Proceed with caution when changing the franchise system

Businesses operating in dynamic environments must change from time to time if they are to survive and thrive. Franchise systems are no exception. The problem in franchising is that while both the franchisor and franchisee may agree on the need for change, how the change is implemented, and which side bears the brunt of the changes is something which they will rarely agree upon. Franchisors who impose what they view as the necessary changes on reluctant franchisees can find that the franchisees have a number of potent remedies at their disposal. From our vantage point, we are noticing that franchise system changes are becoming fertile ground for costly and uncertain litigation.

There are several points that must be considered before a franchisor introduces changes to its business model. The first and most important is whether the franchisor is really contemplating a new or amended form of agreement with its franchisees. The fact that the franchisor believes that the change will improve the long-term profitability of the franchisees themselves makes little difference. Any attempt to impose a different economic model from the model contained in the franchise agreement may be met with strong resistance and possibly system-wide litigation.

Take, for example, the case of a fast-food franchisor which decides to outsource a call centre which it had previously operated as part of its franchisor duties at no extra charge to the franchisee. There are a lot of good reasons why a franchisor would want to outsource this responsibility and just as many good reasons why it would impose a cost-recovery charge for this service. You may be surprised to learn that the franchisor which did this was prevented from imposing any charge on the franchisee for this service. In the words of the Quebec Court of Appeal, imposing the call-centre fee on the franchisee would result ‘in a different contract’. In the court’s view, the changes implemented by the franchisor went ‘beyond the intent of the parties’ and that ‘required the consent of the franchisees.’

The result in that case is all the more surprising considering that the franchise agreement specifically contemplated that the franchise system could be changed and that the franchisee was bound to accept such changes introduced by the franchisor from time to time. Even in the presence of a broad system-change clause such as this, the court required the franchisor to obtain the specific consent of its franchisees before implementing the change.

As a general guideline, any change to the economic relationship between the franchisor and franchisee, or any attempt to impose additional financial burdens on the franchisees, should be considered a material change to the franchise relationship. Unless the franchise agreement explicitly contemplates these types of economic changes, the franchisor may well have to formally amend its agreements with all of its franchisees.

Proceeding without an amendment carries several risks for the franchisor. The first is that the franchisee may simply refuse to accept the change to the relationship. If even one franchisee is able to successfully dispute the enforceability of the change, the franchisor faces a possible wider rebellion and, at the very least, risks losing credibility with other franchisees.

A greater risk is that a franchisee will bring an action against the franchisor for breach of the agreement and damages. There are at least two potential franchise class actions underway that we are aware of at this time concerning franchise system changes. Others will surely follow if either of these two cases is allowed to move forward as a class action. In this era of increasing class actions by franchisees, the issue of whether or not a franchisor has improperly imposed additional charges on its franchisees is ripe for litigation.

It is also important to consider whether the proposed change to the agreement imposes a duty on the franchisor to deliver a fresh disclosure document or statement of material change to the franchisee under the Arthur Wishart Act (Franchise Disclosure), 2000. Such a duty may seem surprising at first since the duty to provide a disclosure document typically arises when the franchisee first purchases a franchise or when a franchise is being renewed after there has been a material change to the franchise system. Nevertheless, an argument could be made that the duty to provide a formal disclosure document is also triggered by an amendment to the franchise agreement which arises during the course of the franchise term. This argument has yet to be tested, but it is safe to assume that the courts will one day be asked to rule on it.

Determining when a change to the franchise system imposes a duty to amend the franchise agreement is rarely a clear-cut question. In cases where the only change is to the operational aspects of the franchise system, it may not be necessary to formally amend the agreement - such changes can usually be effected through the Operations Manual. But whenever the franchisees’ financial interests are materially impacted by a change to the franchise system, prudence would dictate that a formal amendment to the franchise agreement is required. Franchisors can be sure that if the changes are unfavourable, a franchisee will seek legal counsel and the outcome may be a bitter one for the franchisor.