Originally published in the Canadian Franchise Business Magazine on October 21, 2014.
Q: Canadian Business Franchise is celebrating its 20th anniversary. What have been the most significant changes in franchising during the past 20 years, in both business and legal terms?
The changes have been enormous, yet in many ways, the issues that prevailed 20 years ago are still much the same today. The legal complexities of franchising have certainly grown immensely, making the field a specialty of its own, requiring a vast array of franchise legislation knowledge for any lawyer to advise a prospective franchisor or franchisee effectively, without risking a potential liability claim.
Franchising 20 years ago
In the early to mid-1990s, franchising grew rapidly along with the fast-moving economy. Many new startups entered the field and foreign-based franchisors—primarily from the U.S.—sought Canadian franchising candidates and expanded into this country through master franchise arrangements and, to a lesser degree, area development agreements.
At the same time, well-established Canadian franchisors—like Boston Pizza, Shoppers Drug Mart, Mr. Submarine, Country Style Donuts, Tim Hortons, Pizza Pizza, Mr. Lube, Bulk Barn Foods, Mr. Transmission, M&M Meat Shops and Second Cup—continued to grow nationally, though very few ventured into international markets at all.
The legal issues of franchising at that time were not very complex. Only one province, Alberta, had already enacted franchise legislation.
That legislation required the filing of a prospectus or statement of material facts and registration of salesmen before a franchisor could franchise within Alberta. It did not deal with such concepts as fair dealing or the right to associate, although provincial regulators did review franchise agreements and often required changes to provisions considered excessively harsh to franchisees.
Franchise agreements and ancillary documents continued to become more one-sided in favour of franchisors. The courts were most frequently called upon to consider cases of default and termination. They applied general principles of contract law in reviewing issues of misrepresentation and breach and began to look closely at the effect of those clauses drafted in favour of franchisors.
Very few cases went beyond the supreme or superior courts of the provinces. Most were decided on their specific facts, with very little law being established in the context of franchising in general. The 1975 Supreme Court of Canada decision in Jirna v. Mr. Donut—which held the franchisor was not accountable to franchisees for rebates from suppliers, in view of the fact the franchise agreement disclosed rebates could be paid by suppliers to the franchisor—remained the seminal legal case in franchising. Without detailed disclosure of the nature or amount of rebates enjoyed by franchisors, franchisees continued to complain about such allowances not being shared with them, but few were successful in challenging the practice.
For the most part, these franchisees were not sophisticated businesspeople and they often obtained little or no legal, accounting or financial advice before venturing into franchise opportunities. Governments, however, were very active—much more so than today—in promoting franchising as a means of small business ownership and they stressed the importance of investigating before investing.
The federal government, in particular, had conducted national information seminars for prospective investors on the legal, accounting, financial and business aspects of franchising. Some provinces followed with their own seminars and literature.
The media, meanwhile, began to more widely publicize franchise disputes. There was particularly extensive reporting about a major action by 50 Pizza Pizza franchisees against their franchisor for alleged misappropriation of amounts received for rent, advertising, interest and, again, rebates. The franchisor sued The Toronto Star for libel and successfully defended the franchise case on appeal from an arbitrator’s decision, but one of the consequences of the case was an interest on the part of the Ontario government in regulating franchising. This interest led to a white paper, a task force, proposed legislation, legislative hearings and, ultimately, actual legislation.
The franchise legislation boom
The Alberta government, meanwhile, repealed its registration-type franchise legislation, due to the burden of maintaining a governmental branch to administer it and in response to many complaints about the cost of compliance and the manner in which registrations and renewals were being conducted. New legislation was introduced, which provided for a self-regulatory disclosure-type law and included relationship provisions for fair dealing, the right to associate and the non-waiver of statutory rights. The disclosure requirements, however, were not very detailed.
Ontario’s aforementioned initiative led to the introduction in 2000 of the Arthur Wishart (Franchise Disclosure, 2000) Act, which expanded upon Alberta’s new legislation by providing a more extensive meaning of fair dealing, far more detailed requirements for disclosure documents and much more comprehensive remedies for a franchisor’s breach of or non-compliance with disclosure requirements.
In particular, franchisees in Ontario began to use rescission as a very powerful remedy against franchisors they alleged were not in compliance with the act’s disclosure requirements.
Just before the introduction of Ontario’s act, the Uniform Law Conference of Canada (ULCC) launched a national study group to develop a model uniform franchise law and disclosure regulations that could be adopted by other provinces that were considering introducing their own franchise legislation. The model legislation was fashioned after Alberta and Ontario’s laws, but with significant improvements to the wording and content of the relationship provisions and expanded disclosure requirements.
Shortly after the completion of the ULCC project, two provinces—Prince Edward Island and New Brunswick—passed franchise legislation based on it, albeit with some minor, distinct changes. Of particular note, New Brunswick became and remains the only province to adopt the ULCC’s proposal for party-initiated mediation of franchise disputes; similar but less detailed procedures are included in some other provinces’ general rules for civil actions.
The next province to introduce franchise legislation, after a very detailed study, was Manitoba in 2012. Its Franchises Actcontained a controversial provision allowing substantial compliance with disclosure requirements, rather than requiring absolute compliance as in most other provinces. No legal cases have been reported to date that consider the substantial compliance concept.
In 2013, British Columbia released a detailed proposal for franchise legislation that closely follows Manitoba’s model. At press time, it is expected to be introduced by the end of 2014.
Coupled with Quebec’s Civil Code provisions that are applied to franchise agreements as contracts of adhesion, the recent legislation initiative means seven provinces currently or will soon regulate franchising. The only provinces that lack such laws are Saskatchewan, Nova Scotia and Newfoundland and Labrador.
The courts’ response
In the years since Alberta introduced Canada’s first disclosure-based franchise legislation, the courts have clearly shown they recognize the purpose of such legislation is to correct the earlier power imbalance between franchisors and franchisees, particularly by allowing franchisees to make better-informed business decisions.
The courts have been called upon to consider significant remedies for non-disclosure or incomplete disclosure and the consequences of a breach of the duty of fair dealing. Since any waiver or release of statutory rights by a franchisee is considered void, there have been several prominent cases considering release provisions in agreements. The courts have also chastised certain franchisors for violating the statutory right of franchisees to associate, giving consideration to how far this right may be extended.
Franchisees have frequently resorted to the new statutory remedies for non-disclosure, improper disclosure or misrepresentation in disclosure documents. These remedies include repurchase of all equipment, supplies and inventory at cost, reimbursement for all amounts paid by the franchisee to the franchisor for the franchise (subject to amounts paid for repurchase) and damages for all losses incurred in establishing, setting up and operating the franchise. These amounts can quickly total hundreds of thousands of dollars—and in major franchise systems, they can easily exceed several million dollars.
As the courts have been quite strict in interpreting disclosure requirements, franchisors have had to become very diligent in preparing their disclosure documents. The following examples have all been considered breaches of disclosure requirements:
• Improper or stale financial statements
• Incomplete signatures on disclosure certificates
• Failure to include all documents required to be signed by the franchisee
• Failure to include head leases or other documents material to the franchise
• Incomplete disclosure of advertising fees
• Incomplete disclosure of rebates or allowances
• Failure to detail costs of the exact franchise being offered
• Failure to disclose prior operating results of a location being refranchised
• Failure to disclose information of related companies involved in the franchise offering.
From a franchisor’s perspective, the diligence involved to comply with such requirements is paramount, as no outside adviser would have the factual knowledge necessary to prepare a disclosure document. The complexity of a national franchise disclosure document is particularly high, requiring franchisors to seek experienced legal counsel to minimize errors. The cost of compliance may be considerable, but the cost of non-compliance can be exponential.
An additional but often overlooked result of franchise legislation is the expanded list of individuals who may be liable for non-compliance with disclosure requirements. Any director or officer who signs a disclosure certificate is personally liable along with the franchisor and any person considered the franchisor’s associate. In the case of small, privately held corporations, the owners are often involved in franchise sales and will be considered the franchisor’s associates, despite the fact the corporate entity itself is the actual franchisor.
As mentioned, one area of expanded complexity resulting from franchise legislation is the statutory duty of fair dealing. Generally speaking, this is a codification of the common-law contractual duty of good faith and fair dealing, but in most franchise legislation, the duty expressly provides the parties are required to act in good faith and deal fairly with each other in the performance and enforcement of a franchise agreement, including the exercise of discretion under the agreement, and to act in accordance with reasonable commercial standards. Common law cases have added the requirement that a franchisor must take the legitimate interests of a franchisee into account.
These oblique requirements have led to considerable litigation by franchisees seeking declarations from the courts that franchisors have breached the duty of fair dealing. The courts have been receptive to these claims, particularly since they have declared franchise agreements are contracts of adhesion that offer the franchisee little or no right to negotiate. In a few recent cases, the courts have expanded the remedy for breaches of this duty from strict contractual damages to include personal injury damages resulting from mental stress and oppression.
Another consequence of franchise legislation, as mentioned, is the voiding of any franchisee’s release or waiver of rights. Previously, many franchisors required their franchisees to waive any claims against them as a condition of franchise renewal or resale. Several courts have declared these releases void, resulting in a difficult situation for franchisors that may have to deal with ongoing claims by existing franchisees who are permitted to renew or resell their franchises.
From the court decisions, it is clear new legislative provisions have helped shift the power imbalance with a more level playing field by giving franchisees significant, effective remedies. In response, franchisors have had to adjust their practices, as well as their operational conduct with franchisees.
That is not to say franchisors do not have their own remedies, however. The courts have shown franchise agreements will be interpreted in accordance with their clear wording. Franchisors are thus able to seek and be awarded remedies with respect to franchisees who do not comply with their own contractual and statutory requirements.
Ontario introduced class action legislation in 1993. Today, all provinces except Manitoba have enacted similar legislation.
Class actions are ideally suited for large groups of franchisees who have a common complaint against their franchisor. While class actions are complex and require certification by a court before they can proceed, their major advantages over a multi-plaintiff action are (a) only one representative plaintiff is required to institute the action and (b) franchisees do not need to elect to be part of the class to benefit from an ultimate recovery. Indeed, franchisees other than the named plaintiff(s) spend little or no time in the action.
Many plaintiff lawyers will conduct a class action on a contingency basis, in which they usually recover 15 to 25 per cent of the damages or settlement amount as compensation.
Franchisors, meanwhile, must defend the actions and will incur substantial costs and disruption to their business operations, even while working with the very franchisees in the class bringing the action. The amount of time involved in defending a class proceeding—in terms of document production, factual summaries, legal counsel meetings, accounting, valuations and personnel disruption—is enormous.
Further, franchisors must describe pending actions in their disclosure documents. Bad press and negative publicity can impede sales, both to prospective franchisees and to consumers.
As a result, franchisors are highly motivated to settle such actions at an appropriate time to restore operations and stop further expenses and fees. This is certainly a factor in promoting the institution of class proceedings.
In Ontario alone, franchisors as varied as Petro-Canada, Pet Valu, Suncor, Shoppers Drug Mart, Midas, Quiznos, General Motors (GM) of Canada and Bulk Barn—and even the Ontario government itself—have all been defendants in class actions brought against them by franchisees alleging breach of contract and/or the Arthur Wishart Act. Clearly, the combination of class action and franchise legislation has significantly augmented the arsenal of remedies franchisees can use against a franchisor. And with plaintiff counsel carrying the cost of legal fees on contingency, class actions will continue to be a very active method of redress for disgruntled franchisees.
That said, class actions are not always successful. One highly publicized example was a summary judgment decision involving a large group of Tim Hortons franchisees who alleged both breach of the duty of fair dealing and breach of contract. This class action followed the franchisor’s introduction of par-baked goods and new menu items.
The court found the franchisor had more than complied with its obligations and acted fairly and in good faith towards its franchisees. Subsequent appeals were dismissed, including leave to appeal to the Supreme Court of Canada. The lengthy decision is a must-read for all franchisors and franchisees on the subject of fair dealing.
Alternative dispute resolution
Even as class actions have risen, mediation and arbitration are becoming more commonly used to resolve disputes more efficiently, effectively, privately and confidentially. Some provincial governments, franchising associations and courts are actively promoting these alternative dispute resolution (ADR) methods. As such, franchisors are becoming more aware of the opportunity to use ADR to avoid letting disputes reach the trial or class action stage.
So far, there is a small but growing number of ADR ‘neutrals’ who have franchising experience and relevant credentials to assist in the dispute resolution process. Some of the more established franchisors are also considering using independent franchise system ombudsmen to hear and resolve disputes at very early stages.
As franchising continues to expand, it represents a significant percentage of Canada’s gross retail economy, having become a common method of business distribution in many product and service categories. Meanwhile, the number of prospective franchisees is growing as job losses increase and many traditional employment opportunities decrease.
The number of lawyers who spend a majority of their time on franchise matters is also growing. Where 20 years ago you could count on one hand the number of full-service law firms in Canada that promoted franchising a specialty practice, today there are many more, due both to the complexity of commercial laws involved in franchising across the country and the growth of franchise-related litigation.
Indeed, the breadth and depth of laws involved in franchising are somewhat staggering—and certainly not appreciated by the legal and business communities in general. Beyond franchise legislation itself, areas of specialization include contract drafting and enforcement, leasing, personal property security, guarantees and indemnities, promissory notes, trademarks, copyright, gift cards, consumer protection, misleading advertising, competition law, non-competition covenants, anti-spam legislation, privacy laws, electronic communications, social media, Quebec’s Charter of the French Language and consumer warranty laws. There are also laws and bylaws that apply to franchises in regulated industries, especially health care, real estate, pharmacies, travel, mortgage brokerages, automotive repair and home services.
Concurrent with the growth of franchise legal services has been the growth of other service suppliers to the franchising community, including specialized accountants, bankers, advertising agencies, marketing consultants, sales personnel, leasing and real estate brokers, consultants and investment advisers.
Franchising has changed in many ways over the past 20 years, with much more varied opportunities and a much more complex legal landscape. And it will continue to attract the attention of legislators and governments as it becomes a major force in direct and indirect employment and business outsourcing.
It is therefore all the more important for franchisees, franchisors and those advising them to be well-informed. I for one am highly grateful to have had the opportunity to be part of this invigorating, exciting and unpredictable period of development in the franchising sector, which has rewarded so many unusual and creative entrepreneurs and energetic independent business owners.