Duty of Good Faith in Relation to Franchising in New Zealand

Good faith is not enshrined in any franchising laws in New Zealand. In fact there are no franchise-specific laws. However, for more than 10 years I have included good faith clauses in franchise agreements which I prepare for franchisors.

Under the franchisee’s obligations I include the following clause:

“The franchisee shall act loyally and in good faith towards the franchisor at all times.”

Under the franchisor’s obligations I include the following clause:

“The franchisor shall act loyally and in good faith towards the franchisee at all times.”

However the majority of franchise agreements in New Zealand never contain an express term in relation to good faith so the question is – can a duty of good faith be implied in franchise agreements?

The extent of the duties and obligations which franchising parties owe to each other depends upon the legal status of their relationship. If the relationship imports fiduciary obligations, there may be a higher level of obligation and different financial consequences.

The first consideration is whether parties to a franchise are subject to fiduciary obligations. In the Australian case of Hungry Jacks v Burger King [1999] NSW SC 109 the Court of Appeal of New South Wales held that Burger King had a fiduciary duty to its Australian franchisee which it breached by arranging for a mole within the franchisee’s operation to pass it confidential information about the franchisee’s operations. That was not a typical franchise dispute but a high level dispute involving a multi-national franchisor and a national master franchisee.

In 2007 the New Zealand Supreme Court tightened the criteria for establishing the existence of fiduciary relationships. In Aotearoa v Paper Reclaim Limited [2007] NZSC 26 the Court said:

“When parties have formed a contract the correct approach is first to decide exactly what they have agreed upon. Only then should the Court consider whether any particular aspect of their agreement gives rise to a relationship which can properly be characterised as fiduciary, imposing an obligation of loyalty on one or both parties, which supplements the express or implied contractual terms … A fiduciary relationship will be found when one party is entitled to repose and does repose trust and confidence in the other. The existence of an agreement, express or implied, to act on behalf of another and thus to put the interest of the other before one’s own is a frequent manifestation of a situation in which fiduciary obligations are owed. Partners are the classic example of parties in that situation. Their position is different from that of parties to a contract who may have to co-operate but are doing so for their separate advantages.”

The High Court judgments of Justice Thomas in two New Zealand cases are really the starting point. The first case is Livingstone v Roskilly [1992] 3 NZLR 230 and the second is Bobux Marketing Ltd v Raynor Marketing Ltd [2002] 1 NZLR 506. Justice Thomas in both cases favoured implying good faith into all commercial contracts but other Judges in New Zealand have not followed those cases although good faith is implied into joint venture contracts and employment contracts.

The second important consideration is that of relational contracts. To maintain a good relationship in franchising the parties need to treat each other with good faith. The importance of maintaining a relationship in the franchise context was emphasised by the Privy Council in Dymocks Franchise System v Todd [2004] 1 NZLR 289 (PC). However, the Privy Council declined to imply a duty of good faith preferring to decide the case on breach of an express contractual term.

Dymocks, as franchisor, entered into three franchise agreements with the Todds and their companies to operate two Dymocks stores in Auckland at the Atrium on Elliott and at Broadway, Newmarket, and one store at Lambton Quay, Wellington. Those were the three “flagship” stores and together they accounted for approximately 70% of sales nationwide so the Todds held a pivotal role in the franchise network. The franchise agreements incorporated the Dymocks operations manual as part of the contractual documentation. That manual contained language which emphasised the joint venture nature of the relationship between Dymocks and its franchisees. For example, the objectives listed at the outset

“To have a harmonious and mutually profitable relationship between all Dymocks franchise owners and between all Dymocks franchise owners and Dymocks head office.”

The manual encouraged franchisees to work with Dymocks and with each other as a team, not to attempt to become too independent, to follow uniform procedures, and to participate in all group buying deals.

The manual also appeared to directly modify the terms of the franchise agreement. Despite an express right in the franchise agreement for Dymocks to terminate the franchise summarily in the event of certain specified breaches, the manual provided:

“If we believe you have gone beyond the constraints of our Franchise Agreement we will give you fair notice, verbally and in writing, before resorting to legal action and every opportunity will be given to you to rectify the matter.”

The Todds became unhappy with their position as franchisee and claimed there had been misrepresentations as to likely levels of sales and profitability. They alleged insufficient support from the franchisor and the Todds asked to be released from their franchise agreements and to be permitted to debrand their stores. Dymocks refused and the Todds wrote to other franchisees complaining about the Dymocks franchise system and advising that they would no longer take part in group buying. Dymocks responded by immediately terminating the three franchises owned and operated by the Todds. There was no notice given or opportunity to remedy as provided for in the manual.

Hammond J in the High Court held that Dymocks could not terminate summarily on the grounds it did for two reasons:
1. The Operations Manual required notice to be given; and
2. The laws of New South Wales (expressly stipulated as the law governing the franchise agreements rather than New Zealand law) required in a case such as this that powers of termination be exercised in good faith, that is reasonably.

The Judge further ruled that the fax sent by the Todds to other franchisees was not of a character or quality that amounted to breach of the franchise agreement or to repudiation of it. On these points the Judge was upheld by the Court of Appeal.

The question of how to regard an approach made by the Todds to the rival Blue Star Group had to be considered. This approach had been kept secret and only emerged during the trial itself and it provided Dymocks with an extra (late) ground to support their termination. In this case, the obligation of good faith was turned back on the Todds and it was argued by Dymocks that the Todds’ approach to Blue Star provided sufficient ground supporting the termination. Hammond J agreed and on this ground Dymocks succeeded at trial. The essence of his judgment on this point is quoted at paragraph 40 in the decision of the Privy Council as follows:

“… the relationship between franchisor and franchisee is not simply a bilateral contract. It is a relational contract in which a working, ongoing, relationship is set up for the mutual benefit of both parties. And, from an economic point of view, what is central is the joint maximisation of economic benefits. Both parties are to work in good faith to that end.”

The Dymocks case is most often cited for its references to good faith. At paragraph 57 the Privy Council noted the Court of Appeal’s findings on good faith and observed that the Court of Appeal judgment suggested a view that the implication of an obligation of good faith in franchise agreements (as in the case of partnership and other joint venture agreements) is not desirable. Responding to that, the Privy Council said at paragraph 57:

“Their Lordships propose to express no concluded view on these comments [of the Court of Appeal] and wish to reserve their opinion on the suggestion that the implication of an obligation of good faith in a relationship between franchisor and franchisee would be an undesirable development.”

In a minority judgment given in the Court of Appeal by Justice Thomas he said that a distribution agreement was a “relational contract” and he summarised the characteristics of such a contract as follows:

“Relational contracts are often long-term contracts, but not necessarily so; while long-term contracts by their nature are likely to be relational. In essence, relational contracts recognise the existence of a business relationship between the parties and the need to maintain that relationship; the difficulty of reducing important terms to well-defined obligations; the impossibility of foretelling all the events which may impinge upon the contract; the need to adjust the relationship over time to provide for unforeseen factors or contingencies which cannot readily be provided for in advance; the commitment, likely to be extensive, which one party must make to the other, including significant investment; and that they are in an economic sense likely to be incomplete in failing to allocate, or allocate optimally, the risk between the parties in the event of certain future contingencies.”

There is no generally accepted definition of a relational contract, nor statement of additional duties which they superimpose upon a relational contract.

Is a duty of good faith to be imported into franchise agreements in New Zealand? If it is, it will change the nature of the obligations which the parties owe to each other.

A critical issue is whether a good faith term is to be implied as a matter of law or as a matter of fact. If good faith is to be implied as a matter of fact then the five point test in the case of BP Refinery Western Port v Shire of Hastings (1977) 180 CLR 266 (PC) is as follows:

1. Necessary to give business efficacy to contract, such that no term will be implied if the contract is effective without it.
2. Fair and equitable.
3. Capable of clear expression.
4. Not inconsistent with any terms in contract.
5. So obvious that it “goes without saying”.

Good faith requires that contractual powers are used for a proper purpose. For example, if a franchisor has a contractual power to terminate a contract but exercises that right for the collateral purpose of removing the franchisee from the market in order that the franchisor can participate directly in the market, that would infringe the good faith requirement.

The restrictions that a good faith requirement places on the exercise of contractual rights is similar to statutory restrictions on the exercise of rights arising out of other types of contracts. The leading case in New Zealand for analysis of the circumstances in which exercising a contractual right will or will not be oppressive is the Court of Appeal’s decision in Taylor v Westpac Banking Corporation (1996) 5 NZBLC 104 (CA). Taylor was decided under the Credit Contracts Act 1981 (since repealed) but the oppressive provisions in that Act were materially identical to the provisions now found in the Credit Contracts and Consumer Finance Act 2003.

Therefore, it seems likely that if a good faith obligation were to be implied in New Zealand in franchising law then the practical effects of such a development will be less pronounced than some might think for the simple fact that an obligation of good faith will never save the parties from bad bargains, from their own managerial or operational ineptitude, or from the multitude of other circumstances that bring franchisees and franchisors into conflict.

The inclusion of an entire agreement clause in a contract will mitigate against the implication of good faith. Where the parties have gone to the trouble and expense of determining in a detailed written contract how their affairs and obligations are to be regulated, and have further gone to the trouble of expressly recording that their obligations are only as recorded within the four corners of the document, it is difficult to suggest that they have nonetheless omitted an obligation which is now to be implied in the contract.

Clause 3 of the Code of Practice, which is mandatory upon members of the Franchise Association of New Zealand, relates to standards of conduct and states as follows:

“All Members shall act in an ethical, honest and lawful manner and endeavour to pursue best franchise business practice of the time and place. Franchisors and Franchisees shall in their dealings with one another avoid the following conduct where such conduct would cause significant detriment to either party’s business:

(a) Conduct which is unnecessary and unreasonable in relation to the risks to be incurred by one party.
(b) Conduct that is not reasonably necessary for the protection of the legitimate business interests of the Franchisor, Franchisee or franchise system.
(c) Any other conduct which is in breach of the Code of Ethics or of this Code.”

If a franchise agreement contains an obligation of good faith then a breach of that obligation would be tantamount to a breach of clause 3 of the Code in my opinion. However, if a franchise agreement does not contain an express obligation of good faith then it cannot be said that such a good faith obligation will be an implied term.