Franchise renovations and system changes during COVID-19

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This article, written by Ben Hanuka, originally appeared as a two part series in the December 1 and December 2, 2022, issues of The Lawyer’s Daily.

As a condition of the franchise agreement, or a renewal of a franchise, franchisors will typically require that franchisees undertake periodic renovations to bring the location up to the brand’s then current standards.  Franchisors may also make system changes and require franchisees to adhere to them.  In franchise systems involving large physical spaces (big restaurants, hotels, sports facilities, etc.), COVID-19 and the subsequent economic challenges of supply chain and labour shortages have contributed to delays in renovation project completion and cost overruns.

This has created problems for some franchisors and franchisees, particularly where the parties agreed to the renovation requirements before the pandemic, or where the franchisor rolled out the system changes before the pandemic.  The key legal issues involve the contractual framework between the parties and the franchise duty of good faith and fair dealings in the performance or enforcement of the contractual terms.

Legal principles of good faith and fair dealings in Canada and some practical considerations

Canadian provincial franchise statutes impose a mutual obligation on franchisors and franchisees to perform and enforce their rights and obligations under the franchise agreement in good faith and through fair dealings, which includes the duty to act in accordance with reasonable commercial standards.

The caselaw on the application of good faith in franchising is still in its early development.  In franchising, it generally requires that a party to a franchise agreement take into consideration the relevant circumstances and the interests of the other party.  But it does not require one party to prefer the interests of the other.  Rather, the obligation is to consider the interests of the other side.

This is a mutual obligation that applies to franchisors and franchisees.  Practically speaking, neither party should be stringing the other along, and both sides should communicate about the dispute in a transparent manner.

Depending on the scope of the changes to the system, for a franchisor to discharge this obligation, it may be prudent to show evidence of consulting or involving franchisees in the decision-making process.  This duty probably also requires a franchisor, when seeking to impose major changes to the franchise system, to show some commercially reasonable grounds for imposing the changes as a result of the pandemic, including all the restrictions and exclusions that the franchisor is seeking to impose on the franchisees.  This should be done in a genuine and transparent manner.

As to franchisees, the duty of good faith includes an obligation on them to perform their obligations under the franchise agreement to the best of their abilities, in a timely manner, and in a commercially reasonable manner.  Franchisees should not use the pandemic as a blanket justification for delay without a commercially reasonable explanation.

Based on related court decisions about the duty of good faith in broader commercial disputes in Canada, the duty also requires that the parties refrain from taking advantage of contractual rights with an ulterior motive, i.e., in a manner designed to undermine the other side or take an unfair advantage of a contractual provision in a commercially unreasonable manner.

COVID system changes: The recent Greco decision

One recent example of a case involving a dispute about operational changes, in the context of an interlocutory injunction application, is Greco Franchising Inc. v. Franco Milito et al., 2021 ONSC 3950.  The underlying conflict between the franchisor and its Ottawa franchisee revolved around the franchisor’s newly introduced online at-home exercise program during the COVID pandemic, the resulting government shutdown of fitness studios, the restrictions that Greco imposed on franchisees, and how all that impacted the franchisee in this case.

The court’s decision is probably one of the first substantive decisions analyzing the impact of COVID on the franchise business model – what changes the franchisor made to the system and how that impacted the franchisee.  The court found that the changes to the franchise system appeared to be fundamental.

The franchisee argued that the franchisor had fundamentally undermined its rights under the franchise agreement by directly marketing to its members, financially restructuring the franchise system, making major changes to its role, and restricting its opportunity to earn revenue through in-studio activities.  The franchisee’s remaining role was to merely allow members to sign up for programs.  It was thus effectively precluded from competing with the franchisor.

The decision does not indicate that there was any evidence that the franchisor consulted with, or involved, any other franchisees in this process, or if it did, to what extent it may have done so.  This particularly franchisee was strongly opposed to the changes from the outset.  Throughout the dispute, the franchisee had ongoing and apparently intense communications with the franchisor about its concerns and did not take steps without informing the franchisor.

The court noted that the franchisor started developing the system changes and its new online program before the start of the pandemic.  Thus, it could not be characterized as purely a response to the pandemic.  It found that the franchisee had demonstrated a serious issue about whether the franchisor fundamentally breached the franchise agreement.  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, which were significantly different from the original franchise model, appeared to run contrary to the franchise agreement.

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 infringes on contractual rights and does not meet commercial reasonableness and related good faith and fair dealing standards.

Renovation inspections, audits and terminations during COVID

In general, franchisors have a right to ensure that franchisees comply with all requirements set out in the operations manual, policies and procedures.  Franchisors may engage in routine audits to deal with more regular operational issues, such as customer complaints and to ensure that customers have a consistent positive experience across all locations in the franchise system.

When it comes to completing renovation requirements, franchisors should recognize the reality that renovations or system changes create inherent inconvenience to customers, and this can result in customer complaints.  Franchisors should ensure that audit or inspection scores do not end up unfairly penalizing franchisees.  The franchisor’s representatives should clearly communicate to the franchisee both in person and in writing all non-compliance issues and their underlying reasons and assumptions, as well as how they need to be rectified.  The franchisor’s representatives should also consider, where it may be reasonable to do so, the input from the franchisee onsite.

As to franchisees, they should give an accurate representation about the franchised business or attempts to complete the required renovation steps.  They should communicate to the franchisor a realistic goal for completion and give the franchisor periodic updates about the status of the work.

Franchisors should seriously consider granting requests for extensions of time to complete renovations or system changes.  If a franchisor agrees to a franchisee’s request to grant an extension for completion of any phase, the franchisor should communicate the reasons for granting the extension and the franchisor’s expectation for the completion of the project based on the extension of time.

On the other hand, communications coming from the franchisor’s inspectors about ongoing inspections onsite, or potentially what was not communicated, can sometimes seem at odds with actions taken by head office months after the fact.  To the extent that the franchisor later decides to treat the franchisee in default of its obligations because of a failure to comply with requirements and timelines, there may be a disconnect between how the franchisee perceived its standing based on ongoing inspections, and the official notice from head office.

Inspection or audit reports can sometimes provide an implicit approval of how the operation was unfolding onsite.  Any adverse steps franchisors take should be consistent with their inspections.

Adverse steps: Defaults and terminations

In some cases, a franchisor will decide to terminate a franchisee that is in default of its contractual obligations.  A prudent franchisor should carefully document all relevant factors that it had considered and all the steps it had taken leading up to the termination.  Relevant circumstances in favour of the franchisee may be pandemic-related, which are based on a decline in revenues over the better part of a year or more, and severe constraints on hiring contractors.

A franchisor should follow its own internal directives, policies and guidelines, and give the franchisee reasonable notice, if so required.  COVID considerations can also play in the franchisor’s benefit in the context of non-compliance with its own directives, etc., if it is impractical to adhere to those rules.

Where a franchisor concludes that it is impossible for it to follow its own directives, policies, or guidelines, it should ensure that, first, it made this conclusion after considering all relevant circumstances and taking the franchisee’s interests into account (i.e., the impact that this decision will have on the franchisee).  Second, the franchisor should ensure that it communicates to the franchisee its decision and the factors that it has taken into consideration in a timely and transparent manner.  When appropriate, it should aim to allow the franchisee to respond and, then again, to take that response into adequate consideration and in a transparent manner.

Summary

The pandemic has caught all industries by surprise.  Parties were not prepared for, and did not anticipate, the extreme challenges that it would end up causing to renovation projects or system changes in franchising.  That has led to major delays and at least technical non-compliance with requirements for projects that started before the onset of the pandemic.  Franchisors should take that into consideration.  Franchisees should strive to take all commercially reasonable steps to complete their projects.

Neither party should take advantage of the situation.  Franchisees should communicate transparently about delays or any problems with the project, as well as how and when they can complete the project.  They must keep franchisors regularly informed about the project.  By the same token, franchisors should not apply a rigid approach to non-compliance if the commercial circumstances dictate a more flexible approach that mitigates damage to the brand and facilitates an orderly completion to the project.

The author wishes to thank the assistance of Anthony Pugh, associate, and Dan Charzewski, paralegal, at Law Works PC, in writing this article.