Obligations to Perform in Good Faith Do Not Override Express Terms

09/13/2017 / Henry Pfutzenreuter

Claims for breach of the obligation to perform in good faith, whether express or implied, continue to be popular among franchisees who choose to litigate their disputes. However, when the franchise agreements are drafted to address the key issues that are in dispute, these claims fail as courts continue to reject arguments that the obligation of good faith overrides the franchise agreement’s clearly defined, express terms. Two U.S. Court of Appeals cases from this summer illustrate how franchisors were able to overcome these claims, and how enterprising franchisors might even further improve their odds in the future.

In 7 Eleven Inc. v. Sohi, 2017 WL 3635189 (3d Cir. August 24, 2017), the Third Circuit affirmed a district court’s summary judgment dismissal of a franchisee’s claim for breach of the implied covenant of good faith and fair dealing. The franchisor terminated the franchise agreement after discovering that the franchisee had “intentionally failed to report hundreds of thousands of dollars of merchandise sales; secretly used cash illicitly siphoned from the stores to pay workers, some of whom were undocumented; did not comply with State and Federal law regarding minimum wage; and failed to pay applicable sales and payroll taxes at all six of his stores.” The franchisee responded by claiming that the franchisor breached the implied covenant of good faith and fair dealing when it “targeted [his] franchises for termination because he is a vocal critic of [the franchisor’s] franchise management practices.” The court was unpersuaded, holding that “the implied covenant of good faith and fair dealing cannot override an express term in a contract,” and the franchisee’s breach of the franchise agreements was undisputed.

In S. Glazer’s Distributors of Ohio, LLC v. Great Lakes Brewing Co., 860 F.3d 844, 851–52 (6th Cir. June 26, 2017), the Sixth Circuit reversed a district court’s preliminary injunction enjoining a supplier’s termination of a distribution agreement. The supplier terminated the distribution agreement after the distributor failed to seek the supplier’s consent to a merger. The distributor argued that its failure was excused because the distribution agreement, which provided that the supplier would exercise “reasonable business judgement” and not “unreasonably withhold its consent” to an ownership change, was inconsistent with the Ohio Alcoholic Beverages Franchise Act, which required suppliers to “act in good faith” and “in accordance with reasonable standards for fair dealing” in recognizing ownership changes. The court rejected the distributor’s argument that the distribution agreement waived the statutory protections, holding that the agreement and statute “echo[ed]” each other and there was “no meaningful inconsistency” between them. As a result, the court reversed the preliminary injunction because the distributor had no likelihood of success on the merits, having breached the distribution’s agreement express requirement that the distributor first obtain the supplier’s consent to the merger.

These two cases illustrate why a franchisor’s best defense against a claim for breach of an obligation to perform in good faith is usually an express term that more clearly defines the parties’ obligations. As seen in 7 Eleven, courts will usually enforce a franchise agreement’s express terms notwithstanding a franchisee’s argument that the obligation to perform in good faith somehow overrides them. Likewise, in Great Lakes Brewing Co., the supplier ultimately prevailed because the distributor breached the express provision requiring it to first seek the supplier’s consent to the merger. The best way to minimize exposure to claims for breach of the obligation to perform in good faith is to have a well-drafted franchise agreement that anticipates the most likely disputes and addresses them with clearly expressed terms.

But franchise agreements must also reflect the dynamic and continuing nature of the franchise relationship. Consequently, the parties cannot realistically expect to draft an express provision for every possible situation that might arise. A franchisor – as the party who owns, protects, and develops the brand – needs autonomy to perform its functions for the greater good of the system. In return, a franchisee expects some assurance that the franchisor will do so reasonably and in good faith. While the nebulous nature of the obligation to perform in good faith seems to spawn an unnecessary volume of meritless claims, a case like Great Lakes Brewing Co. suggests an alternative framework that is graining traction with some commentators.

If courts are willing to recognize that there is “no meaningful inconsistency” between a franchisor’s obligation to “act in good faith” and exercise “reasonable business judgement,” then it may be acceptable for the franchise agreement itself to stipulate that when the franchisor reserves its discretion to act, it does so in good faith so long as it exercises reasonable business judgment. To this end, the franchise agreement might further define reasonable business judgment to align more with the “business judgment rule,” which prohibits second-guessing of corporate decision-making, meaning that the standard is met so long as the decision is intended to benefit the franchise system as a whole, and despite the fact that the decision also benefits the franchisor, or other decisions are equally reasonable or even seemingly better.