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What is Good Faith? -- Franchise Lawyer Canada

Introduction

Section 3 of the Arthur Wishart Act (Franchise Disclosure), 2000 S.O. 2000 c.3 (the “Act”) imposes a duty of fair dealing on each party to a franchise agreement. The Act then states that the duty of “fair dealing” includes the duty to act in “good faith” and in accordance with “reasonable commercial standards.” What these terms mean has been the subject of considerable interpretation, none of which has definitively given the franchising community a single, workable definition.

Though the Act has only recently been enacted, the duty of parties to a contract to act in good faith is a long standing one and harkens back to the common law doctrine of implied promises and implied conditions to a contract. More recently, the duty of parties to a contract to act in good faith was enunciated by Kelly J. in Gateway Realty Ltd. v. Arton Holdings Ltd. and LaHave (No.3) (1991), 106 N.S.R. (2d) 180 (N.S.S.C.); aff’d (1992), 112 N.S.R. (2d) 180 (N.S.C.A.). In Gateway, Kelly J. stated that “(t)he law requires that parties to a contract exercise their rights under that agreement honestly, fairly and in good faith”. The common law duty of good faith in contract dealings is a well-established one.

Although the Act may not impose requirements above and beyond those that the common law ascribes to parties to a contract, the Act does provide guidance on when and how the standards of fair dealing, good faith and commercial reasonableness should be applied to a franchise relationship.

How is the standard of “good faith” defined?

Simply put, good faith and fair dealing prohibits actions that are contrary to community standards of honesty, reasonableness, or fairness (Gateway). Good faith and fair dealing prohibits actions that destroy, injure, or limit a party’s right or ability to receive the fruits of the contract that were expected at the time of forming the contract.

In a review of the applicable Canadian and American authorities, it is apparent that the term “good faith” has no absolute meaning of its own. Instead, it derives its content from the terms of the contract and the circumstances in each case. In fact, most cases dealing with breaches of the good faith requirement involve the plaintiff party trying to establish an act of bad faith, and then stating that the act of bad faith was clear evidence of a breach of the good faith duty owed to them. Bad faith can be said to occur when one party, without reasonable justification, acts in relation to the contract in a manner where the result would be to substantially nullify the bargained objective or benefit contracted for by the other, or to cause significant harm to the other, contrary to the original purpose and expectation of the parties. Though an act of bad faith has been historically seen as a breach of the good faith requirement, bad faith cannot be definitively defined either. Almost all of the case law approaches this analysis on a case by case basis.

It may be helpful then, to view the fair dealing and good faith requirement more as a “guide” than as an absolutely definable term. Master Funduk in Sahim Woodwork Ltd. v. Edmonton (City) (1993), 41 A.C.W.S. (3d) 1058 (Alta. Q.B.) stated that “[judicial attempts to establish a duty of good faith are all] very nice in Utopia. It is those kind of grand sweeping statements which help to keep lots of courts and lots of lawyers in lots of work.” Nevertheless, many cases in recent history have attempted to define what entails “good faith”. In Imasco Retail Inc. (c.o.b. Shoppers Drug Mart) v. Blanaru, (1995) 9 W.W.R. 44 (Man. Q.B.), affd. [1997], 2 W.W.R. 295 (Man. C.A.), the court held that the standard of good faith is breached when a party “acts in a bad faith manner” and that good faith conduct “is the guide to the manner in which the parties should pursue their mutual contractual objectives”.

In Wallace v. United Grain Growers Ltd. [1997] (S.C.C.) S.C.J. 94, an employment dismissal case, Justice Iacobucci crafted an explanation of the fair dealing and good faith requirement by stating that “while the obligation of good faith and fair dealing is incapable of precise definition, at a minimum...employers ought to be candid, reasonable, honest and forthright...and should refrain from engaging in conduct that is unfair or is in bad faith by being...untruthful, misleading or unduly insensitive”.

The leading American case on point, Kirk LaShelle Co. v. Paul Armstrong Co. 199 N.E. 163 (N.Y. Ct. App. 1933), defined good faith as “the implied covenant that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract, which means that in every contract, there exists an implied covenant of good faith and fair dealing”.

Decades of case law and commentary have given us a panoply of definitions of what good faith and fair dealing may mean, but how should this be applied to the franchise relationship?

How does this standard apply to the franchise relationship?

Once the parties have negotiated and entered into a contractual relationship as franchisor and franchisee, they are under a greater obligation to act in good faith toward the other in the performance and execution of the franchise agreement. In fact, while the Act imposes a good faith requirement for the performance and execution of the franchise agreement, it is silent with regards to any good faith requirement on either party during the negotiation of terms during the time leading up to the execution of the franchise agreement. This apparent exclusion from the good faith requirement may simply be a restatement of the principle that good faith and fair dealing as a concept cannot stand on its own–good faith and fair dealing requires a contract under which terms good faith and fair dealing must be applied.

The case of Shelanu Inc. v. Print Three Franchising Corp. [2000] O.J. No.4129 (Ont. Gen. Div.), currently under appeal, was the first to mention the good faith requirement as set out in s.3 of the Act. In Shelanu, the Plaintiffs alleged, amongst other things, that the franchisor defendant had breached their duty of fair dealing and good faith by opening and operating a “lower-cost alternative” franchise system that would compete directly with the original franchise system, and in fact, would do so within the territories of the existing franchisees. In finding that the franchisor did, in fact, breach the duty of fair dealing and good faith, the Court in Shelanu described the contractual relationship between franchisor and franchisee as “akin to a partnership”. The Court further held that a franchisor must not be tyrannical or abusive of its power over a franchisee. Instead, the relationship between the franchisor and franchisee must consist of mutual respect and the opportunity and outlet for all parties to be able to air their views and express their opinions without fear of recriminations being imposed arbitrarily.

By the wording of the Act, which requires that “each party” to a franchise agreement has a duty of fair dealing in its performance and negotiation, the legislature has taken the even-handed approach of requiring that both parties be subject to a duty of fair dealing. Practically, however, virtually all of the cases on the subject deal with an alleged breach of the franchise agreement by the franchisor, and will likely continue to deal with alleged breaches on the part of the franchisor. This is simply because the vast majority of duties and obligations enumerated in a typical franchise agreement are those that accrue to the franchisee. The franchisor rarely has more than a few cursory duties or obligations, and it is in the context of this contractually unbalanced relationship that the courts have slowly moved to the finding of an implied obligation of good faith and fair dealing and the legislature has now established a similar statutory requirement.

With an almost ethereal description of what good faith and fair dealing encompass, parties to a franchise agreement, and especially those involved in a good faith dispute, must then turn their minds to what evidence may be adduced and presented to a court to either support or refute a breach of good faith claim.

What evidence should be used to establish compliance with these standards?

In general, it is easier to establish what an act of bad faith encompasses, as opposed to setting out what good faith entails. As such, much of the litigation on this topic focuses on what constitutes an act of bad faith. In dealing with the evidentiary issue of establishing an act of bad faith, there are several factors that a court will examine. Primarily, in deciding whether the duty of fair dealing and good faith has been discharged by a party, a court must examine whether the behaviour of the party in question meets or falls below the required community standard or industry practice.

In addition to examining community standards and industry practice, the courts have stated that they will look at the intention of the parties in deciding if an act taken was one of bad faith. In Mason v. Freedman (1958), 14 D.L.R. 529 at p.534, the court, in dealing with the question of whether a vendor, under an agreement of purchase and sale for land, could rely on a rescission clause, had this to say:

When a vendor seeks to void a contract under this clause, which is obviously introduced for his relief, his conduct and his reasons for seeking to escape his obligations are matters of interest to the Court.

State of mind is very important in an action based on breach of good faith. Although the courts have not yet established a definitive approach to analysing good faith and fair dealing, it appears as if the courts will first subjectively determine the expectations of the parties to the contract, then objectively evaluate the particular terms of the contract, whether they have been frustrated by acts or omissions of the other party, and whether those acts conform with, or run contrary with the reasonable commercial standards of that particular industry or community.

In Gateway, Justice Kelly concluded that the party’s state of mind is important in deciding whether a court should interfere with the exercise of a party’s discretion, but he suggested that the court’s duty is to conduct an objective inquiry into that party’s state of mind.

Once a bad faith claim has been advanced, the alleged transgressor can counter the allegation by putting forth or producing evidence that shows a rational, objective business purpose underlying the disputed action or decision. If the alleged transgressor can show that the action or decision in question is evenhanded in its application, the probability of a court interfering with the party’s exercise of its discretion or with the disputed action or decision is much reduced. An alleged transgressor that cannot produce evidence that an alleged bad faith act had a rational and objective business purpose, or which cannot produce evidence that the act was even-handed and not disproportionate may be found to be in breach of the fair dealing and good faith requirements of the Act.

An excellent recent example of this is Shelanu. Finding that there was a breach of the good faith and fair dealing standards imposed by the Act, the Court described the actions of the franchisor as “heavy handed” and “out of proportion”. Furthermore, Nordheimer, J. stated that actionable bad faith would be evidenced by “conduct by a franchisor or by a franchisee which demonstrates bad faith, or manifests an intention not to conduct itself fairly in its dealings with the other”.

As well, the application and methodology of how to apply good faith was reviewed in Kentucky Fried Chicken of Canada, a Division of Pepsi-Cola Canada Ltd. v. Scott’s Foods Services Inc. (1997), 35 B.L.R. 92d) 21 (Ont. Gen. Div.), rev’d (1998) 114 O.A.C. 357 (C.A.). In the KFC decision, good faith was not the primary basis for the Court’s review, however, it was an underlying consideration in its overall assessment of the parties’ conduct. The Court established that where a party engages in activities it believes to be in accordance with its contractual rights, that is a prima facie indicator of good faith conduct. As such, a good faith analysis begins with a subjective review of a party’s conduct. Evidence to the contrary converts the standard to an objective examination. The Court in KFC also established that simply alleging bad faith was not sufficient to support a good faith argument–instead adequate evidence must be adduced by the claimant party and put before the Court.

Likewise, in the United States, the general merchant sections of the Uniform Commercial Code (the “UCC”) hold a party to reasonable, but unspecified standards of conduct as measured by commercial standards. The American courts have typically applied an objective standard regarding the merchant good faith provisions of the UCC, however, a subjective standard may from time to time be warranted. The UCC states that good faith performance can be measured by an objective standard based on the decency, fairness or reasonableness of the community, commercial or otherwise, of which one is a member.

Conclusion

It is optimistic to think that the Act’s fair dealing, good faith and commercial reasonableness requirements definitively refine the vast range of descriptions and commentary on what makes up fair dealing and good faith. What the Act does do, however, is set out when the standards apply and to whom they apply. With the introduction of the Act, combined with the strongly worded judgment in Shelanu, which establishes what standards may apply, those in the franchising sphere may soon see more and more good faith cases being put before the courts, to filter even further what the standards of what fair dealing and good faith truly mean. Furthermore, the Court of Appeal will likely provide much needed guidance on this issue as a result of the wide ranging, and at times questionable reasoning of the Court in Shelanu.

Author:. Peter Macrae Dillon is one of North America’s leading and most-respected franchise attorneys. He is licensed to practice law in Ontario and New York. He specializes in advising start-up franchisors in the conversion and early stages of franchising. His group represents mature Canadian and American franchise systems operating in Canada, the United States, and internationally. Email Peter at peter.dillon@siskinds.com or visit his website at: www.franchiselaw.ca peter macrae dillon franchise fra... Go Deeper | Website

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