Franchise lawyers cannot be too diligent when it comes to the clear and precise drafting of franchise agreements. Franchisors often do not appreciate the risks that they are assuming when their franchise agreements are not well drafted or contain ambiguous or uncertain terms. When faced with the task of interpreting an uncertain, ambiguous or imprecise term in a franchise agreement, the court will resort to general principles of contract interpretation in the context of the franchise duty of fair dealing, often favouring the franchisee.
An example of a recent case in which a prominent Canadian franchisor brought an application for a determination of certain provisions in its franchise agreement is Boston Pizza International Inc. v. 395047 B.C. Ltd., 2008 B.C.S.C. 1016. This case was heard by the Supreme Court of British Columbia. While the result of the case was favourable to the franchisor, Boston Pizza International Inc. (Boston Pizza), regarding the specific franchise dispute, the broader result could have a significantly negative effect on the franchise system generally.
Right of Renewal
The franchise agreement was for an initial term of 10 years and provided for a renewal right as follows:
The company will … grant to the franchisee one renewal of this agreement for a further period of five years. The company will not refuse to renew the Franchise Agreement at the conclusion of the initial term or any subsequent renewal term unless Good Cause exists. For the purposes of this clause … Good Cause shall have the following meanings:
(f) the franchisee having been convicted of a crime which substantially impairs the goodwill associated with the franchisor’s trade-mark, service mark, trade name, logotype, advertising or commercial symbol.
The franchisee operated the franchise for the initial 10-year period and was in the course of completing a five-year renewal. At the time of the renewal, the franchisee was being investigated by the Canada Revenue Agency about the filing of GST returns. The parties extended the term of the agreement during the investigation and prosecution. Eventually, the franchisee was convicted of failure to remit GST and was sentenced and fined.
Following sentencing, the franchisor advised the franchisee that the agreement would expire at the end of the extension term and that there would be no further opportunity for renewal. The franchisee responded that it was entitled to a renewal of the agreement and that the termination of the agreement was wrongful.
The court was required to determine two fundamental issues:
- Did the agreement provide for a single renewal or did it provide for successive renewals?
- If the franchisee had the right to successive renewals, did the franchisor have good cause not to renew the agreement?
Regarding the first question, the court stated two general principles of contract interpretation – namely, that all of the terms of the contract must be construed in light of the agreement as a whole and that the goal in interpreting a contract is to discover objectively the intention of the parties at the time the contract was made by giving the contractual words their ordinary and natural meaning. The court stated that while the language in the agreement “lacks clarity,” when the agreement is read as a whole, the intent of the parties is clear. There was no doubt that a franchisee was entitled to a five-year renewal unless good cause existed.
However, following the first renewal, the agreement also contemplated further renewal terms by reason of the fact that it referred to “any subsequent renewal term.” The court reasoned that the reference to subsequent renewal terms must mean that a franchisee was entitled to seek renewal terms subsequent to the first renewal. The fact that the renewal also stated that the franchisor was required, if the franchisee was not in default, to grant the franchisee one renewal of the agreement did not mean that no other renewal could be sought following the first renewal. The court was emphatic that the agreement stated the obvious, which is that one renewal could be granted at that time and no ambiguity could arise from that language.
The franchisor argued that an interpretation that would grant a franchisee the right to seek subsequent renewals makes no commercial sense because it would mean that there is a perpetual right of renewal. The court flatly disagreed, stating that the franchisor was protected by the provisions on renewal relating to good cause. This interpretation of the agreement, in the words of the court, was also consistent with the “commercial reality” behind the establishment of a Boston Pizza franchise which required a substantial investment of capital by the franchisee. Under these circumstances, it was not surprising that the parties would give a franchisee significant security of tenure.
The result of this interpretation of the renewal provision in the Boston Pizza franchise agreement is that the franchisor must now deal with a court finding that the renewal provisions effectively allow its franchisees an unlimited number of renewal terms unless good cause, as set forth in the agreement, exists. The economic effect on a franchise system where franchisees have perpetual rights of renewal, without rigorous standards of upgrading, new terms and conditions in the agreement, and payment of renewal fees on renewal, will be significant. Clearly, with proper drafting of the renewal provisions of the franchise agreement, the conflict between a provision which allowed “one” renewal of the agreement for a period of five years and another provision stating that the franchisor could not refuse to renew at the conclusion of “any” subsequent renewal term could easily have been avoided.
“Good Cause” Provision
The second issue which the court was required to determine in this case pertained to the interpretation of the “good cause” right to refuse renewal. The court reviewed the severity of the criminal offences committed by the franchisee: the franchisee had misstated revenues with the intent to evade the payment of taxes, had filed completely fictitious GST returns and, in essence, was found to have acted fraudulently.
The court had to interpret the effect of a criminal conviction on the contractual rights of the parties to franchise agreements. While the franchisor relied on some U.S. cases that adopted a presumption that a criminal conviction will harm the franchisor’s goodwill as a matter of law, the franchisee submitted that the franchisor must prove, by the presentation of evidence, that the actions of the franchisee substantially impaired the franchisor’s goodwill. The court stated that its decision did not rest on the subjective evidence of impairment of goodwill put forward by either party, which was largely hearsay. Rather, the proper approach to determine whether there has been a substantial impairment of goodwill is for the court to consider the matter on an objective basis. The court stated that its consideration must proceed as follows:
This means that I must consider the nature of the offence, its relationship to the franchisor’s business and goodwill, policy concerns and any other relevant factors brought to the attention of the court.
Applying this test, the court concluded, without hesitation, that the conviction of the defendants under the Excise Tax Act for tax evasion substantially impaired the goodwill of the franchisor. In dealing with the franchisee’s submission that it was inappropriate to apply a presumption of law of this nature, the court noted that the U. S decisions stated an obvious proposition:
If a franchisee is convicted of a criminal offence which carries with it the taint of fraud and the offence is related to the operation of a business, a court will normally conclude that the franchisor’s reputation and goodwill is significantly impaired or that it has been injured or prejudiced. This conclusion is reached by an objective consideration of the nature of the offence and the connection of the offence with the business operations of the franchisor.
Having arrived at the conclusion that good cause existed under the circumstances, the court agreed with the franchisor that it was entitled to refuse a further renewal of the franchise agreement.
Implications of decision
The franchisor was somewhat fortunate that the court chose to apply an objective test in coming to the conclusion that the franchisee’s conviction, as a matter of law, substantially impaired the goodwill associated with the franchisor’s trade-mark. Otherwise, the franchisor would have had to prove the results of the conviction by adducing subjective evidence. The drafting question that this decision raises about the “good cause” provision in the franchise agreement is quite simple: what would have been the result on the facts if the “good cause” provision simply denied renewal if the franchisee had been convicted of a crime or, more specifically, an indictable offence, without the substantial impairment qualification?
Finally, on this point, U.S.-based franchisors should appreciate the fact that when their typical franchise agreements are reviewed by Canadian franchise counsel for conformity to Canadian law, clauses in U.S. agreements dealing with felonies or moral turpitude offences have no application in Canada as these terms are not used in the Criminal Code of Canada. Once again, precise and accurate drafting would require typical U.S. provisions of this nature to be amended to conform to Canadian legal requirements.
This case clearly illustrates why franchise agreements must be drafted clearly and precisely to eliminate ambiguity and uncertainty. While this franchisor may have won its case against the particular franchisee in question, the broader results of this case cannot be considered beneficial to the franchise system at large. Or, to put it another way, the franchisor won the battle, but lost the war.