Ontario Court Releases Comprehensive and Instructive Decision in Franchise Class Action Proceeding
March 2, 2012
In one of the most comprehensive decisions to date on a motion for certification of a class proceeding by franchisees against their franchisor, and on a motion for summary judgment by the franchisor to defeat those claims, the Ontario Superior Court, in Fairview Donut Inc. v. The TDL Group Corp., has provided some reassurances to franchisors when making important system-wide changes to their franchise networks.
Three lessons for franchisors emerge from this decision:
- Subject to the terms of the franchise agreement, franchisors are free to introduce system-wide changes to products and operational methods, even if those changes do not result in net financial benefits to their franchisees. In addition, where the franchise agreement requires franchisees to purchase products for eventual retail sale from a designated entity, there is no implied contractual duty on franchisors to ensure that the prices paid by franchisees are below the prevailing market rate.
- The duty of good faith and fair dealing does not require each and every system-wide decision made by franchisors to increase the profits of their franchisees. System-wide changes can be made for a number of other legitimate reasons. Where the franchisor’s decision-making process includes meaningful consultation with franchisees, and where the decision was made reasonably and with due regard to the interests of franchisees, the duty of good faith and fair dealing will generally be met. The Court was careful to note that in the case before it, there was no evidence that the applicable system-wide changes destroyed the overall profitability of franchisees within the franchise network.
- There is nothing civilly or criminally wrong with a franchisor selling a product to its franchisee for a profit, nor is there any criminality associated with a franchisor entering into a joint venture agreement with a third party to supply a product to the franchisees for a profit.
The Plaintiffs were two Tim Hortons franchisees. Their complaints stemmed from two system-wide changes implemented by the franchisor. First, the "Always Fresh" conversion, which saw the replacement of scratch baking of donuts, Timbits, cookies and muffins on the franchised premises to a system in which the dough is partially baked (par-baked) and then flash frozen at a centralized facility, and delivered frozen to the franchisees stores where the baking is completed on an as-needed basis. Second, the introduction of the "Lunch Menu" of soups, sandwiches etc. sold 24/7.
In respect of both system changes, the Plaintiffs asserted that they were required to buy ingredients at unreasonably high prices, thus eroding their profits generally. Moreover, in respect of the Always Fresh conversion, the Plaintiffs complained that the par baked donuts that franchisees are required to buy are supplied by a joint venture in which Tim Hortons had an interest. The Plaintiffs further alleged that they are forced to sell the Lunch Menu items either at break-even prices or at a loss, while Tim Hortons is making a profit through rent, royalties and advertising payments, all of which are calculated on the basis of the franchisees’ sales.
Of significance, Tim Hortons argued, that the franchise agreements expressly authorized the franchisor to introduce the specific system-changes in dispute. Specifically, the contract expressly authorized Tim Hortons to introduce changes to the method of production such as the change from the scratch baking method to the Always Fresh method. Similarly, the contract expressly allowed Tim Hortons to make changes to the Lunch Menu.
However, the Plaintiffs alleged that the franchise agreement first required that any change in methods, procedures and techniques in the production of baked goods must be both a "benefit" and an "improvement" and that the "benefit" meant a financial benefit to the franchisees. This argument stemmed from the contractual provision addressing changes to the Confidential Operating Manual, which begins as follows: "in order that the Licensee may benefit from new knowledge gained by the Licensor as to improved methods, procedures and techniques in the preparation, merchandising and sale of donuts and other food items …" and the concluding language of that same provision which qualified the franchisor’s ability to make changes as follows: "… provided that such changes shall not unreasonably alter the Licensee’s rights or obligations under this Agreement." Similarly, the Plaintiffs claimed that this same provision precluded the changes to the Lunch Menu because, through its control of the Lunch Menu, Tim Hortons was causing the franchisees economic loss by increasing its profits at their expense.
Moreover, the Plaintiffs claimed that there was an implied term in the franchise agreement that the ingredients and commodities they were required to purchase would be sold to franchisees at lower prices than they could obtain for the same products in the marketplace.
The final significant argument proffered by the Plaintiffs was that Tim Hortons engaged in price maintenance and price fixing contrary to the Competition Act, giving rise to a civil cause of action under section 36 of the Act.
Certification as a Class Action
At the outset of the decision, Strathy, J. noted that the intersection of the Class Proceedings Act and the Arthur Wishart Act has "provided fertile ground for the growth of franchise class actions." He also noted that class proceedings are an effective procedural tool to enable powerless, vulnerable and voiceless franchisees operating under a standard contract to pursue common complaints. This judicial perspective is not news to those who work in the franchise sector!
Perhaps not surprisingly in this context, it appears that Tim Hortons did not seriously dispute that, if its summary judgment motion failed, it would be possible to identify a class and common issues that would make a class proceeding appropriate for certification. For that reason, Strathy, J.’s reasons in respect of the certification application are somewhat less robust than the reasons given on the summary judgment motion.
In any event, he held that the case as pleaded against Tim Hortons satisfied all necessary criteria under the Class Proceedings Act, except the last one: that there be a representative plaintiff who would fairly and adequately represent the interests of the class. The concern in this area arose because the Plaintiffs refused to answer questions on cross examinations about whether they were receiving funding from a third party.
The Court did not countenance such a refusal. Strathy, J. held that a court being asked to certify a class proceeding is entitled to know "who is calling the shots." In this case, the suspected third party benefactor was a former owner of Tim Hortons, making it clear why the Court was concerned about "the independence and motivations of the representative plaintiff." It was relevant to know whether the third party has an interest in the litigation that is or could be divergent from the interests of the representative plaintiff or the class. Without an answer to this question, the Court was not prepared to certify the claim as a class proceeding.
Breach of Contract
The Court then went on to resoundly reject the Plaintiffs interpretation of the express terms of the franchise agreement:
The Plaintiffs’ interpretation of section 7.03(a) of the Franchise Agreement is, in my view, plainly wrong and has no possibility of success at trial. The words "[i]n order that the Licensee may benefit from new knowledge gained by the Licensor as to improved methods, procedures and techniques…" are not a positive covenant or promise — they are simply introductory or explanatory. They are not reasonably capable of bearing the interpretation that the Tim Hortons System or the Confidential Operating Manual cannot be changed unless the change is an improvement that benefits the franchisee. Even if the Plaintiffs’ distorted interpretation was accepted, there is nothing in the contractual language and no logical reason, to interpret a "benefit" derived from the "improved" method, procedure or technique, as having a financial component. The change might be to address safety issues, to simplify production or to ensure franchise-wide consistency of products. It might be for any number of reasons that could be considered an "improvement" without necessarily resulting in a financial benefit to the franchisee.
This unequivocal statement was topped by a similar rebuke to the suggestion that all changes to operational methods or products must be profitable in their own right: according to the Court, the franchisor is entitled to consider the profitability and prosperity of the system as a whole.
The Court went on to seemingly admonishing the Plaintiffs for making the suggestion at all. Strathy, J. noted that the Plaintiffs contracted to get the benefit of, and to be bound by, Tim Hortons’ operating system. In order to keep that system healthy and competitive, the franchisor must be permitted to introduce new products, new methods of production or sale, and new techniques or systems during the life of a franchise agreement. Tim Hortons’ franchise agreement contemplates this and allows this. As such, it would be "commercially unreasonable" to force Tim Hortons to demonstrate that an improvement benefits a particular franchisee, or that every change will be a financial benefit for every franchisee.
The Court commented that Always Fresh was beneficial to franchisees in a general sense because it outsourced a process that was time-consuming, aggravating and wasteful. The Lunch Menu was beneficial because it brought customers into the stores in off-peak hours, contributed to the cross-selling of more profitable items, and created customer loyalty in the face of aggressive competition. There was no evidence that the price of Always Fresh donuts and Lunch Menu items prevented the franchisors from making a reasonable overall profit.
Finally, the Court found that there was no implied term that ingredients would be sold to franchisees at commercially reasonable prices. One method of ascertaining an implied term is to examine the prevailing customs in the business. In this case, there was no evidence of any custom in any franchise business in general, or in the quick-service retail business in particular, that the franchisor supplies all ingredients or other inputs to the franchisees at prices that are lower than can be generally obtained in the market. The only evidence before the Court was that "as a matter of practice," a franchisor’s volume purchasing power permits it to obtain prices that are generally lower than its franchisees would be able to obtain on their own. But, as the Court noted, there was no evidence that franchisors, as a matter of practice, pass on to their franchisees the benefit of this purchasing power in the case of every input they supply.
Furthermore, under Ontario Regulation 581/00 made pursuant to the Arthur Wishart Act, the franchisor is required to provide a disclosure document to a prospective franchisee that stipulates that "the cost of goods and services acquired under the franchise agreement may not correspond to the lowest cost of the goods and services available in the marketplace." The statutory regime intended for the protection of franchisees implicitly recognizes that the cost of goods supplied under franchise agreements is frequently not the lowest cost available in the marketplace.
Breach of Duties Under the Arthur Wishart Act
The Arthur Wishart Act imposes a duty of fair dealing on parties to a franchise agreement. This requirement is expressly defined to include a reciprocal duty to act in good faith and in accordance with reasonable commercial standards. The Plaintiffs pleaded that if Tim Hortons had the contractual right to require franchisees to use the Always Fresh baking method and Lunch Menu, as the Court found it did, doing so was a breach of its duty of good faith and fair dealing, because it led to commercially unreasonable prices and reduced profits.
The Court easily dismissed this argument. Strathy, J. held that the duties under the Arthur Wishart Act relate to the performance and enforcement of the franchise agreement. The duties are imposed in order to secure the performance of the contract the parties have made, not to replace that contract or to amend it by altering express terms. The Court refused to use the Arthur Wishart Act to rewrite the franchise agreement in a manner that the Plaintiffs would find commercially reasonable. Indeed, the Court went so far as to state that there was nothing in the franchise agreement that entitled the Plaintiffs to make a profit on their franchises generally or on any particular product or product line. Notwithstanding this, the Court found that they were generally profitable and have made a reasonable return on their investments.
In any event, there was no evidence that Tim Hortons used its discretion under the contract arbitrarily or capriciously or for an improper motive, and the franchisees were not deprived of the value of their agreements. In sum, the Court found that a "determination of whether a franchisor has conducted itself in good faith cannot be based on isolated pricing decisions of particular menu items or groups of items. Regard must be had to the conduct of the franchisor taken as a whole and the benefits — or disadvantages — obtained by franchisees as a whole."
There is no question that the Court was significantly influenced by the fact that Tim Hortons had clearly satisfied its obligation to advise and consult in advance with franchisees about its system changes by holding conferences, regional meetings, and one-on-one discussions throughout the various stages of its research, development and implementation. Franchisors and franchisees can be comforted that the Court continues to acknowledge the contractual obligations in this respect and further, appears to place considerable weight on a culture of robust consultation and communication.
The Court found that Tim Hortons did not contravene the Competition Act, and noted that there is nothing civilly or criminally wrong with a franchisor selling a product to its franchisee at a price that results in a profit — even a substantial profit — to the franchisor; nor is there any criminality associated with a franchisor entering into a joint venture agreement with a third party to supply a product to the franchisees at a price at which both joint venturers make a profit.
With respect to the price maintenance claim, the Court noted that section 61 of the Act prohibits an upstream supplier from preventing competition among retailers, but does not prohibit a manufacturer or supplier from increasing the price at which it sells a product. The Court further held that nothing in the distributor or franchise agreements interferes with the ability of the distributors or the franchisees to sell the par-baked donuts at the price of their choice, as long as these prices do not exceed the prices stipulated by Tim Hortons. Accordingly, the Court found no evidence that Tim Hortons attempted to "influence upward" the price at which the distributors or franchisees sell the par-baked donuts.
In addition, the Court noted that since the par-baked donuts are supplied by CyllRyan, Tim Hortons is not directly engaged in the business or producing or supplying such donuts. Accordingly, the Court found that section 61 of the Act does not apply to Tim Hortons.
With respect to the claim relating to the breach of the conspiracy provision of the Act, the Plaintiffs claimed that Tim Hortons conspired with its joint venturer to fix the prices of donuts, and that this agreement resulted in unreasonable high donut prices to franchisees. The claim was brought under the former conspiracy provision, which was subsequently repealed and replaced with a new provision in 2010. The Court dismissed the Plaintiffs claim under both the old and new sections.
With respect to the old conspiracy provision, the Court reminded that, in order to be found guilty of an offence under section 45 of the Act, there must be a conspiracy which, if implemented, would be likely to unduly lessen competition. Applying the test set out in R. v. Nova Scotia Pharmaceutical Society, the Court held that Tim Hortons did not contravene the conspiracy section of the Act given that there is no evidence that the prices charged by the distributor to the franchisee had an anti-competitive effect. The Court added that section 45 does not prevent a franchisor from taking "excessive" profits from sales to franchisees, and that franchisees remained free to sell the donuts at whatever price they choose, up to the price set by Tim Hortons.
The Court also rejected the claim under the new section 45 because Tim Hortons and the joint venturer could not be considered as "competitors" or "likely competitors," within the meaning of section 45, for the supply of par baked -donuts. The Court added that, in any event, any price-fixing agreement between Tim Hortons and the joint venturer would have been saved by the ancillary restraint defence, which requires the parties to establish that the price-fixing is directly related to and reasonably necessary for giving effect to a broader and lawful agreement. The Court confirmed that an agreement to form a joint venture to produce and sell a product at a particular price is not a prohibited price-fixing agreement under the Act, as it would be saved by the ancillary restraint defence.
Franchise & Distribution