franchisor's interest, broadly speaking, to assist its franchisees, to supervise the network, and to collaborate with them by proposing reasonable measures to combat a competitor, who in the longer term, threatens the value of the brand for both parties." [75]
There was a "duty to respond with reasonable measures to help the franchisees as a group to meet the market challenges of the moment and to assist the network of franchisees by enforcing the uniform standards of quality and cleanliness it holds out as critical to the success of the franchise." [77]
"It is up to the Franchisor to police the network by taking reasonable measures to root out the free-riders. It is up to the Franchisor to enforce the authority it has given itself under the franchise agreement. The explicit contractual right it has to insist that the franchisee respect the uniform standards of the system brings with it a correlative obligation of means, owed collectively and individually to the complying franchisees, to see that the franchisees adhere to those standards. This is part of its obligation to protect the brand – an obligation "owed to the network" that, juridically, is a duty owed to each of the franchisees as part of the agreement, whether that duty is explicit or not." [85]

The Court of Appeal further implies that in marketing its particular system and brand for sale, a franchisor makes a form of "representation" of the strength of its brand to prospective franchisees and that when a prospective franchisee enters into a franchise agreement with that franchisor, it does so in reliance on that representation.

"The Franchisor held out to each franchisee, individually, that the brand is something of value as an inducement to join the network. . . .The franchisee naturally, relied on this in deciding to join the network. . . .By denying that it has a duty to protect and enhance the brand, the judge rightly saw the Franchisor as going back on its word in each individual contract by denying the existence of the very cause of the arrangement." [81]

Finally, this decision is significant because it puts to rest a largely held notion in Québec (argued by the franchisor before the Court of Appeal) that a prior decision of the Court of Appeal, Provigo Distribution Inc. v Supermarché A.R.G. Inc., limited the duty of good faith and the implied obligations in the context of a franchise agreement to a duty incumbent upon a franchisor to not compete unfairly with its franchisees or to wrongfully take actions that would harm them.

The Court of Appeal rightly points out that Provigo speaks of a wider duty incumbent upon a franchisor to provide its franchisees with technical support and cooperation in order to maintain the relevance of the franchise relationship, and that Provigo could be applied in the present context in a way that was "merely an application of established law to a new set of facts." [76]

Damages

The undeniable silver lining on this cloud of a decision for the franchisor was the Court of Appeal's significant reduction in the damages award against Dunkin' Donuts. While only about one sixth of that reduction was attributable to the setting-off of the plaintiffs' unpaid royalties against the damages award, the underlying reasoning for that set-off is an important legal point for both franchisees and franchisors. In a situation of an ongoing franchise agreement, obligations continue to flow both ways, and even in a situation of fundamental breach by the franchisor, the franchisees are not relieved of their obligations under the franchise agreement until the resiliation (termination) of that agreement.

Putting the Decision into Context

When considering the decision, franchisors should keep in mind that it is a Québec decision, applying civil law pursuant to the Québec Civil Code, and is not binding on any court outside of Québec. Under the Québec Civil Code, franchise agreements create implicit contractual obligations, which in this case, included the obligation to undertake reasonable measures to help the franchisees support the brand of the franchise. Although central to the decision, the implicit obligations found by the Court of Appeal arose out of the express language of the franchise agreements at issue and the intent of the parties.

Furthermore, the case is very fact specific. There was a very lengthy trial heard over 67 days with evidence of a "host of failings" of Dunkin' Donuts on various fronts for over a decade (1995 to 2005). These failings were established both by the plaintiffs and by acknowledgments and admissions from several of Dunkin' Donuts' witnesses and exhibits.

If nothing else, this case reinforces that franchisors, and those who act for them, should be diligent in enforcing the standards contained in their franchise agreements when faced with uncooperative, under-performing and/or potentially rogue franchisees, because the risk of not doing so on the overall franchise system could create a situation like the one in this case, and attract the franchisor's liability.

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.