'Now for Something Completely Different'

No franchise agreement, despite its length and the genius of its drafting, anticipates all commercial realities and advances over its intended life span. For example, until the mid-to-late 1990s, the Internet was a novelty of the military, academia, and entertainment industry, and it formed no part of the commercial landscape for business format franchises. As franchise systems and methods of operation evolve in our technological society, how much of the future should the draftsperson attempt to enmesh in the agreement? Perhaps this issue is less of a concern than first thought. The answer may lie in a doctrine that is, ironically, viewed by franchisors with less favor.

The implied covenant of good faith and fair dealing forms an increasingly popular element in claims and counterclaims by franchisees that the franchisor engaged in wrongful termination of a franchise agreement. The application of this frequently misunderstood and misapplied doctrine by trial courts changes contract interpretation litigation into contract renegotiation. From the franchisor's perspective, the doctrine's misunderstanding by juries makes civil litigation more closely resemble gaming than the administration of justice.

The covenant is a hallmark in the sale of goods governed by the Uniform Commercial Code (UCG). Under Sec. 1-203, every contract or duty within this Act imposes an obligation of good faith in its performance or enforcement. 'Good faith' in the case of a merchant means honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade, per Sec. 2-103(b). The UCC embodied existing contract law. These formulations have long been observed to govern contracts for services that are not subject to the UCC. 1-5 Williston on Contracts, Sec. 670 (1961).

The covenant has evolved into a doctrine with two branches. Its first application is to interpret contracts or fill alleged gaps in contractual terms. But many courts limit this approach to prevent rewriting the express provisions of the contract. Terms may be implied in a contract because they are so necessary to the contractual relationship that the parties must have intended them; their omission is due only to sheer inadvertence or obviousness. Palisades Properties, Inc. v. Brunetti, 44 NJ 117, 130 (1965). The Seventh Circuit recently held that: 'The covenant is only an aid to interpretation, not a source of contractual duties or liability under Illinois law. (Citations omitted).' The opportunity to supplement the contract does not extend to altering the express terms of the written agreement. Russell W. Zeidler, et al., v. A & W Restaurants, Inc., et al., CCH Bus. Fran.Guide Par. 12,407, (7th Cir. 2002); Glenfed Financial Corp. v. Pen- ick Corp., 276 NJ Super. 163 (App. Div.1994), cert. den. 139 NJ 442 (1995).

The second and more interesting branch is the obligation to perform in good faith, notwithstanding the express provisions of the agreement. The seminal case for the dangers inherent in dubious performance consistent with contractual rights is Sons of Thunder, Inc. v. Borden, 148 NJ 396, 690 A.2d 575 (1997), in which a party was held liable for its lack of good faith in performance of a contract and the exercise of an express right of termination. The New Jersey Supreme Court opinion, a concise disquisition on the implied covenant, lays the groundwork for our thesis, namely, that franchisors should assert breach of the implied covenant for franchisee transgressions that harm the brand and the franchise system. A more recent opinion commented:

'Although the implied covenant of good faith and fair dealing cannot override an express term in a contract, a party's performance under a contract may breach that implied covenant even though that performance does not violate a pertinent express term.' Sons of Thunder, Inc., supra, 148 N.J. at 419. Unlike many other states, in New Jersey 'a party to a contract may breach the implied covenant of good faith and fair dealing in performing its obligations even when it exercises an express and unconditional right to terminate.' Id. at 422; See also Bak-A-Lum Corp. v. Alcoa Bldg. Prods, Inc., 69 N.J. 123, 129-30, 351 A.2d 349 (1976) (finding that defendant's conduct in terminating contract constituted bad faith although conduct did not violate express terms of written agreement); cf. Burger King Corp. v. Weaver, 169 F.3d 1310, 1316 (11th Cir. 1999) (finding that under Florida law action for breach of implied covenant of good faith and fair dealing cannot be maintained in absence of breach of express contract provision); Payne v. McDonald's Corp., 957 F. Supp. 749, 758 (D. Md. 1997) (determining that under Illinois law covenant of good faith and fair dealing does not provide independent source of duties).

Other jurisdictions regard the implied covenant of good faith and fair dealing as merely a guide in the construction of explicit terms in an agreement. See Payne, supra, 957 F. Supp. at 758 (citing Beraha v. Baxter Health Care Corp., 956 F.2d 1436, 1443 (7th Cir. 1992). Alban Wilson, Charles A. Meyer, and Richard S. Loeber, v. Amerada Hess Corporation and Leon Hess, et al., CCH Bus. Fran. Guide Par. 12,115 (NJ 2001).

While the covenant has been most often employed as a sword to reform contracts in favor of franchisees in the face of franchisor actions. See Cathay Enterprises, Inc. v. Ramada Franchise Systems, Inc., CCH Bus. Fran. Guide Par. 12,402 (U.S.D.C. AZ 2002); Sons of Thunder, Inc. v. Borden, Inc., 148 NJ 396; 690 A. 2d 575 (N.J. 1997). it has equal applicability to performance of franchise agreement obligations by franchisees. In every contract there is an implied covenant that neither party shall do anything that 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. Sons of Thunder, supra, 148 NJ 396, 421. This duty of good faith is thus construed to supplement the express terms of the contract that establish the expectations of the parties as to their respective conduct for which they expect to receive the fruits of their performance. 

Applying the Covenant of Good Faith to Franchisees

Let's turn this application of the covenant around to examine franchisee conduct as the commercial world evolves. Most franchise agreements contain an 'inurements' clause that states that the business format system includes many elements that the franchisor may modify in its discretion to maintain the competitiveness of the franchise system in its marketplace over the term of the agreement. The agreement usually restricts the franchisee's use of the licensed marks to the methods authorized by the franchise system manuals.

An 'innovations' clause, similar in concept to an assignment clause in a work-for-hire agreement, assigns to the franchisor all innovations developed by the franchisee relating to the business format franchise. Most franchisors offer their franchisees access to the business format system innovations that are assigned upstream. This cooperative sharing of ideas and innovations is a hallmark of modern franchising, harnessing the intellectual capacity of the franchise system as a whole for the common good. Indeed, part of the fruits of the contract for all parties is the notion of innovation sharing, which forms a part of the economic bargain and pricing terms.

A franchisee that develops and does not share with the franchisor an innovation relating to the business format system violates the implied covenant of good faith, even if the type of innovation is not expressly described in the franchise agreement. The doctrine would have particular application if the franchisee exercised a right of termination and continued in the same business as the franchise system, assuming that a non-competition covenant does not circumscribe the conduct of the franchisee using the non-disclosed innovation.

Consider also the fee-for-service concepts of a franchise agreement. The parties, as shown in both Items 5 and 6 of the franchise offering circular and the franchise agreement, contemplate a fee-for-service concept revolving around gross revenues of the franchised business and other sources of commercial interaction between franchisor and franchisee that form another significant element of the economic bargain. When the franchisee uses marketing channel innovations to circumvent a service that the franchise agreement contemplates the franchisor to provide, particularly when the franchise fee is not based on the gross revenue of the enterprise, the franchisee breaches the implied covenant, even if the marketing channel method is not expressly prohibited.

Comprehensive drafting only goes so far in anticipation of changes in the marketing environment over time. Efforts to streamline and shorten franchise agreements may remove 'what-if' drafting. If the implied covenant has symmetrical application to franchisor and franchisee performance, it should protect revenue/fee concepts from novel circumvention methods in fee-for-service models. This article does not address the issue of whether Internet sales violate territorial exclusivity rights. See In the Matter of Hales v. Conroy, CCH Bus. Fran. Guide Para 12,177 (2001); Emporium Drug Mart v. Drug Emporium, CCH Bus. Fran. Guide Para. 11,966 (2000).

The measure of damages for breach of the implied covenant is the lost profits of the injured party that would have been realized but for the breach that prevented performance, according to the Sons of Thunder holding, which affirmed the jury's award of one year's profits from the enterprise. 148 NJ 396, 427. This measure is a powerful but speculative weapon against misconduct that a franchise agreement does not expressly prohibit.

Joel R. Buckberg is Executive Vice President and Deputy General Counsel for Cendant Corporation, Parsippany, NJ, and serves on the Editorial Board of this newsletter.

No franchise agreement, despite its length and the genius of its drafting, anticipates all commercial realities and advances over its intended life span. For example, until the mid-to-late 1990s, the Internet was a novelty of the military, academia, and entertainment industry, and it formed no part of the commercial landscape for business format franchises. As franchise systems and methods of operation evolve in our technological society, how much of the future should the draftsperson attempt to enmesh in the agreement? Perhaps this issue is less of a concern than first thought. The answer may lie in a doctrine that is, ironically, viewed by franchisors with less favor.

The implied covenant of good faith and fair dealing forms an increasingly popular element in claims and counterclaims by franchisees that the franchisor engaged in wrongful termination of a franchise agreement. The application of this frequently misunderstood and misapplied doctrine by trial courts changes contract interpretation litigation into contract renegotiation. From the franchisor's perspective, the doctrine's misunderstanding by juries makes civil litigation more closely resemble gaming than the administration of justice.

The covenant is a hallmark in the sale of goods governed by the Uniform Commercial Code (UCG). Under Sec. 1-203, every contract or duty within this Act imposes an obligation of good faith in its performance or enforcement. 'Good faith' in the case of a merchant means honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade, per Sec. 2-103(b). The UCC embodied existing contract law. These formulations have long been observed to govern contracts for services that are not subject to the UCC. 1-5 Williston on Contracts, Sec. 670 (1961).

The covenant has evolved into a doctrine with two branches. Its first application is to interpret contracts or fill alleged gaps in contractual terms. But many courts limit this approach to prevent rewriting the express provisions of the contract. Terms may be implied in a contract because they are so necessary to the contractual relationship that the parties must have intended them; their omission is due only to sheer inadvertence or obviousness. Palisades Properties, Inc. v. Brunetti , 44 NJ 117, 130 (1965). The Seventh Circuit recently held that: 'The covenant is only an aid to interpretation, not a source of contractual duties or liability under Illinois law. (Citations omitted).' The opportunity to supplement the contract does not extend to altering the express terms of the written agreement. Russell W. Zeidler, et al., v. A & W Restaurants, Inc., et al., CCH Bus. Fran.Guide Par. 12,407, (7th Cir. 2002); Glenfed Financial Corp. v. Pen- ick Corp., 276 NJ Super. 163 (App. Div.1994), cert. den. 139 NJ 442 (1995).

The second and more interesting branch is the obligation to perform in good faith, notwithstanding the express provisions of the agreement. The seminal case for the dangers inherent in dubious performance consistent with contractual rights is Sons of Thunder, Inc. v. Borden, 148 NJ 396, 690 A.2d 575 (1997), in which a party was held liable for its lack of good faith in performance of a contract and the exercise of an express right of termination. The New Jersey Supreme Court opinion, a concise disquisition on the implied covenant, lays the groundwork for our thesis, namely, that franchisors should assert breach of the implied covenant for franchisee transgressions that harm the brand and the franchise system. A more recent opinion commented:

'Although the implied covenant of good faith and fair dealing cannot override an express term in a contract, a party's performance under a contract may breach that implied covenant even though that performance does not violate a pertinent express term.' Sons of Thunder, Inc., supra, 148 N.J. at 419. Unlike many other states, in New Jersey 'a party to a contract may breach the implied covenant of good faith and fair dealing in performing its obligations even when it exercises an express and unconditional right to terminate.' Id. at 422; See also Bak-A-Lum Corp. v. Alcoa Bldg. Prods, Inc., 69 N.J. 123, 129-30, 351 A.2d 349 (1976) (finding that defendant's conduct in terminating contract constituted bad faith although conduct did not violate express terms of written agreement); cf. Burger King Corp. v. Weaver , 169 F.3d 1310, 1316 (11th Cir. 1999) (finding that under Florida law action for breach of implied covenant of good faith and fair dealing cannot be maintained in absence of breach of express contract provision); Payne v. McDonald's Corp. , 957 F. Supp. 749, 758 (D. Md. 1997) (determining that under Illinois law covenant of good faith and fair dealing does not provide independent source of duties).

Other jurisdictions regard the implied covenant of good faith and fair dealing as merely a guide in the construction of explicit terms in an agreement. See Payne , supra, 957 F. Supp. at 758 (citing Beraha v. Baxter Health Care Corp., 956 F.2d 1436, 1443 (7th Cir. 1992). Alban Wilson, Charles A. Meyer, and Richard S. Loeber, v. Amerada Hess Corporation and Leon Hess, et al., CCH Bus. Fran. Guide Par. 12,115 (NJ 2001).

While the covenant has been most often employed as a sword to reform contracts in favor of franchisees in the face of franchisor actions. See Cathay Enterprises, Inc. v. Ramada Franchise Systems, Inc., CCH Bus. Fran. Guide Par. 12,402 (U.S.D.C. AZ 2002); Sons of Thunder, Inc. v. Borden, Inc., 148 NJ 396; 690 A. 2d 575 (N.J. 1997). it has equal applicability to performance of franchise agreement obligations by franchisees. In every contract there is an implied covenant that neither party shall do anything that 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. Sons of Thunder, supra, 148 NJ 396, 421. This duty of good faith is thus construed to supplement the express terms of the contract that establish the expectations of the parties as to their respective conduct for which they expect to receive the fruits of their performance. 

Applying the Covenant of Good Faith to Franchisees

Let's turn this application of the covenant around to examine franchisee conduct as the commercial world evolves. Most franchise agreements contain an 'inurements' clause that states that the business format system includes many elements that the franchisor may modify in its discretion to maintain the competitiveness of the franchise system in its marketplace over the term of the agreement. The agreement usually restricts the franchisee's use of the licensed marks to the methods authorized by the franchise system manuals.

An 'innovations' clause, similar in concept to an assignment clause in a work-for-hire agreement, assigns to the franchisor all innovations developed by the franchisee relating to the business format franchise. Most franchisors offer their franchisees access to the business format system innovations that are assigned upstream. This cooperative sharing of ideas and innovations is a hallmark of modern franchising, harnessing the intellectual capacity of the franchise system as a whole for the common good. Indeed, part of the fruits of the contract for all parties is the notion of innovation sharing, which forms a part of the economic bargain and pricing terms.

A franchisee that develops and does not share with the franchisor an innovation relating to the business format system violates the implied covenant of good faith, even if the type of innovation is not expressly described in the franchise agreement. The doctrine would have particular application if the franchisee exercised a right of termination and continued in the same business as the franchise system, assuming that a non-competition covenant does not circumscribe the conduct of the franchisee using the non-disclosed innovation.

Consider also the fee-for-service concepts of a franchise agreement. The parties, as shown in both Items 5 and 6 of the franchise offering circular and the franchise agreement, contemplate a fee-for-service concept revolving around gross revenues of the franchised business and other sources of commercial interaction between franchisor and franchisee that form another significant element of the economic bargain. When the franchisee uses marketing channel innovations to circumvent a service that the franchise agreement contemplates the franchisor to provide, particularly when the franchise fee is not based on the gross revenue of the enterprise, the franchisee breaches the implied covenant, even if the marketing channel method is not expressly prohibited.

Comprehensive drafting only goes so far in anticipation of changes in the marketing environment over time. Efforts to streamline and shorten franchise agreements may remove 'what-if' drafting. If the implied covenant has symmetrical application to franchisor and franchisee performance, it should protect revenue/fee concepts from novel circumvention methods in fee-for-service models. This article does not address the issue of whether Internet sales violate territorial exclusivity rights. See In the Matter of Hales v. Conroy, CCH Bus. Fran. Guide Para 12,177 (2001); Emporium Drug Mart v. Drug Emporium, CCH Bus. Fran. Guide Para. 11,966 (2000).

The measure of damages for breach of the implied covenant is the lost profits of the injured party that would have been realized but for the breach that prevented performance, according to the Sons of Thunder holding, which affirmed the jury's award of one year's profits from the enterprise. 148 NJ 396, 427. This measure is a powerful but speculative weapon against misconduct that a franchise agreement does not expressly prohibit.

Joel R. Buckberg is Executive Vice President and Deputy General Counsel for Cendant Corporation, Parsippany, NJ, and serves on the Editorial Board of this newsletter.