The Franchise Memorandum

The United States Bankruptcy Court for the Southern District of Texas recently found the franchisor of Diedrich coffeehouses in breach of the implied covenant of good faith and fair dealing for failing to exercise an option in its master lease that would have allowed plaintiff Magna Cum Latte, a Diedrich franchisee, to continue to sublease from Diedrich the premises of one of Magna’s franchised coffeehouses. Magna Cum Latte, Inc. v. Diedrich Coffee, Inc., et al., 2007 WL 4412143 (Bankr. S.D. Tex Dec. 13, 2007).

Diedrich sold three existing coffeehouses in Houston, Texas to Magna and entered into related franchise, sublease, and purchase agreements with Magna. Under Diedrich’s master leases with the landlords, Diedrich possessed certain options on each of the coffeehouse premises. The subleases between Diedrich and Magna, however, did not “expressly require Diedrich to exercise the options or specify under what, if any, conditions Diedrich could decline the options.” When the franchisor chose not to exercise its option for one of the coffeehouses, Magna brought this lawsuit alleging, among other things, breach of the implied covenant of good faith and fair dealing. In applying the implied covenant to the parties’ contracts, the court held that Diedrich was not free to act on its desires, but was required to exercise its lease option under the master lease. Diedrich contended that it did not violate the implied covenant because it gave Magna ample notice of its intention to decline the lease option in its master lease, if Magna would not agree to an amendment to the sublease. The court found that the reasonableness of any notice or counteroffer was irrelevant. If the implied covenant precluded Diedrich from declining the lease option, Diedrich could not escape the implied covenant’s demands. The court also found that Diedrich’s notice and offer were not made in good faith and that Diedrich’s decision to let the lease option expire was not based on mere negligence or mistake, but was a conscious decision inspired by pecuniary interests. The court noted that while Diedrich’s pursuit of its own pecuniary interests was not necessarily “bad faith,” Diedrich could not pursue its own self interests if in doing so it breached the implied covenant.

In contrast, the court rejected Magna’s arguments that Diedrich violated the implied covenant through alleged misrepresentations, omissions, threats, and business decisions made throughout the parties’ relationship. The court found that alleged omissions and misrepresentations were irrelevant to the implied covenant claim because they occurred during contract formation, before any performance was required by either party.