Franchisee Seeks Rescission for Alleged Bad Faith and Negligent Misrepresentation

This case confirms that the franchise relationship is indeed one of simple good faith and not utmost good faith as was argued by the franchisee… Where a franchisee seeks to establish negligent misrepresentation concerning a franchisor’s non-disclosure about the potential profitability of the franchise, the franchisee will have a considerable burden in establishing reliance and detriment where the franchisee has conducted its own due diligence and has sought independent legal advice.

http://www.osler.com
February 2009

Franchisee Seeks Rescission for Alleged Bad Faith and Negligent Misrepresentation
Andraya Frith

In addition to lessons learned about getting into business with members of your family, the September 2008 decision of the Manitoba Court of Queen’s Bench in TDL Group Ltd. v. Zabco Holdings Inc. provides franchisors and franchisees with guidance on: (1) the scope of the duty of good faith; (2) whether an alleged failure to disclose certain information about the realities of a particular market and of being a franchisee amounts to negligent misrepresentation; (3) the importance of well-drafted entire agreement and non-reliance clauses; and (4) whether rescission is an available remedy for post-contract conduct.

The case resulted from a Winnipeg family’s failed involvement with two Tim Hortons stores. The Tim Hortons franchisor claimed judgment and damages for arrears pursuant to the terms of the franchise agreements covering the franchisee’s two Tim Hortons stores. The defendants (the corporate franchisee and several members of the Zaborniak family) counterclaimed that the franchisor had made negligent misrepresentations which had induced the defendants to enter into the franchise agreement and sublease.

The sole negligent misrepresentation claim relied on by the defendants was that the franchisor had failed to advise them that “no store in Winnipeg was capable of making a profit without concessions.” The defendants argued that the franchise agreement was void because they were induced to enter into the agreement as a result of this “pre-contractual negligent misrepresentation by non-disclosure.” The defendants also alleged post-contractual bad faith on the part of the franchisor. The sole remedy sought by the defendants was rescission and the return of funds actually invested (plus interest and costs). The franchisee did not seek any damages.

Is a franchise agreement a contract of utmost good faith?
The franchisee argued that, at common law, the franchise relationship is one of utmost good faith and that such a duty applies to pre-contractual negotiations, continues to operate for the duration of the franchise agreement and transcends the four corners of the agreement. In addition, the franchisee took the position that, in light of this duty of utmost good faith, the franchisor’s alleged post-contractual bad faith was the basis for rescission.

Justice Joyal held that the weight of Canadian authority supports the notion that the typical franchise relationship is not one of utmost good faith. Rather, like that of every relationship governed by contract, the parties to a franchise owe one another a duty to act in “simple good faith.” The court also confirmed that the franchisor does not owe a fiduciary duty to the franchisee.

Justice Joyal went on to note that if the franchise relationship is simply that of parties to a commercial agreement, bad faith allegations are simply allegations of breach of contract. Justice Joyal also noted that the concept of “good faith” (utmost, simple or otherwise) is irrelevant to the analysis of whether the franchisor owed the franchisee a duty of care. These conclusions are relevant to the court’s findings about the franchisee’s allegations of post-contractual bad faith and pre-contractual negligent misrepresentation by non-disclosure (as discussed below).

Does a failure to disclose information about potential profitability amount to negligent misrepresentation?
The court determined that the franchisee “came nowhere close” to establishing as a fact that, during the relevant pre-contractual period, no Tim Hortons store in Winnipeg was capable of making a profit without concessions. Indeed, the court noted that there was convincing evidence that if there were some Winnipeg stores operating with concessions, those stores were already profitable and the concessions were intended to increase their profit. The court also determined that the evidence established that the franchisor did, in fact, disclose to the franchisee specifically that Winnipeg was a market with below average sales and that the general practice of the franchisor’s sales representative was to caution prospective franchisees that being a Tim Hortons franchisee was a challenging and difficult endeavour.

In the event he had erred on these threshold questions, Justice Joyal considered whether failure to disclose this information to the franchisee would amount to negligent misrepresentation. In citing the elements for negligent misrepresentation as set out in Hedley Byrne v. Heller & Partners Ltd. [1964] AC 465, the court looked at the particular circumstances of the present case and concluded that “any such non-disclosure (even if proven) does not amount to a silent misrepresentation or a non-disclosure which is negligent.”

In reaching this conclusion, Joyal J. pointed to the fact that the franchisor encouraged the defendants to visit and speak to other Winnipeg franchisees, and to seek out whatever additional information they desired as part of their independent due diligence. The court also concluded that the franchisee had failed to establish reliance and detriment – two additional and essential elements for negligent misrepresentation. The court concluded that by speaking with other Tim Hortons franchisees, the defendants could reasonably be expected to have independently learned that one of the particular challenges in the Winnipeg market at that time was the competition faced with Robin’s Donuts. The fact that the defendants had also prepared a relatively sophisticated business plan and had sought independent legal advice was further evidence that the franchisee had not relied on the alleged “pre-contractual misrepresentative silence” to its detriment.

What impact do the entire agreement and non-reliance clauses have?
Citing considerable judicial authority (many of the cases involving franchise agreements), the court agreed with the franchisor’s position that the entire agreement and non-reliance clauses contained in the franchise agreement precluded the franchisee’s claim for negligent misrepresentation. This aspect of the decision reinforces the importance of ensuring that the franchise agreement contains a properly drafted entire agreement clause that excludes any liability for representations or warranties not contained in the actual franchise agreement, and a non-reliance clause confirming that the franchisee has not received or relied upon any representations, warranties or guarantees about potential revenues, profits or the success of the franchised business.

Is rescission available for post-contractual conduct?
The court concluded that since the franchisee’s allegations of bad faith on the part of the franchisor related solely to alleged actions or incidents that occurred post-contractually, rescission was not an available remedy. Allegations of post-contractual bad faith give rise to a claim for damages for breach of contract, not rescission. Justice Joyal was clear on this point:

…[W]here there has been a fundamental breach of contract as a result of post-contractual conduct by one of the parties vis-à-vis its obligations under the agreement, the other party may “repudiate” the contract, not rescind it. Repudiation will relieve (in light of the breach) the party from future performance and gives that party a claim for damages. It does not void the agreement ab initio. Conversely, rescission, properly understood, attaches to pre-contractual misconduct which has inappropriately induced the innocent party to entering into the agreement. In those circumstances, it is seen as appropriate to set aside the contract as if it never existed.”

Conclusion
This case confirms that the franchise relationship is indeed one of simple good faith and not utmost good faith as was argued by the franchisee. Should a franchisor’s post-contractual conduct be found to be in bad faith, the franchisee’s only recourse would be to seek damages for breach of contract, as rescission is not an available remedy for such a claim. Where a franchisee seeks to establish negligent misrepresentation concerning a franchisor’s non-disclosure about the potential profitability of the franchise, the franchisee will have a considerable burden in establishing reliance and detriment where the franchisee has conducted its own due diligence and has sought independent legal advice. A franchisor is further protected in this regard by the insertion of strong entire agreement and non-reliance clauses.

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