Franchising and Automobile Dealers

Franchising and Automobile Dealers

QUESTION:  From last month’s article in Canadian Business Franchise Magazine, it appears well settled that automobile dealers are considered franchisees under provincial franchise legislation.  As a result, they and their automobile manufacturers are subject to the rights and obligations under the legislation, including the right of franchisees to associate, the obligation of a franchisor to deliver a disclosure document, the obligation of both parties to comply with the duty of good faith and fair dealing, and the right of both parties to invoke normal court procedures to resolve disputes under the legislation. 

However, are there special procedures available for automotive dealers and manufacturers to resolve their disputes outside of the usual court process, whether such disputes involve rights or obligations under franchise legislation or contractual disputes under dealer-manufacturer agreements?

ANSWER:  Yes, automotive manufacturers and dealers established a specific program in 1997 known as the National Automobile Dealer Arbitration Program, or NADAP, to provide an expeditious, impartial and less expensive means of resolving disputes that arise from time-to-time between manufacturers and retail dealers. The program outlines specific rules and procedures for such disputes to be submitted to private arbitration.

The program has been reviewed by the manufacturers and dealers and revised every 5 years in 2002, 2007 and 2012.  The program handles roughly ten cases a year, which is a testimony to the constructive and cooperative working relationship between most manufacturers and their franchised new car dealers.

ADR Chambers, a professional, independent arbitration and mediation firm in Toronto administers NADAP on behalf of the manufacturers and dealers.

The purpose of NADAP is to settle any of the following disputes between a manufacturer and its dealers involving:

  • The interpretation/application of the franchise agreement, generally called a Dealer Sales and Service Agreement (“DSSA”) in the automotive industry, for that dealer.
  • The termination of the agreement based on a dealer or dealer employee conviction that will hurt the manufacturer’s or dealer’s reputation or interest.
  • The reasonableness of the length of a cure period provided by the manufacturer in light of the dealer deficiencies to be cured.
  • A refusal of the manufacturer to reasonably provide prior approval to a dealer’s request to sell or transfer by succession the dealership interest including:
    • The reasonableness of the manufacturers conditions and written standards, and any specific requirements set for that new dealer, and if so, whether the new dealer meets them;
    • Whether the new dealer is unwilling to be bound by the terms of the existing agreement;
    • Whether the dealer or new dealer fails to cure an existing dealer default;
    • Whether the demographic or economic factors set by the manufacturer for the continued operation of the dealership by the proposed successor, are reasonable. If so, the dealer can continue to operate the dealership or can the manufacturer close the dealer-point until economic or demographic factors support its re-opening.
  • Failure of the manufacturer to approve the sale or transfer of the dealer interest where the dealer can show that the manufacturer knew for a considerable time that the sale or transfer had occurred.
  • The termination of the dealer agreement based on the adequacy of the dealer’s line of credit/working capital.
  • Whether a dealer owes money to a manufacturer, or vice versa, and the length of time for payment. Where a dealer’s failure to pay funds is grounds for termination of the agreement, the agreement can be terminated. If the termination is set aside, and the arbitrator finds that the dealer owes funds to the manufacturer, the dealer must pay the funds to be reinstated as a dealer.
  • The termination of the agreement for failure to resume dealership operations within a reasonable time following its closure for more than 7 days where the closure was beyond the dealer’s control.
  • The proposed appointment of a new abutting dealer-point or relocating of an existing dealer.
  • The manufacturer’s termination, refusal to renew or extend, without cause the dealer agreement including the awarding of damages by the arbitrator for such wrongful termination or refusal.

These types of disputes are primarily disputes under the DSSA, and do not involve rights or obligations under provincial franchise legislation.  Accordingly, they would ordinarily proceed to court as regular civil suits governed by normal court procedures, resulting in substantial costs, time delays and uncertainty.  NADAP allows a much more defined and speedy process with a high success rate.  In fact, over 70% of the disputes are resolved by mediation, usually within 30 -60 days and at minimal cost, without any steps in arbitration.

Some of the highlights of NADAP include the following:

  • There is an administrator with the power to appoint arbitrators
  • The arbitrators are part of a fixed panel and thereby develop specific subject-matter expertise
  • The procedures are fast and follow a complex track
  • Mediation is available within 15 days
  • The quick procedure results in little need for interim relief like injunctions, resulting in substantial savings to the parties
  • There are rights of appeal to three arbitrators
  • The average length of a dispute to final resolution is 5 months
  • Most cases can be resolved in less than 60 days
  • The process defines specific issues and standards for certain disputes.

The NADAP Statement of Principles can be found at: http://www.globalautomakers.ca/files/Nadap%20Dispute%20Resolution%20Rules%20-%20Eng.pdf, and the NADAP Rules can be found at: http://www.globalautomakers.ca/files/Nadap%20Dispute%20Resolution%20Rules%20-%20Eng.pdf.

The history of NADAP and its evolvement over time is interesting.  When the program was first launched in 1997, almost 95 per cent of Canadian dealers signed implementation agreements with their manufacturers that committed them to NADAP for an initial five-year term during which neither the dealer nor the manufacturer could terminate its application to them. The parties agreed, however, to review the program every five years to ensure the program functioned as it was intended to.  The parties involved are the Canadian Automotive  Dealers’ Association (CADA) and original equipment manufacturers  represented by the Canadian Vehicle Manufacturers’ Association (CVMA) and the Association of International Automobile Manufacturers of Canada (AIAMC).

The first review in 2002 resulted in enhancements to the program, as did a second review in 2007.  For the 2012 review, CADA created a committee made up of dealers, CADA provincial association representatives and CADA staff who met regularly to determine whether the program continued to meet dealers’ needs. Dealers were also surveyed for their input, and the committee studied the results of disputes that went to mediation and arbitration.

After reviewing the program and other comparable provincial and U.S. state franchise laws, the committee recommended a renewal of the NADAP program, but with some suggested enhancements. These included:

1 ) Ensuring NADAP is offered to all dealers by getting a letter from the manufacturer associations committing to this principle and altering language in the NADAP Principles to enshrine it;

2 ) Ensuring CADA got an updated list of all dealers signed onto NADAP,  an issue that has caused uncertainty amongst dealers particularly when they are contemplating using the program;

3 ) Ensuring ADR Chambers, the body responsible for mediating and arbitrating NADAP proceedings, knows which cases have been made public;

4 ) Extending the notice period that a party must provide to the other that a NADAP decision will be made public from 48 hours to 5 days;

5 ) Resolving a cost award language ambiguity; 

6 ) Reviewing the arbitration appeal process and standard to ensure it is still appropriate for the program and following this review agreeing to make no changes to the arbitration appeal process and standard;

7 ) Ensuring that the French rules translation better reflect the English text;

8 ) Further review that any settlement agreement parties enter into does not truncate a party’s right to use NADAP by discussing the insertion of clarification language in the NADAP Principles;

9 ) Reviewing the timeline for bringing a complaint and initiating arbitration and agreeing to make no changes.

For the most part, dealers are fortunate to have NADAP available to them as complaints that a dealer can make under NADAP are not available in contract or common law to dealers in other industries.  There are circumstances in which a dealer can actually challenge the reasonableness of provisions in a dealer agreement which dealers in other industries cannot.

Despite the sophistication of NADAP and its fairly long history, certain disputes (often highly publicized) have resulted in a conflict between the application  of the NADAP Principles and Rules and the normal judicial litigation process.

What follows is a discussion of three such cases in different jurisdictions.

In a 2010 decision of the Ontario Superior Court of Justice, 21 dealers from across the country brought a multi-party action against General Motors of Canada Limited (“GMCL”) in Toronto for specific performance of their DSSA’s. The dealers had been given notice by GMCL in May 2009 that their agreements would not be renewed at the expiry of the current term. The dealers relied on a provision of the agreement which “assured them of the opportunity to enter into a new agreement” at the expiry of the current five-year term provided they were not in default of any provisions of their existing agreement. GMCL’s position was that it had the right under another provision of the DSSA to control its dealer network.

Most of the plaintiffs had signed agreements agreeing to resolve any disputes including non-renewal or termination of their dealer agreements in private one-on-one industry arbitration under the NADAP Rules. GMCL brought a motion to stay the dealers’ group action on the basis of the arbitration agreement. Alternatively, GMCL took the position that the dealers’ claims had been improperly joined under ordinary court rules and should be severed.

The NADAP Rules state that class, multi-party or representative claims are non-arbitrable, and ultimately the court held that the multi-party action was not subject to arbitration. The court found in fact that the NADAP Rules’ preservation of the dealers’ right to advance a class action, multi-party or representative action against GMCL reflected the dealers’ right to associate under Ontario’s franchise legislation. 

It should be noted that the NADAP Rules do provide that an arbitrator has the power to join one arbitral proceeding with another arbitral proceeding but only after each dealer has commenced the arbitration process separately by filing its own request for mediation.

The Stoneleigh case is an illustration of the court’s concern for access to justice as a driver of collective action. The court was heavily influenced by the “litigation realities” of small businesses across the country litigating against a large and powerful franchisor. Further, the court was persuaded by the dealers’ evidence (which was not opposed) that they lacked the informational, economic and human resources to litigate individually against GMCL. Although the court denied GMCL’s motion to stay, the court did recognize that one action with so many plaintiffs would be somewhat cumbersome and that effective trial management by the court would be required. But in the court’s opinion, the alternative of so many separate actions would not promote the convenient administration of justice.

Although not a class action, the dealers in fact presented the case in many respects as a class action. The court emphasized the existence of core questions of fact and law common to all of the plaintiffs’ claims. Of particular significance was the fact that both the claim and the defence were premised on single uniform provisions of the DSSA which were identical to all plaintiffs. In deciding that the plaintiffs’ claims should not be severed, the court made the point of indicating that it should not be taken as accepting the plaintiffs’ proposed procedure nor their proposal to treat the evidence of some of the plaintiffs as evidence of all. The court stated that procedural issues would be properly addressed at a judicial case conference.

In a 2011 case before  the Quebec Court of Appeal, the court provided guidance with respect to an important issue in the law of arbitration in Quebec, outlining that a future potential need for injunctive relief amounted to insufficient justification to find that an arbitrator lacked jurisdiction. As in Stoneleigh, GMCL formally advised the dealer that it would not be renewing the DSSA. The DSSA encouraged the parties to adhere to NADAP and, in fact, following the conclusion of the DSSA, both GM and the dealer agreed that any future disputes would be resolved by way of arbitration undertaken pursuant to NADAP. NADAP provided that GMCL was to launch an internal management review, following an initial request by a dealer; thereafter, if GMCL maintained its position, the dealer could initiate mediation proceedings, followed by arbitration proceedings, if necessary.

When GMCL informed the dealer that it would not renew the DSSA, the dealer immediately availed itself of NADAP and on the same day requested a management review. Subsequently, the dealer advised GMCL that it would no longer be adhering to NADAP.  Thereafter, following its management review, GMCL advised the dealer that it was maintaining its initial decision, and the DSSA would not be renewed.

The dealer then  initiated proceedings before the Quebec Superior Court, requesting that the court issue a safeguard order to maintain the contract and allow the dealership to remain open until a decision on the merits was rendered. GMCL objected to the Superior Court's jurisdiction on the basis that NADAP arbitration was the proper forum for the dispute.  The court agreed with GMCL and ruled that the parties had first to avail themselves of NADAP.  The dealer then appealed to the Quebec Court of Appeal.

The dealer based its appeal on two grounds:

  • The purview of the arbitration provisions in the contract - recourse to arbitration under the contract was optional; the nature of the dispute was not within the purview of NADAP; and because the dealer had rescinded its adherence to NADAP, it could seek court intervention so as to obtain relief; and
  • The jurisdiction of the arbitrator in relation to injunctions - pursuant to Quebec law, only the Superior Court, as opposed to arbitrators, has the power to award injunctive relief.

The Quebec Court of Appeal maintained the lower court ruling and held that in light of the undertaking to arbitrate, the dealer had to carry out NADAP arbitral proceedings so as to obtain relief.

The dealer argued that the undertaking to arbitrate was neither valid nor conclusive because the agreement outlined that should a dispute arise, the parties could have recourse to either arbitration or judicial proceedings. The court dismissed this argument because when a party entered into a franchise contract with GMCL, adherence to NADAP was encouraged, but not obligatory; thus, it was logical that the agreement outlined possible recourse to both judicial and arbitral proceedings. However, in this case, since the parties elected to rely on NADAP, the reference to judicial proceedings in the agreement could be discounted and the undertaking to arbitrate was both valid and conclusive.

Furthermore, the court of appeal also found that the nature of the dispute fell within the purview of  NADAP which specifically outlined that the decision by GMCL not to renew a franchise agreement was arbitrable. In an attempt to demonstrate that the dispute was not arbitrable, the dealer also set forth two arguments in relation to the fact that:

  • another dealer was also a party to the dealer’s claim against GMCL, giving rise to possible class proceedings; and
  • GMCL's decision not to renew the contract was a direct result of its decision to discontinue the Pontiac line of cars.

However, the court dismissed both of these arguments because it found that the English version of the contract provided a restrictive interpretation of what amounted to a 'class action' and the proceedings submitted by the dealer made no mention of GMCL's decision to discontinue the Pontiac line-up as the basis for its claim.

Finally, the dealer had also claimed that its notice informing GMCL that it would no longer be adhering to NADAP precluded the dispute from arbitration.  However, the court ruled that when the dealer initiated the management review, the dispute had crystallised and the dealer could not thereafter attempt to rescind its adherence to NADAP once the dispute resolution procedure had been initiated.

After citing several Supreme Court of Canada cases which affirmed that the granting of injunctive relief in Quebec was the sole jurisdiction of the Superior Court, the court of appeal concluded that the dealer’s attempt to seek injunctive relief was at this point premature.

The court found that the NADAP Rules granted the arbitrator the capacity to ensure specific performance of the agreement; thus, the parties had already agreed that if an arbitrator concluded that GMCL had failed to renew the agreement, the arbitrator could then issue an order so as to force GMCL to implement the appropriate action. The court then pointed out that orders for specific performance were not automatically forms of injunctive relief.  Rather, the dealer’s need for injunctive relief would arise only after an arbitrator's order for GMCL to renew the agreement was followed by GMCL's failure to respect this order. Consequently, the court dismissed the dealer’s appeal and the parties were required to undertake arbitration proceedings pursuant to NADAP.

The case illustrates the substantial importance of the parties' contractual intentions and reinforces that when an undertaking to arbitrate is both valid and conclusive, the Quebec courts will strive to ensure not only that the parties' intention receives full merit, but also that arbitral proceedings should be allowed to proceed without unnecessary recourse or intervention by the courts. Had the court followed the dealer’s line of reasoning, it would have possibly allowed the claimants to undermine their earlier choice of arbitral proceedings and seek specific performance by way of court intervention, under the guise of injunctive relief.

In a 2012 case before the Alberta Court of Queen’s Bench, a Chrysler dealer brought a motion for an order granting an interlocutory injunction preventing the defendant Chrysler Canada Inc. from permitting or approving the placement of a new automotive dealership proposed by another dealer group and prohibiting the group from taking any further steps with respect to the proposed new dealership pending trial. 

There were currently seven Chrysler dealerships in Calgary, one of which is the plaintiff.  Chrysler proposed an eighth dealership essentially located in the middle of the dealer’s existing trade zone. The dealer argued that establishing the proposed dealership in this area would essentially eliminate any business from the surrounding affluent communities and that such actions were in breach of Chrysler's obligation to conduct its dealings with the dealer in good faith.

The sole issue to be determined in the case was whether the dealer should be granted an interlocutory injunction.  The dealer alleged that in granting the proposed dealership Chrysler failed to exercise good faith, as required under contract, statute and common law and would cause the dealer to suffer economic loss. It submitted that an injunction was necessary before trial.

Chrysler argued that there was no serious issue to be tried, given the contractual rights afforded under the DSSA and NADAP. It submitted that Chrysler was well within contractual its rights to establish the proposed dealership and that there was no evidence of bad faith. The proposed dealership was approximately 12 kilometers from the plaintiff’s dealership and NADAP only created a limited right of dealers to challenge the creation of a new dealership where it is less than 8 kilometers from an existing dealership.

Chrysler submitted that it is critical to the success of its business that it has the right to determine the size and structure of its dealerships and that this right is expressly preserved in the DSSA and NADAP. It argued that its only motivation was to address the market need for an additional dealership to service the requirements of the expanding population.

The dealer argued that it had plainly established that a serious issue exists to be tried, namely, whether Chrysler had failed to deal with it in good faith. It stated that this duty exists under contract, relevant legislation and at common law.  NADAP requires the parties to interpret the DSSA in good faith and to exercise any discretionary rights contained in the DSSA in good faith  as defined in NADAP.

However, the DSSA stated that its terms shall be governed by the laws of Ontario. The court noted that Ontario and Alberta have almost identical legislation governing franchises. Each statute states that every franchise agreement imposes on each party a duty of fair dealing in its performance and enforcement, and the duty of fair dealing includes the duty to act in good faith and in accordance with reasonable commercial standards, and that the provisions of good faith cannot be waived.

The dealer submitted that the duty to act in good faith can be breached when one party to an agreement substantially nullifies the bargained objective or acts in a manner which is inconsistent with the reasonable expectations of the parties. The dealer took the position that the establishment of the proposed dealership nullifies the objective of its agreement with Chrysler, and is inconsistent with the expectations of the parties. While the dealer acknowledged that the proposed dealership was outside of the eight kilometre radius established under NADAP, it contended that given the fact that it is located in a largely industrial area the eight kilometre boundary is inappropriate as it will leave the dealer with very little residential market.  The dealer alleged that Chrysler failed to act in good faith and with due regard of its interest as franchisee.

The court found that the dealer had established the existence of a serious issue to be tried visavis Chrysler. Simply because the DSSA grants Chrysler the right to determine the number and location of its dealerships, it is not relieved of its obligation to act in good faith. The dealer had demonstrated that it has an argument that mere compliance with contractual terms does not mean that there has not been a breach of the duty of good faith. An argument also exists as to whether Chrysler was obligated to  and did  consider any interests other than its own.

The dealer raised a viable argument that it is not limited from challenging the proposed location simply because it is outside of the eight kilometre zone. It submitted that an issue exists as to whether NADAP simply provides an express ability to challenge within the zone, as opposed to operating as an exclusionary rule. Moreover, the DSSA does not provide a similar restriction. In these circumstances, there is a good argument that the location of the proposed dealership is seriously problematic and the granting of Chrysler’s approval was not made in good faith.

The court acknowledged that while the risk of financial harm would not actually materialize until the opening of the proposed dealership, the court did not think the fact that the opening is not imminent must be fatal to this application.  The test is whether the dealer will likely suffer an irreparable harm; the timing of the harm is not necessarily determinative.  The court stated that it may not be possible to have the ultimate issues determined by a trial court prior to the proposed dealership becoming operational.

Finally, the court had to consider determine which of the parties will suffer a greater harm from the granting or the refusal to grant an interlocutory injunction.

After examining the harm that each party submitted it will suffer from either the granting or the refusal to grant an interim injunction, the court was persuaded that the dealer would suffer the greater harm. While Chrysler may suffer an inconvenience caused by delay in pursuing the project, which may result in an overall short term loss of a potential expansion of market share and connected profit, this is not as detrimental as the risk of harm facing the dealer.

The court awarded an order granting an interlocutory injunction prohibiting  Chrysler from permitting or approving the placement of a new franchise automobile dealership at the proposed location, and directing that no further steps be taken to effect the proposed dealership pending a final determination in the action.

The decision is very important as it establishes that a court will apply the duty of fair dealing to circumvent a NADAP Principle which by its very wording is permissive but not exclusionary.

From these cases, it is quite apparent that the courts will pay significant respect to NADAP when faced with an alleged conflict between NADAP and the judicial process.  Automotive dealers or manufacturers who choose to resort to judicial proceedings when NADAP has been agreed to face the likely prospect of being rejected by the courts and forced back into the very procedures to which they originally agreed.

NADAP is a clear example of a successful alternate dispute resolution program that has been adopted by a particular franchise industry segment to streamline the resolution of disputes and save the parties time, money and possible maintenance of the franchise relationship.  Other industries where there is a franchise relationship would be well advised to consider  the NADAP model in establishing their own alternate dispute resolution programs to achieve the same purposes.  These could include any one or a combination of the well accepted alternate dispute resolution models – private franchise system ombudsman program, mediation and arbitration.

Legal Issues and Franchise Legislation

Originally published in the Canadian Franchise Business Magazine on August 25, 2014.

By Frank Zaid
Q:
 What key legal issues were left uncertain when franchise legislation was introduced in Alberta, Manitoba, Ontario, New Brunswick and Prince Edward Island, but have since been considered by the courts?

A: Several issues have very significant implications for franchisees, in particular, but also for franchisors, whose liability in certain circumstances has been unclear. Two cases that have recently been considered in Ontario courts, for example, have shed some light on issues and will allow for greater certainty in the future.

Release and waiver clauses
For many years, it was common practice for franchisors to insist their franchisees waive any claims they may have against the franchisor when renewing or assigning their franchise agreements. The reasoning was simple—no franchisor wanted to carry on a business relationship with a franchisee who is suing (or threatening to sue) the franchisor. Further, no franchisor wanted to allow a franchisee to transfer or sell a franchise and then sue or threaten to sue the franchisor.

This practice may well be continuing today, but Section 11 of Ontario’s Arthur Wishart (Franchise Disclosure, 2000) Act—which is typical of the provisions in all provincial franchise laws—states any such waiver or release by a franchisee of a right given under the legislation or of an obligation or requirement imposed on a franchisor under the legislation is void. The problem with this provision is it refers only to rights and obligations under the legislation and not to other rights or obligations in common law or under franchise agreements generally.

In a recent case, a franchisee wanted to assign and transfer the franchise agreement to a new franchisee, but the agreement required a comprehensive general release, in the form to be specified by the franchisor, of any claims against the franchisor as a condition of the franchisor consenting to the assignment. The franchisee asked the Ontario Superior Court of Justice to declare this clause void and unenforceable.

The court did exactly that. It stated a general release included rights under Ontario’s legislation.

In response, the franchisor offered to qualify the release by excluding claims relating to rights under the statute, but the court pointed out this qualification was not in the franchise agreement and, therefore, it was too late to narrow the clause. To do so would allow for abuse, in that a franchisor could ‘wait and see’ if any objection was raised by the franchisee.

Further, the words “in the form specified by the franchisor” did not take the clause outside of the legislation. These words related to the form of release, not the substance.

The court stated the legislation is very broad and does not contemplate whether or not a clause in a franchise agreement that offends the non-waiver provision can be void or unenforceable only in part. Instead, the entire clause will be void and unenforceable.

The court made reference to several previous cases in which it had been determined a general release—or a release of rights or obligations under the legislation—would not be considered if made in the context of a settlement where there was a known, existing breach of the legislation and the franchisee has sought the advice of legal counsel.

However, what was not determined in this case is if a carefully crafted release which does not include a waiver or release of claims under the legislation will be enforceable if the form of release is specifically agreed to in and as part of the franchise agreement. (Indeed, this issue was not raised in the case; and in one earlier case where it was raised, a final determination of the point was not made by a court on a full hearing.)

So, it is still open for franchisors to try to obtain releases or waivers of contractual or equitable rights under common law; but if such a claim were mixed with, for example, a claim for breach of the duty of fair dealing under franchise legislation, then the issues would become overlapping and complicated and would need to be determined by a court.

In the meantime, franchisees can rest easy, as any clause in a franchise agreement waiving or releasing their rights or a franchisor’s obligations under franchise legislation, either directly or indirectly, will most likely be declared void and unenforceable by a court.

Also, all franchise legislation considers the ‘franchise agreement’ to include any other agreement entered in furtherance of it. Therefore, similar clauses in leases, subleases, guarantees, security agreements, software licences and other agreements or contracts entered as part of the franchise arrangement will also likely be void and unenforceable.

These provisions in franchise laws are being considered by the courts strictly and in accordance with the intent of the legislation, “to mitigate and alleviate the power imbalance that exists between franchisors and franchisees,” as reiterated by the court in this case.

Measuring damages for statutory rescissions
In another recent case, the Ontario Superior Court of Justice heard an action brought by a franchisee for losses and damages resulting from the rescission of a franchise agreement. Representations were made that the franchise, a restaurant, would be up and running by June 2012 for an expenditure of approximately $150,000. When the restaurant was still not open by October 2012 and the franchisee’s expenditures had exceeded $226,000, the franchisee rescinded the franchise agreement, based on the failure of the franchisor to comply with its disclosure obligations.

The plaintiff sought to establish the following losses and damages:

  1. Motor vehicle/transportation expenses.
  2. Salaries during setup of the operation.
  3. Cost of meals provided to suppliers and tradespeople through networking.
  4. Loss of profit while the restaurant was not operational.
  5. Damages for breach of duty of fair dealing.

The court stated the Wishart Act provides specific remedies in favour of a franchisee on rescission of an agreement based on the failure of the franchisor to provide proper disclosure. These remedies include: the return of any money paid to the franchisor; compensation for any inventory, equipment and supplies purchased pursuant to the franchise agreement, at the prices paid by the franchisee; and compensation for losses incurred in acquiring, setting up and operating the franchise.

The court accepted the calculations of losses for the motor vehicle expenses and salaries. No receipts or accounting details were provided for the meal expenditures, however, and without some evidence in support, there was no basis for those amounts claimed.

With respect to loss of profit, the court stated this claim appeared to be more appropriately compensable for misrepresentation under the act, i.e. where a franchisee suffers a loss because of a misrepresentation contained in the disclosure document or as a result of the franchisor’s failure to comply with disclosure requirements.

The act specifically provides for certain payments to be made to the franchisee within 60 days of the effective date of rescission. It also clearly provides if a franchisee suffers a loss as a result of a franchisor’s failure to comply in any way with the disclosure requirements, then the franchisee has a right of action for damages. And in circumstances where a franchisor fails to make the payments required, the damages could include such amounts.

The court stated the loss of profits is recoverable, if a sufficient evidentiary basis has been provided for the court to make an informed determination of the potential loss. In this particular case, there was non-compliance with the disclosure requirements of the act because the restaurant was not up and running in June 2012, as promised, nor even before October 2012.

The court was satisfied the franchisee’s evidence of the loss of potential profits—based on the pro forma calculations provided and representations made by the franchisor—was reasonable and provided a sufficient basis to award damages in the amount claimed.

The last area where the franchisee sought damages was with respect to the franchisor’s breach of its duty of fair dealing in the performance of the franchise agreement. Under the act, the franchisor owed a statutory duty to act in a commercially reasonable manner in respect of its performance and in enforcement of the agreement.

The defendant’s representations to the plaintiff with respect to the anticipated cost of opening the franchise, the size of the restaurant, the ability to sell the business in six months for $400,000 and the failure to provide adequate architectural drawings, menus, signage and training were sufficient to establish bad faith by the franchisor and failure to act in a commercially reasonable manner. The franchisor had failed to provide the support and guidance required of it.

The court was satisfied by the admissions of the principals of the franchisor that it had knowingly and willingly breached its contractual obligations under the financial agreement and its duty of fair dealing in the performance of the franchise agreement.

The court agreed with earlier court decisions on the breach of the duty of fair dealing, which held damages may be awarded separate and apart from damages in compensation of pecuniary losses. The court also went further to state any such award must be commensurate with the degree of the breach or offending conduct in the particular circumstances.

In this case, there was no overt evidence of active concealment of material information, but the franchisor had misrepresented the potential expansion of the franchise system with the addition of six competing franchises, as well as the value of the franchise operation. Further, the franchisor had failed repeatedly to act in accordance with reasonable commercial standards and provide the required support and guidance to the franchisee. Such conduct was a breach of the duty to act fairly and warranted an award of damages in the amount of $25,000.

So, in the end, the court awarded damages to the franchisee in the following amounts:

  1. Vehicle expenses in the amount of $10,080.
  2. Compensation for salaries in the amount of $35,000.
  3. Compensation for setting up the operation part-time in the amount of $5,000.
  4. Damages for loss of profit in the amount of $113,803, based on the estimates submitted.
  5. Damages of $25,000 for breach of the duty of fair dealing.

The total award in damages was therefore $188,883, with prejudgment interest at a rate of three per cent per annum. In addition, under the act, the defendant franchisor and its principals, who are franchise associates, were held jointly and severally liable.

The lesson from this case is franchisors may be liable for significant damages—particularly in the area of loss of profit—for failure to comply with their disclosure obligations, with an ancillary area of liability in terms of damages for breach of the duty of fair dealing, depending on the conduct of the non-compliant franchisor.

Franchisors must be certain they comply with disclosure requirements or face liability for significant damages for up to two years after the date when that disclosure was made (or was supposed to be made).

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.

Mistakes to Avoid in Franchising

Q&A With Frank Zaid

Originally published in the Canadian Business Franchise Magazine on November 6, 2017.

Dispute resolution
As suggested, some of the aforementioned challenges and mistakes can lead to disputes between franchisees and their franchisor. And unfortunately, many franchisors do not have a program in place to deal with such potential disputes before or after they arise.

There are numerous ways through which franchise disputes can be avoided or, at least, resolved prior to litigation, including the implementation of a franchisee hotline, the formation of a franchise advisory board or peer review panel, the designation of a dispute officer or independent ombudsman, mediation or arbitration. Each option calls for experienced counselling before implementation. And whichever dispute resolution program is selected, it should be well-documented and openly disclosed among the franchisees.

Communications
Indeed, in my experience, the most common problem affecting franchise systems is poor communication between the franchisor and the franchisees. A successful business must be built on trust, so positive relationships between these parties are paramount.

Ups and downs in financial performance, the threat of competition and the level of consumer acceptance are all normal, but if the franchisor does not maintain an ongoing, informed and open process of communication with its franchisees, then a lack of trust can easily arise between the parties at times of stress or unrest.

Communications within a franchise system can take many forms, including newsletters, e-mail blasts, a dedicated intranet, franchise advisory boards, ‘town hall’ meetings, national and regional conferences and conventions, independent ombudsman programs, senior management hotlines, controlled social media, field visits, inspection reports, performance reviews, supplier announcements, training sessions and operations manuals, just to name a few.

Communication must be frequent, open, objective, direct, useful and honest. Franchisors should welcome suggestions and recommendations from their franchisees.

Any negative communication must be conveyed in a responsible manner, with appropriate rationale and expectations. Franchisees’ complaints should be dealt with in a professional and timely manner. And franchisors should not denigrate franchisees among one another, but should instead focus on recognizing good performance and encouraging success.

Some examples of topics and items that would merit communication with franchisees include changes in management, withdrawal of the founders, changes in the industry, arrival of new competition, consumer research and preferences, new technology, new governmental regulations, product recalls, enforcement of system standards, financial assistance programs, franchise advisory board reports, franchisee performance and milestones, ombudsman reports, renewal procedures, additional franchise policies, social media policies, new franchise openings, crisis management and, as referred to earlier, alternate dispute resolution (ADR) programs.

Many potential problems and challenges can be avoided with frequent, open and honest communications, with the franchisor exercising reasonable and responsive consideration for franchisees’ concerns. The key is to start ahead of time. When communications about a given challenge only begin after that challenge has already arisen, they are only likely to escalate the problem.

Some of the most highly publicized franchise class or group actions in recent years have involved systems in which communications were addressed. In some cases, the courts praised the franchisors’ communications and the franchise advisory boards in question, while in other cases, they were highly critical of them.

In any case, successful franchisors understand the value of strong communications, which can be seen in their excellent relations with franchisees and are also reflected in a high level of consumer acceptance and an absence of negative publicity. It is never too early to start.

“Many potential problems and challenges can be avoided with frequent, open and honest communications, with the franchisor exercising reasonable and responsive consideration for franchisees’ concerns.“

 

 

Franchise Disputes

Originally published in the Canadian Business Franchise magazine on March 27, 2014

Q: Why are mediation and arbitration important in the resolution of franchise disputes today?

A: My experience so far in alternative dispute resolution (ADR), through the mediation and arbitration of franchise disputes, has convinced me it is a natural and expanding resource for possible solutions to franchising problems. Indeed, more and more franchise disputes are likely to head to ADR in the future, for a number of external reasons.

For one thing, franchising has become big business in Canada. It is estimated there are more than 78,000 franchise units across the country, directly employing more than one million people, accounting for one out of every five consumer dollars spent in Canada on goods and services and representing 10 per cent of the country’s gross domestic product (GDP).

And franchising is stronger in some sectors than others. In retail, for example, franchises account for 40 per cent of sales in Canada.

Commensurate with the growth of franchising in the marketplace, franchise legislation has been enacted in five provinces (listed in chronological order): Alberta, Ontario, Prince Edward Island, New Brunswick and Manitoba. In Quebec, franchising is generally regulated under the province’s Civil Code, which considers franchise agreements legally binding ‘contracts of adhesion.’ And British Columbia is in the process of developing franchise legislation, which may be introduced this year.

All Canadian franchise legislation is founded on two major principles.

Disclosure
The first principle is that a franchisor must provide a disclosure document—which outlines in considerable detail the franchise being offered—to the prospective franchisee, unless an exemption is available.

Specifically, the disclosure document must be provided at least 14 days before the prospective franchisee (a) signs any agreement relating to the franchise or (b) pays any consideration to the franchisor or the franchisor’s associate relating to the franchise.

If the disclosure document is not provided—or it is provided, but contains deficiencies—within that period, then the franchisee will have the statutory right to rescind the franchise agreement. This right will hold for two years in the case of no disclosure or 60 days in the case of deficient disclosure, starting from the date the franchisee signed the agreement.
The statutory right of rescission creates a highly punitive and costly remedy in favour of the franchisee. If the agreement is rescinded pursuant to this right, the franchisor is required to do the following:

  • Refund to the franchisee any money received from or on behalf of the franchisee, other than money for inventory, supplies or equipment.
  • Purchase from the franchisee any inventory, supplies and equipment that the franchisee had purchased pursuant to the franchise agreement at a price equal to the purchase price paid by the franchisee;
  • Compensate the franchisee, without duplication, for any losses incurred in acquiring, setting up and operating the franchise.

Given the cost of establishing a franchise in some of the larger sectors, such as hotels, car rentals, automotive dealerships, full-scale restaurants and grocery stores, multiplied by the number of franchisees operating within a particular system, it is clear the exposure of a franchisor to rescission claims could easily run into the hundreds of millions of dollars.

Fair dealing
The second principle of all franchise legislation in Canada is the imposition on each party to the franchise agreement of a statutory duty of fair dealing in the performance and enforcement of the agreement. This duty includes the obligation to act in good faith and in accordance with reasonable commercial standards.

Breach of the duty of fair dealing, coupled with an alleged breach of an obligation or the assertion of a right under the franchise agreement, would expose a franchisor to a significant claim for breach of contract. And if the alleged breach is in respect of a matter common to all or substantially all franchisees within a given system, then the aggregate potential damages claim against a franchisor could, again, run into the hundreds of millions of dollars.

The growth of disputes
Franchise relationships are governed principally by franchise agreements, which are complex documents reflecting the rights granted to the franchisee, the obligations of the franchisee to operate a business in accordance with the franchise system and the rights and obligations of the parties to each other in respect of the franchisor’s administration of the franchise system and the franchisee’s standards of operation of the franchised business.

Over the years, a considerable number of franchise disputes have been heard by Canadian courts, usually on an individual franchisee-franchisor basis. As the number of franchisees within a given franchise system grows, however, so too do the number of disputes revolving around a common issue to all or virtually all of the franchisees within that system, both past and present.

In recent years, some large group actions have been brought for damages allegedly caused to franchisees by their franchisor, in respect of contractual breaches or misrepresentations. With the introduction in Ontario of class action legislation in 1992, under the Class Proceedings Act, franchise disputes common to a distinguishable group of all or substantially all the franchisees within a specific system started to become the subject matter of very large and significant class actions. Many well-known franchisors, including Tim Hortons, Shoppers Drug Mart, Midas, Pet Valu, Quiznos and Bulk Barn, have been or are currently involved in franchise class actions.

Given all of this activity, one may well question why more franchise disputes are not resolved through mediation, arbitration and other alternative methods, rather than go to court.

ADR initiatives
Franchise agreements have been characterized by the courts as contracts of adhesion prepared by franchisors with little or no ability for franchisees to negotiate terms, often between a corporation with significant assets and resources and an individual entrepreneur with very limited assets and resources. Litigation between these parties has the potential to cause substantial damage to the reputation of the franchisor and significant exposure to huge damage awards, but also possible ruination and bankruptcy for the franchisee.

As a result, the franchise legal and business community has seen many recent initiatives to direct franchise disputes into ADR at an early stage.

In 2005, for example, after nearly five years of consultative activity by a specialized committee of lawyers, government officials and franchise industry participants (of which this author was co-chair), the Uniform Law Conference of Canada (ULCC) released a report containing a model ‘uniform franchises act,’ disclosure regulation and mediation regulation. The latter included detailed provisions allowing either party to a franchise agreement to require any dispute between them to be submitted to mediation. So far, among the three provinces that have adopted franchise legislation since the release of the ULCC report (i.e. Prince Edward Island, New Brunswick and Manitoba), it is notable that New Brunswick has substantially adopted the mediation process included in the report’s model legislation.

Although Ontario’s franchise legislation—the Arthur Wishart (Franchise Disclosure) Act, which was enacted in 2000—does not include a mediation process, the Ontario Rules of Civil Procedure now include a program of mandatory mediation in various areas of the province, including Ottawa-Carleton, Toronto and Essex County. Certain actions are exempted from this procedure, including those placed on the Commercial List in the Toronto region and those certified as class proceedings under the aforementioned Class Proceedings Act of 2002; but for all other actions in Ontario, the Rules of Procedure stipulate a mediation session shall take place within 180 days after the first defence has been filed, unless the court orders otherwise.

Matters that may be placed on the Commercial List include applications, motions and actions that involve, among other matters, “suitable complex cases under the Arthur Wishart Act.” While mandatory mediation does not apply to cases on the Commercial List, the Practice Direction establishing the Commercial List states, “resort to the techniques of alternative dispute resolution (ADR), where appropriate, is recognized and encouraged as an effective aid in the disposition of issues and matters on the Commercial List.”

Further, “it is the duty of the case management judge and the obligation of counsel to explore methods to resolve the contested issues between the parties, including the resort to ADR, at the case conferences and on whatever other occasions it may be fitting to do so.”

In addition, “at any time, particularly on consent of the parties, the case management judge may refer any issue for ADR, as appears appropriate.” At that point, once a matter—or any issue with the matter—has been referred to ADR, counsel will be required to “report to the case management judge at regular intervals as to the progress of the ADR proceedings. The timing of such report shall be agreed upon by counsel and the case management judge.”

As a result of these rules and the recognition that complex cases under the Arthur Wishart Act are appropriate subject matter for Commercial List applications, motions and actions, there has been a recognized and encouraged initiative to attempt to resolve such disputes in Ontario through mediation or arbitration prior to court proceedings.

Promoting mediation
There are already signs present in all provincial franchise legislation that highlight government initiatives to promote mediation of franchise disputes.

Regulations under Ontario’s act dealing with the content of disclosure documents, by way of example, provide that “if an internal or external mediation or other ADR process is used by a franchisor in disputes with a franchisee, the disclosure document must include a description of the mediation or other ADR process and the circumstances when the process may be invoked.”

In addition, every disclosure document is required include the following statement: “Mediation is a voluntary process to resolve disputes with the assistance of an independent third party. Any party may propose mediation or other dispute resolution process in regard to a dispute under the franchise agreement and the process may be used to resolve the dispute if agreed to by all parties.”

Further, under all provincial franchise legislation, a disclosure document must contain statements, including descriptions of details, regarding the following circumstances:

  • If the franchisor or a director, general partner or office of the franchisor has ever been convicted of fraud, unfair or deceptive business practices or a violation of a law that regulates franchises or business.
  • If there is a charge pending against the person involving such a matter.
  • If the person has been subject to an administrative order or penalty imposed under a law of any jurisdiction regulating franchises or business.
  • If the person is the subject of any pending administration actions to be heard under such a law.
  • If the person has been found liable in a civil action of misrepresentation, unfair or deceptive business practices or violating a law that regulates franchises or businesses, including a failure to provide proper disclosure to a franchisee.
  • If a civil action involving such allegations is pending against the franchisee.

The provincial regulations do not include any requirement, however, to disclose if a dispute has been submitted to ADR, nor the results or settlement of any such dispute by ADR.

Franchisors would prefer not to have descriptions of these matters—especially civil suits—included in their franchise disclosure documents, because of the negative implications for prospective franchisees and, in certain cases, because such actions may disentitle the franchisor from relying on an exemption from the requirement to disclose financial statements.

So, if a franchise dispute is submitted to ADR and resolved without further court process, then the resolution or decision will be confidential and private to the parties and likely not subject to inclusion in a franchise disclosure document, unless considered to constitute a “material fact” as defined in the legislation.

A growing trend
In conclusion, all aspects of franchising today point to the need for—and desirability of—submitting disputes to ADR and, in particular, to mediation whenever possible. Legislators, judicial administrators and industry associations are all encouraging this direction, as franchising continues to grow and occupy a major position in Canada’s economy.

Further, with continued media interest in reporting on franchise disputes before the courts, particularly those involving well-known brands, it is almost a foregone conclusion more franchise disputes will proceed to ADR in the future.