THE IMPLIED COVENANT OF GOOD FAITH & FAIR DEALING

Excerpted and updated in September 2003 from a presentation by Carmen D. Caruso to the Association of Trial Lawyers of America (ATLA) in a“Litigation at Sunrise” program during their annual meeting in Chicago, July, 2000.

Franchisees who believe that their franchisor has not honored the franchise agreement may find that the express contract terms do not always provide a claim for breach of contract.   The franchise agreement was drafted by the franchisor and for the franchisor.   However, in proper circumstances, the courts will recognize a claim for breach of contract that goes beyond the express terms.

In many jurisdictions, a franchisee's best claim is for breach of the implied covenant of good faith and fair dealing (the "implied covenant") which is implied as a matter of law in every contract (in states that recognizes this doctrine). The implied covenant has been described as a "clever chameleon," as it applies in myriad factual settings, e.g., quality, service and cleanliness (QSC) testing, and renewal, termination and encroachment questions.   As a matter of law, where a party to a contract retains discretion as to performance of contract terms, the covenant requires that party not exercise his discretion arbitrarily, capriciously, or in any manner inconsistent with his co-party's reasonable business expectations.   Good faith is "the duty to avoid taking advantage of gaps in a contract in order to exploit vulnerabilities that arises during performance."

Another way of looking at this covenant is that the test for whether a contracting party has acted with good faith is whether that party's discretionary act was "commercially reasonable."   In effect, this holding can make the trial of a "good faith" case the functional equivalent of a commercial negligence case, although, most franchisors would contest the viability of any claims of commercial negligence.

However, this claim is often misunderstood. It does not impose a general duty of good faith, does not create an independent cause of action, or create a claim in either tort or contract for bad faith per se. The claim is derivative in nature, aimed at defining and furthering the terms of the parties' agreement. ... To be actionable, the allegedly bad faith conduct must relate to specific terms of the contract that the breaching party allegedly performed in bad faith. The inquiry when a breach of this covenant is alleged is objective, not subjective, making proof of motive irrelevant. Moreover, a claim for breach of the implied covenant of good faith and fair dealing is contractual in nature. Therefore, in most jurisdictions, it will not support a claim for punitive damages in franchising cases.

              Territorial Encroachment

To what extent does the franchisor have a duty to refrain from opening new outlets "too close" to existing units? How close is "too close" if the license agreement is silent? In a 1997 decision that is widely hailed by attorneys representing franchisees, a the Ninth Circuit Court of Appeals in In re Vylene Enterprises held that a franchisor breached the implied covenant of good faith and fair dealing by opening new stores close to the plaintiff/franchisee's store – though the franchisee had not bargained for express territorial protection in the franchise agreement.

Franchisees complain about territorial encroachment (the franchisor's opening of a new store within the franchisees market area) more often than they complain about any other single issue.   But despite Vylene, unless the franchise agreement creates express protection for the franchisee's defined territory, some courts (particularly those in the Eleventh Circuit) are increasingly reluctant to find that there was an implied duty not to encroach under the covenant of good faith and fair dealing - and regardless of whether the franchisor arguably violated an internal policy in opening the new store.

These cases remain fact intensive. In a 1979 decision, Photovest Corp. v. Fotomat, the Seventh Circuit held that territorial encroachment was actionable despite the absence of express contractual protection, where the franchisor had the goal of driving the franchisee out of business. Photovest was decided under California law, but should remain good in other jurisdictions.

[Added in 2003:   In other recent cases, including Interim Health Care, the courts have refused to find that any territorial protection was "implied" into a franchise agreement based on the implied covenant.   The basic reasoning is that something so important would not be left for implication.   Both parties to a franchise agreement should consider territorial issues at the outset and not leave the subject for litigation.    Where territorial issues arise after the agreement is signed, the language of the agreement must be closely examined in relation to the disputed conduct].

            Other Areas of Good Faith Litigation

▪        Training and support: Has the franchisor provided training and technical support promised?
▪        Control: What degree of control is the franchisor entitled to exercise over the franchisee's products, suppliers and pricing? To what extent may the franchisor derive profit from the franchisee's supplier relationships?
▪        New Products: To what extent does the franchisor have a duty to introduce new products to keep ahead of the competition? Once the decision to introduce new products is made, is the franchisor held to any "standard of care" to ensure that the product is successful?
▪        Expansion or Contraction of the System: Is the franchisor's natural desire to expand the franchise system in conflict with a franchisee's desire to maximize profits at his or her location? Conversely, what duties, if any, does a franchisor owe to franchisees in a particular market if the franchisor plans to withdraw from that market for strategic reasons?
▪        Expansion by the Franchisee: To what extent is an individual franchisee's desire to expand in conflict with what is best for the system as a whole?
▪        Reinvestment: May a franchisor require a franchisee to reinvest a portion of his revenue back into the business? Does the answer to this question depend on whether the franchisee owns or leases the real estate?
Termination Issues
The end of a franchise relationship may also provide grounds for litigation:
▪        Renewal: Does a franchisor have a duty to renew a franchisee beyond the initial term of his or her license agreement, if no option to renew is stated in the contract? If there is a right to renew, it probably requires the franchisee to renew under the franchisor's "then current" form of the franchise agreement that may be less favorable than the original franchise agreement.
▪        Early Termination: Under what circumstances may a franchisor terminate a franchise before the expiration of its contractual term?
▪        Sale of a Franchise: Under what circumstances may a franchisor veto a franchisee's proposed sale of his or her franchise to a third party?

  Attempts to Eradicate The Implied Covenant

Because the implied covenant frequently leads to ambiguous situations and often to litigation, franchisors have increasingly attempted in their franchise agreements to eliminate the implied covenant. Sometimes this is done expressly (by a clause stating that the implied covenant does not apply).

Other times, the franchisor might insert a clause stating that there are "no implied agreements." In that situation, the franchisor might argue that the implied covenant has been negated by agreement of the parties, while the franchisee will likely disagree.   The franchisee's argument is that since the implied covenant is not an independent term of the contract, it is not affected by the "no implied agreement" language. Nonetheless, the presence of this type of clause is probably disadvantageous to the franchisee.

The role of the implied covenant in franchising is complex. Both franchisors and franchisees are advised to consult experienced franchise counsel in regard to implied covenant issues.