Franchisors may have inherent obligation to protect and enhance brand

The decision of the Québec Superior Court in Bertico Inc v Dunkin’ Brands Canada Ltd (2012 QCCS 2809) has raised a few eyebrows in Canada. Adjudicating claims made by 21 franchisees who operated 32 Dunkin Donuts stores in the province of Québec, the court granted all the franchisees’ claims. The court resiliated all their contracts, including their leases and franchise agreements, and ordered the franchisor to pay the franchisees a total of C$16,407,143 as compensatory damages.

Disputes between franchisees and franchisors are not remarkable and neither are large damage awards. The global damage award merely aggregates claims by the franchisees, with individual damage awards ranging from C$125,966 up to C$1,167,275. The decision is remarkable, however, for other reasons: comments made by the court suggest that a franchisor may have an inherent obligation to protect and enhance the brand, including the obligation to maintain market share in the face of competition.

In the mid-1990s the Dunkin Donuts brand led the Quebec coffee/donut and fast food market, both in terms of sales and number of outlets. In less that 10 years, sales plummeted and store numbers dropped from 212 to 13. Dunkin Donuts’ dominance was threatened by a competitor called Tim Hortons. In its decision, the court summed up the threat and decline as follows:

"[38] Clearly, Tim Hortons had captured the lions’ share of growth in the coffee/donut fast food market and, at the very least, materially contributed to the precipitous collapse of the 'Dunkin Donuts System' in Quebec during this period. Tim Hortons’ stores had multiplied five times from 60 stores in 1995 to 308 by 2005.  Dunkin Donuts’ market share in Quebec had plummeted from 12,5% in 1995 to 4,6% in 2003. […]

[40] It is a sad saga as well of how a once successful franchise operation, a leader in its field – the donut/coffee fast food market in Quebec – 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 franchisor acknowledged the threat in its defence, but claimed that it was the franchisees who were responsible for the decline of the brand:

"8. Throughout many of these years, the Quebec market thrived. There was virtually no competition and the Quebec Dunkin’ Donuts franchisees were […] very successful. Then came the 'Tim Hortons’ phenomenon'.  As Tim Hortons grew increasingly in the Quebec market, towards the end of the nineties and in the early two thousands, competition intensified and Quebec franchisees were starting to feel the brunt of this heightened competition.

9. Tim Hortons was coming out with brand new stores, great execution, and was increasing its number of locations. At the same time, an increasing number of Dunkin’ Donuts stores were experiencing decreasing sales, becoming timeworn, execution was uneven and many franchisees were not working as hard as they could to deliver a first rate Dunkin’ Donuts experience."

The trial lasted 67 days, allowing the court to hear and weigh extensive oral and documentary evidence from fact and expert witnesses. In its decision, the court held that the franchisees’ concerns were well-founded and that the franchisor had failed to address the threat of competition.

Key to finding liability was the court’s appreciation of two contractual provisions binding the litigants: the franchise agreement and a later amendment. First, Paragraph 3C of the franchise agreement provided that the franchisor undertook, among other things:

“[15] 3C To continue its efforts to maintain high and uniform standards of quality, cleanliness, appearance and service at all DUNKIN DONUTS SHOPS, thus protecting and enhancing the reputation of DUNKIN DONUTS CANADA, DUNKIN DONUTS OF AMERICA INC and the demand for the products of the DUNKIN DONUTS SYSTEM and, to that end, to make reasonable efforts to disseminate its standards and specifications to potential suppliers of the FRANCHISEE upon the written request of the FRANCHISEE."

Second, a preamble to one of the later amendments recognised the importance of "protecting and enhancing the brand". A reading of that later version prompted the court to conclude that "[n]ot only is [the obligation to protect and enhance the brand] important, it is the essence of any franchise agreement" (Decision, Paragraph 18). Whether this statement is obiter, unnecessary or limited to the particular contracts between the parties will be the object of much debate in appeal.

The court referred to both of these provisions to find liability:

"Far and away, the most important explicit obligation of [Dunkin’ Brands Canada Ltd] under its Franchise Agreement is the one found at Paragraph 3C of the 1990 Agreement and the last 'considérant' [recital] on page 1 of the 2002 agreement wherein it promises to protect and enhance both its reputation and the 'demand for the products of the Dunkin Donuts System'; in sum, the brand. It did neither between 1995 and 2005. The brand has withered in Quebec by all relevant measures, however successful it may continue to be in the United States or elsewhere in the world according to [a witness]." (Decision, Paragraph 54)

By inscription dated July 23 2012, the franchisor appealed. The appeal should be watched for two reasons. First, what is source and the extent of a franchisor’s obligation: should and how must a franchisor act in order to protect or enhance the brand when faced with competition? Is the franchisor solely responsible for succeeding or for merely making reasonable attempts to compete? Second, which facts demonstrate failure to meet that obligation?

With regard to the first issue, the appeal will have to decide whether these obligations are merely limited to the contracts in question or whether the obligation to protect or enhance the brand is “the essence of any franchise agreement”. The franchisor objects to the court’s interpretation of the contract and the law, remarking that the court has “saddled the appellant with the sole responsibility to maintain for its franchisees their market dominance in perpetuity” (Inscription, Paragraph 5). The franchisor argues on appeal that it “does not have the legal or contractual obligation to remain, at all times, the leader of its market in Quebec” (Inscription, Paragraph 93e).

The franchisor also objects to the court’s interpretation of Section 3C:

"The trial judge erred in law in misinterpreting this provision and in creating and imposing a new, direct and unintended obligation upon the appellant to enhance and protect the brand. This reasoning amounts to a distortion of the very nature and essence of franchise agreements."

The franchisor further states that the decision "imposes upon the franchisor a duty to thwart all competition and effectively guarantee the financial success of its franchisees. No such obligation exists under the contract or in law" (Inscription, Paragraph 6).

With regard to the second issue, the franchisor challenges the court’s appreciation of its efforts to counter competition: "[b]y considering who won the war instead of looking at how the battle was fought, the trial judge erred by assessing appellant’s liability on the basis of the final result" (Inscription, Paragraph 49). The franchisor also objects to the court’s perceived failure to defer to the franchisor’s business judgment:

"The trial judge deployed result-oriented, and after-the-fact reasoning, in concluding that when the outcome was negative, the decision must have been erroneous, negligent or made in bad faith. The appellant, as franchisor, had a common interest with the franchisees to keep its business vibrant and profitable. The franchisor, in no way, benefits when franchised shops fail. The trial judge erred in failing to give the appropriate deference to these facts and efforts." (Inscription, Paragraph 60)

Some may limit the ruling to the parties’ particular contractual agreements, whereas others may read the reasoning as applying to franchise agreements in general. The appeal will likely be heard in late 2013.

Daniel Urbas, Borden Ladner Gervais LLP, Montréal