Saturday, June 9, 2018

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.

Sunday, June 3, 2018

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.