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.