Keep Your International Expansion Expectations Realistic

Originally published on February 2010 for the International Franchise Association 

 

All too often franchisors require that their international agreements be substantially the same as those which they use in their home countries

International franchising can be glamorous, exciting and exotic for both the franchisor and the international franchisee. The risks and rewards for both parties can be significant, and the negotiations and business arrangements can be lengthy and complex. Franchisee entities involved in international expansion are usually much more sophisticated than domestic franchisees. They are much more aware of the local and relevant cultural and legal considerations, and are often well connected to important business and government entities that will be necessary for a successful launch in their countries.

While franchisors generally refuse to negotiate franchise agreements in their own countries, international franchising follows a much different pattern. Negotiations are difficult because of travel and language barriers, costs of multiple legal, business and accounting advisors, and delays relating to required foreign legal and government compliance. Franchisors will be concerned about the fact that they have little control in international franchise operations while their trademarks, business systems and reputation are exposed to potential adverse risk. To the contrary, the international franchisee will be concerned that it may not receive sufficient support and assistance from the franchisor for successful development of the franchise program. These conflicting objectives and concerns can lead to unrealistic expectations by both parties.

All too often franchisors require that their international agreements be substantially the same as those which they use in their home countries. Again, all too often, franchisors do not take the time to understand the relevant local customs, business practices and economic conditions in the target country, and to temper their expectations accordingly.

Similarly, international franchisees, caught up with the excitement and exuberance of the opportunity, too frequently agree to unrealistic commitments and legal arrangements. 

A few concrete examples will illustrate how both parties can enhance their opportunity for successful international franchise expansion by keeping their expectations and commitments realistic. Assume that the international franchise arrangement takes the form of a master franchise agreement allowing the master franchisee to sell subfranchises in the territories involved. This arrangement will allow for rapid market penetration, accelerated growth of the franchise system and attraction of sophisticated investors. Since the development and operational expansion efforts will be with the master franchisee, the franchisor’s financial and management resources will be reduced from what would be the case in direct unit franchising. However the financial rewards to a franchisor the international franchisee is successful will be significant in terms of the return on invested capital. But if the relationship ultimately fails, the franchisor risks financial loss by reason of the expenses required to salvage the franchise system in the foreign market.

Territory and Exclusivity 
Often a matter of first negotiation in international franchising relates to exclusivity and territorial rights and restrictions. The franchisee entity will expect complete exclusivity within the foreign market. The franchisor, accustomed to reserving certain rights in its favor domestically, may insist upon similar rights being reserved in the foreign market. For example, the franchisor may wish to reserve the right to sell the same or similar products or services associated with the franchise system under different trademarks, or through other channels of trade, including on the Internet. These reserved rights are often unnecessary and unrealistic, and if implemented can result in competition and conflict between the franchisor and the international franchisee. In most cases it is best for the franchisor to cede responsibility for development of the franchise system to the international franchisee without any expectation that the franchisor will intervene or compete directly or indirectly.

Another similar issue which may result in conflict or unrealistic expectations is the description of the territories involved. For countries whose borders may be under scrutiny or subject to political change, both parties must understand what may happen if there is a change of borders or country description. For example, how would a franchise agreement entered into several years ago giving exclusivity to a franchisee for the Union of Soviet Socialist Republics or Yugoslavia be interpreted after the demise of either of these countries? A map or a description of the boundaries as they exist at the time of the agreement could be referenced, or the agreement could provide that if the political boundaries change during the term of the agreement any affected parts of the territory are forfeited and automatically withdrawn from the exclusivity grant. 

Fees 
Another topic often subject to intense negotiation and unrealistic expectations pertains to the fees payable for the international franchise rights being granted. Most international franchisors seriously underestimate the costs involved in developing their franchise systems internationally, particularly in less developed countries.

It is not uncommon for franchisors to require a large, front-end fee. Such an approach may be unrealistic in the sense that it will impair capital needed to ensure successful development of the system. A more practical approach may be to accelerate or increase payments as the international development reaches certain milestones.

Similarly, some franchisors seek reimbursement of their expenses in developing products and services for the franchise system for foreign markets. However, from the franchisee’s perspective, an open requirement to reimburse all such expenses could result in a completely unrealistic financial outlay at the initial stage of the arrangement. It is wise for both parties to be realistic and definite as to their expectations. For example, the agreement could provide that only certain expenses incurred in connection with the conversion of a franchisor’s packaging, signage and advertising materials for the foreign country, or expenses incurred in connection with governmental reviews and approvals, are required to be reimbursed. Similarly, the agreement could specify that expenses incurred for training of the franchisee and its staff, and translation and other development costs for the operations manual will be required to be reimbursed.

Some international franchise agreements stipulate that the fees payable by the franchisee will be subject to an inflation factor or adjustment based on a published cost-of-living index. Many franchisors insist that the cost-of-living index applicable in their home country should be inserted in the agreement. But this approach is unrealistic in countries where there has been an historical record of high inflation. The franchisor’s may be better served by insisting on a cost-of-living index relevant in the foreign country. The franchisee, however, may wish to put a cap on the inflation factor to have some degree of certainty in its financial commitments.

Taxes 
The subject of taxes payable on the payment of fees by the foreign franchisee to the domestic franchisor needs to be understood by both parties and approached realistically. In most countries withholding taxes will be eligible on royalty, interest and similar payments from a franchisee to a franchisor residing outside of the target country. The franchisee will usually be responsible for calculating, withholding and paying such taxes to the foreign country’s tax authorities, and to provide the franchisor with receipts for payments for the franchisor to be able to claim foreign tax credits in its own country. But often international franchisors insist upon a “gross-up” clause requiring the franchisee to pay the full amount of the royalty, interest or other payments without regard to any amount being withheld under local law. Gross-up clauses like these will impose a huge financial burden on the franchisee as the franchisee will still be required to make the withholding payments, but at the same time must make full payment to the franchisor without deduction of the taxes withheld. In many jurisdictions this may result in what a 15 percent or greater burden on the franchisee, making the financial arrangements unrealistic.

Development Obligations 
Another area of unrealistic expectations in international franchising often pertains to the franchisee’s development rights and obligations which may be set out in a development schedule specifying a minimum number of outlets to be opened and operated within a particular time framework. Franchisors are often unrealistic in their expectations by applying domestic growth criteria to the foreign market. They should not seek and franchisees should not commit to unrealistic development obligations. Both parties should also realize that if the development obligations are not met, the ultimate sanction does not have to be termination of the arrangement. More realistic consequences, such as the possible reduction of exclusivity or surrender of a part of the exclusive territory, may be more sensible.

If the franchisee cannot meet the development schedule due to unexpected economic or market changes, the agreement should allow the parties to negotiate a reduced development schedule. Clearly the recent worldwide financial crisis and economic recession have illustrated that development schedules entered into with the best of intentions can be made unrealistic due to events beyond the reasonable expectation of the parties.

System Modifications
Another area in which international franchisors are often unrealistic is with respect to the ability of the franchisee to modify the franchise system in the foreign market. It is a fundamental fact that franchise systems require modifications and adaptation in the target due to local country laws, regulations, customs and cultural considerations. While some elements should not be subject to modification unless absolutely necessary, others should be subject to reasonable modification by the franchisee. 

Typical franchise system development criteria which may have to be modified in the target country include site selection, franchisee selection, specifications for equipment, fixtures, furnishings, decor and signage, and modification of approved products or services. With respect to the operations manual, the franchisee should typically be allowed to suggest modifications or changes to comply with local standards, including language requirements, but the agreement should state that all modified versions of the manual will be owned by the franchisor. While the international franchisor may wish to maintain approval rights over each and every change or modification, such an approach is both impractical and unrealistic.

Subfranchise Agreements
It is common in international master franchise arrangements for the form of subfranchise agreement to be in a standard form approved by the franchisor. It is not unrealistic for an international franchisor to require approval of modifications or changes, but at the same time the franchisee should be able to make nonmaterial modifications or changes for compliance with local requirements. The franchisor should be given notice of such changes, and perhaps to be given a reasonable right of approval.

Supply Arrangements
Most international franchise arrangements need to address the subject of supplier issues at an early stage. Franchisors will typically wish to have the right to designate or approve suppliers or sources of products and services, but should not insist that the arrangements be the same as in the franchisor’s domestic operations if local suppliers or sources are available. The more practical approach is for the franchisor to provide standards and specifications to the franchisee which the franchisee must adhere to. The franchisor may have a right to inspect and monitor the suppliers’ premises and facilities, to receive samples for testing purposes and to change or disapprove of an approved supplier or source of supply. arrangements. These are all realistic business arrangements.

Dispute Resolution 
Finally, the subject of dispute resolution always needs to be addressed in a realistic manner. Neither party wants to be involved in lengthy and costly judicial or litigious proceedings. A practical approach in international franchising is that the first step in attempting to resolve any dispute should be the requirement that there be discussions and meetings of the chief executive officers of the parties as a prerequisite to the initiation of dispute-resolution proceedings. If the parties cannot resolve the dispute by such means, then the agreement could specify that third-party mediation be undertaken.

If neither of these dispute resolutions produces an acceptable result for both parties, the agreement may provide for international arbitration rather than litigation.

Governing Law 
With respect to choice of governing law, a franchisor will typically wish to have as the governing law of the agreement the law of its home country. The franchisee, not unexpectedly, will wish to have the law of the target country. Generally, unless there are some specific political or jurisdictional reasons why the governing law of the franchisee’s target country should not apply, the governing law provision should favour the laws of the target country since remedies will have to be sought before the courts of the target country. Franchisors that insist that the governing law of their home jurisdiction apply in international franchise arrangements are not only unrealistic, but impractical in taking such an approach.

In a similar manner, the agreement must address a realistic choice of forum clause. The franchisor may wish to designate the forum for dispute resolution as being in the franchisor’s home country, while the franchisee will wish to designate the forum as being within the target country. One solution which is sometimes used is to provide that the courts of the jurisdiction of the party that does not initiate legal proceedings be used as the choice of forum. While this may not necessarily lead to a practical result, it does impose a substantial obstacle on the party wishing to initiate legal proceedings. Another possible solution is to confer concurrent jurisdiction on the courts of both the domicile of the franchisor and the franchisee. A third, but somewhat less practical approach is to confer exclusive jurisdiction of the courts of a neutral country.

Keep It Realistic 
The examples discussed above are only some of the more common issues which are negotiated in almost all international franchise arrangements. Each one is complex and involves serious economic, business and legal considerations for both parties. There are many other issues which will be encountered in most international franchise arrangements. What may be the most desirable approach for one party will often be the least desirable approach for the other. Therefore, it is critical that both parties be understanding, practical and reasonable in their demands, negotiations and ultimate arrangements. As is often stated by both franchisor and franchisee in an international franchise arrangement, and their respective advisors, if both parties feel that they achieved some degree of recognition of their respective positions on issues most important to them, but at the same time yielded in a similar manner on the issues most important to the other party, the arrangement will likely have the best chance of success. And that, of course, is exactly what both parties hope for in the first instance.

Intellectual Property Issues in Franchising

Q&A with Frank Zaid

This article was originally published in the Canadian Business Franchise Magazine on April 18, 2017.

Q: What issues are being raised in today’s Canadian franchise agreements and disclosure documents with regard to intellectual property?

Historically, the term ‘intellectual property’ referred to statutory patents, trademarks, industrial designs and copyrights. With the fast-changing world of the Internet and social media, however, the term has become much broader in its relevance to the operation of franchise systems. As a result, references to intellectual property in franchise agreements and disclosure documents need to be reviewed and revised, both to protect the interests of franchisors and to ensure full disclosure to franchisees.

For a baseline example, one can refer to the disclosure requirements of Canada’s most recently enacted franchise legislation: British Columbia’s Franchises Act, which came into force on Feb. 1, 2017. As in other provinces that have enacted franchise legislation, the act requires franchisors to provide disclosure documents—containing specifically prescribed information—to prospective franchisees within a certain period.

One of the disclosure items prescribed in British Columbia, like most other regulated provinces, relates to ‘trademarks and other proprietary rights.’ Specifically, the disclosure document must contain a description of the rights the franchisor has to the trademark, trade name, logo, advertising or other commercial symbols associated with the franchise system. This type of disclosure seems to focus on brand identification, rather than to intellectual property rights by either a traditional or contemporary definition.

A disclosure document in the regulated provinces must also contain a description of all ‘material facts,’ which in British Columbia (and most of the other provinces) would include any information about the franchisor’s business, operations, capital, control and system that would reasonably be expected to have a significant effect on the price or value of the franchise to be granted and, for that matter, the franchisee’s decision to acquire
the franchise.

Issues to address
Thus, the term ‘material facts’ is very broad, requiring a comprehensive review of all background information relating to a franchise system. Since many aspects of intellectual property relate to the franchise and are indeed relevant to its value for the prospective franchisee, the inclusion of a high degree of disclosure about the rights to intellectual property may be legally required in the disclosure document.

Some or all of the following issues, for example, could turn out to be relevant:

  • What specific trademarks and trade names are used in association with the franchise?
  • Have applications been filed to officially register those trademarks?
  • If so, what is the status of these applications? Have they been allowed? Are the trademarks already registered?
  • In which specific countries has the franchisor filed applications for registration of its trademarks and what is the status of each?
  • Is the franchisor aware of any possible obstacles to obtaining registration, such as use of the same or similar trademarks by unrelated third parties?
  • Are there any known threatened or pending legal or regulatory proceedings regulating to
    the trademarks?
  • Does the franchisor reserve the right to amend, modify or otherwise change its trademarks or introduce new ones and, if so, what are the obligations for the franchisee in such events?
  • Can the franchisor require the franchisee to stop using earlier trademarks or trade names when new ones are being introduced?
  • Does the franchisor provide an indemnity to the franchisee with respect to the franchisee’s use of its trademarks or trade names?
  • What are the obligations of the franchisee if he/she becomes aware of a possible infringement or unauthorized use by a third party of the trademarks or trade names?
  • What are the requirements of the franchisee in respect of his/her own use of the trademarks or trade names?
  • Can the franchisee use the trademarks as part of its corporate business name?
  • Are there specific graphic standards regarding
    how the franchisee can use the trademarks or trade names?
  • Can the franchisee enter contracts with its suppliers or customers using the trademarks or trade names?
  • Can the franchisee continue to use the trademarks or trade names if his/her franchise agreement expires or is terminated?

Visual materials
As mentioned, trademarks and trade names are not the only types of intellectual property that legally require disclosure. Logos, advertising and commercial symbols associated with the franchisor must be disclosed, too.

Logos are fairly easy to understand. They generally take the form of artistic renderings of designs representing trademarks or trade names. As such, the issues regarding logos are similar to those listed above for trademarks and trade names.

Advertising may be a less clear-cut concept, but there should be a separate disclosure item regarding how it is undertaken in general. It is common for franchisees to pay into a centralized ad fund for national or regional campaigns, but they might also access some of the same materials for local advertising on their own accord, with the franchisor’s approval.

‘Commercial symbols’ is a much less common term, referring to certain types of renderings and drawings that are not strictly logos, but are directly associated with the franchise system and, as such, must be disclosed.

Undisclosed intellectual property
The other core types of intellectual property include patents, industrial designs and copyrights, but none of the regulated provinces currently address these in their franchise legislation.

Interestingly, in 2005, the Uniform Law Conference of Canada (ULCC) developed and adopted a ‘Uniform Franchises Act,’ for the purpose of suggesting a model regulatory regime for use across Canada. (At the time, only Alberta and Ontario had legislation in force that directly regulated franchising.) The model regulation included considerably expanded disclosure regarding intellectual property, including descriptions of the following:

  • Any patents, copyrights and proprietary information and rights associated with
    the franchise.
  • The status of those items.
  • The franchisor’s right to modify or discontinue
    their use.
  • Any known impediments to their use.
  • Any known or alleged material infringements
    of them.

More than 10 years later, British Columbia’s new franchise legislation does not involve a more inclusive disclosure requirement with regard to intellectual property. Nevertheless, if a franchisor has applied for or obtained patents for certain proprietary products or services that are fundamental to its franchise system, then those would most likely be legally considered material facts that should be disclosed. The same issues could apply to copyrights or industrial designs, which are also essential components of franchise systems.

As such, franchisors should pay careful attention to the preparation of their franchise agreements and disclosure documents in relation to all forms of intellectual property that are important to the operations of their businesses. And in turn, any franchisees who feel they have suffered a loss due to inadequate or incomplete disclosure should consider their associated legal rights to all of the material facts.

20 Years of Canadian Business Franchise

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?

Frank says:
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.

Class actions
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.

Franchising today
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.

 

Know the Difference with U.S. Franchisors

Originally published in Canadian Business Franchise magazine on January 10, 2012

Q: I am thinking of acquiring a franchise from a U.S. franchisor with no Canadian offices, employees or operations. Are there any specific considerations I should take into account in this scenario?

A: Canada has long been the first choice for international expansion by many U.S. franchisors. Although there are many similarities between the two countries, there are also significant differences. Quite frequently, Canadian adaptations of U.S. franchise documents do not reflect these differences.

There are a number of points of concern you must review in your franchise agreement before proceeding with this type of purchase. Here are some of the most common:

Legal structure of the franchisor
A U.S. franchisor may directly offer Canadian franchises from the same entity that offers U.S. franchises. This is most desirable, since the U.S. franchisor has an established revenue stream and asset base.

However, many U.S. franchisors incorporate a Canadian subsidiary or, depending on tax considerations, a U.S. subsidiary, to conduct Canadian franchise operations. This insulates the franchisor’s U.S. assets and revenue stream from any problems or losses that may arise in Canada. The subsidiary, however, will have limited assets and revenue, making it more difficult for you to seek damages in the event of a dispute. If the franchisor is very anxious to sell to you, you could ask for a guarantee of performance of the Canadian franchisor by its parent company in the U.S.

Tax obligations
As a Canadian franchisee, you have certain obligations under the Income Tax Act, but most U.S. franchisors do not carry on business or have a permanent establishment in Canada. As a result, you must withhold tax, generally at the rate of 10 per cent, on certain types of payments to a U.S.-based franchisor. Payments normally subject to withholding include initial franchise fees, royalties, interest and rent. Payments for actual services rendered, supplies and inventory are not subject to withholding tax.

If you fail to withhold the required taxes and remit them to the Canada Revenue Agency on the franchisor’s behalf, you will be personally liable for the amount not properly withheld. Many U.S. franchisors (and Canadian franchisees) are unaware of these requirements.

Trademark protection
Virtually every franchise system has a strong identification with one or more trademarks used in association with the goods or services associated with the franchise system. Many U.S. franchisors mistakenly believe acquiring trademark protection in their country will protect them in Canada.

In actuality, these franchisors must apply for and register trademarks in Canada in order to grant valid and enforceable rights to franchisees to use them in Canada. Even if trademarks are properly registered, the registrations may not be valid if the marks are not properly licensed to the franchisees. You need to ensure your prospective franchisor has taken all necessary and appropriate steps to register its trademarks in Canada, and that your franchise agreement gives you the right to use them.

Another trademark-related concern is that some terms commonly used in the U.S. either have no meaning or different spelling in Canada. In the U.S., the term ‘service marks’ is used in association with services, while trademarks refer to products. In Canada, the term trademark is used for both products and services. Also, in legal documents, the Canadian spelling is ‘trade-mark,’ while the U.S. spelling is ‘trademark.’

Non-competition clauses
Canadian and U.S. franchise agreements often contain very different non-competition covenants, which prevent you from competing with the franchisor both during and after the term of your agreement. Under Canadian law, non-competition covenants are valid if they are reasonable, both between the parties and in the public interest. To be deemed reasonable, the covenant must protect a proprietary interest of the franchisor, but must not be broader in geographical area, time or scope than is necessary to protect these interests.

In the U.S., non-competition covenants tend to be much broader, often restricting competition by a franchisee “in a competing business” or in respect of “products or services similar to those associated with the franchise system.” These covenants are usually unenforceable in Canada because they are generally considered too broad to protect the franchisor’s legitimate business interest and unfairly restrict your economic freedom.

In this case, however, you may not object to these differences. Failure to modify the non-competition covenant will work in your favour should you ever need to challenge the covenant’s enforceability.

Choice of law provisions
U.S. franchise agreements often state the law of the franchisor’s home state will apply, and will attempt to grant the courts of that state exclusive jurisdiction over matters in dispute under the franchise agreement. However, in provinces where franchise legislation has been enacted, the law requires any disputes over your rights must be determined in accordance with the provincial law and be conducted in that province.

If the franchise agreement requires that U.S. law governs, or that disputes be conducted in a state court, you should not only object based on applicable franchise legislation, but on the basis that it is impractical for a Canadian franchise agreement to be governed by foreign law, and unfair for you to be required to appear in a foreign court over on a dispute relating to your Canadian franchise business.

Interest rates
Some U.S. franchise agreements provide that interest rates on overdue amounts be the “maximum interest rate allowed by law.” In Canada, this concept does not generally exist, except when interest rates in excess of 60 per cent are charged. Also, unless the rate is specifically disclosed as an effective annual interest rate, the franchisor will only be entitled to the rate of interest set by Canadian federal law, which is presently five per cent. If you are faced with a U.S. interest rate clause, you should insist your agreement clearly specify the actual rate of interest being charged, disclosed on an effective annual rate.

Privacy issues
Canadian privacy law can affect many aspects of your franchise business, and will differ from U.S. practices. For example, you must obtain consent from your customers before collecting, using or disclosing their personal information to your franchisor. Provisions requiring you to share this data with your franchisor will put you in breach of privacy legislation if consent is not obtained; as such, you must resist these clauses.

Franchise manuals
Almost all franchise systems make reference to policy and procedures manuals as the instruments through which franchise system standards, specifications and procedures are established. However, U.S. manuals will inevitably contain chapters dealing with certain laws, practices or customs relevant south of the border. You should always ensure that any manuals referred to in the franchise agreement or made available to you have been modified to comply with Canadian legislation, customs and practices.

Advertising funds
If you are required to contribute to a national advertising fund, you should determine whether a separate fund is being maintained for Canadian franchisees, and ensure the franchise agreement confirms that your contributions will be spent in Canada. If advertising payments are made to a U.S.-based advertising fund and combined with contributions from U.S. franchisees, you may not get a proportionate benefit. For example, national advertising placed on U.S. TV networks will be blocked on Canadian cable stations and replaced by Canadian ads. You must insist on advertising adapted for use and direction to the Canadian marketplace.

Product labels
If your prospective franchise system involves the sale of pre-packaged products, these products must comply with the federal Consumer Packaging and Labelling Act. This legislation specifies certain information be included (in English and French) on all pre-packaged products including:

  • standardized container sizes, warnings and information symbols;
  • metric product quantities;
  • the name and address of the importer; and
  • the country of manufacture.

You must be certain that any prepackaged products supplied by the franchisor are compliant with the legislation in order to sell them to Canadian consumers.

Regulated industries
Finally, if your prospective franchise involves a regulated industry, there will likely be considerable differences between U.S. and Canadian regulatory requirements. For example, real estate brokerages, personnel and employment agencies, professional services, pharmacies, travel agencies and health care systems are all subject to specific Canadian regulations. You must be aware of any professional accreditations, licences or permits you need to run these types of businesses in Canada. U.S. franchisors will frequently not have researched these issues.

Know the differences
In summary, while opportunities abound for Canadian franchisees to become a part of, or even establish a Canadian presence for, U.S. franchisors, you must always be aware that franchising in Canada and the U.S. differ in many respects. You must do as much research as possible, get appropriate legal, accounting and tax advice, and ensure your prospective franchisor has made the necessary and appropriate changes to its system to make it workable and compliant with Canadian standards, customs and legal requirements.