Franchise & Distribution @ Gowlings – November 2006

Edited by Leonard Polsky and Ned Levitt

• The Prince Edward Island Franchises Act

• Measure of Damages for Future Lost Royalties Case Comment: 2 for 1 Subs Ltd. v. Ventresca et al

• The Termination and Non-Renewal of Dealership Agreements

• The Duty of Fair Dealing

• Franchising in Russia

Prince Edward Island, with the passage of its Franchises Act R.S.P.E.I. 1988, Cap. F14.1, became the third province in Canada to enact franchise specific legislation. The disclosure provisions come into force on January 1, 2007, the rest of the statute came into force on July 1, 2006.

This development occurred soon after the publication by the Uniform Law Conference of Canada of a model franchise statute. The PEI statute follows much of that model statute, which means it incorporates the best of both the Alberta Franchises Act and Ontario's Arthur Wishart Act. However, there are also some, "made in PEI" provisions, which are unique to that province and challenge those of us who labour to create a single uniform franchise disclosure document and procedures for use throughout Canada.

On the franchise relationship side, PEI is the same as Alberta and Ontario, dealing only with the right of franchisees to organize and implying a fair dealing covenant in all franchise agreements. The differences are in the disclosure requirements and procedures. This article canvasses some of the more significant differences.

Many franchisors in Ontario have longed for the ability to have prospective franchisees sign secrecy and confidentiality agreements before they receive a franchise disclosure document. This is not safe to do, because such an agreement would likely be considered an agreement relating to the franchise for which prior disclosure would be required. Such agreements are specifically allowed in PEI, with some restrictions.

Unique in PEI, franchise disclosure documents can be delivered electronically. There are, however, a number of specific technical requirements which must be met to effect delivery by this means.

PEI, Alberta and Ontario all allow the more developed franchisors, with significant net worth, to not include their financial statements in their disclosure documents. Although, the net worth requirement in PEI is lower at $2 million than the $5 million threshold in Alberta and Ontario. However, PEI is unique in allowing any franchisor to apply for a ministerial exemption from disclosing financial statements, regardless of the experience, net worth, etc. of the franchisor. The only criteria mentioned in the statute is that the Minister must be satisfied that to do so would not be prejudicial to the public interest.

The PEI statute, as is the case with Alberta and Ontario, does not require the franchisor to provide financial projections, but if given, they must comply with specified requirements. The PEI requirements go somewhat further than those in Alberta and Ontario.

For information to be disclosed about directors and officers, PEI is a hybrid of the Alberta and Ontario statutes. With regard to civil litigation, criminal prosecutions, and administrative proceedings, as in Ontario, the disclosure must be for all directors and officers. All other items of disclosure, as in Alberta, need only be for those directors and officers who will have day to day management responsibilities relating to the franchise.

In an unusual step, PEI requires disclosure about existing franchises and closings, not only in PEI, but also in New Brunswick and Nova Scotia. The PEI statute also differentiates itself by often requiring that the disclosure item relate to the franchisor's associates and include practices along with policies.

As in Alberta, the PEI statute allows for the use of a disclosure document from another jurisdiction, with the appropriate addendum. However, like Ontario, PEI requires that the disclosure be clear and concise, which, in many circumstances, would make the use of a foreign disclosure document, with a great volume of unrelated information, a dangerous decision.

Fortunately, the PEI statute has, like Alberta, made it clear that traditional distribution arrangements are not caught and that a substantially complete disclosure document is compliant. Like in Ontario, the PEI statute would appear to take jurisdiction in the case of a grant of a master franchise for Canada. This is so because the PEI statute applies to the grant of a franchise to be operated "partly or wholly" in PEI, without the additional requirement of the franchisee being resident or having a permanent establishment in the province, which is the case in Alberta.
By Edward N. Levitt

Measure of Damages for Future Lost Royalties Case Comment:
2 for 1 Subs Ltd. v. Ventresca et al

In April 2006, the Ontario Superior Court of Justice handed down its decision in the franchise case of 2 For 1 Subs Ltd. v. Ventresca et al.

This case considered a number of franchising issues, however this comment is confined to only one of them, namely the measure of damages for future lost royalties, in cases where a franchisee has had its franchise agreement terminated, for default.

The franchisee operated a 2 for 1 Subs franchise, wished, after seven years of operation, to transfer its franchise, and sought the franchisor's consent to the transfer, as required under the franchise agreement. During this process, both the franchisee and the purchaser refused to pay the prescribed transfer fee and training fees and related legal costs to the franchisor.

The franchisee proceeded with the sale anyway, and did not give the franchisor the opportunity to exercise its right of first refusal to buy the franchised business. The purchaser removed the signs, repainted the interior, and opened the operation under a new name.

This unauthorized transfer was a breach of the franchise agreement, and resulted in its termination. The franchisor sued the former franchisee, and claimed damages for lost future royalties which the franchisor would have received from the franchisee, if the franchise had continued rather than being terminated.

This type of action is not new, but it is surprising how few cases there have been in Canada which have dealt with this type of issue. They number less than 10 cases in 24 years.

The real struggle in these cases has not been for the Courts to determine whether or not the franchisor should be entitled to recover these type of damages from the defaulting franchisee. That entitlement appears to be a given, in the appropriate circumstances of franchisee breach.

Rather, the challenge has been for the Courts to determine the proper means of measuring the amount of the damages which the franchisor is entitled to recover.

In cases like this one, the franchisor will inevitably claim for damages for the lost future royalties it would have received, from the point of termination of the franchise agreement and right up to the end of the franchise agreement term, no matter how many years that period of time might be. In the present case, the franchise agreement had been for a 10-year term, and at the point of termination, there were still three years left to run in that franchise term.

In respect of such a claim, however, the plaintiff (franchisor) must take reasonable steps to mitigate its damages, rather than simply claim the maximum damages from the defaulting party (franchisee), without making any efforts of its own to save the situation from its worst possible outcome.

Courts in these cases have embraced this principle, and taken the position that the proper way to measure the amount of the franchisor's damages, is by considering what period of time the franchisor would need in order to find a new franchisee, and if need be, a new franchised location, and have that location open, the franchisee trained, and in operation for a sufficient period of time that the royalties being earned by the franchisor (after the growing pains of any start-up situation) are roughly equivalent to those which were being earned by the franchisor from the defaulting franchisee prior to the franchise agreement being terminated.

By way of specific comments, the Judge in this most recent case had this to say:

The case law suggests that a reasonable period of time for the franchisor to open a new franchise in the same area is in the range of 18 to 24 months…

…

In my view, in the circumstances and based on the case law noted above, a mitigation boundary of no more than two years is appropriate. I therefore conclude that the damages award against the Ventrescas for the loss of the franchise should be the equivalent of two years of royalties …

As a result, the damages awarded were calculated, based on the average annual royalties paid by the franchisee to the franchisor over the seven-year life of the franchise, multiplied by two. This result is consistent with the findings in the previous franchise cases mentioned.

This type of claim is always available to a franchisor in those instances where the franchisee's breach of the franchise agreement has caused its termination, and thus the loss of an income-producing franchise to the franchisor.

For franchisees – beware this potential consequence of breaching the franchise agreement.

For franchisors – consider adding this to the claims being made against a defaulting franchisee, where an action for damages for breach of the franchise agreement by the franchisee is being taken or contemplated.
By Leonard H. Polsky

The Termination and Non-Renewal of Dealership Agreements

What is the reasonable notice which a manufacturer needs to provide its dealer to terminate a dealership agreement without a fixed term and to avoid the renewal of a dealership agreement with a specific term?

While these questions must be answered on a case by case basis, some guidance is given in the comments and guidelines which the Quebec Court of Appeal confirmed in an important decision rendered on August 23, 2006. The case involved BMW Canada Inc. and Automobiles Jalbert Inc., a Quebec dealer of BMW cars and SUVs in Quebec City and in Kirkland, just outside of Montreal.¹

Jalbert had two BMW dealerships: one in Kirkland and one in Quebec City. The contract regarding the Kirkland dealership was a contract with no specified term but with a minimum ten year term, whereas the contract regarding the Québec City dealership was to terminate on December 21, 2002.

On September 28, 2001, BMW confirmed in writing to Jalbert that the Quebec dealership contract would end at the end of its term, on December 21, 2002, and would not be renewed. As for the Kirkland dealership, BMW provided Jalbert with a notice that the contract would not be continued beyond October 8, 2002.

On July 3, 2002, Jalbert instituted proceedings against BMW contesting the termination notices. Regardless of the judicial proceedings dealing amongst other things with the validity of the September 28, 2001 non-renewal notices for both dealerships, the two dealerships were extended three times; a last time until December 21, 2005.

The Superior Court Judge rendered his decision on December 15, 2004 and granted Jalbert's action against BMW. The Judge annulled the termination notices of the Kirkland and Quebec City dealership contracts sent by BMW on September 28, 2001 and declared that the contractual relationship between the parties would continue, other than if terminated for cause, up until December 21, 2012, more than 10 years after the notices.

In his decision, the Judge at first instance indicated that he thought BMW had not fulfilled its duty of fairness and good faith towards Jalbert by putting an end to the Kirkland dealership contract and by deciding not to renew the Quebec City dealership contract.

The Court of Appeal overturned the Superior Court Judge and addressed in great detail the issue of appropriate notice in the termination, without cause, of dealership agreements.

With respect to the Kirkland dealership contract, which was without a fixed term, the Court of Appeal concluded that the contract did not exclude the possibility of being terminated, even without cause, by one or the other party, upon sufficient notice. The Judge at first instance had decided that the termination notice sent by BMW on September 28, 2001 was null and void and that the dealership contract would terminate on September 21, 2012 based on "the necessary period to allow Jalbert to recoup its investment at the Kirkland dealership and obtain an appropriate return" (our translation).

The Court of Appeal confirmed that this approach of the Superior Court Judge was erroneous in that it outrageously simplified the exercise required in order to determine the reasonable notice. Based on the facts pertaining to the specific situation involving Jalbert with respect to the Kirkland dealership, the Court of Appeal confirmed that the September 28, 2001 notice of BMW to its dealer, announcing the termination of the contract for October 8, 2002, 13 months later, and thereafter for January 21, 2005, 40 months later, was sufficient.

As for the Quebec City dealership, which was for a fixed term terminating on December 21, 2002, the Court of Appeal found in favour of BMW and confirmed that the dealership agreement with a fixed term did not grant to the dealer a right of perpetual renewal and that, unless one was able to demonstrate that a custom of perpetual renewal existed in a specific industry, termination at the end of a term was possible, even without cause.

The Court of Appeal confirmed that the decision of BMW not to renew the dealership agreement beyond the end of its term, without invoking any reason in support thereof, did not necessarily go against its duty to act fairly and in an equitable manner. The Court added that the implicit obligation to act equitably and in good faith cannot, and must not, have the effect of rendering obsolete the contractual rules; adding that the good faith principle is relevant to the length of the delay and, given the circumstances, against an unreasonable termination of the agreement.

The Court added, that it is possible, and even probable, that the good faith principle in franchise contractual relationships implicitly obliges the franchisor (and we would add, the distributor, the manufacturer or others in similar positions), under the threat of damages, to renew short term agreements for a sufficient time when the franchisee has invested significant amounts in the business. The Court indicated, however, that between this need to provide notice, and the existence of an obligation to continuously renew an agreement, there was a line which it was not ready to cross, except if exceptional circumstances existed.

Surprisingly, and notwithstanding its findings, the Court rendered its decision in August 2006 and outlined specific measures which it imposed upon BMW and Jalbert to assure the harmonious termination of the contractual relationships between them, for the protection of the parties, as well as that of their clients and employees. The Court of Appeal confirmed the termination of both the Quebec City and Kirkland dealership agreements as of January 21, 2005 but at the same time preserved the status quo between the parties until December 21, 2006.

Footnote

1. BMW Canada Inc. v. Automobiles Jalbert Inc. and Denis Jalbert, QAC 200-09-005070-054
By Joëlle Boisvert

The Duty of Fair Dealing

Under Section 3 of the Arthur Wishart Act (Franchise Disclosure) 2000, S.O. 2000, c. 3 (the "Act") a party to a franchise agreement has a "right of action for damages against another party to the franchise agreement who breaches the duty of fair dealing in the performance or enforcement of the franchise agreement."

The duty of good faith is an implied term of franchise and other commercial agreements. How is the statutory duty different from the implied contractual term? It is has not thus far been interpreted to be any different from the implied contractual term. See the Court of Appeal's decision in Shelanu Inc. v. Print Three Franchising Corp. (2003), 64 O.R. (3d) 533. However, it may be seen as somewhat broader than the implied contractual term as the implied term is the duty to act in "good faith" whereas the statute speaks of "fair dealing" which is defined as including the "duty to act in good faith and in accordance with reasonable commercial standards". The Act adds an "unreasonableness" bent to what is already a duty not to act in "bad faith."

The duty of good faith includes a duty to act fairly and to take all reasonable steps to achieve the objectives of an agreement and the expectations of the parties.

Can the innocent party recover damages for breach of this duty over and above amounts due under a contract?

In CivicLife.com Inc. v. The Attorney General of Canada (Ont. C.A., June 21, 2006), Industry Canada had paid the plaintiff all amounts due under a contract to create an internet portal. It, however, was found to have tested a competitor's portal in breach of the agreement and to have deliberately taken steps to undermine the contract's objectives. It kept its transactions with the competitor secret and led the plaintiff to believe that it was proceeding with the project beyond its initial stages when it, in fact, it was going to go with the competitor's product.

As a result of this breach, it took CivicLife.com double the time and resources to finally obtain approval of its portal. Damages under this head were fixed at twice the cost of the contract or $1.52 million. It also was entitled to damages for the lost opportunity to roll out the program nationally fixed at another $1 million.

The plaintiff also recovered punitive damages because of the "very oppressive and highhanded" conduct of Industry Canada fixed at $400,000.00.

The Court of Appeal first looked at the express provisions in the contract to establish the objectives of the parties or their reasonable expectations which included Industry Canada's obligation "to use its best efforts to assist CivicLife during the currency of this Agreement with the commercialization of the Civic Portal Software…" and a term whereby the parties agreed "to be true and faithful to each other in all dealings and transactions relating to the Civic Portal Software."

After establishing the overall intention of the parties, the Court then upheld the trial judge's finding that Industry Canada breached the duty of good faith in undermining the objectives of the contract.

In its analysis, the Court of Appeal considered Professor McCamus' examination of the duty of good faith in The Law of Contracts (Toronto: Irwin Law, 2005) in which the duty was grouped into three categories:

those imposing a duty to cooperate in achieving the objectives of the agreement;

those imposing limits on the exercise of discretionary powers provided for in the contract; and

those precluding parties from acting to evade contractual duties, such as by engaging in conduct not strictly prohibited by the letter of the terms of their agreement but that has the effect of defeating rights under the agreement.

Industry Canada's conduct, in the CivicLife.com case, was held to have come within each of these three categories.
By Jeffrey P. Hoffman

Franchising in Russia

Russia appears to be an attractive market for the expansion of franchise systems, but it is not an easy market and it is certainly not for everyone. This article looks at some of the ways to structure a franchise relationship in Russia.

Russia has no specific "franchise law," but it does have some rules which are focused on a type of franchise transaction called a "Commercial Concession."

The essence of the Commercial Concession is that the rights holder (franchisor) grants the user (franchisee) use of a "complex of exclusive rights," including the rights to use the franchisor's company name, proprietary commercial information (including know-how) as well as trademarks and service marks. The complex of rights must include the use of the franchisor's company name and know-how, but rights to use trademarks and other rights are optional.

The use of the company name is the critical flaw with the Commercial Concession. Most franchisors do not want to grant the right to use the company name, as it is nearly impossible to compel a former franchisee to change its corporate name. For this reason, many franchisors look for structuring options.

Commercial Concession rules prohibit any price planning by a franchisor, including setting maximum and minimum prices. While one should expect difficulty in enforcing these types of provisions in any context under Russian law, the Commercial Concession rules explicitly forbid them.

A Commercial Concession agreement is not valid until registered, so royalties cannot be paid until the registration is completed.

Because of problems with the Commercial Concession structure, many franchise arrangements are cast as trademark licenses. The distinctions between a Commercial Concession and a trademark license involve the use of the franchisor's company name and trademark registration requirements.

A trademark license does not grant the right to use the franchisor's company name. For this reason, many franchisors choose trademark licenses rather than Commercial Concessions.

Like a Commercial Concession agreement, a trademark license is not valid until registered, and a trademark license may be registered only in relation to registered trademarks (registered either directly or through the Madrid System). So, both the trademark and the trademark license must be registered in Russia. This takes time, so a franchisor should plan well ahead.

A Russian franchisee may not remit royalty payments during or for periods before the trademark license agreement is registered (as the agreement is not valid until it is registered).

Many franchise relationships use several agreements. While a trademark license may be used for the use of the trademarks, another agreement may be used for the transfer of know-how. These agreements are often cast as consulting agreements and are used to start the payment and information flows pending trademark license registration. Since a consulting agreement is not subject to registration, it is valid upon execution. Payments under consulting agreements are usually configured as a fee rather than a royalty.

The Russian legal system is in transition and enforcement of rights is not as reliable as many would like. As a result of this, legal recourse in a franchise relationship may be difficult.

Therefore, the most important part of any franchise structure is the right franchisee. The right franchisee would have both ethical integrity and operational integrity. Ethical integrity focuses upon whether the franchisee is likely to voluntarily follow the terms of the relationship while operational integrity relates to whether the franchisee has the capability to successfully establish, operate and expand the business.

Maintaining the relationship is a second key to success. A successful franchisor will build the relationship as an on-going dialogue in growing the business along with the franchisee. Ultimately, a strong relationship is the best structure and the best legal protection a franchisor can have in Russia.
By Michael Malloy

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.