The Doctrine of Implied Honesty in Contract: Is Neither a Slippery Slope Nor a "new Vista" of Contract Nullification That Should Concern Businesses or Franchisors

• Publication year: 2021

The Doctrine of Implied Honesty in Contract: Is Neither a Slippery Slope nor a "New Vista" of Contract Nullification That Should Concern Businesses or Franchisors

John J. Jacko III

THE DOCTRINE OF IMPLIED HONESTY IN CONTRACT: IS NEITHER A SLIPPERY SLOPE NOR A "NEW VISTA" OF CONTRACT NULLIFICATION THAT SHOULD CONCERN BUSINESSES OR FRANCHISORS

John J. Jacko, III^*

In the fourteen years since the New York Law Journal published Franchising: LJL Transportation, Contract Nullification by Franchisor,¹ the sky has not fallen nor has the concept of honesty in contract slipped down any slope that threatens contract law generally or franchise systems, specifically. Time has proven the critic, the criticism, and any consternation for the franchise termination opinion in LJL Transportation, Inc. v. Pilot Air Freight Corp.² and the implied honesty in contract doctrine to be wrong.

One franchise contracts treatise embraces and cites the LJL case for the proposition that "[h]iding revenue from the franchisor in order to avoid paying royalties, which conduct is in breach of the franchise agreement, does not entitle a franchisee to an absolute right to cure its breach prior to termination of the agreement."³ In other words, franchisors are permitted to immediately terminate—and are not otherwise required to adhere to cure periods in franchise agreements—when the franchisee commits acts of dishonesty that go to the heart of the business relationship, like paying royalties. Conceptually, there is no reason that this implied honesty in contract concept cannot be applied to permit immediate termination of non-franchise contracts containing cure periods where the breaches arise from severe acts of dishonesty by the breaching party.

In LJL, an intermediate Pennsylvania appellate court held that "there are circumstances where the nature of the breach permits the aggrieved party to immediately terminate the contract despite a 'cure' provision" and affirmed a franchisor's immediate termination of a franchise agreement for breach of an implied honesty obligation, even though the franchisor failed to abide by the franchise agreement's cure provision. Thus, LJL and the decisions it cited⁴

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imposed an implied honesty obligation in contract performance that superseded any "cure" right. Analyzing the LJL decision's impact, this author suggested that the implied honesty obligation would be beneficial to franchisors,⁵ while a critic suggested that it represented a "new vista" of contract nullification that would be neither beneficial to contract law, generally, nor franchise systems, specifically.⁶

The criticism of the implied honesty doctrine was that it threatened contractual certainty. Both 1) time, and 2) the lack of slippery slope evidence, have exposed the fallacy of this criticism. In truth, dishonesty in contract performance poses a greater threat to franchising and contract law than does any potential for "inconsistency" in the application of the implied honesty obligations on contracting parties. The rarity with which severe dishonesty breaches justify immediate termination is evidenced by the fact that, after the first seven years following the LJL decision, the U.S. Court of Appeals for the Third Circuit recognized it as "the only case in which the Pennsylvania Supreme Court found a breach to be severe enough to justify immediate termination of a contract with a right-to-cure provision involv[ing] fraudulent conduct by one of the contracting parties."⁷ Contrastingly, one decisional dissent concluded that the majority "seemingly" endorsed an expansion of the doctrine to encompass a company's "obstinate behavior" to frustrate the purpose of a shareholder agreement even though the issue was not addressed in detail in the majority's memorandum.⁸

The Pennsylvania Supreme Court affirmed the intermediate appellate LJL decision in 2009, holding without "difficulty" that "when there is a breach of contract going directly to the essence of the contract, which is so exceedingly grave as to irreparably damage the trust between the contracting parties, the non-breaching party may terminate the contract without notice, absent explicit contractual provisions to the contrary."⁹ To reach this decision, the LJL court cited case law from multiple jurisdictions, including New York federal cases like Southland Corp. v. Froelich.¹⁰ Subsequent courts have applied LJL's

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reasoning in contract contexts outside of franchising.¹¹ Time and the conceptual underpinnings of the implied honesty doctrine provide additional support to assuage any "new vista" concerns about that doctrine's effect on modern contract law or franchising.

At issue in LJL was the propriety of the franchisor's immediate termination of a franchise agreement in response to a franchisee's demonstrated and admitted dishonesty, where the franchisor did not provide notice and an opportunity to cure under a 90-day cure provision. There was no express right to immediate termination for dishonest conduct in the franchise agreement. The grounds for termination were that the franchisee (1) improperly shipped products through third parties affiliated with the franchisee, and (2) failed to disclose the shipments and make royalty payments on them. The trial court awarded summary judgment to the franchisor because the franchisee was hiding its transactions and cheating the franchisor.¹²

On appeal, the franchisee unsuccessfully argued that the termination was improper because 1) it deprived the franchisee of the absolute right to a ninety-day cure period, and 2) the absolute right to cure meant that the franchisee should have been given the opportunity to pay the royalties on the shipments that were improperly diverted. Rejecting these arguments, the intermediate appeal court, and later the Pennsylvania Supreme Court, adopted the reasoning of cases from New York¹³ and other jurisdictions relating to incurable breaches arising from egregious conduct.¹⁴

The critic's concerns of the threat to contract law and franchising, which LJL represented, were always overstated. LJL is nothing more than an incremental extension of the U.S. Supreme Court's 138-year-old decision in Lyon v. Pollard.¹⁵ The franchisor in LJL cited Lyon, as did a few of the cases on which the LJL courts relied.

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In Lyon, a hotel owner terminated the hotel manager's employment because she was deemed unfit to perform due to her use of opiates and unsound mental condition. Recognizing that the owner's exercise of the contractual right of...