Franchisor’s Fundamental System Changes Led to Dismissal of its Injunction Application

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By Ben Hanuka, Law Works

This article was originally published in The Lawyer’s Daily as a two-part series on June 9 and 11, 2021. 

This article analyzes the recent franchise decision of June 1, 2021, from the Ontario Superior Court of Justice in Ottawa in Greco Franchising Inc. v. Milito et al., involving an interlocutory injunction application by a fitness studio franchisor, Greco Franchising, against an Ottawa-based franchisee, which the court ultimately dismissed in the franchisee’s favour.

The underlying conflict between the franchisor and the Ottawa franchisee in this case revolved around Greco’s newly introduced online at-home exercise program during COVID-19 pandemic and the resulting government shutdown of fitness studios, and the restrictions that Greco imposed on franchisees and how that impacted the franchisee.

The court’s decision by Justice Hackland in Ottawa is probably one of the first substantive decisions analyzing the impact of Covid-19 on the franchise business model – what changes the franchisor made to the system and how that impacted the franchisee.  In this case, the court found that the changes to the franchise system – and therefore to contractual rights – appeared to be fundamental.  This had a significant impact on the interlocutory injunction application test.

Key facts

Greco Franchising Inc. (“Greco”), the franchisor of Greco System of fitness studios, brought an interlocutory injunction application to refrain the respondent franchisees and related parties from operating a fitness studio outside of the Greco franchise system.

The franchisor’s main ground was that the franchisee, 2483425 Ontario Inc. (“248”), was operating a competing fitness studio from the original franchised premises in violation of the in-term non-compete covenants of the franchise agreement.

Greco rolled out its online at-home exercise program, which it called Greco Method At Home (which in this article will be referred to simply as the “online program”).  The online program imposed several new operational and financial restrictions.  Unlike the original in-studio programs, Greco was now in charge of soliciting and offering the online program directly to 248’s gym members.

Importantly, even though Greco made the online program optional to franchisees, it did not allow franchisees to offer any online or virtual programming themselves (which of course begs the question if the online program was genuinely optional during the government shutdown).

The financial terms of Greco’s online program also substantially differed from other programs.  Before the pandemic, franchisees retained the membership fees, subject only to payment to Greco of a fixed monthly royalty.  With the new online program, Greco set the prices, collected payment directly from studio members, and then shared the net revenues 50/50 with the respective franchisees, after accounting for the monthly royalties.

Also, of significant importance to the legal analysis, these changes were not purely in response to the pandemic and the government shutdown and were not temporary.  The evidence showed that Greco started developing the online program before the pandemic and that it intended to make it and its new financial arrangements permanent (all of which are inconsistent with the argument that this online program was purely in response to the pandemic).

Greco also attempted to amend the franchise agreement with 248 to reflect these changes.  248 refused to sign the amendment.

The dispute between Greco and 248 intensified over time.  They engaged in extensive negotiations through legal counsel.  These evolved into termination negotiations, including permitting 248 to de-brand its fitness studio.

Greco seemed agreeable that 248 would pay it certain amounts and would withdraw from the franchise system and continue operating an independent fitness studio from the same location.

Before the parties finalized the negotiations, 248 sent an email to all its active members advising that it was converting its Greco franchise to re-open as a “TG Athletics” studio.  Later, 248 sent a termination letter to Greco, alleging a fundamental breach of the franchise agreement and a breach of the duty of good faith and fair dealing.   Greco took the position that 248 breached its in-term non-competition covenant.

Court applied the strong prima facie test

The court held, albeit in relatively brief reasoning, that the applicable test on the first leg of the interlocutory injunction test was a ‘strong prima facie case’.  This is of course a much higher bar than the normal first leg of the interlocutory injunction test, which is ‘serious issue to be tried’.   The court explained that the bar of strong prima facie case meant an almost certainty of succeeding (as opposed to the much lower ‘serious issues to be tried’ threshold which is normally met, generally speaking, by merely showing some merit to a party’s position).

The main ground for applying this much higher threshold of strong prima facie case was the little time left in the franchise term – there were only about three months left.  The court held that it would be impossible to bring the issues to trial before the expiration of the agreement, and therefore an interlocutory order would have the effect of finally determining or rendering moot at least some of the issues in dispute.

Another factor that the court relied on in applying this higher standard was the impact of the injunction – it would interfere with a person’s ability to earn a livelihood.

Greco did not meet the strong prima facie case

The court found that, on the one hand, it was clear that 248 was, strictly speaking, in violation of the non-compete covenant in the franchise agreement.

On the other hand, the court also found that 248 had demonstrated a serious issue about whether Greco fundamentally breached the franchise agreement. 248 argued that Greco had fundamentally undermined the franchise agreement by directly marketing to 248’s members, financially restructuring the system and making major changes to 248’s role and restricting its opportunity to earn revenue through in-studio activities.

It is also noteworthy that, throughout this ordeal, 248 had ongoing and apparently intense communications with Grego and did not take steps without informing Greco.  248 had prolonged communications about its objections to the changes in the system.

Since 248 was able to show serious issue about whether Greco had fundamentally breached the franchise agreement, it necessarily meant that Greco did not show a strong prima facie case in support of its position.  In other words, the two are mutually exclusive – if a respondent demonstrates a serious issue in support of its case, an applicant cannot at the same time meet the strong prima facie case threshold.

The balance of convenience did not favour granting the injunction

On the irreparable harm and balance of convenience legs of the test, the court found that any damage to Greco’s goodwill, reputation, and membership allegiance as a result of 248’s independent operation may be compensated in damages.  Competition had already stared, and based on the evidence from the parties’ negotiations, Greco was prepared to accept appropriate financial and de-branding arrangements to allow 248 to operate an independent fitness studio.  For the court, these factors were not consistent with alleged irreparable harm to Greco.

In addition, granting an injunction would put 248 out of business, since there was little chance that it would rejoin the franchise system.  Incidentally, this would have also reduced the ability of Greco to collect any damages from 248.

The court also considered the interests of the 21 employees of 248 and the 190 members who joined the new fitness studio, who would suffer harm if the gym were to close.

There was also a side issue about 248’s new name, “TG Athletics”.  “TG” stood for Tony Greco, who was a founder of the Greco fitness system.  Greco alleged that the name was confusing with its franchise system for this reason.  The court tended to agree with this, however it noted that Mr. Greco had contractual permission from Grego to grant rights to the TG name and that it possible that 248 was using the name legitimately.  Greco did not provide details of its contractual arrangements with Mr. Greco, and the court appeared to make a negative inference against Greco on this issue.

Reflections about Greco’s changes to the business model and impact on the franchisee

In essence, the franchisor overhauled the business model and financial structure of the franchise by taking over the fitness classes, marketing, member payments, and financial compensation.  These changes were contrary to the franchise agreement and were significantly different from the original franchise model.

248’s remaining role appeared to merely allow members to sign up for programs.  It was thus effectively precluded from competing with the franchisor.

It was an important finding for the court that this may have very well amounted to fundamental changes to the franchise system (the ultimate finding on this issue is of course for the trial judge down the road, if it comes to that).

Further, Greco conceived of its new online program before the start of the pandemic.  It therefore cannot be characterized as purely a response to the pandemic.  If the system changes were necessary because of the pandemic, the evidence in the decision does not show why Greco wanted to make them permanent.

The decision does not indicate that there was any evidence that Greco consulted with or involved any other franchisees in this process, or if it did, to what extent it may have done so (unlike other cases about system changes, such as Fairview Donut Inc. v. The TDL Group).  Certainly, this particularly franchisee was strongly opposed to it from the outset.

There is a mutual duty of good faith and fair dealing on parties to a franchise agreement both at common law and under the provincial franchise legislation in Canadian provinces.  Given the far-reaching implications of the fundamental changes and their permanent nature, the good faith and fair dealings duty likely imposed on Greco an obligation to show that it had consulted with 248 and other franchisees in a meaningful and genuine way.

This duty probably also requires a franchisor in these circumstances to show some commercially reasonable grounds for imposing these fundamental changes as a result of the pandemic, including all the restrictions and exclusions that the franchisor sought to impose on the franchisees.

In the overall analysis, this decision appears to correctly imply that serious, fundamental and permanent changes to a franchise system can be meaningfully challenged by an affected franchisee if the impact on him or her is not fair, contravenes the contractual terms and does not meet the good faith and fair dealing standards of commercial reasonableness.