Good faith in Franchising (published Law Talk)

Instances of lack of good faith by franchisors are a common complaint made by franchisees. A franchisee complains they are being singled out for a breach notice procedure when other franchisees are also in breach. A franchisor repeatedly declines prospective purchasers of a franchisee’s business because they want the franchisee to eventually walk away from the franchise so they can sell it themselves. A franchisee unexpectedly faces fresh competition when their franchisor buys a competing brand and opens a new franchise right next door to them.

To understand how readily these sometimes dreadfully unfair sounding situations can arise and what can be done about them, it is necessary to understand, first, the nature of the franchise relationship and, second, the characteristics of a franchise agreement generally and how it impacts that relationship.

The nature of the franchise relationship

Franchise agreements are “relational contracts”. These were described in Bobux Marketing Ltd v Raynor Marketing Ltd [2002] 1 NZLR 506 (CA) at [43] as long-term contracts which recognise the existence of an ongoing business relationship between the parties, the need to maintain that relationship, the difficulty of reducing important terms to well defined obligations and the impossibility of foretelling all the events which may affect the contract.

Thomas J said, in Bobux (at [44]):“The parties are not ‘strangers’ in the accepted sense and much of their interaction takes place ‘off the contract’ requiring a deliberate measure of communication, co-operation, and predictable performance based on mutual trust and confidence. Expectations of loyalty and interdependence mark the formation of the contract and become the basis for the rational economic planning of the parties”.

The nature of a franchise agreement

The second key factor about franchises is that agreements are drafted by franchisors. The ability to draft the contract enables franchisors to cast their obligations in largely discretionary terms and, conversely, the franchisee’s role as largely non-negotiable rock solid obligations, with no room for equivocation or discretion in terms of what the franchisee must do. It is a well-known feature of franchise agreements that they are top-heavy on obligations for franchisees and light on franchisor obligation. As such, a form of power imbalance can arise, particularly in a low barrier to entry system where franchisees are unsophisticated and do not take legal advice before buying their “business” and where there is considerable control exercised by the franchisor over the franchisee’s business.

What does good faith mean?

It is notoriously difficult to define good faith. It was observed in Bobux at [41]: “The principle [of good faith] is already beset by agonising inquiries into what is or can be meant by good faith. …. Good faith is closely associated with notions of fairness, honesty and reasonableness which are already well recognised in the law.”

Good faith is one of those expressions which is sometimes best defined and understood in terms of what it is not. It has therefore been described as the “antithesis of bad faith”. Specific conduct has been identified by various courts as constituting bad faith or a lack of good faith including acting arbitrarily, capriciously, unreasonably or recklessly.

More esoterically, good faith has been characterised as “a general organising principle of the common law of contract”. Cromwell J, in Bhasin v Hrynew [2014] 3 SCR 494 at [63], said that this organising principle is “simply that parties generally must perform their contractual duties honestly and reasonably and not capriciously or arbitrarily”.

Good faith involves having appropriate regard to the legitimate interests of the contracting partner. While that “appropriate regard” will vary depending on the context of the particular contract, it does not require a party to subordinate its own interests to the other’s in all cases. Rather, it requires that a party must not seek to undermine those interests in bad faith.

Anecdotally, good faith has sometimes been categorised as something hard to describe but immediately recognisable once it comes along. This is the “know it when you see it” test. Specifically, in the franchising space, lack of good faith will often present as a situation which appears grossly unfair or which smacks of a stronger party seeking to take advantage of a contractual right to usurp the interests of the weaker party, for some ulterior purpose.

Good faith in franchising generally

Occasionally, but not often, franchise agreements contain an express obligation of good faith. Even less occasionally, and almost counter-intuitively, such obligations will sometimes provide that the obligation of good faith is owed by the franchisee to the franchisor, not as mutual obligations and not the other way around.

In Australia, all franchise agreements are subject to an obligation of good faith, courtesy of the Australian Franchising Code of Conduct that franchisors must adhere to.

There is no franchise-specific legislation in New Zealand. The question of whether franchise agreements generally are subject to an implied obligation of good faith has been left open by the Privy Council in Dymocks Franchise Systems (NSW) Pty Ltd v Todd[2004] 1 NZLR 289.

Thus, as the law stands in New Zealand, there is no implied obligation of good faith generally in franchise agreements.

Good faith in the exercise of a contractual power?

All is not lost for franchisees who experience what appear to be instances of bad faith at the hands of their franchisors, acting pursuant to the seemingly unbridled powers conferred on them by their franchise agreements.

Franchisees in this situation can draw on the “default rule” that applies in the exercise of contractual powers. The default rule is explained by Kós J, in his article “Constraints on the Exercise of Contractual Powers” (2011) 42 VUWLR 17, as the rule that “a contractual discretion must not be exercised arbitrarily or in bad faith, or unreasonably in the sense that no reasonable contracting party could have so acted.”

Leaving aside the vexed question whether there is or should be an implied obligation of good faith in franchise agreements, there is ample case law which supports the principle that in the exercise of a contractual power a party cannot act in bad faith. In his article, Kós J explains that with contractual powers must come constraint: “otherwise the powers would instead become mechanisms for oppression and neither efficient nor acceptable in a common law jurisdiction.”

Whilst not the subject of extensive consideration in New Zealand, New Zealand cases have directly referred to the Kós J article as correctly stating the law in New Zealand.

Cases where the default rule has been invoked specifically in the franchising area in New Zealand are few on the ground, but the principle was at play in a recent High Court case on an application for an interim injunction to restrain a franchisee from trading in breach of a restraint of trade clause, Dorn Investments Ltd v Hoover [2016] NZHC 1325.

The agreement had come to an end, following the franchisor taking a sizeable amount of work away from the franchisee, something it was contractually entitled to do without giving the franchisee the opportunity to first rectify or remedy any default in the franchisee’s performance.

The franchisee alleged that, procedurally, the process of removing that work was carried out unfairly to him, even although there was no contractual requirement of procedural fairness.

In declining the injunction, Asher J noted that there was no express term in the franchise agreement requiring the franchisor not to take any work away from a franchisee, or to follow a certain process before any such work is taken away. In his view however, it was seriously arguable that there could be an implied term in the franchise agreement to that effect (akin to there being an implied term of good faith). Asher J said at [30]:

“It would be surprising if a franchisor or sub-franchisor such as Dorn Investments, controlling the allocation of significant work as it did, could take away one-third of a contractor’s turnover without at least giving the franchisee the opportunity to rectify the complaint that was the basis for the removal.”

The case is a good example of the types of incredibly unfair scenarios some franchisees face where franchisors are exercising a contractual discretion of a right of enforcement. This seems to be especially so in the homes services sector, where barriers to entry are low and the inequality of bargaining power is perhaps more acutely felt, particularly since franchisees do not seek legal advice and the opportunity to negotiate is really only a theoretical one.

Conclusion

Many complaints by franchisees against their franchisors fall into the category of complaints around the exercise of such power and rights. Most will not, of course, find their way to the courts because franchisees rarely have the money to fund such litigation. Notwithstanding there is no general obligation of good faith implied in franchise agreements generally, there clearly are good faith constraints around the exercise of contractual powers and rights. Otherwise franchisors could act heavy handedly and arbitrarily. The decision in Dorn Investments Ltd v Hoover is a welcome illustration of the dangers franchisors face in acting in a grossly unfair manner.


Deirdre Watson This email address is being protected from spambots. You need JavaScript enabled to view it. is a barrister, specialising in franchising disputes. She regularly presents on franchise issues, appears and acts regularly as counsel in franchising disputes, lectures at Auckland University in franchising and is a board member of the Franchise Association of New Zealand.