The Canadian duty of good faith in hotel renovations disputes post-pandemic

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This article, written by Ben Hanuka, originally appeared in the December 2022, issue of Hotel Business Review.

By Ben Hanuka, Law Works PC (Toronto)/Law Works LC (Vancouver)*

As a condition of rebranding a hotel for a new franchise system, a franchisor will typically require a franchisee to undertake extensive renovations (Property Improvement Plans, or PIPs) to bring the hotel up to the brand’s standards.  Covid and the subsequent economic challenges, such as supply chain issues and labour shortages, have contributed to delays in project completion and cost overruns. This has created problems for some franchisors and franchisees, particularly where the parties agreed to their PIPs before the pandemic.

Canadian provincial franchise statutes impose on both franchisors and franchisees a mutual obligation 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 PIP and the impact of the pandemic

Hotel PIPs are, by their nature, very long and detailed, extend over a long period of time, and come at a high cost.  PIPs that were put into place before the pandemic were made based on expectations that existed at that time, i.e., business as usual, a stream of room revenues, as well as relative availability of contractors and supplies.  The pandemic has obviously severely impacted these conditions.  For a period of time, average hotel revenues plunged.  Countries were in a lockdown and, while construction was deemed an essential service, not much could be done for a time because of lack of financing, a lack of contractors, and a breakdown in the supply chain.

This has resulted in misalignments between the timing requirements in PIPs and what franchisees were able to accomplish within those time frames.  In some relationships, franchisors and franchisees have been able to work out their differences and bring the renovation projects to completion on amicable terms.  In other situations, projects have stalled, and franchisors have ultimately opted to terminate their franchise relationships, creating losses for both sides.  For franchisors, terminations can result in lost opportunities to develop other properties in the affected areas.  For franchisees, the results can be costly if the renovations were underway, thus requiring yet additional rebrands to new systems midway through the existing renovation projects at a significant cost.  This is in addition to potential liability to franchisors for major liquidated damages under the provisions of the franchise agreement.

The relevant legal principles of good faith in Canada

Although the caselaw in Canada on the application of good faith in franchising is in its early development, the legal obligation of good faith in franchising generally requires that a party to a franchise agreement take into consideration all relevant circumstances and the interests of the other side.  However, the duty 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 must be done in a genuine manner that requires transparency.  Based on related court decisions about the duty of good faith in broader commercial contracts in Canada, the duty also requires that the parties not take advantage of contractual rights with an ulterior motive, i.e., designed to undermine the other side or to take unfair advantage of a contractual provision in a commercially unreasonable manner.

Applying these legal principals of good faith and fair dealing to the more specific scenario of hotel franchise disputes about PIP compliance, both sides to the franchise agreement have an obligation to live up to their obligations under the PIP, as required under the franchise agreement and the PIP itself.  But the caveat is that each side must perform and enforce its rights and obligations, as they relate to PIP requirements, in compliance with the legal principles of good faith, i.e., a commercially reasonable manner.  Neither party should be stringing the other along, and both sides should communicate about all PIP issues in a transparent manner.  This is a mutual obligation that applies to franchisors as well as franchisees.

Franchisors’ expectations

Franchisors’ primary objective is to see the successful completion of renovation projects and properties in the system reaching their projected room revenue capacities.  Franchisors have legitimate reasons to follow up on agreed-upon PIP completion schedules by way of inspections, compliance, and, if needed, enforcement.

Notwithstanding the obstacles caused by the pandemic, franchisors may argue that it was an opportune time to undertake renovations, i.e., when hotels were empty.  On the other hand, franchisors are likely required to take into consideration the obvious challenges posed by the pandemic and how the completion time of the PIPs may need to be adjusted based on the specific circumstances of the properties and their areas.

Franchisees’ expectations

By the same token, the duty of good faith, as it applies in the context of hotel renovations, includes an overarching obligation on franchisees to perform their obligations under PIPs to the best of their abilities, in a timely manner, and in a commercially reasonable manner.

Franchisees should not rely on Covid as a reason to put renovation projects on hold.  Similarly, franchisees should not use the pandemic as a blanket justification for delay without a reasonable explanation.  Rather, completing PIPs to the best of franchisees’ capabilities in the circumstances should be the primary objective.

As a rule of best practice (not a legal rule of good faith principle), a franchisee who owns several properties that all require extensive renovations, should not involve more than one property in a renovation project at a time.  Overly ambitious plans beyond the financial and other capabilities of the franchisee are doomed to fail.  By the same token, a franchisor should carefully assess whether it is prudent to agree to put more than one property owned by the same franchisee into a renovation plan.

Inspections and audits

Hotel franchisors, like other franchisors, may engage in detailed inspections of projects to check on the progress of the renovations and more routine audits to deal with more regular issues, such as customer complaints.  In addition to expecting compliance with PIP requirements, franchisors have a right to ensure that hotel guests have a consistent positive experience across all properties in the system.

Franchisees should give an accurate representation about the status of the project, or about attempts to complete the required steps.  They should communicate to the franchisor a realistic goal for completion and give the franchisor genuine periodic updates about what has been completed and what remains outstanding and why.

In general, franchisors have a right to ensure that franchisees are complying with all the requirements set out in the operations manual, policies and procedures.  Having said that, franchisors should recognize the reality that a renovation project creates inherent inconvenience to customers, and this can result in customer complaints.

As such, franchisors have an obligation to ensure that audit 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 with PIP requirements and their underlying reasons and assumptions, as well as of course 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.

Franchisor’s decisions and actions

Franchisors should obviously seriously consider granting requests for extensions of time to complete PIPs.  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, there may be a disconnect between a franchisor’s inspection or audit reports and its ultimate decisions and actions.  The 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.

Inspection or audit reports can sometimes provide an implicit approval of how the renovation project was unfolding on site.  To the extent that the franchisor later decides to treat the franchisee in default of its obligations because of failure to comply with PIP 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.

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 taken into consideration and all steps taken leading up to the termination.  The franchisor should follow its own internal directives, policies and guidelines, and give the franchisee reasonable notice, if so required.  Relevant circumstances may be pandemic-related, which are based on a sharp decline in revenues over the better part of a year or more, and severe constraints on hiring contractors.  Any adverse steps by franchisors should be consistent with their inspections.

They should also be firmly footed within the confines of their own official directives, policies and guidelines.  On the other hand, Covid considerations can also play in franchisors’ benefit in the context of non-compliance with their 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 in a timely and transparent manner its decision and the factors that it has taken into consideration.  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 and the hotel industry is not an exception.  Parties were not prepared for, and did not anticipate, the extreme challenges that the pandemic would end up causing to hotel rebranding renovation projects.  That has led to major delays and at least technical non-compliance with PIP requirements for projects that started before the onset of the pandemic.  Franchisors should take that into consideration when assessing non-compliance with PIP.  Franchisees should strive to take all commercially reasonable steps to complete their renovation 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.

Ben Hanuka is a member of the Ontario and British Columbia Bars.  He is principal of Law Works PC/LC, a boutique in Ontario and British Columbia, practising in the areas of franchise and commercial litigation.

The author wishes to thank Dan Charzewski, paralegal at Law Works, for his assistance in writing this article.