SWIRE & MACLAINE LTD AND ANOTHER v. KENTUCKY FRIED CHICKEN INTERNATIONAL CORPORATION AND ANOTER

IN THE SUPREME COURT OF HONG KONG

HIGH COURT

COMMERCIAL LIST

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JUDGMENT

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Nature of the hearing

1. This is a trial of preliminary issues which relate to the construction of the contractual documents entered into between the Plaintiffs and the Defendants.

Agreed Facts

2. The following facts are agreed by the parties.

1. The 1st and 2nd Plaintiffs are wholly owned subsidiaries of Swire Pacific Limited ("Swire").

2. By a Letter of Agreement dated 10th August 1984, ("the Letter Agreement"), the 1st Defendant ("KFC") agreed to grant to the 1st Plaintiff the right to own and operate "Kentucky Fired Chicken" quick service restaurant outlets through Beldare Enterprises Ltd. or any other wholly owned subsidiary of Swire.

3. Swire established 18 Kentucky Fried Chicken quick service restaurant outlets in Hong Kong of which 16 remain in operation.

4. In respect of each of the outlets, Beldare or the 2nd Plaintiff entered into an International Franchise Agreement ("IFA") with the 1st Defendant or 2nd Defendant.

5. By a letter dated 24th June 1986 signed by the 2nd Plaintiff, the 1st Defendant and Beldare, it was agreed that (a) the 2nd Plaintiff would replace Beldare as the 2nd Defendant's franchisee in Hong Kong with effect from 1st January 1986; and (b) all references in the IFA dated 18th September 1985 to Beldare should be deemed to refer to the 2nd Plaintiff.

6. By a letter dated 18th March 1994 from the 1st Plaintiff to the 1st Defendant, the 1st Plaintiff communicated the desire to have the Letter Agreement renewed.

7. By a letter dated 8th August 1994 from the Defendants to the 2nd Plaintiff, the Defendants stated that (1) they had decided not to renew the Letter Agreement; (2) it was their intention "in any event not to permit Swire to operate any outlets other than those currently existing"; and (3) they would commence in 1995 a second KFC system meaning thereby that they would sell or grant franchises to persons other than the 2nd Plaintiff to sell Kentucky Fried Chicken products in Hong Kong in parallel and in competition with the Plaintiffs outlets during the subsisting term of the IFA.

8. The assets and liabilities of the 1st Defendant were acquired by the 2nd Defendant and the 1st Defendant ceased as a separate corporation.

The Letter Agreement

3. The following are the relevant clauses of the Letter Agreement:

International Franchise Agreement

Principles of Construction

The preliminary issues

6. I will now deal with the preliminary issues.

1. On its true construction, does Clause 8 of the Letter Agreement oblige the 2nd Defendant not unreasonably to withhold renewal of the Letter Agreement upon expiry of the term of 10 years on 31.12.94?

7. Both parties agreed that Clause 8 is badly drafted. For ease of reference, I will break up Clause 8 into three parts:

Swire's Argument

8. Mr Mills-Owens, Q.C., Counsel for the Plaintiffs, submitted that the words "an option of KFC to renew" in the 1st sentence might be thought to grant to KFC an absolute right to choose whether or not to renew the master franchise in the Letter Agreement, as one does not normally refer in English to the exercise of an option being "unreasonably withheld". But he submitted that here the parties must have intended to impose a fetter on KFC's right to refuse to exercise its option to renew the Letter Agreement.

9. He submitted that the words "aforementioned renewals" in the 3rd sentence of Clause 8 must refer to the renewal of the master franchise in the Letter Agreement because, firstly, it would be odd if the parties intended the 3rd sentence of Clause 8 to refer to the renewal of an IFA. This is because subject to certain conditions, Clause 13 of the IFAs grants an automatic right to the 2nd Plaintiff to renew a particular IFA for an additional term of 10 years. Provided that certain conditions are met, the right to renew under Clause 13 is otherwise unrestricted. KFC would have no residual right to refuse renewal on any grounds, whether reasonable or not. Thus, despite the use of the plural, "aforementioned renewals" in Clause 8 can only refer to renewal of the master franchise in the Letter Agreement. Even though it may sound strange as a matter of standard English, as a matter of construction it appears that the parties intended, as they were free to agree, to fetter KFC's discretion to exercise its option under Clause 8.

10. Secondly, to construe the 1st sentence of Clause 8 as granting an absolute option to KFC would be to deprive the 3rd sentence of any meaning, when an alternative commercially viable reading is available.

11. Mr Mills-Owens argued that at best, the extent of the option in Clause 8 is ambiguous. In such circumstance, Clause 8 should be construed against KFC as grantor of the franchise or as the person for whose benefit the option was apparently inserted into the Letter Agreement.

12. Even if "aforementioned renewals" in Clause 8 could be construed as referring to renewal of an IFA, it would not make commercial sense for a restriction of reasonableness to be imposed on the right to renew an IFA without a corresponding restriction being imposed on KFC's option to renew the master franchise. The general intention of the parties must at least have been to maintain the relationship of franchisor and franchisee until one or other party had reasonable grounds for refusing to renew the main franchise or an IFA.

13. He argued that if the Plaintiffs' answer to the sixth issue is correct, that would further support the case that the parties intended that KFC could not unreasonably refuse to renew the Letter Agreement. Issue No.6 is whether Clause 3 of IFA gives the Plaintiff an exclusive franchise to sell products bearing the name or trademark "Kentucky Fried Chicken". He submitted that if the Plaintiffs' answer is right, it could not assist KFC to refuse to renew the Letter Agreement when it was bound to renew an IFA. This is because termination of the master franchise in the Letter Agreement during the lifetime of the IFAs would not enable KFC to market "Kentucky Fried Chicken" products in Hong Kong, by itself or through others, without the 2nd Plaintiff's approval. KFC could not derive any benefit from the termination of the master franchise independently of the life of an IFA, which (subject to complying with certain conditions in Clause 13) 2nd Plaintiff can renew for an additional period of 10 years.

14. He argued that by Clauses 1 and 12 of the Letter Agreement, the terms of the Letter Agreement must be construed in light of the terms of the IFAs (the terms of which were already known and agreed at the time of the Letter Agreement). Given the 2nd Plaintiff's rights under the IFAs, the parties could not have intended that KFC would be able in its absolute discretion to refuse to renew the master franchise under the Letter Agreement. There would be no point in doing so if the IFAs continued. It would be more natural (and would make better commercial sense for the parties) to construe the Letter Agreement and the IFAs as having been intended to be coterminous so that, where the Plaintiffs had reasonably performed their obligations and wished to renew their franchise, the Defendants could not arbitrarily reject the Plaintiffs' request to extend either the Letter Agreement or the IFAs.

Unqualified right of KFC

15. In my view, the answer to the first question is no. The renewals in the third sentence of Clause 8 does not refer at all to the option of KFC to renew the Letter Agreement in the first sentence of Clause 8, but only to the renewals of each of the new outlets under Swire's 10 year right of renewal in the second sentence. The phrase "unreasonably withheld" refers only to the renewals of each of the new outlets and not to KFC's option to renew in the first sentence.

16. The definitions of "option" given by the Shorter Oxford English Dictionary, are:-

17. In Gardner v. Blaxill & Anor. [1960]2 All ER 457 at 460g-h, Paull, J. held that "....the plain meaning of the word 'option' is 'choice'".

18. Hoffinan, J. in Spiro v. Glencrown Properties Ltd. [1991] I All ER 600 at 604f-g held that "the granting of an option imposes no obligation upon the purchaser and an obligation upon the vendor which is contingent upon the exercise of the option. When the option is exercise, vendor and purchaser come under obligations to perform as if they had concluded an ordinary contract of sale".

19. Devlin, L.J. in Reardon Smith Line Ltd. v. Ministry of Agriculture, Fisheries and Food [1963] AC 545 held at 729 that: "... option in its widest interpretation means simply choice or freedom of choice".

20. The word "option" in the first sentence of Clause 8 is clear. It is a right or choice given exclusively to KFC to renew the Letter Agreement for an additional term of 10 years. It is totally inconsistent with the right or choice of KFC to renew if it has to consider the convenience or interest of Swire. No conditions were to be attached to the exercise by KFC of its options. Whether KFC chose to exercise the option or not is something entirely within its province. The question of reasonableness simply does not arise in the exercise of this option. In my view, the meaning of Clause 8 of the Letter Agreement is clear. It gives an unqualified right to KFC to decide whether it wishes to renew the Letter Agreement or not. If in considering whether to renew or not a further requirement of reasonableness is to be considered, then the exercise of the option would not be a right or choice, it would not be an unqualified right in the hands of KFC but a qualified right in the hands of Swire. There is nothing to suggest that an option to renew means an obligation to act reasonably in deciding whether to renew. As Mr Huggins, Q.C., Counsel for the Defendant, submitted an option is the very antithesis of obligation.

Renewal of IFA not automatic

21. In respect of the renewal of the outlets under Clause 13 of the IFAs, they are not automatic as submitted by Mr Mills-Owens. Such renewal may only be made at the time of expiration of the term of each IFA, if certain conditions are fulfilled. Swire is unable to fulfil those conditions unilaterally. For example, in respect of Clause 13(b) of the IFAs, it provided that if renovation and modernisation of the outlet is not possible or feasible, the franchisee shall relocate the outlet, within such areas as may be approved by franchisor in writing in accordance with franchisor's relocation procedure. Consequently, KFC's approval is required and that approval should not be unreasonably withheld.

22. Other areas in which KFC might act unreasonably and thereby hinder the renewal process under Clause 13 are:

23. The restriction on Swire to renew the IFA does not mean such a restriction should also exist in KFC's option to renew the Letter Agreement. At the end it really is a matter of construction of the relevant clauses.

Development rights

24. The Defendant also argued that in order to properly construe the terms of the Letter Agreement and IFA, it is necessary to have regard to the factual matrix in which these contracts were made : Readon Smith Line Ltd. v. Yngvar Hansen-Tangen [1976] I WLR 989 at 997; Chitty on Contracts 27 edn. vol.1 at para. 12.104.

25. It was argued that the present case is one where KFC was coming afresh to Hong Kong. It looked for an experienced business partner, such as Swire, and negotiated an agreement with it, in the form of a Letter Agreement, which dealt with basic issue rather than with detailed operational matters contained in the franchise agreements for each outlet. The Letter Agreement was designed to ensure that:-

26. Mr Richard Mills-Owens submitted that the five year development right is not pleaded by the Defendants and the existence of such right is inconsistent with the matters now pleaded in the Defence and Further and Better Particulars of the Defence. In any event, this is not a issue that the parties have agreed that I should try as a preliminary issue. I agree and as such, I would refrain from dealing with this issue of development rights. My construction of Clause 8 is not dependant on the existence of such a right.

Further, having construed Clause 8 in this manner, it is not necessary for me to deal with the Defendant's alternative argument that should I held the first sentence to be meaningless, then it must be ignored as surplusage. Also I do not consider Clause 8 to be so ambiguous as to resort to the contra proferentem rule. In respect of Mr Mills-Owens' argument on the effect of Issue No.6 on Clause 8, I shall deal with that issue later on in this judgment.

Can the Letter Agreement be renewed?

27. The Defendant, as a separate and distinct point, argued that Clause 8 should not be interpreted as giving Swire a qualified right of renewal of the Letter Agreement but the effect of that would be to oblige KFC to renew the Letter Agreement which contains rights and obligations which by their nature simply cannot be renewed. Again, since I have concluded that KFC has an unqualified right whether to renew the Letter Agreement or not, it is not necessary for me to deal with this point.

2. On its true construction, does Clause 8 of the Letter Agreement provide to the 2nd Defendant an unqualified and unfettered option whether or not to renew the Letter Agreement for a further period of 10 years upon its expiry?

28. The answer to this question is "Yes".

3. On its true construction, does Clause 8 of the Letter Agreement provide to the Plaintiffs or any other person other than the 2nd Defendant (and if so, to whom) an option or other right to renew the Letter Agreement for a further period of 10 years upon its expiry?

29. The answer to this question is "No".

4(i). On its true construction, does Clause 8 of the Letter Agreement provide any right to the Plaintiffs to require the 2nd Defendant to exercise the 2nd Defendant's option whether or not to renew the Letter Agreement for a further period of 10 years upon its expiry?

30. The answer to this question is "No".

4(ii). If the Plaintiffs have any such right, is the same exercisable:

          (a) as they see fit; or

          (b) if not, in what circumstances may such right be exercised?

31. As the Plaintiffs do not have such right it is not necessary to answer this question.

5. On its true construction, is the last sentence of Clause 8 of the Letter Agreement to be disregarded as mere surplusage?

32. It is not necessary for me to deal with this issue.

6. On its true construction (and in the light of the terms of the Letter Agreement including in particular Clauses 6,10(b) and 12), does clause 3 of any of the IFAs entered into in respect of any of the outlets currently operated by the 2nd Plaintiff (which is, in each case, in identical terms) operate so as to prevent the 2nd Defendant from selling, or granting to any person other than the 2nd Plaintiff a franchise to sell, products bearing the name or trademark "Kentucky Fried Chicken" or the trademarks and service marks listed in Addendum A to the IFAs, in supermarkets, grocery stores, quick service restaurants or otherwise, in Hong Kong during the currency of any such IFAs or any renewal thereof?

Swire's argument

33. The Plaintiffs argued that Clause 3, in particular Clause 3.4 gives them an exclusive right to sell products with the name or trademark of "Kentucky Fried Chicken". Mr Mills-Owens submitted that each of the IFAs (18 in all) were entered into by the 2nd Plaintiff at some time subsequent to the Letter Agreement over a 10 year period up to 1993. These IFAs confer rights which are separate and distinct from rights conferred under the Letter Agreement and which must be given effect to.

34. Clause 3.4 of each IFA provides that KFC "may sell or grant franchises to others to sell through supermarkets, grocery stores, quick service restaurants or otherwise, any products other than products bearing the name of trademarks 'Kentucky Fried Chicken'''. The corollary must be that KFC may not sell or grant to others franchises to sell "Kentucky Fried Chicken" products during the term of an IFA.

35. Clauses 3.2 and 3.3 of the IFAs support this exclusivity given to the 2nd Plaintiff by providing machinery by which it can cater for special events. Only in default of it giving notice to KFC of its intention to do so can KFC undertake sales or license others to do so.

No exclusive right

36. The answer to the sixth issue is no. In my view IFAs are agreements regulating the operation of an individual outlet. By definition, a franchised business is likely to have more than one outlet in operation. The IFAs are specific agreements and it would be surprising that one single IFA were construed as containing of provision of such fundamental and wide reaching consequence as exclusivity.

37. To construe Clause 3.4 in the manner urged upon me by the Plaintiffs is inconsistent with the terms of the Letter Agreement, namely, Clauses 4, 5 and 6. In Clause 4 of the Letter Agreement, KFC may terminate the Letter Agreement by notice if Swire fails to meet in a timely manner any of its obligations under the development schedule. It is provided that such termination will only affect the right to build further stores in Hong Kong. Existing outlets shall continue to be governed by the IFA executed for such outlets. Under Clause 5, KFC may by notice invite Swire to develop new outlets. If Swire does not exercise this option within the period of notice, KFC have the right to develop the outlet itself or through another franchise. Clause 6 provided that upon the expiration of the rights of Swire under the Letter Agreement either by default (an example being the termination by KFC under Clause 4) or by the timely exercise of the option (an example being under Clause 2 which enables KFC to terminate the agreement if Swire does not retain the ownership and control of a majority of the shares of the franchisees), all rights to establish new Kentucky Fried Chicken outlets in Hong Kong shall revert to KFC subject to the rights of Swire in Clause 5, Such new outlets may be owned directly by KFC or by 3rd parties licensed by KFC. In my view if Clause 3.4 of the IFA contains such an exclusive right, then it means the rights given to KFC to develop stores upon the termination of the Letter Agreement or upon failure of Swire to exercise the option to open new outlets would be meaningless. With such exclusivity given to Swire, these new outlets just could not sell any Kentucky Fried Chicken products. The combined effect of Clauses 4, 5 and 6 of the Letter Agreement clearly indicated that KFC is entitled to sell or grant to any persons other than the 2nd Plaintiff a franchise to sell products bearing the name or trademark "Kentucky Fried Chicken" in Hong Kong during the currency of any such IFAs or any renewal thereof and this militates against any claim to exclusivity by Swire.

38. Mr Mills-Owens, Q.C. accepted that new outlets opened by KFC pursuant to Clause 5 of the IFA are entitled to sell products with the name or trademark of Kentucky Fried Chicken but argues that does not affect the exclusivity given to Swire under Clause 3. In my view the IFA makes no express reference to exclusivity. The language in Clause 3 is extremely unemphatic in this regard and there is nothing in the clause to suggest that this is an entrenched exclusivity clause intended to override or supersede any provisions in the Letter Agreement.

39. In Pagnan v. Tradax Ocean Transportation S.A. [1987]2 LI LR 342 Bimgham, L.J. held that it is a common place of documentary construction that an apparently wide and absolute provision is subject to limitation, modification or qualification by other provisions. It does not make the later provisions inconsistent or repugnant. The exclusivity contended by Swire must be looked at in the context of the contract as a whole which includes the Letter Agreement as well. The specifically negotiated clauses of the Letter Agreement should prevail over clauses in the printed form where the two are inconsistent. Clauses 3.2 and 3.3 of the IFAs do not support Swire's argument of the exclusivity clause in Clause 3.4. It is not necessary to make such an implication of exclusivity and as I have indicated, the implication is inconsistent with the whole framework of the Letter Agreement and the IFA itself.

Reference to deleted clause

40. The Defendants further argue that where parties use a standard form and delete parts of it, regard may be paid to what has been deleted as part of the surrounding circumstances in the light of which the meanings of the word they choose to leave in is to be ascertained : Chitty para. 12-058; Punjab National Bank v. de Boinbile [1992] I WLR 1138 at 1147 and 1149 and also Team Services Plc v. Kier Management and Design Ltd. 36 CONLR 32.

41. The standard form IFA was amended by the Letter Agreement to remove a clause (i.e. Clause 3.4) which prohibited KFC from opening outlets and selling KFC brand products, or granting franchises to others to do so within a specified geographical area surrounding a Swire outlet. The deleted Clause 3.4 is as follows:-

"Except as provided otherwise herein, during the Agreement Term, FRANCHISOR shall not establish or grant to others the right to establish an outlet for the purpose of using any of the trademarks or service marks licensed hereunder within a radius of one (1) kilometer of the Outlet, unless such outlet is outside of a circular area having the Outlet as its center and within which 20,000 people reside or work."

However, the typical IFA (i.e. typical in the Swire/KFC relationship), expressly permit KFC to open outlets/grant franchises and to sell products other than KFC brand products without regard to geographical limitation.

42. The Defendants argued that the removal of the geographical prohibition evidences the parties' intention that KFC was to be allowed to do what had been prohibited by the old Clause 3.4. This is understandable in a place as densely populated as Hong Kong. The removal of a prohibition can only put KFC into a better position than it would have been in without the deletion of Clause 3.4. It still has the benefit of the permissive provision contained in Clause 3.5 and the amendment made was designed to benefit the KFC organisation because it wanted to limit what it could not sell within the radius restricted area. The greater freedom given to KFC is inconsistent with Swire's claim to exclusivity.

43. In my view, it is not necessary for me to refer to the deleted Clause 3.4 of the IFA to arrive at my conclusion on the issue of exclusivity.

Effluxion of time

44. In his arguments Mr Mills-Owens stated that Clause 6 of the Letter Agreement provided for the determination of the agreement by default and by the timely exercise of the option, it did not provide for the determination of the Letter Agreement by effluxion of time. In my view, it is not necessary for the Letter Agreement to provide for such an event. Under the Letter Agreement, the Plaintiffs have a 10 year franchise (a development right of 5 years as argued by the 2nd Defendant). Unless the 2nd Defendant renewed the franchise for another 10 years, the Letter Agreement will come to an end by its natural course. It would be superfluous to expressly provide for such an event.

Costs

45. As I have answered the questions in favour of the 2nd Defendant. I shall order the costs nisi of the trial of the preliminary issues to the 2nd Defendant.