Conflicts Between Franchise Agreements and Operating Manuals: A Canadian Perspective

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By: Ben Hanuka, Law Works

This article was originally published in HotelExecutive on December 6, 2015

The vast majority of franchise systems, including hotel systems, depend on operating standards, procedures and policies. These requirements are typically contained in a franchise operating manual that is separate from a franchise agreement.

Particularly in established hotel franchise systems, operating manuals tend to be comprehensive and often complex documents. They may contain extensive requirements with respect to virtually every aspect of the operation of the hotel, from the brand and quality assurance to the use of technology.

These provisions are typically contained in a manual, rather than in the contract. By their nature, operating standards, procedures, and policies are subject to ongoing modification and amendments as the franchise system evolves. In addition, most of these provisions are purely operational, rather than legal, and do not generally relate to the contractual intent of the parties.

Most standard franchise agreements in circulation, including hotel franchise agreements, contain extensive provisions incorporating by reference the requirements of the operating manual, as well as the ongoing revisions in the manual which the franchisor may make from time to time.

The franchise agreement typically incorporates the operating manual by reference through provisions relating to the definition of terms such as the ‘system’, ‘operating standards’, ‘products’ or ‘services’, and many other related definitions and provisions.

The Conflict

Disputes may arise between franchisors and franchisees about conflicts between operating standards in an operating manual and express or implied provisions in a franchise agreement. This may be particularly so in hotel franchises where operating standards are complex and extensive, and on occasion may result in a significant impact on the operation of the business.

For instance, this conflict may arise when a franchisor seeks to amend a provision in an operating manual which conflicts with an existing provision in a franchise agreement.

Where a conflict arises between a provision in a franchise agreement and an operating manual, which governs over the other?

Is a franchisee deemed to have agreed to the terms of the operating manual – including future new terms that did not exist at the time of entering into the franchise agreement?

Even if the operating manual contained the provision in dispute from the outset, what if the franchisee did not receive and did not review the operating manual at the time of entering into the franchise agreement, as often happens? Is a franchisee deemed to have agreed to all terms and conditions in the operating manual?

Subsidiary questions are whether the terms of an operating manual are legally binding on a franchisee, and whether the operating manual is necessary to give business efficacy to the franchise agreement.

What Constitutes a Material Change

At the heart of the problem is the significance of the proposed operational change – how much it impacts the franchisee’s business. In other words, whether the change is expected or has a material or fundamental impact on the franchisee’s business.

Ultimately, it is up to the court or arbitration panel in any case to determine whether a particular change in the system, policy or procedure is so material that it can only be implemented through an amendment to the franchise agreement.

Franchise statutes in Canadian provinces contain definitions of ‘material fact’ and ‘material change’ in the context of the disclosure obligation. These definitions relate to the disclosure of information in a franchise disclosure document at the time of franchise sale or renewal. While they are not directly relevant to determining whether a change in an operating manual contractually conflicts with a franchise agreement, they may serve as a helpful guideline in the analysis: whether the change is expected to have, or does have, a material impact on the business.

Each of Canada’s five provincial franchise statutes defines a ‘material change’ as “a change in the business, operations, capital or control of the franchisor”, or “a change in the franchise system”.(1) As the definition states, a material change covers any information about any aspect of the franchisor, franchisor’s associate, the franchise system or the franchised business.

Recently, a decision on point was addressed by the Yukon Territory Supreme Court, a Canadian trial-level court, on a judicial review from an arbitration.

In the case of Church v. H & R Block Canada Inc.,(2) the franchisor, H & R Block, amended the operation manual to require all franchisees to use its software program for the preparation of tax returns. However, the use of the software under the franchise agreement was optional.

At the arbitration, one of the main issues was whether the amendment to the operating manual was enforceable.

The franchisee argued that the change in the manual with respect to the required software program was unenforceable for the following reasons:
(i) the requirement conflicted with the permissive language in the franchise agreement;
(ii) the franchisor’s attempt to impose this requirement through the manual was conduct in bad faith, and
(iii) the conflict between the amended manual and the franchise agreement resulted in contractual ambiguity, which should be resolved in favour of the franchisee based on the contra proferentem rule.

The majority of the arbitration panel acknowledged that the language in the amended manual and the franchise agreement was contradictory. It also noted that the amended requirement in the manual may have gone beyond a matter of policy and procedure, to a fundamental deviation from the original intention of the parties in the franchise agreement.

However, it ultimately decided that the amendment to the manual overrode the franchise agreement and was legally enforceable.

Underlying the majority’s decision was its conclusion that only material changes that were fundamental to the operation of the franchise had to be implemented through a formal amendment to the franchise agreement. It determined that the change to the use of the software did not meet this high threshold.

With respect to evidence, the majority found that the franchisee did not presented evidence about the impact of the software requirement on her business. As a result, there was no evidentiary basis to determine that the change could be considered fundamental.

On a more technical basis of interpreting the terms of the franchise agreement, the majority relied on this established contractual interpretation principle: searching for an interpretation from the whole of the contact that promotes and advances the true intent of the parties at the time they entered into the agreement (see the Supreme Court of Canada decision from 1980 in Consolidated-Bathurst Export Ltd. v. Mutual Boiler and Machinery Insurance Company).(3)

Based on this approach, the majority applied provisions in the franchise agreement – commonly found in most franchise agreements across many industries – requiring the franchisee to operate the franchise in accordance with the “H&R Block system”, as well as the rules and regulations specified in the manual.

In addition, the franchise agreement contained provisions permitting the franchisor to amend those rules and regulations from time to time. It also noted the definitions of ‘system’ and other standard definitions in the franchise agreement, which tied back to operational standards. As well, the franchise agreement was replete with references to the manual and its important applications to the operation of the franchise.

Moreover, the majority of the panel noted that the franchisee initially entered into a separate software licence agreement with the franchisor, which also referred to existing or any future policies that the franchisor established from time to time.

The majority found that, taken together, these requirements created “an overriding obligation” on the franchisee to operate the business in accordance with the system, which includes policy amendments from time to time with respect to the use of the software program.

Based on this approach the majority concluded that the parties could not have intended to require a signed formal amendment to the franchise agreement for each policy change.

The dissenting member of the arbitration panel held that the amendment altered the “fundamental relationship” between the franchisor and franchisee. He concluded that such a requirement could only be enforced through a written amendment to the franchise agreement.

On an application by the franchisee to the Yukon Territory Supreme Court to set aside the arbitration award, the court applied the normal limited grounds of judicial review of commercial arbitral awards and dismissed the franchisee’s application.

Summary

Applying these legal principles to any particular franchise dispute, a conflict between the provisions of an operating manual and a franchise agreement should focus on the following elements:

• Whether the change that the franchisor is seeking to implement has or can be expected to have a material impact on the system or the franchisees’ business;
• Whether a franchisee has evidence of the impact and resulting losses, and
• On a more technical level, how well the franchise agreement incorporates by reference the requirements of the operating manual and ongoing amendments to the manual, through express contractual provisions, as well as through key definitions such as the franchise system, the description of services, etc.

Assuming that the franchise agreement contains the necessary contractual provisions incorporating the requirements of the manual by reference, if the franchisee is able to demonstrate that the change is expected to have, or in fact has, a material impact on his or her business, the franchisee has a stronger case to resist the change through an operating manual, on the basis that it can only be agreed through a formal amendment to the franchise agreement.

If there is no credible evidence to demonstrate that the proposed change to the procedure or policy is expected to have a material impact on the business, the franchisee will generally find it more difficult to object to such an amendment through an operating manual.

References

(1) See section 1(1) in Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000, SO 2000, c 3, New Brunswick’s Franchises Act, SNB 2014, c 111, Prince Edward Island’s Franchises Act, RSPEI 1988, c F-14.1, Manitoba’s The Franchises Act, CCSM c F156, and Alberta’s Franchises Act, RSA 2000, c F-23. Other components of the statutory definition relate to the reasonable, objective standard on which to evaluate the material change, which is more relevant to the disclosure test, rather than a contractual assessment.
(2) 2013 YKSC 76, 233 A.C.W.S. (3d) 284, 2013 CarswellYukon 74
(3) [1980] 1 S.C.R. 888.