Legal Risk Management In Franchise System Change

As a matter of competitive necessity, franchisors must continually evolve and adapt their products, services and internal operations. However, given the risk of litigation and indeed class actions from franchisees and dealers who may be negatively affected, franchise system change must be managed with special care. In a recent article published in the Ontario Bar Association's Focus on Franchising, members of McCarthy Tétrault's Franchise & Distribution Group have reviewed the legal trends that emerge from the franchise system change case law in Canada and distill several risk management strategies. The authors reach three key conclusions in the article:

Every proposed policy or practice that may economically effect the franchise network as a whole should be identified as carrying class action risk early in the process. This allows for early risk management. Franchise agreements should be reviewed and revised at the earliest opportunity to ensure that they provide the widest practical scope of flexibility for potential system changes. However, it is important to recognize the limitations inherent in general reservation of rights clauses. Franchisors should consider the benefits of developing good faith compliance programs for any significant system changes, with appropriate consultation with its franchisees and due consideration of their economic interests. The full article, entitled "Legal Risk Management in Franchise System Change," is provided below.

In business, evolution and adaptability are absolute prerequisites to success.1 Shifting consumer preferences, aggressive competitors, and new technologies require that businesses improve and adapt their products and services, as well as their supply chains and internal operations.2 For businesses that have chosen franchising as their organizational model, the requirement to evolve and adapt gives rise to a legal risk that is unknown to non-franchised businesses: the risk of opposition and litigation from your independent network of franchisees. For franchised businesses seeking to preserve and grow market share in the face of market demands, system change must be managed with special care in light of this unique legal challenge.

Franchise system change is a broad concept that encapsulates the evolution and adaptation of the system's products, services, internal operations, and supply chains in response to market pressures. Whether a franchise seeks to reduce service delivery costs, to expand its geographical presence, or to offer new products or services, system changes may have significant economic effects on franchisees. As a result of these financial effects on franchisees, system changes by Canada's franchisors have given rise to a relatively large volume of litigation, beginning in the mid-1990s, often in the form of class actions.3 In these proceedings, franchisees have often raised claims of breach of contract and breach of the duty of good faith, among other causes of action. Similar litigation began to be reported in the U.S. in the late 1980s.4

This article explores the legal trends that emerge from the franchise system change jurisprudence in Canada with an emphasis on risk management strategies. In section one, we propose a broad working definition of franchise system change to assist franchisors as early as possible in the process in identifying system changes that may provoke a response from franchisees. In section two, we discuss some best practices for ensuring that the franchise agreement and ancillary documents best anticipate and accommodate system changes that the franchisor may make during the ensuing term. Finally, we conclude with a discussion of the duty of good faith and the risk management strategies that can be distilled from the recent landmark decision of the Ontario Court of Appeal in Fairview Donut Inc. v. The TDL Group Corp.5

1. A Broad Definition of System Change for Early Identification of Risk

   The "franchise system" is an extremely broad concept, encompassing all aspects of the operations, marketing, and branding of the franchised business.6 From the perspective of legal risk, the key aspect of system change is that it generally gives rise to legal issues that are "common" to all franchisees (or to all members of a class of franchisee) and thus may be well suited for certification in class action proceedings.7 Whether the issue is the interpretation of a particular provision of the franchise agreement or system-wide conduct of the franchisor directed at all franchisees, the requirement for "common issues" under provincial class action statutes may easily be met.8 Given this, franchisors should proceed cautiously and with special care whenever a policy or practice is contemplated which could potentially have a financial effect on its entire network of franchisees (or a well-defined class of franchisees). By defining the contours of legal risk from this broad perspective, franchisors can ensure they identify specific risks as early in the process as possible, when the best risk management tools are still available.

   In some cases, it will be easy for franchisors to identify the riskier system changes. For example, in Mont-Bleu Ford Inc. v. Ford Motor Co. of Canada,9 the franchisor established a new class of dealer that competed directly with existing franchisees. It was likely not surprising when a class action was commenced by existing franchisees. Similarly, in the landmark case of Fairview Donut Inc. v. The TDL Group Corp.,10 the franchisor introduced two substantial changes to the product offerings in the Tim Hortons system, including the introduction of a new class of product (lunch items) and a major (and arguably expensive) shift in how franchisees baked doughnuts onsite. While these changes were viewed as generally positive by most franchisees, it was almost certainly foreseeable that those franchisees that may not profit from the changes might consider litigation.

   However, it will not always be as easy to identify legally risky system changes...