The Covenant of Good Faith and Franchising in 2019: Survival, Opportunism, and Distortion
By: Jeffrey M. Goldstein
The seemingly-omnipresent, but erroneous, belief that franchisors are legally prohibited at all times and in every instance from acting unreasonably or in bad faith vis-à-vis their franchisees is held not just by franchisees, but also by some prominent franchise lawyers. Rarely a day goes by without a potential client suggesting to me that his or her franchisor has acted unlawfully by having failed to meet its obligation to act in good faith and with fair dealing. Many times these franchisees repeat to me verbatim what they’ve just been told by another franchisee litigator to whom they’ve just spoken on the phone. Whereas franchisees generally readily latch onto the incorrect belief as a matter of survival, some franchise lawyers regularly peddle the myth to generate business. Quite simply, the misuse, misunderstanding and misapplication – intentional and unintentional — of the covenant of good faith in conversation, teaching and litigation leads ineluctably, over time, to a severe diminution in the inherent worth of the covenant of good faith as well as its use as a potential litigation tool for franchisees.
The implied covenant of good faith and fair dealing is not applied uniformly by courts. Indeed, the covenant of good faith is a pure doctrinal bastard – sometimes it is viewed by courts as implied, and other times it is viewed as only explicit; sometimes it is used by courts to merely interpret a contract, and other times it is used to find substantive rights; sometimes it is used by courts only where discretion on an issue has been given in an agreement to a franchisor, and other times it is used by courts in the face of contractual silence on that issue; sometimes it is applied by courts only to terminations, and other times it is applied by courts with regard to all franchisor conduct; sometimes it is used by courts as a free-standing tort, and other times it is applied by courts only when tethered directly to explicit contractual language; and, sometimes it is limited by courts to specific types of commercial contracts, and other times it is implied by courts in every type of contract.
Similar to its application, the definition of the covenant of good faith and fair dealing is not theoretically stable over time or across jurisdictions. An examination of the Restatement (Second) of Contracts Section 205, which is a comprehensive treatise setting forth established legal doctrine on contracts, shows this analytical woolliness:
Meanings of “good faith.” Good faith is defined in Uniform Commercial Code § 1-201(19) as “honesty in fact in the conduct or transaction concerned.” “In the case of a merchant” Uniform Commercial Code § 2-103(1)(b) provides that good faith means “honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.” The phrase “good faith” is used in a variety of contexts, and its meaning varies somewhat with the context. Good faith performance or enforcement of a contract emphasizes faithfulness to an agreed common purpose and consistency with the justified expectations of the other party; it excludes a variety of types of conduct characterized as involving “bad faith” because they violate community standards of decency, fairness or reasonableness. The appropriate remedy for a breach of the duty of good faith also varies with the circumstances.
In the franchise world, use of the covenant of good faith by franchisees has been, and continues to be, prolific, pervasive, and precarious. It has been used to contest terminations, infringements, remodeling demands, franchisor internet competition, expansion, supply requirements, menu pricing, prices of franchisor-supplied services and products, new contiguous store openings, quotas, market divisions, failures to renew, diminishing profits, and almost every other act – fair and unfair — carried out by a franchisor on the other side of a franchisee in a franchise business dispute. When applicable and successful, the covenant of good faith is a great equalizer in the franchise context. However, unfortunately, its suitability changes over time; this is because, in part, many covenant of good faith cases currently pivot off of the contractual discretion – or lack thereof — accorded to the franchisor in the putative franchise agreement; and over time, of course, franchisors in lock-step expectedly have modified their specific contracts to reserve to themselves sole discretion regarding how, whether and when they must provide required conduct.
Khorchid v. 7-Eleven, Inc.
Two cases in the last few months illustrate typical dispositions of covenant of good faith and fair dealing claims. In the first, Khorchid v. 7-Eleven, Inc., Civil Action No. 18-8525 (JBS/JS), 2018 U.S. Dist. LEXIS 180609 (D.N.J. Oct. 22, 2018), the 7-Eleven franchisee argued that the franchisor had devised a plan to terminate the franchisee pursuant to a wider scheme to whittle down franchisees in the Philadelphia and South Jersey market. One of the franchisee’s claims was that the franchisor had violated the covenant of good faith and fair dealing. The 7-Eleven Court not only lambasted the franchisee for what it viewed to be poor pleading of the claim, but also appeared on some level to launch a frontal assault on the good faith doctrine itself.
The 7-Eleven Court began its analysis by noting that under New Jersey law the alleged wrongful conduct could not support simultaneously both an explicit breach of contract claim as well as a breach of the implied covenant of good faith and fair dealing. In this regard, the franchisee pled, inter alia, that “By failing to repair Plaintiff’s store as agreed following damage from Hurricane Sandy, imposing unreasonable charges that entirely diminished Plaintiff’s profits, failing to properly advertise for Plaintiff as agreed and paid for, failing to let Plaintiff obtain the lowest cost merchandise as stated in the Franchise Agreements, and targeting Plaintiff’s store for ‘take back’ Defendant violated the covenant of good faith and fair dealing.” As the Court stated “They cannot attach to both, however, because they are mutually exclusive.” In its pleading opposing the franchisor’s motion to dismiss the franchisee attempted to cure this pleading failure by arguing that the following claims were “separate” and non-duplicative breaches of the good faith covenant:
16. Defendant initiated new policies and charges to Plaintiff designed to diminish the profits of Plaintiff.
17. As an example, where Plaintiff’s store generated $1,239,030.25 in total sales in a one-year period in 2011 and net income for Plaintiff of $36,050.11 representing 2.91% of total sales as profit for Plaintiff, a one-year period ending in April of 2016 for the same store generated $1,265,306.67 in total sales but only $2,790.77 in net income for Plaintiff, representing only .02% of sales as profit for Plaintiff.
19. Therefore if Plaintiff found merchandise at a lower cost he nonetheless could not purchase them and he must buy from 7-Eleven vendors, who at times are overly expensive and diminish Plaintiff’s profits.
20. The prices with Defendant’s approved vendors are negotiated and established by defendant, which is commonly known as the “7-Eleven price.”
23. Defendant failed to change its stores, products, and marketing despite the ever-changing market and expectations of consumers.
24. Defendant failed to market and advertise for Defendant as agreed, despite charging Defendant for said advertising.
25. Due to, inter alia, the lack of response by 7-Eleven to the competition, Plaintiff’s gross sales and net profits decreased.
In rejecting these additional allegations as “insufficient”, “jumbled” and “unspecified”, the 7-Eleven Court also opined that the claims were inadequate as a matter of law because they failed to allege that the franchisor acted with “bad motive.” Moreover, after scouring the 7-Eleven franchise agreement, the Court concluded that:
In stark contrast to Plaintiff’s allegations, the Second Franchise Agreement gives defendant broad discretion in determining whether to provide maintenance to stores and how to advertise. Plaintiff claims Defendant did not ‘market and advertise as agreed’ despite that Plaintiff paid for said advertising. However, the Contract allows Defendant to advertise in a way that provides ‘general benefit of the 7-Eleven System . . .’ and even goes on to say that Defendant will have “the sole and absolute right” to determine how these advertising fees are spent.
In rejecting the sufficiency of the good faith allegations, the 7-Eleven Court also commented as follows:
Additionally, Plaintiff asserts ‘despite the terms of the Agreement which state otherwise, 7-Eleven was not getting the lowest prices for the Plaintiff.’ Defendant has agreed to make a ‘commercially reasonable effort’ to obtain the lowest cost from vendors to Defendant. Therein lies the minor discrepancy in language between Plaintiff’s assertion and the contract language itself: Plaintiff avers the ‘Franchise Agreements’ indicate Defendant will get ‘best prices for Plaintiff,’ whereas the Second Franchise Agreement presented states Defendant will make a ‘commercially reasonable effort’ to obtain the lowest cost. Nowhere in the Second Franchise Agreement is there language that Defendant will get the lowest prices for Plaintiff. If the latter contention was violated, that being the obligation to make a commercially reasonable effort, such a claim should be made out in the Complaint.
GWO Litig. Tr. v. Sprint Sols., Inc.
Seemingly on the other end of the spectrum of good faith franchise cases is a decision by the Connecticut Superior Court, GWO Litig. Tr. v. Sprint Sols., Inc., No. N17C-06-356 PRW CCLD, 2018 Del. Super. LEXIS 1141 (Super. Ct. Oct. 25, 2018). In this case, Sprint Solutions, Inc. (“Sprint”) entered into a series of contracts with General Wireless Operations, Inc. (“General Wireless”) in early 2015 for the purpose of revitalizing the bankrupt RadioShack Corporation (“RadioShack”) through unified Sprint/RadioShack store locations, referred to in the agreements as the “Store-Within-A-Store” (“SWAS”) model. The General Wireless Organization Litigation Trust (“GWO Trust”), the successor-in-interest to General Wireless, sued Sprint.
According to GWO Trust, the following conduct by Sprint violated the implied covenant including: (i) opening competing Sprint stores in close proximity, (ii) diverting customers away from co-branded stores to Sprint stores, and (iii) failing to adequately train its employees working in the co-branded stores. GWO Trust alleged that Sprint’s breaches of the covenant of good faith caused reduced customer traffic, sales, revenues, and cash flow at the co-branded stores.
The business partnership between the parties began back in 2015, when Sprint sought to expand its footprint in the American market, at the same time that RadioShack was experiencing financial distress. On April 1, 2015, General Wireless and Sprint entered into the Alliance Agreement under which the parties would establish co-branded retail stores. These stores were intended to use the SWAS format to sell RadioShack products and Sprint products exclusively. The parties also entered into an operations agreement, the OMS Agreement, as well as leases, a distribution agreement, a retailer agreement, and an Investor Rights Agreement.
Under the SWAS model, the parties were required to use commercially reasonable efforts to meet an agreed-upon schedule in opening co-branded stores, setting up joint signage, staffing, training employees, and maintaining inventory. Shortly after the program began operating, the parties determined that the SWAS model did not produce the anticipated profits; four months into the Alliance Agreement, only about one-quarter of the SWAS model locations had been completed. Shortly thereafter, progress in achieving the partnership’s goals stalled.
Sprint moved to dismiss the covenant of good faith claim on the ground that the conduct complained-of was covered by the express terms of the Alliance Agreement and the OMS Agreement, and therefore could not be asserted a second time as the basis of an implied good faith claim. After agreeing that an implied covenant claim could not be sustained where it was merely duplicative of the parties’ explicit contractual terms, the Sprint Court identified several of the many independently determinative rules regarding good faith claims. “The implied covenant cannot be used to re-write the agreement, to circumvent the parties’ bargain, or to create a free-floating duty unattached to the underlying legal document.” Most importantly, the Sprint Court pointed out that “When a sophisticated party could have easily drafted the contract to expressly provide a specific contractual protection, the failure to do so cannot be remedied by employing the implied covenant.”
Addressing GWO Trust’s first claim that Sprint violated the good faith covenant when it opened competing stores located close to co-branded stores, Sprint argued that there can be no undefined non-compete zone written in via the implied covenant because the agreements “comprehensively detail the operations and locations of the co-branded SWAS stores.” Although GWO Trust conceded that the Alliance Agreement did deal with SWAS locations in general, it contended that its good faith allegations arose “from Sprint’s implied duty not to open nearby competing stores; not from Sprint’s express duty to open (or to cooperate in opening or re-tooling) stores at designated SWAS locations”.
The Sprint Court then decided upon the two criteria that it would embrace in determining the good faith claims, including: (1) whether the contract is truly silent with respect to the contested fact; and (2) whether the parties’ expectations were so fundamental that they clearly would not need to negotiate about nor memorialize them. As the Sprint Court stated:
The Court is mindful that the implied covenant cannot be used to inflict free-floating obligations on a party simply because the claimant fails to secure a protection through contract during the negotiations. Disfavor of the implied covenant shall not, however, preclude the claim when a contract is truly silent on a matter, and when the expectations of the parties thereon were so fundamental that one would expect the alleged offending behavior would need be neither negotiated over nor scrivened. Thus, to determine whether the implied covenant applies, the Court must employ a factual inquiry into the conduct complained-of and discern the parties’ ‘reasonable expectation’ given the factual backdrop of the case.
The Sprint Court, in ruling for GWO Trust on the first issue, found that the necessary contractual silence existed: “The Court finds that the Alliance Agreement and the OMS Agreement, taken as a whole, do indeed address the locations of the co-branded stores, and are silent as to any restrictions on Sprint opening competing stores.” On this issue, the Court further stated: “Sprint’s duty to open co-branded stores at the agreed-upon locations is sufficiently different from Sprint’s implicit duty to refrain from opening nearby competing Sprint-alone stores.”
The Sprint Court then carried out a relatively elastic evaluation of the second requirement for application of the good faith covenant – that the parties’ expectations were so fundamental that they clearly would not have needed to memorialize them in the agreement:
… when assessing the parties’ expectations, the Court must consider the totality of the convoluted factual background of these agreements: General Wireless and Sprint entered into a strategic business relationship, executed a series of agreements to materialize the details, and implemented—albeit unsuccessfully—the SWAS model. Under the SWAS model, the co-branded stores would sell RadioShack and Sprint products exclusively. Implicit to this exclusivity was RadioShack/General Wireless’s forbearance from selling Sprint competitors’ products. Commercial profitability is achieved, in many instances, by increasing the competitiveness, and/or limiting the competition. Taking these commonsensical business considerations and the unique facts of this case, the Court finds General Wireless would reasonably expect Sprint to forbear from opening competing Sprint-stores carrying the exact same products in proximity to the co-branded stores.
Although under certain circumstances and in some jurisdictions the covenant of good faith and fair dealing can provide a ‘get out of jail’ free card for franchisees in litigation, in other courts, even under the same circumstances, the covenant of good faith can offer no help. Most important, unlike the Get out of Jail Free Chance Card in the Monopoly game that “may be kept until needed, or sold”, the covenant of good faith card does not necessarily hold a fixed value over time, even in the same jurisdiction. Legal articles, attorney speeches and court decisions have a short shelf-life, regardless when written, given or published. In many cases, those who consume expired products are just as much to ‘blame’ for the results of using the expired products as is the provider for having sold them.
Paradoxically, a few notable decisions in favor of franchisees on the covenant of good faith have created legends upon which many franchisees’ litigation dreams have been shattered. Nobody is to blame for the creation of legends. Indeed, legends many times provide emotional support for the downtrodden during times of need. However, the intentional morphing of legends into myths (especially of esoteric and complicated legal principles) by franchisee attorneys who should — and do — know better is harmful. This combination of legally uninformed franchisees and opportunistic litigators leads ineluctably to an increasing number of anti-franchisee court decisions and dissatisfied franchisees.