In my article in LawTalk 912 (November 2017), I explored the topic of whether or not there is an implied obligation of good faith in a franchise agreement. In this article, part one of a two-part series, I delve in more detail into what is meant by good faith, specifically in the franchise context.
There is little New Zealand law on the topic of good faith in franchising. I put that down to a couple of factors. One is the lack of financial resource on the part of franchisees to pursue claims or grievances concerning instances of bad faith.
The second is that, in my experience, the most serious instances of heavy handedness or bad faith on the part of a franchisor tend to arise in lower barrier to entry franchise systems. In these types of systems, there will already be a significant power imbalance between the parties. Franchisees will often be uneducated, unsophisticated in business, and largely lack the wherewithal or knowledge to seek legal advice at any point in the relationship, much less when there is trouble brewing. They just won’t have an awareness that something is grossly commercially unfair, much less be aware of the fact they should be seeking legal advice about it.
For whatever the reason though, the net effect is that there are few cases that have dealt with the question of good faith in franchising.
That doesn’t mean instances of bad faith are not happening.
One of the most common instances I see regularly relates to termination of a franchise agreement by a franchisor where there is a contractual right of termination but an ulterior motive at play. The franchisor may have technical grounds of termination, for instance, for non-payment of fees, but the amount of outstanding fees is low, and the real reason the franchisor wants to terminate is that they have a prospective franchisee sitting in the wings interested in that territory.
A second instance, becoming increasingly more common as franchises mature and need to adjust to changing market conditions, relates to proposed alterations to significant parts of the franchise model and the franchise agreement. Franchise agreements will generally require franchisees to sign, upon renewal, the “then” terms of the franchisor’s franchise agreement. When the franchise model undergoes considerable change, franchisees have little contractual ability to negotiate the terms of the “then” franchise agreement upon renewal.
In this situation, there are some competing tensions at play. On the one hand, the franchisor needs to be able to change the model and the agreement to adjust to market conditions. On the other, the franchisee needs the certainty of knowing that those changes won’t substantially alter the original bargain. Where things have the potential to go wrong, is where a perfectly legitimate sounding commercial need to change the model then morphs into an opportunity to hike up fees and make other changes of no perceived value to franchisees.
It might be argued in this situation that there is an obligation on the franchisor to act in good faith by at least considering the legitimate interests of the franchisees before imposing broad ranging changes. Good franchisors seem to be aware that this is at least best practice, and are doing this, if for no other reason than they don’t want to deal with the expensive fallout of a mutiny when all of the franchisees group together and challenge the imposition of a new agreement. In good franchise systems that I have seen, franchisors are already acting as if they are subject to an obligation of good faith by consulting with and taking into account the legitimate interests of franchisees.
But the law as it stands in New Zealand at the moment says that there is no implied obligation of good faith in a franchise agreement (other than, of course the implied obligation of good faith which arises in the exercise of a contractual discretion). Indeed, this question is generally regarded as having been left open by the Privy Council in Dymocks Franchise Systems (NSW) Pty Ltd v Todd [2004] 1 NZLR 289, the last notable decision in New Zealand to consider this issue.
What is bad faith?
Setting to one side the question of whether there is or should be an implied obligation of good faith in a franchise agreement, what is “bad faith” and how can one identify it when it comes along?
In my earlier article, I referred to the usual attempts at definition of good faith that are bandied about, ranging from the somewhat self-evident notion that it is the “antithesis of bad faith” (Terry and Di Lernia, “Franchising and the quest for the Holy Grail: Good faith or good intentions?” (2009) 33 MULR 542, at 557), to the idea that good faith is “a general organising principle” (Bhasin v Hrynew 2014 SCC 71; [2014] 3 SCR 494 at [33]) that parties generally must perform their contractual duties honestly and reasonably and not capriciously or arbitrarily, and to the oblique “know it when you see it” test (“Franchising and the quest for the Holy Grail…”, n5, at 574), otherwise referred to as being, “in the absence of clear definition, in the eye of the beholder” (same page). Nestled amongst these tests is one with a ring of commercial practicality to it, namely, that good faith simply involves having appropriate regard to the legitimate interests of the contracting party (see Heli Holdings Ltd v Helicopter Line Ltd [2016] NZHC 976, [113] to [114]), but without subordinating one party’s interests to the other.
It is useful to draw on some of the Australian case law which has dealt with the question of whether bad faith was present in franchising. It is readily apparent from even a cursory review of some of the cases in that jurisdiction that bad faith remains a hot topic, notwithstanding that, since 2015, all parties to franchise agreements became subject to an industry-wide Franchising Code of Conduct requirement that imposes an express obligation of good faith in all franchise agreements.
Burger battles
Prior to the imposition of that requirement, the law was already moving in the direction of imposing an implied obligation of good faith in franchise agreements.
For example, in Far Horizons Pty Ltd v McDonald’s Australia Ltd [2000] VSR 310, it was found that there had been no breach of an obligation of good faith by the franchisor. Far Horizons operated two franchise McDonald’s stores. McDonald’s opened up two new stores in the same geographical area, as it was contractually entitled to do. The court found that the decision to expand into the area on the part of McDonald’s was not based on disadvantaging Far Horizons but rather that it was merely part of McDonald’s’ usual business strategy. The outcome might have been commercially unfair and unreasonable from Far Horizons’ point of view, but that did not translate to bad faith.
In a second case, Burger King Corp v Hungry Jacks Pty Ltd [2001] 1 NSWCA 187, it was alleged that Hungry Jacks was in breach of a development agreement which required it to open a certain number of restaurants itself and through franchisees throughout Australia. Hungry Jacks argued that the reason it was in breach of that clause was because Burger King, in bad faith, consistently refused approval of its expansion plans and refused to approve franchisees.
The court found Burger King to be in breach of an implied obligation to act in good faith in turning down franchisees, defining good faith as:
- cooperation in achieving the objects of the contract;
- honesty; and
- reasonable regard to the other parties’ legitimate interests.
The court said: “While parties to a contract are allowed to pursue their own legitimate commercial interests within the framework of the contract, to do so for a purpose extraneous to the contract would be a breach of good faith.”
The Australian Franchising Code of Conduct
The Australian Franchising Code of Conduct gives some guidance around what will amount to a lack of good faith. In section 6(3), it provides:
“Without limiting the matters to which a court may have regard for the purpose of determining whether a party to a franchise agreement has contravened subclause (1), the court may have regard to:
(a) whether the party acted honestly and not arbitrarily; and
(b) whether the party cooperated to achieve the purposes of the agreement.”
In section 6(6), the Franchising Code of Conduct provides that:
“To avoid doubt, the obligation to act in good faith does not prevent a party to a franchise agreement, or a person who proposes to become such a party, from acting in his, her or its legitimate commercial interests.”
The drafters of the Australian Code were therefore well alive to the tension between the legitimate commercial interests of both franchisor and franchisee and the can of worms which would potentially be opened if the answer to whether or not there was bad faith in any given situation simply boiled down to an unwinnable competition between the two legitimate interests.
Under the Australian Code, so long as the franchisor has acted honestly, not arbitrarily and in cooperation with the franchisee to achieve the purposes of the franchise agreement, including considering the legitimate commercial interests of the franchisee, then the franchisor will not be required to subordinate its own legitimate interests to the interests of the franchisee.
The Australian Franchising Code probably pushes the definition of good faith as far as it can be pushed, without bringing the business of the franchisor to a grinding halt, which would almost certainly happen if the franchisor was required to subordinate its own legitimate interests to the interests of the franchisee.
In part two of this article next issue I will discuss a recent New Zealand decision in which franchisees who disagreed with operational aspects of the franchise were unable to get any traction in the High Court, with disastrous consequences for them. The case highlights that mere unreasonable behaviour by a franchisor or behaviour that doesn’t have any element of dishonesty, ulterior purpose or arbitrary aspect to it will not meet the threshold of bad faith. Just because an action taken by a franchisor looks unreasonable from the point of view of the franchisee, doesn’t mean there is a lack of good faith. Actions which are taken in advance of a legitimate business interests are likewise, not actions which demonstrate bad faith.
