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Beyond the Four Corners: Trouble Brewing for Franchisors?
Two recent victories for franchisees caught our attention for the diametrically opposite conclusions that were reached in those cases. In one, the franchisor was held liable for failing to exercise a lease renewal option that was not expressly required under the contracts; in the other, the franchisee was excused from compliance with a mandatory provision in the franchise agreement. Stated differently, one franchisor was deemed to have breached an obligation that did not appear within the four corners of the agreement, while the other was found liable despite the franchisee's failure to satisfy a specific contractual provision.
In In Re: Magna Cum Latte, Inc., 2008 WL 2047937 (Bkrtcy.S.D.Tex. 2008), a coffee shop franchisee was awarded $678,825 based on the franchisor's breach of the implied covenant of good faith and fair dealing and wrongful termination. The judgment followed the court's previous ruling that the franchisor had breached the implied covenant by declining to exercise its lease renewal option with a third party landlord for one of the franchisee's stores after it became apparent that the franchisee would be unable to obtain its own lease. In Re: Magna Cum Latte, Inc., 2007 WL 4412143 (Bkrtcy.S.D.Tex. 2007).
Neither the leases nor subleases at issue in Magna required the franchisor to exercise its renewal option or specified under what, if any, conditions the option could be declined. Applying California law, however, the Magna court held that the implied covenant of good faith and fair dealing imposed a duty on the franchisor not to deprive the franchisee of the benefits of the contract.
The court noted that the implied covenant "finds particular application in situations where one party is invested with a discretionary power affecting the rights of another." (Citation omitted). In support of its ruling, the court cited the following analysis of the Hon. Richard A. Posner, one of the most widely respected federal judges in the country, in Market Street Assoc.'s Ltd. Partnership v. Frey, 941 F.2d 588, 595, 597 (7th Cir. 1991):
[C]ontracts do not just allocate risk. They also (or some of them) set in motion a cooperative enterprise, which may to some extent place one party at the other's mercy . . . The office of the doctrine of good faith is to forbid the kinds of opportunistic behavior that a mutually dependent, cooperative relationship might enable in the absence of rule . . .
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To be able to correct your contract partner's mistake at zero cost to yourself, and decide not to do so, is a species of opportunistic behavior that the parties would have expressly forbidden in the contract had they foreseen it. The immensely long term of the lease amplified the possibility of errors but did not license either party to take advantage of them.
The Magna court further found that at the time of contract formation, the parties had contemplated that the franchisor would exercise its lease renewal option in the event that the franchisee was unable to obtain his own lease directly with the landlord; declining the option under such circumstances was not within the parties' reasonable contemplations.
By comparison, in Gueyffier v. Ann Summers, Ltd., 43 Cal.4th 1179, 184 P.3d 739 (Cal. 2008), the California Supreme Court held that an arbitrator did not exceed his powers under California law by ruling that the franchisee was excused from compliance with a provision of the franchise agreement requiring written notice and at least 60 days to cure before the franchisor could be held liable for breach, because doing so would have been futile under the circumstances.
The arbitrator awarded $478,030 as consequential damages for the franchisor's failure to meet its obligations to provide operations manuals, training and assistance, and an advertising program. Applying California law, which allows for equitable excusal of contractual conditions causing forfeiture where the circumstances make performance futile, the arbitrator found that "[b]y the time Gueyffier was finally able to open the Beverly Center store, the effect of the breaches was not curable. Giving written notice to provide operations manuals, training and assistance, and an advertising program within a reasonable period of time would have been an idle act. Therefore, the requirement of giving sixty (60) days written notice (Article 7.2) is moot."
The precedential impact of these cases may be minor, given that (i) both decisions involved California law, (ii) the Magna decision was issued by a federal bankruptcy court in Texas, and (iii) the judicial review in Gueyffier was limited to whether the arbitrator exceeded his powers, rather than whether the decision was erroneous. In our view, however, these cases serve as useful reminders to franchisors and franchisees alike that the implied covenant of good faith and fair dealing is alive and well, and that courts and arbitrators may look beyond the four corners of the franchise documents, focusing on bigger picture issues instead. |
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Greetings!
Welcome to the latest edition of our franchise law newsletter, an informative monthly look at current topics in franchise law.
Eric H. Karp
Partner
David J. Meretta
Associate |
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