Legal Issues and Franchise Legislation

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

By Frank Zaid
 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).