August 29, 2012

The not so sweet side of donuts: Quebec Court finds franchisor in breach of its duty to enhance brand strength

Following what has been called a “landmark decision out of the Quebec Superior Court,” franchisors may be well served to take an inventory of their policies surrounding brand protection and promotion.  In this decision, the court awarded 21 Quebec Dunkin’ Donut franchisees $16.4 million dollars, plus legal costs, for the franchisor’s negligence, incompetence, lack of assistance and support, and breach of the franchise agreement that amounted to its failure to protect and enhance the Dunkin’ Donuts’ brand.

In the early nineties, the Dunkin’ Donuts system was known as the market leader in the Quebec fast-food donut and coffee market, having over 250 stores across Quebec.  Over the next ten years, however, and in spite of franchisee warnings, Tim Hortons aggressively expanded into the Quebec market and took over as market leader.

The franchisees sued the franchisor for its continuous failure to fulfill its contractual obligations to protect and enhance the Dunkin’ Donuts brand in Quebec.  The franchisor denied any breach of its obligations and argued that the franchisees were responsible for the eventual demise of the brand, claiming, among other things, that the franchisees “failed to operate clean, renovated establishments in accordance with [Dunkin’ Donut] standards”.  The franchisor further denied any liability on the basis that “it is not the insurer of the [f]ranchisees nor does it guarantee their success”.

Agreeing with the franchisees that the franchisor had breached both its express contractual obligations as well as the duty of good faith and loyalty, the Quebec Superior Court stated it was a “sad saga … of how a once successful franchise operation, a leader in its field … fell precipitously from grace in less than a decade; literally, a case study of how industry leaders can become followers in free market economies”.

The Court further concluded, relying on a provision of the franchise agreement that provided that the franchisor would “continue its efforts to maintain high and uniform standards … thus protecting and enhancing the reputation of [the brand] … and the demand for the products,” that the franchisor “had assigned to itself the principal obligation of protecting and enhancing its brand. It failed to do so, thereby breaching the most important obligation it had assumed in its contracts. It must accept the consequences of such a failure”.

In addressing the franchisor’s arguments, the Court found that the franchisor failed to show that the franchisees were poor operators and that this defence was “utterly devoid of substance”.  Despite finding the franchisor ultimately liable for the harm it caused to the franchisees, the Court was careful not to go so far as to saddle the franchisor with the obligation of insuring or guaranteeing franchisee success.

Like many franchise decisions, this decision grapples with the ever contentious issue of who is responsible when a franchise system fails.

While many franchise lawyers may interpret this decision as imposing a new duty on franchisors to maintain brand strength, one should not gloss over the specific facts of the case.  In particular, the Court relied heavily on specific provision of the franchise agreement regarding the franchisor’s obligation to protect the reputation of the brand and the demand for the products.  That is not to say that the Court’s reasoning will not be applied absent such a provision in a franchise agreement, as the Court made it clear that an “underlying assumption of all franchise arrangements is that the brand will support a viable commerce”.

While we cannot say with certainty how this decision will be interpreted by courts in Ontario, franchisors may wish to err on the side of caution and review their existing franchise agreements with legal counsel  to ensure that they are in the best position to defend against a similar claim.