Managing Franchise Defaults in the Post-COVID Era

In that last two and half years (dating back to the start of the COVID-19 pandemic in early 2020) the business world has experienced drastic changes and challenges. By way of example, many businesses have been affected by:

• A shift to online delivery models;
• Labour market shortages and staff absences;
• Supply chain shortages;
• Heightened inflation and increased material costs; and
• Legal and legislative developments.

These and other changes and challenges have impacted franchising generally, as well as many of the industries that franchising is common in. In many cases, these changes have caused or contributed to franchisees defaulting under their franchise agreements. Strictly enforcing franchise agreements in these situations may be complicated by the ever-evolving duty of good faith and fair dealing. Moreover, in many cases, strict enforcement and/or termination of franchise agreements would not be in the best interest of the franchisor or the franchise system as a whole.

As the business world continues settling into a new normal, it is worth considering strategies for managing defaults in franchise relationships in the new business environment that franchise systems are operating in.

Update on Duty of Good Faith and Fair Dealing

Last year the Supreme Court of Canada (the “SCC”) released two decisions in which it revisited and clarified the principle of good faith contractual performance as previously formulated in Bhasin v. Hrynew.[1] In C.M. Callow Inc. v. Zollinger,[2] the SCC affirmed the duty of honest performance as a general organizing principal of contract law and provided additional guidance on what constitutes “active dishonesty” sufficient to trigger a breach of the duty. In Wastech Services Ltd. v. Greater Vancouver Sewerage and Drainage District,[3] the SCC more clearly defined the duty to exercise contractual discretion in good faith.

Although neither of these decisions involved a franchise relationship, Ontario courts have previously indicated that the statutory duty of good faith and fair dealing in the Arthur Wishart Act, 2000[4] is a codification of the common law duty of good faith.[5] Accordingly, these decisions inform and expand the statutory duty of good faith and fair dealing in provincial franchise laws.[6]

Indeed, there are certain key takeaways from these cases that franchisors ought to consider when managing franchisee defaults and potential terminations. First, franchisors need to avoid knowingly misleading franchisee on matters relating to defaults and possible terminations. Second, franchisors should exercise caution when exercising contractual discretionary powers, even where the agreement states that such power may be exercised in the franchisor’s sole and absolute discretion.

Managing Defaults Without Terminating

As a result of the expanding scope of the duty of good faith and fair dealing, franchisors should be more careful then ever when dealing with a franchisee that is in default of their franchise agreement. This is especially true if the default may be caused or contributed to by changes or challenges in the marketplace that are beyond the franchisee’s control. Certain best practices for managing such situations are explored here:

Documenting Defaults & Informal Warnings

Early documentation of franchisee defaults and the issuance of preliminary, informal warnings can serve several important functions for franchisors.

First, if and when a franchisor decides to formally enforce the franchise agreement, having reliable evidence of all of the franchisee’s defaults will be important in order to establish the franchisor’s rights and remedies. This is particularly true for operational defaults that do not necessarily generate supporting documentation the way that reporting or financial defaults do.

Second, informal and preliminary (but written and documented) warnings are a useful way to bring defaults or potential defaults to a franchisee’s attention while creating an early record of the issue in a manner that avoids the more damaging effect on the relationship that issuing a formal notice of default can have. Indeed, courts have considered early awareness of the franchisor’s position regarding default as a relevant factor when assessing the franchisor’s conduct in relation to a subsequent termination/cancellation of a franchise agreement.[7]

These strategies are also consistent with the franchisor satisfying its duty of good faith and fair dealing in the context of a franchisee default. In line with the takeaways from the Callow and Wastech decisions, by documenting and issuing informal warnings to franchisees, franchisors are actively ensuring that they are not knowingly misleading the franchisee leading up to enforcement and/or possible termination of a franchise agreement. Such warnings will support an assertion that a franchisor’s subsequent exercise of discretionary enforcement or exercised of termination rights is reasonable.

Issuing Notices of Default

Formal notices of default continue to serve as an important tool for franchisors. Franchisors should issue a formal notice of default if a franchisee fails to cure a default in response to an early and informal warning. A franchisor may also want to issue one immediately in response to certain material or more significant breaches where an informal warning would not adequately convey the seriousness of the default.

Formal notices of default are a necessary step where a franchisor’s right to terminate the franchise agreement is triggered by a franchisee failing to cure a defaults within a specified cure period or by a franchisee committing multiple defaults within a specified period of time.[8] A properly prepared notice of default should:

1. Clearly set-out and describe the franchisee’s default with reference to the applicable sections of the franchise agreement;
2. Cite any applicable cure periods and demand that the applicable defaults be cured within such periods; and
3. State the intended or possible consequences of failing to cure the defaults, again with reference to any applicable sections of the franchise agreement.

Forbearing from Enforcement or Termination

Courts have frequently upheld a franchisor’s rights to strictly enforce or terminate franchise agreements where such rights are clearly defined and the franchisor has properly followed the agreement.[9] Nevertheless, the exercise of such rights typically involves the exercise of discretion by the franchisor and, therefore, must be exercised in accordance with the expanding duty of good faith and fair dealing. Moreover, strict enforcement or termination of the terms of a franchise agreement may not be in the interest of the franchisor or the franchise system, particularly if the default is related to economic or business conditions beyond the franchisee’s control.

In such cases, a franchisor may, and should, consider forbearing from strict enforcement or immediate termination. While courts have acknowledged that a franchisor may forbear from exercising its contractual remedies without doing so in writing, a written forbearance agreement is recommended in order to confirm the terms and conditions of the forbearance and to avoid establishing a pattern forbearing or otherwise waiving compliance with the franchise agreement.[10]

A forbearance agreement should cover the following key terms and conditions:

1. An acknowledgment by the franchisee of the defaults under the franchise agreement, of the corresponding rights and remedies available to the franchisor, and that it would be fair and reasonable for the franchisor to exercise those rights and remedies;
2. An agreement to cure the defaults within specified periods of time;
3. An affirmation of the franchise agreement and undertaking to strictly adhere to its terms, as modified by the forbearance agreement; and  
4. Subject to the franchisee’s compliance with its obligations under the agreement, an undertaking of the franchisor to forbear from enforcing some or all of its rights and remedies under the franchise agreement, including the right to terminate.

Termination

Termination is generally a remedy of last resort, but remains appropriate if a franchisee is unable or unwilling to cure defaults. As noted above, courts have consistently found that a franchisor’s unilateral termination of a franchise agreement does not breach the duty of good faith and fair dealing as long as the franchisor follows the terms of the franchise agreement and does not terminate for an improper purpose.

Nevertheless, the determination of what constitutes an improper termination is fact specific and the scope of the duty of good faith and fair dealing continues to be clarified and expanded. Therefore, unilateral terminations attract a risk of a claim that the termination was a breach of the duty of good faith and fair dealing. To mitigate against the risk of such a claim, franchisors should consider the use of a mutual termination and release agreement whereby the franchisee agrees to mutually terminate the franchise agreement on terms that are more favourable than those that would otherwise apply on unilateral termination by the franchisor.

One form of mutual termination agreement and release agreement is similar to a forbearance agreement, but without the possibility of the franchisee continuing to operate the franchise at the end of the forbearance period. Instead, the agreement permits the franchisee to attempt to sell the franchise during the forbearance period, failing which the franchise agreement will automatically terminate. In Dairy Queen Canada, Inc. v M.Y. Sundae Inc., the British Columbia Supreme Court endorsed this type of mutual termination agreement and found that the threat of unilateral termination did not result in the franchisee entering into the agreement under duress.[11]

If attempting to effect a sale of the business is not possible or practical in the circumstances, the franchisor may instead agree to waive or reduce some of the franchisee’s obligations on termination. For example, a franchisor may agree to waive or reduce amounts the franchisee will owe on termination, to waive or modify restrictive covenants, or to repurchase the franchise (or the assets thereof) on more favourable terms.

Other terms typically included in a mutual termination and release agreement include:

1. A comprehensive release by the franchisee and its principals in favour of the franchisor;[12]
2. An acknowledgment and affirmation of any obligations of that franchisee that will apply on termination;
3. An acknowledgment and agreement from the franchisee the in the event of a breach of the agreement, any waivers or concessions granted by the franchisor will be void;
4. A confidentiality clause whereby the franchisee agrees not to disclose the terms of the agreement; and
5. Non-disparagement covenants from the franchisee and its principals.

Of course, mutual termination will not always be an option, and situations will arise where a franchisor may have no choice but to resort to unilateral termination. Where a franchisor exercises that right, following some of the considerations and recommendations outlined above will help franchisors avoid claims of terminating or enforcing agreement in bad faith.