Technical Requirements of Franchise Disclosure Legislation

Originally published in the Canadian Business Franchise magazine on February 5, 2013

Q: How strict are Canada’s courts in interpreting and enforcing the technical requirements of franchise disclosure legislation?

A: When it comes to the actual requirements for the content of disclosure documents, the courts have been very strict. Franchise legislation in the five provinces that have enacted such legislation—Alberta, Manitoba, Ontario, New Brunswick and Prince Edward Island—mandates that certain information and documents must be included and the disclosure document must be provided to a franchisee in a certain manner and by a certain time.

If a franchisor delivers a disclosure document that is deficient or lacks certain information or supporting documents, the franchisee generally has a period of 60 days from delivery of the document to rescind the franchise. If the franchisor does not deliver a disclosure document at all, the time permitted for rescission is two years from (a) the date on which the franchisee first paid any money to the franchisor or (b) the date on which the franchisee entered the franchise agreement, whichever is earlier.

In some cases where a disclosure document has been delivered, but is so deficient in terms of its content or is missing key documents—such as financial statements, copies of agreements the franchisee is required to sign or a signed certificate of disclosure—the courts have stated the franchisor, in essence, did not deliver a disclosure document at all. So, they have allowed the franchisee the full two-year period to exercise the right of rescission.

Technical details
In a leading case decided by the Alberta Court of Appeal involving a hotel franchise, the court held a franchisee was entitled to rescind a franchise agreement for a two-year period after entering it, in circumstances where a disclosure document was delivered with a certificate of disclosure in required form, but the certificate of disclosure was not signed by the two officers whose names appeared on it. The court stated the legislation in Alberta required the certificate to be signed and, without the signatures, the franchisee would have been deprived of the right to sue the officers directly. The court held it did not have any discretion under the legislation to allow a disclosure document that did not have a signed certificate of disclosure to satisfy the required form, even though the franchisee did receive the actual form of disclosure document and had the benefit of its contents.

When it comes to some of the technical details regarding the delivery of a disclosure document, most franchise lawyers have generally assumed the courts will be equally vigilant in enforcing the mandatory requirements of franchise legislation. All Canadian franchise legislation—except the most recently passed legislation in Manitoba—requires a disclosure document to be one document, delivered as one document at one time. While the provinces differ somewhat as to how a disclosure document is to be delivered, they all specify their methods of permitted delivery.

Document delivery
So, what happens if a franchisor delivers a disclosure document that is compliant with the content requirements of the legislation, but is not delivered as required under that same legislation? This has become not just a technical problem for franchisors, but also a practical problem, because franchise disclosure documents are large, running into hundreds of pages once all of the agreements required to be signed and the financial statements are included. Personal delivery and registered mail are the two most common methods permitted in each province.

While delivery by registered mail is allowed, it is for the most part impossible, because Canada Post will not accept a registered mail package for delivery if the contents weigh more than 500 g (16 oz).

While Manitoba, Prince Edward Island and New Brunswick will allow disclosure documents to be delivered by e-mail, their requirements in this regard are somewhat complex. Simply e-mailing the document will not be satisfactory.

Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000 states a disclosure document must be delivered personally, by registered mail or by any other prescribed means. To date, however, no other means have been prescribed. Since registered mail is not really an option, this means personal delivery is, in effect, the only permitted means.

Even though personal delivery can be difficult and costly, particularly to reach franchisees based in remote areas, most franchisors will not risk a claim of rescission by delivering the disclosure document through some other means.

A recent case in Ontario, however, has considered the issue and, to the surprise of most franchisors and franchise lawyers, determined otherwise. While it is a good, practical result, this decision has left the franchise community wondering how far the courts will go in bending the mandatory requirements of franchise legislation.

Electronic, but not late
In Vijh v. Mediterranean Franchise Inc., the Ontario Superior Court of Justice determined, based on the facts of the case, that section 5(2) of the Arthur Wishart Act relates to the question of what happens if the franchisor delivers a disclosure document by e-mail with the franchisee’s consent. Could the franchisee, after waiting almost two years, rescind the agreement under section 6(2) of the Arthur Wishart Act and recover costs and damages, simply because of the improper delivery method—or would the franchisee be restricted to the damages remedy provided under section 7(1)?

In every other respect, both sides agreed the franchisor had fully complied with the disclosure requirements set out in that legislation. The only deficiency was the method of delivery.

With the franchisee’s consent, the franchisor had delivered the disclosure document by e-mail, rather than via registered mail or personal delivery as prescribed in the legislation. The franchisee, having operated the franchise for almost two years, now wanted rescission and damages. The court concluded that rescission under section 6(2) of the Arthur Wishart Act, simply because the disclosure document was delivered by e-mail, was not available to the franchisee.

The franchisee submitted that any breach of the Act that relates in any way to a disclosure document—including a breach regarding the method of delivery, however minor—should allow rescission under section 6(2), even if almost two years have gone by.

The court did not agree with this submission, stating this interpretation of section 6(2) did not make sense, given the plain language and the other sections of the Act dealing with disclosure and the obvious legislative intent to provide two routes for rescission:

● A 60-day right of rescission if a disclosure document was provided late (i.e. after the 14-day requirement) or lacked some of the required content; and

● A two-year right of rescission if no disclosure document was ever provided.

(The Act also provided a damages remedy under section 7(1) for breach of any of the disclosure document requirements.)

“If the franchisee’s interpretation of section 6(2) is right (i.e. the franchisee may rescind for up to two years for any breach of the Act, however minor) then why have section 6(1)?” the court asked, referring to the 60-day period. “Why differentiate between the 60-day rescission right for late or incomplete delivery of the disclosure document and the two-year rescission right for no delivery? The reason, surely, is to make clear the two-year rescission right is reserved for the much more serious situation where no disclosure document is provided.”

The court relied on earlier decisions, which held the two-year right of rescission is only available where there is “a complete failure to provide a disclosure document” or where the disclosure document provided was “materially deficient,” but not where it was “merely late.”

By the same reasoning, the two-year right of rescission is not available where a complete disclosure document was provided, as in this instance, but by e-mail, rather than registered mail. If a breach of the timing or content requirements allows only a 60-day right of rescission under section 6(1), then a breach of the method of delivery requirement, which by any measure is much less significant, cannot sensibly justify a two-year right of rescission under section 6(2).

The court therefore limited the franchisee to the damages remedy in section 7(1). Counsel for the franchisor suggested the only damage sustained by the franchisee was the cost of printing the e-mailed disclosure document. The court stated, “He may well be right.”

The court dismissed the franchisee’s case and awarded costs in favour of the franchisor.

What to take from this case
This court decision does not yield any general principle suggesting delivery of a disclosure document by e-mail is an acceptable practice in Ontario. Rather, two clear factors influenced the court.

First, the parties agreed, for the purposes of this case, the contents of the disclosure document were fully compliant with the legislation. The case was only about the method of delivery.

Second, the franchisee had agreed to have the document delivered by e-mail. The court looked rather skeptically at the result that would have occurred had the franchisee been entitled to rescind the franchise it had already operated for two years, just because the document had been delivered by a method not specifically permitted in the legislation, when the franchisee had consented to this method.

However, to keep within the framework of the Act, the court essentially said that proper remedy should have been rescission within 60 days, as opposed to two years. So, franchisors should not take comfort in delivering disclosure documents in Ontario by e-mail, because they will likely still be exposed to a 60-day rescission claim by a franchisee, assuming the contents of the document are not materially deficient.

This will certainly lead to further confusion.

Delivering Disclosure Documents Before Location is Set

Disclosure of Franchise Locations

Article originally published in the Canadian Business Franchise Magazine on December 15, 2016.

Q: Can a franchisor deliver a disclosure document to a franchisee and sign a franchise agreement before a location for the franchise has been determined?

A: Until a recent decision by the Ontario Superior Court, it was a very common practice—promoted by both franchisors and their legal advisors—for the franchise disclosure document (FDD) to be delivered to franchisees in situations where the location of the franchised business was not determined until after the franchise agreement was signed. In such situations, the FDD cannot include a copy of the head lease, of course, because it does not yet exist; and the location of the franchised business cannot be considered a material fact requiring disclosure, because it is not yet known.

The business rationale for this practice applies to both parties. The franchisor wants to secure a franchisee who is committed to search for a location in accordance with the provisions of the franchise agreement, while the franchisee wants to know he/she has secured a franchise before spending further time and money to find a location.

Despite this long-accepted practice, however, in a decision of the Ontario Superior Court on September 7, 2016, in the case of Raibex Canada against AllStar Wings & Ribs (ASWR) Franchising, the latter—a restaurant franchisor—was found liable for rescission under the province’s Arthur Wishart (Franchise Disclosure, 2000) Act for failing to disclose a copy of the head lease and location-specific development costs for the franchise, despite the fact the location was to be determined after the franchise agreement was signed, pursuant to a site selection process detailed within the franchise agreement.

A costly conversion
The facts of the case are quite clear. The plaintiffs at Raibex, i.e. the franchisees, received the FDD in early 2013 and subsequently signed the franchise agreement. The FDD included an estimate it would cost between $805,500 and $1,153,286 to build the restaurant from a shell building. There was no estimate for converting an existing building, even though all of ASWR’s current franchised restaurants were themselves conversions, but the FDD contained the following disclaimer with regard to such costs: “While conversions may be available and offer certain savings to the prospective franchisee in development costs, the franchisor has no reasonable means of estimating or predicting those costs with any certainty.”

A few months later, an existing restaurant that would have to be converted to the franchise system’s format was identified for the franchise location. The plaintiffs participated “to some degree” in the negotiation of the head lease.

The lease contained a requirement for an initial tenant payment of approximately $120,000 in security deposits and prepaid rent, which the plaintiffs learned about during the negotiations. A sublease was signed, but the plaintiffs did not receive an executed copy of the head lease until later.

The site conversion was completed in March 2014. The franchisor advised the plaintiffs the cost of building out the franchise totalled more than $1 million. The franchisor invoiced the franchisees for the security deposits and prepaid rent, which the franchisees refused to pay.

The franchisor then issued a notice of default. The plaintiffs responded with a notice of rescission (i.e. termination of the franchise agreement). The franchisor issued a notice of termination and commenced the action. The franchisees brought a summary judgment motion in an action for rescission.

A strict interpretation
In court, the franchisor argued signing a franchise agreement prior to a site being identified is not an unusual practice in franchising and, in such a case, the franchisor cannot disclose a head lease that does not yet exist.

The court disagreed. It emphasized the Wishart Act’s remedial nature and strict disclosure requirements that protect the interests of franchisees. The court said unscrupulous franchisors could deliberately issue their FDDs prematurely, when material facts are not yet known, so as to evade their full disclosure obligations. The court stated the only solution for this problem would be for franchisors to delay all disclosure until all material facts are known.

“If it is simply impossible to make proper disclosure because material facts are not yet known, then the franchisor is not yet ready to deliver the statutorily required disclosure document,” the court stated. “The franchisor must wait. It does not get excused from its statutory obligations.”

The court made this finding even though, under the location selection process outlined in the franchise agreement, the franchisees could have opted to terminate their franchise agreement and receive a refund of their franchise fee if they were not satisfied with any locations available after 120 days from execution.

The implications for franchising
The practical effect of the decision is significant. The court’s position on the timing of disclosure affects when both parties—franchisee and franchisor—can enter a franchise agreement. As such, it has serious ramifications for franchising in Ontario, as well as in other provinces that have enacted franchise disclosure legislation.

Previous court decisions have held the FDD must be specific to the franchisee receiving it and, as a result, have enlarged the scope of disclosure beyond the items actually prescribed in provincial legislation. The decision in this case, however, may even question whether franchisors and franchisees can continue the common practice of selecting a site after the franchise agreement has been signed. Following the logic of the decision, it may be possible for a franchisee who wants to get out of a signed deal to claim rescission if a material fact was unknown to the franchisor at the time of disclosure or once the franchise agreement has been signed.

The court also focused on the fact the head lease included a specific provision for an upfront payment for security deposits and prepaid rent. It is possible that, in another case, the court would have found disclosure was not premature if there had been no upfront cost or if an estimate of the cost had been included in the franchisor’s overall estimate of the costs of establishing the franchise. Indeed, the court suggested the “possibility proper disclosure could be made” even in cases where the site is not known at the time of disclosure.

Identifying deficiencies
The court found the ASWR FDD’s estimate of the costs of establishing the franchise was deficient. As mentioned, the FDD included an estimate for building a restaurant from a ‘shell’ and suggested converting an existing building could result in significant cost savings in comparison. The plaintiffs’ restaurant conversion, however, was almost as expensive as the high end of the estimated cost for constructing from a shell.

On several occasions, the court noted the franchisor did not have experience with building from a shell, as all of its existing locations were conversions. The court indicated the FDD should have contained an estimate of costs based on the actual conversion format. In the future, franchisors may have to include the costs for all different construction formats in their FDD’s overall estimate of the costs of establishing a franchise.

In this case, of course, the franchisor did not include estimated costs of converting an existing restaurant, but did include a disclaimer statement explaining it had no reasonable means of predicting conversion costs, which could vary dramatically from one site to the next. The court felt this approach was unacceptable and considered the disclaimer to be an admission the franchisor could not meet its own obligations, stating a “broad disclaimer is also no answer to the mandatory statutory disclosure obligations.”

An impracticable decision
The decision is not only surprising, but also—in its result—impossible in practice for franchisors and for franchising in general. It has the potential effect of increasing standards for disclosure and, particularly, in respect of the timing of the FDD’s presentation to franchisees, as well as for determining when franchisors and franchisees can enter franchise agreements and related leasing contracts. The case may also discourage franchisors from assisting their franchisees in the process of locating, securing and arranging for leases or other location-related documents.

The court’s decision creates a new requirement under Ontario’s Wishart Act with respect to the timing and content of disclosure, in that all material facts relevant to the location (which are often unknown at the time of disclosure)—including the terms of the head lease and the specific development costs related to the location—must be known before proper disclosure can be made and the franchise agreement can be signed. Further, the decision concludes that by entering a franchise agreement before the franchise location is known, a franchisor has committed an “egregious” violation of its disclosure requirements under the act, entitling the franchisee to rescind the franchise within two years. This is a very significant change from the status quo.

It is noteworthy the court did not make any distinction between situations where (a) the franchisor assumes the head lease and then subleases the location to a franchisee and (b) the franchisee is responsible for entering the lease directly with the landlord. As the court put it, “to suggest the head lease is not material is absurd. The terms of the lease are a critical component of franchise disclosure.” As a result of the case, it can possibly be inferred that a franchise location’s lease will always be considered material for disclosure purposes, regardless of whether or not the franchisor is subleasing the location to the franchisee.

 

It is somewhat questionable why the court did not consider the facts that (a) the franchisees were fully aware there was no lease at the time they signed the franchise agreement and (b) they had the choice after signing the agreement whether or not to proceed based on the suitability of the location to be determined. The franchisees were specifically afforded the good faith and fair dealing protections of Ontario’s Wishart Act in the performance and enforcement of that legal provision. And the franchisor was required to act in accordance with reasonable commercial standards throughout the site selection process.

Stay tuned
The decision has been appealed by the franchisor. While it is still under appeal, franchisors that grant franchises for locations yet to be determined should review its implications when delivering FDDs to and signing franchise agreements with their franchisees.