SYSTEM CHANGES - SOMETIMES NECESSARY, BUT CAN’T CREATE A NEW AGREEMENT
CO-WINTER 2010Author :
John Sotos 
Lawyer, Sotos LLP
John Sotos is a lawyer with Sotos LLP. He specializes in domestic and international franchise, licensing and distribution law with a large national and international client base. Represents franchisors in connection with franchise transactions, workouts, defaults, purchases and sales of franchise networks, master franchising and creditor and debtor rights on both franchisor and franchisee insolvencies.
“If you want to make enemies, try to change something.”
- Woodrow T. Wilson, 28th President of the USA
Businesses operating in dynamic environments must change from time to time or else risk losing market relevance. Franchise businesses are no exception and changes must take place given that the franchisor and franchisee enter into an agreement that will govern their relationship for 10 to 20 years depending on the size of the capital invested. While everyone recognizes the need for system change, successful implementation depends on the careful balance of franchisors to feature the latest image, technology or menu items against the franchisees need to recoup their investment and make a profit. Issues such as term remaining under the franchise agreement versus magnitude of investment result in different options for differently situated zees.
While ideally all of the potential changes that a franchisor can make to the franchise system are disclosed in the franchise agreement so that each party has a reasonable idea as to the scope of permitted changes, this would be impractical given that the franchise agreement is a living document governing a relationship that could span well into the future. For this reason, franchisees accept the fact that changes to the franchise system are inevitable, however, disputes arise over what kind of changes can be made, how are they to be implemented, and whether or not they are even necessary.
Changes to the franchise system are periodically required in order to account for such external factors as changing demographics and consumer tastes, increased competition, changes in technology and even legislative changes among many other things. These combined with the economic factors facing a franchisor may often necessitate the need for changes to the franchise system in order for the franchise system to remain viable. While often a franchisee due to its own experiences operating the franchise may wish to implement a system change, the ultimate decision of what changes are made to the franchise usually rests with the franchisor who then attempts to mandate the change to the franchisees.
For franchisors, the first point to consider is whether the change they are seeking to implement is so fundamentally different so as to constitute a new system. Likewise, a franchisee must consider whether the change falls outside the scope of their reasonable expectations and creates an obligation that differs from what they signed up for. The fact that the franchisor believes the change will improve profitability is irrelevant and any attempt by the franchisor to impose a different economic model from the model contained in the franchise agreement may be met with strong resistance by the franchisee and potentially costly litigation.
Take, for example, a situation where a fast-food delivery franchisor decides to outsource the central telephone ordering system to a third-party supplier who is responsible for forwarding orders to the franchisees at a small cost to each franchisee per order given. While the franchisor may have valid business reasons for not continuing to operate the ordering system itself and outsourcing the service, this type of system change may be met with resistance by the franchisee, particularly when they are faced with the potential of additional costs. This example was precisely the case in a recent Quebec Court of Appeal decision, where the court held that the changes implemented by the franchisor went beyond the intent of the parties and that such an important change to the financial aspects of the franchise system required the consent of the franchisees. This was so despite a general clause in the franchise agreement which allowed for the franchisor to make system changes at its discretion. Although the franchisor thought it was entitled to make these changes, the end result was the franchisee was successful in its claim that the system change was not allowed under the terms of the franchise agreement.
However, even if a system change is permitted under the terms of the franchise agreement, a franchisor still must implement such changes taking into accounts its duty of fair dealing. Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000, imposes a duty of fair dealing on both the franchisor and franchisee, which includes the duty to act in good faith and in accordance with reasonable commercial standards. This means that, when mandating a system change, the franchisor must have regard to the legitimate interests of the franchisee and be acting reasonably.
Before a franchisor implements a system change, it should test the change at several representative locations. Only if the franchisor has achieved its anticipated results in a cost-effective manner should the system change then be implemented. It is also important that a franchisor communiciate any proposed change early and often with the system. A franchisee will be more willing to accept the change if the franchisor can communicate the business reasons for implementing the change and how it will help the franchisee become more profitable.
Determining the extent of permitted changes is hardly a clear-cut issue. If the only changes are to the operational aspects of the system, it may not be necessary to formally amend the agreement as such changes are usually affected by updates to the Operations Manual. As a general guideline, any change to the economic relationship where the financial interests of the franchisee are materially impacted or a substantial change to the products or services offered should be considered a material change to the franchise relationship. Unless the franchise agreement specifically contemplates these changes, the franchisor may well have to formally amend its agreements with its franchisees. Otherwise, it is open to the franchisee to not accept the change and if necessary, to seek legal counsel and bring an action for damages for breach of the franchise agreement, an outcome the franchisor surely must wish to avoid.
- Woodrow T. Wilson, 28th President of the USA
Businesses operating in dynamic environments must change from time to time or else risk losing market relevance. Franchise businesses are no exception and changes must take place given that the franchisor and franchisee enter into an agreement that will govern their relationship for 10 to 20 years depending on the size of the capital invested. While everyone recognizes the need for system change, successful implementation depends on the careful balance of franchisors to feature the latest image, technology or menu items against the franchisees need to recoup their investment and make a profit. Issues such as term remaining under the franchise agreement versus magnitude of investment result in different options for differently situated zees.
While ideally all of the potential changes that a franchisor can make to the franchise system are disclosed in the franchise agreement so that each party has a reasonable idea as to the scope of permitted changes, this would be impractical given that the franchise agreement is a living document governing a relationship that could span well into the future. For this reason, franchisees accept the fact that changes to the franchise system are inevitable, however, disputes arise over what kind of changes can be made, how are they to be implemented, and whether or not they are even necessary.
Changes to the franchise system are periodically required in order to account for such external factors as changing demographics and consumer tastes, increased competition, changes in technology and even legislative changes among many other things. These combined with the economic factors facing a franchisor may often necessitate the need for changes to the franchise system in order for the franchise system to remain viable. While often a franchisee due to its own experiences operating the franchise may wish to implement a system change, the ultimate decision of what changes are made to the franchise usually rests with the franchisor who then attempts to mandate the change to the franchisees.
For franchisors, the first point to consider is whether the change they are seeking to implement is so fundamentally different so as to constitute a new system. Likewise, a franchisee must consider whether the change falls outside the scope of their reasonable expectations and creates an obligation that differs from what they signed up for. The fact that the franchisor believes the change will improve profitability is irrelevant and any attempt by the franchisor to impose a different economic model from the model contained in the franchise agreement may be met with strong resistance by the franchisee and potentially costly litigation.
Take, for example, a situation where a fast-food delivery franchisor decides to outsource the central telephone ordering system to a third-party supplier who is responsible for forwarding orders to the franchisees at a small cost to each franchisee per order given. While the franchisor may have valid business reasons for not continuing to operate the ordering system itself and outsourcing the service, this type of system change may be met with resistance by the franchisee, particularly when they are faced with the potential of additional costs. This example was precisely the case in a recent Quebec Court of Appeal decision, where the court held that the changes implemented by the franchisor went beyond the intent of the parties and that such an important change to the financial aspects of the franchise system required the consent of the franchisees. This was so despite a general clause in the franchise agreement which allowed for the franchisor to make system changes at its discretion. Although the franchisor thought it was entitled to make these changes, the end result was the franchisee was successful in its claim that the system change was not allowed under the terms of the franchise agreement.
However, even if a system change is permitted under the terms of the franchise agreement, a franchisor still must implement such changes taking into accounts its duty of fair dealing. Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000, imposes a duty of fair dealing on both the franchisor and franchisee, which includes the duty to act in good faith and in accordance with reasonable commercial standards. This means that, when mandating a system change, the franchisor must have regard to the legitimate interests of the franchisee and be acting reasonably.
Before a franchisor implements a system change, it should test the change at several representative locations. Only if the franchisor has achieved its anticipated results in a cost-effective manner should the system change then be implemented. It is also important that a franchisor communiciate any proposed change early and often with the system. A franchisee will be more willing to accept the change if the franchisor can communicate the business reasons for implementing the change and how it will help the franchisee become more profitable.
Determining the extent of permitted changes is hardly a clear-cut issue. If the only changes are to the operational aspects of the system, it may not be necessary to formally amend the agreement as such changes are usually affected by updates to the Operations Manual. As a general guideline, any change to the economic relationship where the financial interests of the franchisee are materially impacted or a substantial change to the products or services offered should be considered a material change to the franchise relationship. Unless the franchise agreement specifically contemplates these changes, the franchisor may well have to formally amend its agreements with its franchisees. Otherwise, it is open to the franchisee to not accept the change and if necessary, to seek legal counsel and bring an action for damages for breach of the franchise agreement, an outcome the franchisor surely must wish to avoid.