Due to its seemingly nebulous and open-ended nature, the duty of good faith, which

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1 Best Practices for Managing Default, Termination and the Duty of Good Faith Canadian Franchise Association Law Day September 26, 2017 Eli Lederman, Lenczner Slaght Royce Smith Griffin LLP and Chris Horkins, Cassels Brock and Blackwell LLP 1 I. Overview Due to its seemingly nebulous and open-ended nature, the duty of good faith, which exists both at common law and under franchise legislation, can be one of the most challenging legal obligations for franchisors to grapple with. Issues concerning good faith are particularly important when managing default and termination of problem franchisees within a franchise system. Given the discretion involved and the stakes for the franchisee, it is not uncommon to see good faith claims against franchisors arising from a termination. The good news is that courts have helpfully prescribed some limits to the duty of good faith which can be applied to managing default and termination. This paper will outline the current jurisprudence on the parallel common law and statutory duties of good faith as they apply to franchisors, with particular focus on their application in default and termination scenarios. The paper will outline the authors suggested best practices for franchisors to follow when managing default and termination in a franchise system. II. The Common Law Duty of Good Faith and Honest Performance Applicable to Franchisors Courts have long recognized that the duty of good faith has a particular role in the franchisor-franchisee relationship. By way of example, in Ontario, the seminal decision of Shelanu Inc. v Print Three Franchising Corp. confirmed that franchisors in the province had a duty of good faith in that they have an obligation to have regard to the franchisee s legitimate 1 The authors are grateful for the assistance of Laura Robinson of Lenczner Slaght Royce Smith Griffin LLP in preparing this paper.

2 - 2 - interests and to deal promptly, honestly, fairly and reasonably with the franchisee. 2 The Shelanu decision considered acts occurring prior to the Arthur Wishart Act coming into force and found that, irrespective of whether the statutory duty could apply retroactively, the franchisor was nevertheless subject to a common law duty of good faith arising from the nature of the franchise relationship. 3 While the Court of Appeal confirmed the existence of franchisors good faith obligations, the Shelanu decision does not provide specific guidance for what that duty requires. Instead, the Court prescribed a general requirement of fairness, holding that whether or not a party has breached the duty of good faith will depend on all of the circumstances of the case, including whether the party subject to a duty of good faith conducted itself fairly throughout the process. 4 However, the Court of Appeal was careful to distinguish the duty of good faith on the part of a franchisor from that of a fiduciary. The duty of good faith does not oblige a franchisor to act only in accordance with the franchisee s interests in the exercise of powers or discretion arising out the relationship. Instead, where Party A owes a duty of good faith to Party B, A must give consideration to B s interest as well as to its own before exercising its power. The Court confirmed that, so long as A deals honestly and reasonably with B, B s interests are not necessarily paramount. 5 The common law obligations on contracting parties, including franchisors and franchisees, have recently been supplemented by virtue of the Supreme Court decision in Bhasin v. Hrynew. In Bhasin, the Supreme Court established the additional common law duty to act honestly in the performance of contractual obligations. 6 This duty was expressed as a 2 Shelanu Inc. v. Print Three Franchising Corp., 2003 CarswellOnt 2038 (Ont CA), at para 5 [ Shelanu ]. 3 Shelanu, supra at para Shelanu, supra at para Shelanu, supra at para Bhasin v Hrynew, 2014 SCC 71, at para 33 [ Bhasin ].

3 - 3 - manifestation of the newly recognized organizing principle of good faith contractual performance. The Supreme Court similarly agreed that good faith performance of a contract was not an equivalent obligation to that of a fiduciary. However, the Court did not provide specific guidance to parties on what this new organizing principle of good faith required in practice, other than to specify that parties generally must perform their contractual duties honestly and reasonably and not capriciously or arbitrarily, and that a contracting party should have appropriate regard to the legitimate contractual interests of their contracting partner. 7 In conjunction, this jurisprudence requires a party to a franchise agreement to not lie or knowingly mislead their counterpart in matters directly linked to the performance of the contract, and to give some consideration to their counterpart s interest when exercising contractual discretion. The abstract nature of these requirements ensures that courts will continue to engage in highly fact-specific analyses in the adjudication of franchise disputes. III. The Duty of Good Faith and Fair Dealing under Franchise Legislation In addition to the common law duty of honest performance discussed in Bhasin, franchisors are subject to a parallel statutory duty of good faith and fair dealing in many provinces, including Ontario. Section 3 of Ontario s Arthur Wishart Act imposes a duty of fair dealing on all parties to a franchise agreement: Fair dealing 3. (1) Every franchise agreement imposes on each party a duty of fair dealing in its performance and enforcement. Right of action 7 Bhasin at paragraphs 63 and 65.

4 - 4 - (2) A party to a franchise agreement has a right of action for damages against another party to the franchise agreement who breaches the duty of fair dealing in the performance or enforcement of the franchise agreement. Interpretation (3) For the purpose of this section, the duty of fair dealing includes the duty to act in good faith and in accordance with reasonable commercial standards. 8 Franchise statutes in force in Alberta, Manitoba, New Brunswick, Prince Edward Island and British Columbia also impose such a duty. 9 With the exception of Alberta, the legislation in other provinces also expressly provides that the duty of fair dealing includes a duty to act in good faith and in accordance with reasonable commercial standards. Ontario courts have held that there is no practical distinction between the good faith and fair dealing aspects of this duty. 10 The statutory duty merely codifies the existing common law duty of good faith, as described by the Supreme Court in Bhasin. 11 In Trillium Motor World Ltd. v General Motors of Canada Ltd., the Ontario Superior Court described the limits on the statutory duty of good faith under the Wishart Act: At a minimum, the duty of good faith requires the honest performance of contractual obligations. That is, it requires that parties not lie or knowingly mislead each other about matters directly linked to the performance of the contract. And it is clear that the duty of good faith has an upper limit namely, it does not require the contracting parties to act as fiduciaries to one another. But in between those two extremes lies a wide, context-sensitive range of obligations, rights and responsibilities Arthur Wishart Act (Franchise Disclosure), 2000, SO 2000, c 3, s 3. 9 Franchises Act, RSA 2000, c F-23, s 7; Franchises Act, SM 2010, c 13, s 3; Franchises Act, RSNB 2014, c 111, s 3; Franchises Act, SPEI 2005, c 36, s 3; Franchises Act, SBC 2015, c 35, s Trillium Motor World Ltd. v General Motors of Canada Ltd., 2015 ONSC 3824 at para 153; aff d by 2017 ONCA 545 [ Trillium ]. 11 Trillium, supra at para 153; see also Spina v. Shoppers Drug Mart Inc., 2012 ONSC 5563 at para 146 [ Spina ]. 12 Trillium, supra at para 154.

5 - 5 - Determining what the duty of good faith and fair dealing actually requires of franchisors, however, is context specific. Ontario courts have generally outlined some guiding principles, such as: a) A franchisor may act self-interestedly, but must also have regard to the legitimate interests of the franchisee when exercising its powers under the franchise agreement; 13 b) Franchisors must deal honestly, fairly and reasonably with franchisees; 14 c) Where the franchisor is given discretion under the franchise agreement, it must be exercised reasonably and with proper motive and not arbitrarily, capriciously or in a manner that is inconsistent with the reasonable expectations of the parties; 15 d) A franchisor will only breach the duty when it acts in bad faith; 16 e) The duty of good faith is not a stand-alone duty intended to trump or re-write the express terms of the franchise agreement; 17 and f) Good faith is a two way street. Whether a franchisor has breached the duty will depend, in part, on whether the franchisee alleging the breach has also conducted itself fairly. 18 As noted above, the duty of good faith and fair dealing is a minimal standard and can be loosely defined as the absence of bad faith. In Katotikidis v Mr. Submarine Ltd., the court recognized the difficulty in defining good faith, choosing to focus instead on the more readily identifiable concept of bad faith which it said occurs when one party, without reasonable justification, acts in a manner which substantially nullifies the bargained objective or benefit contracted for by the other, or to cause significant harm to the other, contrary to the original purpose and expectation of the parties. 19 In Landsbridge, the court held that the duty of good Ontario Inc. v. Cara Operations Ltd., 2008 CarswellOnt 6444 (Ont SCJ), at para. 68 [ Cara ]; Shelanu, supra at paras [ Shelanu ]. 14 Cara, supra at para 68; Landsbridge Auto Corp. v Midas Canada Inc., 2009 CarswellOnt 1655 (Ont SCJ) at para 24 [ Landsbridge ]; Shelanu, supra at paras 5, Landsbridge, supra at para 17; Shelanu, supra at para Cara, supra at para Fairview Donut Inc. v TDL Group Corp., 2012 ONSC 1252 at para 500 [ Fairview Donut ]. 18 Cara, supra at para Katotikidis v. Mr. Submarine Ltd., 2002 CarswellOnt 1655 (Ont SCJ), at para. 73 [ Katotikidis ].

6 - 6 - faith is intended to ensure that parties do not act in such a way that eviscerates or defeats the objectives of the franchise agreement. 20 The duty of good faith, importantly, does not require that every decision of a franchisor be subjected to a standard of commercial reasonableness in isolation. 21 Assessing whether a franchisor s conduct complies with the duty of good faith must be done holistically, with view to the entire contractual relationship between the parties and the surrounding circumstances. IV. Best Practices for Managing Default and Termination in Compliance with the Duty of Good Faith Default and termination scenarios raise particular concerns from a good faith perspective. Deciding to issue a notice of default or termination to a franchisee will nearly always involve an exercise of discretion by the franchisor. To ensure compliance with the duty of good faith, that discretion must be exercised reasonably and not arbitrarily, capriciously or for an improper motive. The following best practices can be gleaned from case law concerning the duty of good faith in default and termination scenarios. (a) Consider the Context of the Situation Context and the surrounding circumstances of the particular default or termination is critical when determining if the franchisor s exercise of its discretion to terminate a franchisee has been exercised in good faith. In Trillium, for example, the court considered whether GM had breached its duty of good faith and fair dealing by offering a tight timeline for the acceptance of proposed wind-down agreements following the decision to downsize its dealer network in Canada. The plaintiffs argued the timeframe was unreasonably short and deliberately timed to jam the dealer 20 Landsbridge, supra at para Fairview Donut, supra at para 293.

7 - 7 - franchisees with short window for acceptance. The court, however, held that this argument required too much of GM in the circumstances of the ongoing financial crisis of 2008 and 2009 and its potential insolvency. While finding that GM s decision was not ideal the court ultimately found it to be reasonable and in good faith given the financial realities of the surrounding circumstances. 22 In contrast, in Ontario Inc. v Cara Operations Ltd., the court found that the franchisor did breach its duty of good faith by deciding to terminate a franchise license early without offering fair compensation to the franchisee. After experiencing supply problems, the franchisor decided to unilaterally pull a product from its menu and terminate the associated license for that product five years into a seven year agreement. The court found that the franchisor s offer of a predetermined amount of compensation for this decision was arbitrary and unfair in relation to the franchisees sunk costs and losses associated with the termination of the license. As such, it constituted a breach of the franchisor s duty of good faith. 23 Accordingly, franchisors should consider not only the relevant obligations under the franchise agreement, but the impact of surrounding circumstances in assessing whether a particular default or termination is commercially reasonable and in compliance with the duty of good faith. (b) Honesty is the Best Policy, Don t Withhold Critical Information As the Supreme Court noted in Bhasin, the duty of good faith places particular importance on the honesty and candour of contractual parties in their dealings with one another. Unsurprisingly, breaches of the duty of good faith have often been found in default and 22 Trillium, supra at paras Ontario Inc. v Cara Operations Ltd., 2008 CarswellOnt 6444, at paras [ Cara ].

8 - 8 - termination scenarios where the franchisor has deliberately withheld material information from the franchisee regarding the termination. In Salah, for example, the franchisor entered into a lease for a new location within the same shopping centre as the plaintiff, and a new franchise agreement with a different franchisee to begin operating once the plaintiff s franchise agreement expired, despite an earlier promise to renew the plaintiff s agreement if a new lease was entered into with the shopping centre. Central to the court s findings that the franchisor breached its duty of good faith was the fact that the franchisor had deliberately kept [the franchisee] in the dark about its intentions and withheld critical information. 24 In Country Style, the court also found that the franchisor s deliberate decision to withhold information in the context of an end of term scenario was in breach of the duty of good faith. The court found the franchisor, in that case, had breached its duty of good faith by withholding critical leasing information out of a desire to hedge its bets and prevent the franchisee from walking away from the business. As a result, the court found the franchisor had favoured its own business needs at the expense of its statutory disclosure obligations under the Wishart Act. 25 It is worth noting, however, that the duty of good faith does not impose a wide-ranging duty to disclose all material facts throughout the life of the franchise agreement, nor does it impose a duty for the franchisor to disclose information that would assist the franchisee in pursuing litigation against them. 26 From the above examples, it is clear that honesty is a franchisor s best policy in dealing with franchisees during default and termination scenarios. While there is no wide-ranging 24 Salah v Timothy s Coffees of the World Inc ONCA 673, at paras [ Salah ] Ontario Inc. v Country Style Food Services Inc., 2012 ONSC 881 at paras [ Country Style ]. 26 See for example: Spina, supra; Ontario Inc. v. Pet Valu Canada Inc., 2016 ONCA 24 [ Pet Valu ].

9 - 9 - positive duty to disclose information, the duty may be breached where a franchisor actively withholds or misrepresents information that is important to the decision to terminate and where non-disclosure has a demonstrable adverse impact on the franchisee. (c) Follow the Agreement and Avoid Ulterior Motives Courts have repeatedly held that, provided that the termination is done in accordance with the terms of the franchise agreement and not for any improper purpose, then the franchisor s conduct in deciding to terminate will satisfy the duty of good faith and fair dealing. 27 In CM Takacs Holding Corp. v Canada Ltd., the court held that the franchisor s prior decisions not exercise its termination rights against the plaintiff franchisee in respect of past defaults did not render the franchisor s decision to terminate in bad faith. The presence of a standard non-waiver provision in the franchise agreement was sufficient to dispose of this argument. The court also concluded that the duty of good faith did not operate to require more notice than was required under the franchise agreement. In that case, the franchisee was terminated without notice which the court found was permitted by the termination provisions of the franchise agreement in the circumstances. 28 Similarly, in Elliott v Trane Canada Inc., the New Brunswick court found no breach of the franchisor s duty of good faith in terminating the plaintiff s franchise agreement due to multiple defaults. The court found that the franchisor had complied with the notice provisions required under the franchise agreement s termination provisions and that the decision to terminate was not for any improper purpose. The court suggested, however, that if there had been evidence that of the franchisor meeting and conspiring with a prospective new franchisee to take over 27 See for example: Seto v Wendy s Restaurants of Canada Inc., 2016 ABQB 493, at para 34 [ Seto ]. 28 CM Takacs Holding Corp. v Canada Ltd., 2015 ONSC 5358, at para 11 [ CM Takacs ].

10 the plaintiff s territory following the termination, that such conduct would constitute dishonesty and improper motive sufficient to constitute bad faith. 29 In Seto, the Alberta court dismissed a franchisee s claim that the franchisor had breached the duty of good faith by terminating the franchise agreement on the basis of multiple uncured defaults, since the plaintiff was attempting to sell the franchise in order to remedy its ongoing financial difficulties. The court found that the franchisee s admitted defaults were sufficient to justify the termination and that the franchisor had complied with the termination provisions under the agreement. With respect to the potential sale, the court found that it was in its early stages and that there was no evidence to suggest the franchisor s true purpose was to frustrate the sale. The court did, however, suggest that the duty may have been breached if the sale was imminent at the time of termination. 30 The perception that a default or termination may have ulterior motives may still be problematic, particularly where that motive interferes with a franchisee s other statutory rights under franchise legislation. In Sobeys, the court considered a franchisor s decision to issue notices of default and termination arising from the franchisees withdrawal of funds from their businesses for legal fees in relation to an ongoing class action. The agreement prohibited franchisees from retaining outside counsel or spending beyond a prescribed amount on legal fees without the franchisor s consent. The franchisees argued that this was intended to interfere with an ongoing class action. Despite evidence from the franchisor that the notices were not issued in response to the litigation, the proximity in time was sufficient to meet the test for an interlocutory injunction restraining the franchisor from terminating the franchisees Elliot v Trane Canada Inc., 2008 NBBR 79, at paras [ Elliott ]. 30 Seto, supra at paras Ontario Ltd. v Sobeys Capital Inc., 2010 ONSC 4141, at paras [ Sobeys ].

11 (d) Where Possible, Use Mutual Cancellation and Release Agreements In appropriate circumstances, the use of a mutual cancellation (or mutual termination) and release agreement may be helpful in avoiding a claim for breach of the duty of good faith. Such arrangements typically involve: a) An acknowledgement by the franchisee that it has committed defaults entitling the franchisor to proceed with immediate termination of the franchise agreement and an agreement to cure those defaults, to the extent possible; b) An agreement by the franchisor to forbear from terminating the franchisee for a specified period of time, within which the franchisee may seek to sell the business to a new franchisee; c) An agreement by the franchisee to adhere strictly to the terms of the franchise agreement during the period of forbearance, subject to immediate and without notice termination of the agreement in the event of a further breach; and d) A release by the franchisee of any and all claims related to the franchise agreement, including claims arising from the termination of the franchise agreement and any known statutory claims such as for breach of the duty of good faith. 32 In some iterations, the franchisor and franchisee actually opt to terminate the existing franchise agreement and enter into a new, short-term franchise agreement on the same terms for the length of the forbearance period. While, practically, the effect of this is substantially the same, franchisors must be careful to ensure that disclosure obligations are either not triggered or complied with in relation to the new agreement. This strategy was recently endorsed by the British Columbia Supreme Court in Dairy Queen Canada, Inc. v M.Y. Sundae Inc. After providing notice of default to a franchisee for various operational defaults, the franchisor offered to enter into a six-month Mutual Cancellation and Release agreement with the franchisee, rather than terminate immediately. However, during the six-month period of the agreement, the franchisee became delinquent in remitting its 32 With respect to the release of statutory claims, it is important to ensure that the release is drafted to ensure compliance with the exception to the non-waiver provisions present in all provincial franchise statutes (e.g. s. 11 of the Arthur Wishart Act) as recognized in Ontario Inc. v. Tutor Time Learning Centres, LLC, 2006 CanLII Franchisors should consult with their legal advisors in this respect.

12 monthly reports and royalties. In consequence, the franchisor accelerated the termination to be effective approximately three weeks before the six-month period was to expire. The franchisee brought a claim for, among other things, breach of the duty of good faith. The court found that the Mutual Cancellation and Release agreement provided a full answer to the duty of good faith and other claims advanced by the franchisee as a result of the robust release provisions. In particular, the court rejected arguments by the franchisee that the Mutual Cancellation and Release was unconscionable based on an inequality of bargaining power between the parties. In dismissing this claim, the court noted: I agree with the [franchisor] that the Cancellation and Release is more generous on its face than the Agreement itself, allowing the franchisee time to recoup its investment through the sale of an operating franchise rather than immediate termination of the Agreement and an accompanying demand to cease and desist. 33 The ruling highlights the reluctance Courts will have to set aside mutual cancellation agreements, particularly when such agreements are more favourable to the franchisee than the termination rights under the existing franchise agreement. Importantly, the decision confirms that an enforceable release can be built into mutual cancellation agreements and that such releases can be effective in limiting a franchisor s liability. From a franchisee-relations standpoint, a mutual cancellation and release strategy presents an opportunity for a win-win corporate divorce by giving the franchisee a chance to sell their business. Such a strategy will not always be appropriate, as in many cases a serious default may preclude, either legally or practically, allowing the franchisee to continue operating even for a limited time. Before exercising a termination right under a franchise agreement, franchisors should consider whether a mutual cancellation and release can be used to both limit risk and preserve goodwill with the franchisee. 33 Dairy Queen Canada, Inc. v. M.Y. Sundae Inc., 2017 BCSC 358, at para 89 [ Dairy Queen ].