Five Crucial Legal Tips for Start-up (and Other) Franchisors

1. Never Franchise an Unproven Concept.

This is not, strictly speaking, a legal point, but it has legal implications.  The bottom line is this: franchisees who are making money do not normally sue their franchisors; however, franchisees who are not making money frequently do. Accordingly, one of the keys to ensuring that you do not face a litany of franchisee law suits is to ensure you are selling a proven business concept that has been shown to create a reasonable return on investment.

2. Apply to Register Your Trademark A.S.A.P.

Start-up franchisors should apply to register their trademark(s) as early as possible.

In Canada, registration of a trademark gives the trademark owner the exclusive right to use that trademark across Canada. Without a registered trademark, a franchisor and its franchisees must rely on common law trademark rights, which must be enforced through "passing off" actions. A major limitation of the passing off action is that, in order to succeed, you must prove, among other things, that you have a valuable reputation in the trademark in the area in which the alleged passing off took place. If infringement occurs in a market in which the franchisor and/or its franchisees have not yet established the brand, the chances of success are low. Registration of a trademark avoids this problem and ensures that, in most cases, the franchisor can enforce its trademark rights anywhere in the country. 

While trademark registration is a must, the registration process takes considerable time from start to finish (12-18 months or more). While franchisors may begin granting franchises before their trademarks are registered, franchisees and their lawyers will typically want to see, at a minimum, that the franchisor has one or more trademark applications in process. Offering to grant a franchise without a registered trademark and without a trademark application pending will be a "red flag" for prospective franchisees who are paying attention.

3. Make Sure You Have a Properly Drafted Franchise Agreement.

In addition to having properly protected trademark rights, a franchisor must have a properly drafted franchise agreement. The franchise agreement is the central document in the franchise relationship. The franchisor relies on the franchise agreement to enforce payments owed to it, enforce system standards, make modifications to the system and generally to ensure productive and brand-appropriate franchisee behaviour. Although all franchise agreements tend to cover the same ground, they are not all created equal. Franchise agreements prepared by lawyers who do not have extensive experience in franchise law tend to suffer from significant problems.

One such problem is the use of what could be termed “soft” language, i.e., language that does not set out the franchisor’s rights comprehensively or explicitly enough. Since Franchise Agreements are “contracts of adhesion” (i.e., contracts that are presented on a “take it or leave it” basis) they are interpreted contra proferentum (against the person who presented the agreement). This means that if there is any wording in the agreement that could be interpreted in more than one way, a court will always interpret it in the way that helps the franchisee at the expense of the franchisor.

Franchise agreements are also interpreted in light of the franchisor’s duty of fair dealing. This duty limits the franchisor’s ability to act in its own self-interest in the performance or enforcement of the franchise agreement. That said, the duty of fair dealing cannot override the express terms of the franchise agreement. Accordingly, if the franchisor wants to reserve certain rights or benefits to itself under the franchise agreement at the expense of the franchisee, these rights and benefits should be set out in the agreement very explicitly. If it is not clear that the franchisor is exercising an express contractual right, there may be room for franchisee's counsel to argue that the franchisor is performing or enforcing a term in bad faith or in an unreasonable manner. The franchisor’s rights vis-à-vis supply chain matters require particular attention in this respect.   

Developments in franchise case law, which occur on an ongoing basis, must also be taken into consideration to ensure the enforceability of the agreement.

4. Be Careful What Amendments You Negotiate to Your Franchise Agreement.

As noted above, franchise agreements are typically viewed as “contacts of adhesion”, i.e., contracts the terms of which are presented on a take it or leave it basis. However, the reality for start-up franchisors is not that simple. In the early days of a franchise system, before the franchisor has a track record of success and significant brand recognition, it will likely be required to negotiate concessions or grant incentives, such as future development rights, to franchisees in order to sell franchises.

  

However, as much as possible, concessions should be limited to the financial aspects of the deal, i.e., reduced or deferred franchise fees, royalties or advertising payments. Changes should not be made to the standard legal terms and conditions of the franchise agreement. Not only do such changes weaken the franchisor’s ability to enforce consistent standards across the system, but allowing ad hoc variations in its franchise agreements means the franchisor will inevitably incur higher costs and a greater drain on its resources to administer franchisee relations in the future, e.g., once the franchisor has 50 or 100 franchises, all operating under materially different versions of the franchise agreement.

Incentives, such as rights of first refusal, options and future development rights should, as much as possible, be limited and scope, so as not to lock up undeveloped territory too tightly. If the franchisor grants rights of first refusal, for example, they should be limited by time and geography and otherwise drafted in such a way that, if the franchisee that holds the right of first refusal does not jump at the new opportunity as soon as it is offered, the franchisor will have a free hand to develop the territory with another franchisee.

Again, advice from an experienced franchise lawyer will do a long way towards avoiding pitfalls in this area.

5. Know and Properly Protect Against Your Potential Liabilities Under Franchise Disclosure Laws.

While the franchise agreement is key to governing the franchisor-franchisee relationship, the pre-contractual phase of the relationship poses arguably the most acute legal risk to the franchisor. Franchise statutes in NB, PE, ON, MB, AB and BC require franchisors to deliver a franchise disclosure document to prospective franchisees not less than 14 days before the prospective franchisee signs any agreement or pays any money. The disclosure document is, essentially, a long and detailed franchising prospectus, which must be tailored to each prospective franchisee.

If the franchisor fails to deliver a fully-compliant franchise disclosure document, the franchisee has the right to rescind (cancel) the franchise. Depending on the facts of the case, this right may remain available for up to two years from the date on which the franchisee signed the franchise agreement. 

Upon rescission (cancellation), the franchisor is required to repay all amounts it has received from the franchisee over the course of the relationship, repurchase all inventory, supplies and equipment at original prices and compensate the franchisee for any other losses it has incurred in establishing and operating the franchise. 

The amount payable under a rescission claim can be quite substantial and, as noted above, will often be enough to bankrupt a small franchisor. Moreover, certain individuals who are involved in running the franchisor are personally liable, along with the franchisor, to pay the franchisee’s damages. This means that the founders of a start-up franchise system will likely face the spectre of personal bankruptcy if a franchisee successfully rescinds its franchise agreement. 

As alluded to above, franchise case law makes it clear that a generic franchise disclosure document, which is not tailored to include transaction-specific information, will not satisfy the franchisor's disclosure obligations in most cases. Moreover, as more material information becomes known in the course of the deal-making process, it will often be necessary, in order to comply with provincial franchise legislation, to update the franchise disclosure document using a Statement of Material Change. 

Given the complexity of franchise disclosure requirements, franchisors, especially new ones, require considerable support from experienced franchise legal counsel in order to ensure their obligations are met and their exposure to statutory rescission (and other) claims is contained.

Conclusion

There are many other legal tips that could be offered to start-up franchisors.  However, a franchisor that acts on all five tips above will have gone a long way towards ensuring that its legal position in respect of its franchisees and others is as strong as possible. 

Three Critical Points All Franchisors Need to Understand about Earnings Projections

Many franchisors in Canada find that they can't close franchise sales without providing earnings information to prospective franchisees. While this information is often indispensable from a sales perspective, franchisors must be very careful how they deliver this information to their prospects. 

In provinces that regulate franchising, namely New Brunswick, Prince Edward Island, Ontario, Manitoba, Alberta and British Columbia, franchisors expose themselves to significant risk of statutory rescission claims if they don't deliver this information in strict compliance with franchise legislation. Below are three key points franchisors should bear in mind when giving any earnings-related information to prospective franchisees. 

1.    Any type of information that relates to potential earnings will be considered “earnings projections” or “earnings claims”.

The definition of an “earnings projection” in Prince Edward Island, New Brunswick, Manitoba and British Columbia and the language around “earnings claims” in Alberta is very broad.  It covers any information “from which a specific level or range of actual or potential sales, costs, income or profit[s]…can be easily ascertained”. In Prince Edward Island, New Brunswick, Manitoba and British Columbia, it includes information of this sort that is given “indirectly”. 

Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000 (the “Wishart Act”) uses the term “earnings projection” without defining it; however, recent case law suggests Ontario courts will interpret this term broadly. In Giroux et al v. 1073355 Ont Ltd et al, 2018 ONSC 143, 287 ACWS (3d) 64 (“Giroux”), a franchisor tried to argue that several graphs in its disclosure document showing franchisee earnings over the past 31-48 months were not “earnings projections” because they contained only historical information. The Court dismissed the franchisor’s argument and found that the graphs were “earnings projections”. 

Accordingly, franchisors should assume that any information they provide about past or future earnings will be subject to the disclosure requirements for “earnings projections” or “earnings claims”.

2.    Earnings information provided verbally or otherwise without delivering documentation will still be considered “earnings projections” or “earnings claims”.

Moreover, information regarding earnings will be considered “earnings projections” or “earnings claims”, even if provided verbally and even if no earnings-related documentation is delivered to the prospective franchisee.

In the Alberta case of Essa v Mediterranean Franchise Inc, 2016 ABQB 178, 266 ACWS (3d) 597 (“Essa”), the principal of the franchisor verbally stated to the prospective franchisee that foods costs were typically 33% of the selling cost of products sold from its franchises (30% in Alberta). The court held that this information was captured by the “earnings claims” language of the Alberta Franchises Act since it was information “given…to a prospective franchisee from which a specific level…of actual or potential…costs can easily be ascertained…”.  It was therefore required to be disclosed in accordance with the regulation under the Alberta Franchises Act.

In the Ontario case of 2212886 Ontario Inc. v. Obsidian Group Inc., 2017 ONSC 1643, 278 A.C.W.S. (3d) 63 (“Obsidian Group”) the franchisor’s salesperson was found to have “showed or flashed” an earnings projection at a meeting with the prospective franchisee, without delivering a copy. The court had no trouble finding that, by doing so, the franchisor had provided the franchisee with an earnings projection.

3.    Failure to properly disclose and substantiate “earnings projections” or “earnings claims” is a fatal flaw in the franchisor’s franchise disclosure document and exposes the franchisor to statutory rescission claims for up to two (2) years.

The disclosure requirements for “earnings projections” and “earnings claims” require that they be disclosed in the disclosure document (or possibly in a statement of material change, if applicable) and be accompanied by certain substantiating information listed in provincial franchise regulations. The required substantiating information varies somewhat from province to province and will differ in its details depending on the sort of “earnings projection” or “earnings claim” being provided.

Failure to disclose earnings projections in the franchise disclosure document and to include the required substantiating information is a fatal flaw that will, in and of itself, invalidate the disclosure document (Obsidian Group, supra, at paras. 50-53 and para. 65; see also Sovereignty Investment Holdings Inc. v. 9127-6907 Quebec Inc, 303 DLR (4th), [2008] OJ No 4450 (Ont Sup Ct) at paras. 15-17 (“Sovereignty”), Apblouin Imports Ltd v Global Diaper Services Inc, 2013 ONSC 2592, 229 ACWS (3d) 412 at paras. 28-32, Giroux, supra, at paras. 122-128 and Essa, supra, at para. 108).  If the franchisor’s disclosure document is invalidated in this way, the franchisor will be considered, in law, to have given no disclosure at all. In these circumstances, the franchisee will be entitled to rescind the franchise agreement for up to two (2) years.

In New Brunswick, Prince Edward Island, Ontario and British Columbia, disclosing earnings projections outside of the disclosure document (or statement of material change, if applicable) also exposes the franchisor to statutory rescission claims on the basis that the disclosure was not given “as one document at one time”. The obligation to give disclosure as one document at one time is an express statutory requirement in these provinces.  Failure to observe this statutory requirement is a fatal flaw that will also, in and of itself, invalidate the franchisor’s disclosure document and expose the franchisor to statutory rescission claims for two (2) years after the franchise agreement is signed (See 1490664 Ontario Ltd. v. Dig This Garden Retailers Ltd., 2005 CarswellOnt 3097 and Sovereignty, supra)  

There is no question that providing earnings projections or earnings claims to prospective franchisees creates significant statutory rescission risks under franchise legislation, as well as other common law and statutory risks that are beyond the scope of this article. However, franchisors that find, as a practical matter, that they cannot close franchise sales without giving earnings information are far better off acknowledging this fact and disclosing this information in compliance with franchise legislation than disclosing it haphazardly. As always, franchisors are strongly urged to consult with experienced franchise counsel regarding the preparation of their earnings-related disclosure.

Has the Ontario Court of Appeal Done Away with the Concept of “Premature” Disclosure in Raibex Canada Ltd. v. ASWR Franchising Corp.?

It’s now been several months since the Ontario Court of Appeal released its decision in the case of Raibex Canada Ltd. v. ASWR Franchising Corp., 2018 ONCA 62 (“Raibex 2018”), in which it overturned troublesome aspects of a 2016 summary judgment decision (See Raibex Canada Ltd. v. ASWR Franchising Corp., 2016 ONSC 5575 (“Raibex 2016”)).

The Raibex 2016 decision was troublesome for franchisors, in part, because it held that franchisors could not enter into franchise agreements with franchisees before all “material fact” information was known and disclosed to the franchisee. If franchisors chose to provide a franchise disclosure document before all material facts were known, they would be found to have given “premature” disclosure. “Premature” franchise disclosure documents would, by their nature, have “stark and material deficiencies” and would amount to no disclosure in law. Accordingly, franchisees receiving “premature” disclosure documents would be entitled to rescind their franchise agreements for up to two (2) years pursuant to section 6(2) of the Arthur Wishart Act (Franchise Disclosure), 2000.

This aspect of the Raibex 2016 decision arose primarily in connection with arguments relating to the franchisor’s failure to disclose the terms of a head lease for the franchisee’s premises in its franchise disclosure document. As is often the case in franchise sales, no location for the franchisee’s premises had been identified and no head lease had been signed at the time the parties entered into the franchise agreement. Accordingly, no information about the location or head lease had been included in the disclosure document. Relying on the Ontario Court of Appeal’s decision in 6792341 Canada Inc. v. Dollar It Ltd., 2009 ONCA 385 (“Dollar It”), the motion judge found that the terms of the head lease were material and a “critical component of franchise disclosure”.

The franchisor argued that it could not be expected to disclose information that it did not know at the time the franchise disclosure document was delivered. However, the motion judge rejected this seemingly common sense argument. The motion judge referred to the Superior Court of Justice’s decision in 2337310 Ontario Inc. v. 2264145 Ontario Inc., 2014 ONSC 4370 ( “DeliMark”)  in which the Court rejected a similar argument from a franchisor. In DeliMark, the franchisor did not know the terms of a head lease when its franchise disclosure document was delivered but became aware of them before the franchisee signed its franchise agreement. In rejecting the franchisor’s argument that it could not disclose what it did not know, the Court in DeliMark stated at para. 37:

“In my view, in the context of franchise disclosure requirements, it is no answer for a franchisor to explain non-compliance on the basis that a document or information did not exist or was unavailable at the time the disclosure statement was prepared. To accept that submission, would be to create a potentially large lacuna in the disclosure system: it would be easy for a franchisor to pare down its disclosure obligations on the basis that certain material or information was simply not available at the time the disclosure statement was prepared; this excuse could be used to respond to a broad range of complaints about non-disclosure. I therefore reject this approach.  [Emphasis added.]”

Following the DeliMark reasoning and ruling in the franchisee’s favour, the motion judge in Raibex 2016 wrote at paragraph 78 of her decision:

“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 franchisor must wait – it does not get excused from its statutory obligations”

Needless to say, this aspect of the summary judgment decision was extremely problematic for franchisors.  With respect to franchisors’ head leasing practices, it left franchisors with two main options: (1) secure a head lease and disclose its terms to the franchisee before signing the franchise agreement, which would require franchisors to invest significantly more time and resources in a prospect before giving disclosure (and could potentially leave them “on the hook” for a head lease if the franchise sale did not close); or (2) step back from head leasing entirely and leave often inexperienced franchisees to negotiate their own leases.

Fortunately for franchisors, the Court of Appeal, in Raibex 2018, provided franchisors with a way around the “premature” disclosure problem as it relates to leasing practices. In considering this aspect of the Raibex 2016 decision, the Court of Appeal held that the motion judge had erred in her analysis of whether or not a disclosure document had been provided for the purposes of section 6(2) of the Wishart Act.  On this point, the Court of Appeal stated at para. 52 of its decision:

“…whether a breach of [the disclosure obligations under the Wishart Act] is sufficiently serious to engage s. 6(2) should be determined on a case-by-case basis, with a view to all relevant circumstances bearing on whether the franchisee can make a properly informed decision about whether or not to invest. This inquiry requires, where appropriate, taking into account the terms of the parties’ franchise agreement.”

The franchise agreement provided that both the franchisee and the franchisor were required to collaborate and exercise reasonable best efforts in selecting a location, which constrained the franchisor’s ability to unilaterally impose a lease without considering the franchisee’s legitimate interests.  The franchise agreement also contained an “opt out” clause which enabled the franchisee to reject a lease and/or terminate the franchise agreement if it found a proposed location or lease unsuitable. The Court of Appeal found that these features distinguished the case from Dollar it. The Court stated (at para. 54):

“[t]hese safeguards, in my view, provide a complete answer to the complaint that the Franchisor’s failure to disclose the head lease justified rescission under s. 6(2). The absence of that information had little impact on the Franchisee’s ability to make an informed investment decision…”

In making its ruling, the Court of Appeal provided franchisors with a means of continuing the widespread practice of signing franchise agreements with franchisees before locations and head lease terms are known.  So long as the franchise agreement includes robust protections for the franchisee, such as collaborative site selection language and an “opt out” clause, which protect the franchisee from having unfavourable lease terms foisted upon it, the franchisee will be in a position to make a properly informed decision whether to sign a franchise agreement, even without head lease disclosure. 

However, the Court of Appeal did not take issue with the motion judge’s statement in paragraph 78 of her decision, quoted above, regarding premature disclosure, nor with the Superior Court of Justice’s reasoning, quoted above, from the DeliMark decision. The logical inference from this is that, in the absence of robust contractual protections for the franchisee like those described above, the head lease disclosure requirements from Dollar It will continue to apply and franchisors will not be excused from disclosing the terms of a head lease simply because they are not known at the time the disclosure document is given. Accordingly, outside of the head lease disclosure “guardrails” provided by the Court of Appeal in Raibex 2018, the concept of “premature” disclosure appears alive and well.

 
Moreover, since Raibex 2016, the concept of “premature” disclosure has arisen in several other cases. The motion judge’s statement regarding “premature” disclosure, from para. 78 of Raibex 2016, was relied upon in 2122994 Ontario Inc. v. Lettieri, 2016 ONSC 6209, aff’d 2122994 Ontario Inc. v. Lettier, 2017 ONCA 830, as authority for rejecting a disclosure document that contained stale-dated financial statements. In addition, while it did not cite Raibex 2016, the Ontario Court of Appeal itself took the same position regarding the prematurity of a disclosure document containing stale-dated financial statements in the case of Mendoza v. Active Tire & Auto Inc., 2017 ONCA 471 at para. 34,  stating: “[i]f a franchisor…cannot comply with the Act because it does not have current financial statements, then it cannot proceed to engage with prospective franchisees…” Accordingly, as a general principle, the concept of “premature” disclosure appears to be here to stay.  The question that remains to be answered is whether future applications of this concept will be as practically disruptive as its application to head lease disclosure practices in Raibex 2016.