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When Can Franchisors' Profit from Franchisees?

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In Spina v. Shoppers Drug Mart Inc., 2012 ONSC 5563, Justice Perell for the Ontario Superior Court has given judgment in the first stage of a class action certification motion brought on behalf of franchisees of Shoppers Drug Mart. The decision addressed the threshold requirement for certification, namely whether the claim disclosed reasonable causes of action.

In the process, the Court reviewed and determined the legal validity of the varied and interrelated causes of action asserted by the representative plaintiffs.

While only a pleadings motion, Spina provides useful guidance to franchisors and franchisees in Ontario. Although the decision addressed numerous issues, this comment focuses on the following three lessons:

Franchisors should review their standard form franchise agreements to ensure that the key financial terms are absolutely clear and leave no doubt regarding the scope of the franchisor's rights to earn profits from the franchise system.

In Spina, the Court allowed the Franchisees' claim to proceed on the allegation that the Franchisor had improperly profited from certain services provided to the Franchisees. While the franchise agreement contained detailed provisions on these issues, it was not plain and obvious that the Franchisor could earn a profit on these services provided to the Franchisees.

The duty of good faith and fair dealing does not provide franchisees with the right to receive ongoing disclosure throughout the term of the franchise relationship. The Court struck the Franchisees' claim in this respect, rejecting the argument that such ongoing disclosure was necessary for the Franchisees to verify that the Franchisor was complying with its obligations under the franchise agreement. The Court held that imposing an ongoing disclosure obligation of this nature would be impossible to meet, would turn management of the franchise relationship over to the franchisees, and would encourage litigious fishing expeditions.

The Ontario Courts are demonstrating an increasing willingness to dispose of weak contractual arguments at the pleadings stage, even in class action proceedings. In Spina, the Franchisees -- ignoring an explicit clause that provided the Franchisor with the right to retain rebates earned from suppliers of merchandise -- asserted a contractual right to such rebates. The Franchisees relied on a general clause in the agreement that suggested they would benefit from the franchise system's use of "bulk purchasing". The Court struck the Franchisees' claim for rebates upholding the express language of the agreement over what Justice Perell deemed a "tortured interpretation of the contract".

The Franchisor's Ability to Profit on Fees Charged to Franchisees

The Plaintiffs in this case claimed that, contrary to the terms of the franchise agreement, the Franchisor had improperly earned profits in respect of certain services that it provided to the Franchisees.

The franchise agreement contained several, interrelated provisions that addressed the financial aspects of the franchisor-franchisee relationship. These included a profit-sharing provision, under which the Franchisor was entitled to receive a percentage of all of the Franchisees' gross sales. This, according to the Franchisees, was the sole mechanism through which the Franchisor was permitted to earn a profit from the Franchisees. In addition to this profit-sharing provision, there were additional clauses that obligated the Franchisees to contribute to a national advertising fund and marketing in initiatives, as well as additional fees for ancillary services provided by the Franchisor. The additional fees provision in the franchise agreement explicitly stated that the quantum of fees was to be set by the Franchisor "in the good faith exercise of its judgment".

The Franchisees claimed that the Franchisor had improperly earned a profit from the additional fees that it charged to Franchisees, and that this was a breach of the franchise agreement and contrary to the statutory and common law duties of good faith and fair dealing.

The Franchisor countered that it was perfectly entitled to include margin and return-on-investment in the additional fees it charged to its Franchisees, and that such fees were subject only to the obligation that it exercise good faith judgment.

Unlike other claims of improper profits raised by the Plaintiffs the Court was not prepared to strike this claim, holding that it had "sufficient traction" under the franchise agreement. As it was ambiguous whether the Franchisor's obligation to exercise good faith judgment permitted it to establish the fees at such a level that would allow it to derive a profit, it was not plain and obvious whether such claims would fail.

Although we do not know whether the Franchisees' claims will ultimately prevail, this holding should serve as a cautionary tale to franchisors. These financial aspects of the franchise relationship are foundational and lie at the heart of the business model. As such, financial clauses that address profit sharing should be explicit and drafted with clarity. Where they are absent or ambiguously crafted, franchisors may be vulnerable to the argument that their ability to make profits from certain aspects of the franchise system are limited by more general clauses in the franchise agreement or the duties of good faith and fair dealing.

The Right to Share in Rebates

Another element of the Franchisees' claim relied on a provision in the franchise agreement which obligated the Franchisor to provide each Franchisee with the "advantages of bulk purchasing". The Franchisees asserted that, pursuant to this provision, the Franchisor was obliged to provide them with any rebates that were received from product suppliers.

The Court held that it was plain and obvious that this claim would fail. The franchise agreement at issue contained a specific provision that expressly held that the Franchisor was "entitled to the benefit of any and all discounts, rebates, advertising or other allowances, concessions, or other similar advantages" received from a supplier of merchandise. Given this clear, specific provision, it was plain and obvious that the principles of contractual interpretation did not support the Franchisees' position. The Court also held that it was plain and obvious that the statutory and common law duty of good faith and fair dealing did not modify the contract by establishing a right for the Franchisees to share in the rebates.

By contrast, the Court was not willing to strike out a related claim by the Franchisees for "professional allowances" provided by pharmaceutical suppliers to pharmacists under the Ontario Drug Benefit Act. The Court held that it was ambiguous whether "professional allowances" fell within the definition of "rebate" in the franchise agreement and thus would not determine whether they were governed by this clause.

The Right to Continuous Disclosure Throughout the Franchise Relationship

In part related to their two previous claims regarding profit-sharing and access to rebates, the Franchisees also asserted that the common law and statutory duties of good faith and fair dealing obligated the Franchisor to provide ongoing disclosure of information that would permit the Franchisees to verify whether the Franchisor was complying with its financial obligations. For example, the Franchisees claimed that they had a right to disclosure of the costs that the Franchisor incurs for the programs it provides to Franchisees, in order for the Franchisees to know whether the Franchisee was improperly profiting from those programs.

The Court rejected this argument and held that it was plain and obvious that the duties of good faith and fair dealing did not impose an obligation for intra-term disclosure in this circumstance. Justice Perell distinguished the circumstances of this case from the situation where a Franchisor is in possession of material information that could reasonably influence a Franchisee's decision with regard to the franchise. The Court emphasized that imposing this obligation would effectively "turn over design, supervision, and management of the franchise system to each franchisee, who gets to fish for grounds to sue the franchisor".

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About this Entry

This page contains a single entry by Sarit Batner published on October 18, 2012 9:53 PM.

Was Burger King Legally Entitled to Suspend Bettencourt? was the previous entry in this blog.

The Five ways to Negotiate & Win with a "Weaker" China is the next entry in this blog.

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