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Posted on Apr 02, 2012

Franchise Law for Beginners Part 2: The Implied Covenant of Good Faith and Fair Dealing

One of the most misunderstood concepts in the world of franchise law is the implied covenant of good faith and fair dealing. The basic definition of the implied covenant is actually quite simple.

Courts have held that the implied covenant obligates a party who is vested with contractual discretion to “exercise that discretion reasonably” and in a manner consistent “with the reasonable expectations of the parties.” (Interim Health Care of N. Illinois, Inc. v. Interim Health Care, Inc., 225 F.3d 876, 886 (7th Cir. 2000)) The common law developed the implied covenant as a reasonable standard of care upon contracting parties in performing their express contractual duties. There are elaborations of this duty, but at the end of the day the implied covenant is a duty to be “fair.” (Dayan v. McDonald’s Corp., 125 Ill. App. 3d 972, 990, (Ill. App. Ct. 1984))

A duty to be fair or to be reasonable hardly seems to be unfair or unreasonable, but many franchisors and their attorneys believe that the implied covenant is dangerous or ill-advised and should be abolished. Their concern is that, by its very nature, a duty to act in “good faith” or to “deal fairly” or “reasonably” is inherently unclear.

They fear that a franchisor might honestly believe that it is acting in good faith to its franchisees only to find that the franchisees disagree. This is tantamount to an open invitation for second-guessing by a judge, jury, or arbitrator – and a legal standard that creates confusion by encouraging disagreement over exactly what might be required in any given situation can hardly be deemed the ideal that we should strive for.

However, just as Winston Churchill once said that “democracy is the worst form of government except all the others that have been tried,” the much maligned implied covenant may be the worst possible way to measure contract performance in franchising, except for everything else that has been, or could be, tried. Put another way, to understand why the implied covenant remains vitally important in franchising, we must first consider the alternatives.

Alternatives to the Covenant of Good Faith and Fair Dealing

One alternative considered was to impose fiduciary duties on the franchisor, but the courts rejected that duty as being too strict, for franchising is an arm’s length business relationship. The franchisor is not your uncle. The common law implied covenant, which requires nothing more than good faith or reasonableness, seems quite modest in comparison to a strict fiduciary duty, so it's hard to understand why so many franchisors continue to object.

A theoretical alternative to the implied covenant would be to say that the franchise agreement does not confer any discretionary rights or duties on the parties. If that were true, the implied covenant would not be needed, as all of the parties’ respective duties would be express. But this would be impossible to achieve, and it would be very unwise even if it were possible. Franchise agreements are not “single event” transactions like the sale of a house. No matter how hard lawyers might try, in drafting a franchise agreement, it remains impossible to anticipate every future question that might arise in the course of the relationship.

For example, the franchisee is required to comply not only with the franchise agreement but also with the operations manual, which will evolve over time. These inevitable changes will impact the franchisees, who have the right to expect that changes be made in good faith.

Likewise, the franchise agreement requires the franchisor to provide training but leaves open the details as to what will be covered.
The same holds true for ongoing support such as advertising and the introduction of new products and services to keep ahead of the competition. In virtually every area of the franchise relationship the franchisor has substantial discretion as to how it will perform. It would be dangerous if not impossible to try and straightjacket the system by eliminating franchisor discretion.

The final alternative, and the one that many franchisors would prefer, would be to say that the franchisor’s discretionary decision-making cannot be second-guessed or challenged in any way.

Few franchisors actually admit that this is their preference for fear of making the franchises less marketable. And so we see franchise agreements say things like a particular discretionary decision is committed to the franchisor’s sole discretion, or if that is not enough, then to the franchisor’s sole and exclusive discretion, or even to the franchisor’s “absolute discretion.”

These words are apparently intended to let franchisees know upfront that their opinions won’t count for much. But as “stealth attempts” to obtain waivers of the implied covenant, these clauses arguably don’t hold water. Making one’s discretion “absolute” only serves to heighten the application of the implied covenant, which requires that the discretion be exercised reasonably.

Some franchisors may be bold enough to say in their franchise agreements that “in entering into this contract, the parties expressly waive the protection of the implied covenant of good faith and fair dealing.” Such a proclamation would at least have the virtue of honesty, but make no mistake, this sort of contract language would quite literally license the franchisor to behave “unreasonably” and to act solely in their own self-interest without regard for their franchisees. In essence the franchisor would be above the law and free to act like a dictator or a tyrant. Any franchisee would be foolish to accept a waiver of the implied covenant.

To be sure, the franchisor might claim to be a benign dictator, not a harsh one, but times change, and the personnel running the franchise might change as well. The human tendency is to exploit available opportunities. No franchisee should ever accept a waiver of the implied covenant – and no court should ever uphold such a waiver even if the franchisee was foolish enough to sign such an agreement. Franchisors seeking to abolish the implied covenant are threatening the ruination of franchising as a viable and attractive business model. Franchisees have every right to demand good faith and fair dealing in all aspects of the franchise relationship. The implied covenant of good faith and fair dealing is an imperfect but essential ingredient of every franchise relationship.

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