John Sotos and Arthur J. Trebilcock
Published on November 1, 2007
Posted in: Blog
This article was originally prepared for the materials of the Ontario Bar Association Continuing Legal Education, November 2007
Does counsel who prepares a franchise disclosure document have any obligation to readers of the document to independently verify the information that the client provided for the document, or may counsel simply collate, paraphrase and transcribe that information? This paper tries to answer this difficult questions, and offers some suggestions on what counsel can do to managing his or her exposure to claims by franchisees should the disclosure document not comply with the applicable statutory disclosure and delivery requirements.
To date four Canadian provinces have enacted franchise-specific legislation requiring franchisors to provide prescribed pre-sale written disclosure to prospective franchisees, and imposing certain “basic fairness” obligations on both parties to the continuing franchise relationship. While some franchisors may choose not to involve counsel in the preparation of their franchise disclosure documents, prudent franchisors will ask for counsel’s assistance in both the information gathering process and the drafting of the disclosure document. In deciding whether to provide this assistance counsel must carefully consider his or her risk of exposure to claims by franchisees if it turns out that the disclosure document is inadequate or was improperly delivered to them. To effectively manage this risk counsel must be intimately familiar with both the statutory disclosure requirements and the statutory and common law grounds on which a franchisee assert a claim against counsel.
In this paper we briefly summarize the statutory disclosure requirements of the four provinces and the statutory and common law remedies that a franchisee may assert against counsel should they not be followed. The paper discusses counsel’s exposure to claims by various participants in the entire disclosure process, should there be a problem with the disclosure, and offers some suggestions for managing the risk of such claims. The paper concludes by discussing whether it is possible to correct a disclosure problem “after the fact”, that is, after the franchisee has acquired the franchise. For the reader’s convenience, Appendix A sets out the text of those parts of the Act and the Regulation which are referred to in this paper.
1. The Statutory Disclosure Obligations
We discuss the Ontario Act first, simply because both of us live in Ontario. If a franchisor wishes to grant a franchise for a business that will operate either wholly or partly in Ontario, then the Ontario Act requires the franchisor to provide the prospective franchisee with a disclosure document at least 14 days before the prospective franchisee signs any agreement relating to the franchise or pays any consideration relating to the franchise to the franchisor or the franchisor’s associate. The disclosure document must disclose all material facts, and must contain other required information such as contracts, financial statements, risk warnings, and certain “deemed material facts”. The franchisor must certify through its directors and officers that the information in the disclosure document is both accurate and complete. The information in the disclosure document must be clearly and concisely set out. The disclosure document must be one document, and must be delivered personally, by registered mail or by other prescribed method as one document at one time. The franchisor must provide the prospective franchisee with a written statement of any material change as soon as practicable after the change occurs, and in any event before the prospective franchisee signs any agreement relating to the franchise, or pays to the franchisor or its associate any consideration relating to the franchise
It is important to note that these statutory requirements are obligations of the franchisor alone: the Ontario Act imposes no obligation on counsel or anyone else to disclose material information to prospective franchisees
The statutory disclosure requirements in the Alberta, New Brunswick and Prince Edward Island Acts and their Regulations differ in many important ways from those in the Ontario Act, including:
- The Alberta Act uses a different definition of “franchise”.
- The definitions of “material fact” in the Alberta, New Brunswick and PEI Acts begin with the word ‘means’ rather than the ‘includes’ of the Ontario Act.
- The definitions of “material fact” in the New Brunswick and PEI Acts add ‘franchise’ to the shopping list of “business, operations, capital…franchise system” appearing in the Alberta and Ontario Act definitions.
- The requirements of the Alberta and PEI Regulations differ markedly from each other and those of the Ontario Regulation (New Brunswick is still finalizing its disclosure regulation).
We end this section of the Paper with a warning to you. Evidently a great many franchisors who ought to know better still have no appreciation of the extent of their disclosure obligation. You can see from their disclosure documents the thought process that they used to produce them: (a) parrot the words of the “disclosure document requirements” part of the provincial disclosure regulation, (b) add the required answers, (c) add the required financial statement, (d) add the required contracts, (e) slap on the required certificate of disclosure, (f) Bingo! – we’re done! Well, they are done all right, done like dinner, because their disclosure documents fall far short of the statutory requirements. Oh yes, each disclosure document clearly and concisely discloses all of the information required by the disclosure regulation, but, as you know, that’s just not good enough: the disclosure statute requires that all material facts be disclosed.
So what’s missing that is so important?
As just one of the very many examples of what’s missing, consider pooled advertising funds. If franchisees are required to contribute to an advertising fund, then the Ontario Regulation requires the franchisor to disclose the percentages of the fund that were spent on national advertising and local advertising or that it retained during the last two fiscal years, the corresponding percentages that it projects will be spent or retained for the current fiscal year, and the amount it projects for the franchisee’s advertising contribution for the current fiscal year. But that’s all that the Ontario Regulation requires. However since effective advertising of the goods and services being distributed in association with the principal trade-mark is crucial to the continuing success of any franchise system, surely the disclosure document should concisely address at least the following material facts for each pooled advertising fund:
(i) the purpose of the fund, and whether it is operational,
(ii) how the fund will be administered, including
(A) if the franchisor or the franchisor’s affiliate will have authority and responsibility to administer the fund, how, when and where the fund will be spent, and
(B) if a person independent of the franchisor will have authority and responsibility to administer the fund, how that person is selected,
(iii) the manner in which contributions will be made to the fund, and whether company-owned units, affiliate-owned units, and units owned by directors, officers or senior managers of the franchisor or its affiliate will contribute to the fund,
(iv) the manner in which the fund will be maintained, including whether a separate bank or other depository account will be used to prevent commingling of fund money with the general revenue of the franchisor or its affiliate,
(v) whether the franchisee will receive an accounting for receipts and disbursements of the fund, or any other reports about the activities to be financed by the fund, and if so, the nature and frequency of the reports and whether they will be subject to audit or review by an accountant independent of the franchisor, and
(vi) the manner in which any of the above factors may be changed.
Don’t you fall into the trap of just responding to the provincial disclosure regulation!
2. The Statutory Disclosure Remedies
We again discuss Ontario first. The Ontario Act provides a franchisee (but nobody else) with both a rescission remedy and a statutory damages remedy, should the franchisee receive improper or no disclosure.
Rescission Remedy: The franchisee may rescind the franchise agreement:
(a) for up to two years after entering into it, if the franchisor never provided a disclosure document, or
(b) for up to 60 days after receiving the disclosure document, if the franchisor abridged the statutory time period for delivering the disclosure document or a statement of material change,  or if the disclosure document did not comply with the statutory content requirements.
If the franchisee exercises the rescission remedy, then the franchisor must pay statutory compensation to the franchisee within 60 days after the rescission. Ontario courts have held that the rescission remedy is available regardless of the franchisee’s conduct.
Statutory Damages Remedy: If the franchisee suffers a loss because of a misrepresentation in the disclosure document or because the franchisor did not comply with the Ontario Act’s disclosure content and delivery requirements in some other way, then the franchisee has a statutory right of action for damages against the franchisor, the franchisor’s associate, the franchisor’s broker, the franchisor’s agent, and anyone who signed the disclosure document. The franchisee does not have to prove that he or she relied on the misrepresentation, nor does the statutory damages remedy supersede any common-law remedy available to the franchisee. Ontario courts have held that if a franchisee rescinds under Section 6 of the Ontario Act but the franchisor fails to pay the required statutory compensation, then the franchisee may use the statutory damages remedy to recover that compensation from the franchisor and the other statutory defendants named in Section 7.
Defences: There is no defence to a Section 6 rescission remedy if the statutory rescission conditions are met. The Ontario Act provides four statutory defences to a Section 7 damages action for misrepresentation. The first defence (acquiring with knowledge of the misrepresentation) is available to all statutory defendants, but the other three defences (based on ‘due diligence’) are not available to the franchisor. Note that these statutory defences apply only if there is a misrepresentation in the disclosure document or a statement of material change, not if there is some other inadequacy in the content of the disclosure or in its delivery.
The Alberta, New Brunswick and PEI Acts provide similar statutory remedies and defences, but add a fourth ‘due diligence’ defence to the statutory damages action: a defendant (other than the franchisor) is not liable for a misrepresentation in a “non-expertised” part of the disclosure document if he or she believed that there was no misrepresentation and had reasonable grounds for that belief.
3. Counsel’s Exposure to Franchisee Claims
What is counsel’s liability to a franchisee should the franchisor fail to provide a disclosure document? What is counsel’s liability to a franchisee should the franchisor deliver a disclosure document contain a misrepresentation, or should the franchisee otherwise receive improper disclosure?
Statutory Liability Counsel has no statutory liability to a franchisee if the franchisor failed to provide a disclosure document in the first place, because, as we mentioned above, counsel has no statutory disclosure obligation to the franchisee. Because the statutory damages remedy is only available for a misrepresentation in the disclosure document or a statement of material change, counsel has no statutory liability to a franchisee if there is some other defect in the disclosure document or some defect in its delivery. Even if the franchisor delivers a disclosure document or statement of material change that contains a misrepresentation, counsel will only have statutory liability to a franchisee if counsel “signed the disclosure document”, or (in New Brunswick, Ontario and PEI only) “signed a statement of material change” or was the franchisor’s associate or broker, or (in Ontario only) was the franchisor’s agent.
A cautionary note: these words “signed the disclosure document” are in our view murky. If counsel permits his or her opinion on some issue (or an extract or summary) to be included in the disclosure document, has counsel “signed the disclosure document’? If no, then counsel would appear to have no statutory liability to a franchisee even if the opinion was negligently formed. That certainly seems to be inappropriate. But if inclusion of the opinion or extract in the disclosure document means that counsel has “signed the disclosure document”, then counsel will be statutorily liable to a franchisee if there is a misrepresentation in some other part of the disclosure document. That, too, seems equally inappropriate. The proper result should be that counsel should be statutorily liable to a franchisee only for that part of the disclosure document which counsel has “expertised” (i.e. the opinion), but that is not what the legislation says.
Common-Law Liability If a franchisee wishes to assert a common-law claim against counsel because the franchisee received inadequate or no disclosure, then the claim must be based on either negligence or negligent misrepresentation, since the franchisee presumably has no basis for asserting a claim against counsel for breach of contract.
To succeed in a claim for simple negligence against counsel the franchisee must prove three things:
- counsel owed the franchisee a duty of care because there was a “special relationship” between them
- counsel did not meet the applicable standard of care
- as a result the plaintiff suffered damages which are not too remote.
To succeed in a claim for negligent misrepresentation against counsel the franchisee must prove five things:
- counsel owed the franchisee a duty of care because there was a “special relationship” between them
- counsel made an untrue, inaccurate or misleading representation to the franchisee
- in making this representation counsel did not meet the applicable standard of care
- the franchisee actually and reasonably relied on counsel’s representation
- as a result the franchisee suffered damages which are not too remote.
(1) Is the relationship between plaintiff and defendant such that the defendant should reasonably have foreseen that carelessness on his or her part might cause damage to the plaintiff? If yes, then the defendant owes a prima facie duty of care to the plaintiff.
(2) If there is such a prima facie duty of care, are there any policy considerations which ought to limit the scope of that duty, or the class of persons to whom the duty is owed, or the damages for breaching the duty?
Applying the first part of the Anns test in the franchise disclosure context, it seems reasonably foreseeable that franchisees will read the disclosure document that counsel prepared and will rely on it in deciding whether to acquire their franchises. Such reliance certainly seems reasonable. Therefore the necessary “special relationship” is established, and counsel owes the franchisee a prima facie duty of care. Applying the second branch of the Anns test, there seems to be no good policy reason for limiting counsel’s prima facie duty of care, since counsel knew or ought to have known that the disclosure document would likely be used by the franchisee to acquire the franchise, and the franchisee used it for that very purpose.
We are now in position to determine whether a franchisee can successfully claim against you, as counsel to the franchisor, based on negligent misrepresentation or simple negligence.
Consider first a claim for negligent misrepresentation. The franchisee will almost always succeed in proving under the Anns test that you owed the necessary duty of care. However unless you ‘expertised’ part of the disclosure document (for example your opinion or an extract appears in the document), or you otherwise permitted your name to become associated with the disclosure document in manner that would reasonably lead a reader to conclude that you are underwriting all or part of the document, you didn’t represented anything in the disclosure document, the franchisor did. So although the franchisee may well have a negligent misrepresentation claim against the franchisor, he cannot sustain such a claim against you. Even if you did negligently ‘expertise’ part of the disclosure document, you can still avoid liability by proving that you conducted a reasonable investigation that provided reasonable grounds to support your belief that the part you ‘expertised’ did not contain a misrepresentation. Of course if you permitted your name to become generally associated with the disclosure document, then you must extend that investigation to everything in the disclosure document.
Let us now consider a claim framed in simple negligence: the franchisee claims that you were negligent in your drafting of the disclosure document, or that you negligently failed to independently verify the accuracy and completeness of the information provided to you by your client, or that in some other manner you negligently performed your retainer with your client, and as a result the franchisee suffered a loss. As we mentioned, this requires the franchisee to prove, first, that you and the franchisee were in a ‘special relationship’ that gave rise to a duty of care on your part, second, that you fell below the applicable standard of care, and, third, that as a result the franchisee suffered damages that are not too remote.
We have shown that the franchisee will almost always succeed in proving the duty of care element, and the franchisee likely will have little difficulty in proving the damages element. So the franchisee’s case boils down to whether or not you met the applicable standard of care. That standard requires you to apply to the task at hand the skills and standards of a reasonably prudent franchise disclosure lawyer. In our view this means, at least, that:
- you must be intimately familiar with the applicable provincial franchise disclosure law and related case law,
- you must be reasonably familiar with the franchise disclosure laws, advisory opinions of regulators and related case law of other North American jurisdictions that are relevant to the provincial disclosure law governing the document that you are producing, and
- you must properly advise your franchisor client about:
- its statutory disclosure obligations, the available statutory and common-law franchisee remedies, and the available defences to them,
- how to collect and collate the information that needs to be disclosed,
- how to reasonably investigate various matters to verify the accuracy and completeness of the information that is gathered, and
- how to establish the foundation for a due diligence defence (assuming that one is available to your client), by properly documenting the collection and investigation processes.
That leaves the question of whether counsel who drafts a disclosure document has a duty to franchisees to independently verify the accuracy and completeness of the information that your franchisor client has supplied for inclusion in the disclosure document. Unfortunately, to date there is no sure answer to this question, and it doesn’t really help to analogize to securities law, because there are important differences between a securities issue and a franchise offering. First, the prospective investor in securities has no real opportunity to independently investigate the underlying business, but must rely almost entirely on the prospectus. In contrast, the prospective franchisee can visit existing and former franchisees to ask lots and lots of questions, and can meet with the franchisor’s personnel to ask lots and lots of questions and judge their abilities. Second, the legal cost of preparing a prospectus for an initial public offering typically runs to hundreds of thousands of dollars. This would be prohibitively expensive for a franchise offering, since the proceeds of a typical franchise offering pale in comparison to the proceeds of a typical IPO. Finally, a securities offering is of limited duration, but a franchise offering continues in time. If franchise counsel had a duty to independently verify the accuracy and completeness of the information in the disclosure document, then he or she would be involved in a never-ending due diligence review.
So our answer to whether or not counsel has an obligation to independently investigate the accuracy and completeness of the information which the franchisor supplies for the disclosure document is this:
- Counsel always has an obligation to carefully review the information that the client provides
- If that review leads counsel to suspect that any of information is materially inaccurate or that material information is missing, then counsel has an obligation to franchisees to take reasonable steps to investigate and correct the problem or to verify that in fact there is no problem.
- Otherwise, we don’t think that counsel has any obligation to independently verify the accuracy and completeness of the information provided by the client for disclosure.
4. Managing Counsel’s Claims Exposure
To better manage claims exposure, counsel who prepares a franchise disclosure document should maintain a “due diligence” file to record all important action that he or she took during the disclosure preparation process. The due diligence file should document the steps counsel took to gather information and track its sources, and the steps (if any) taken to independently verify that information. The file should also include such things as copies of engagement and non-engagement letters, copies of signed and completed questionnaires and other material which counsel used to gather information, notes of important points discussed and advice given at formal or informal meetings or in telephone conversations, correspondence dealing with important matters, copies of the contracts and other documents that counsel reviewed for disclosure purposes, copies of draft disclosure documents and any notes feedback on those drafts, any other written material which counsel deems to be important.
If counsel does suspect that information provided by the client is materially inaccurate or misleading, so that further investigation is warranted, then the nature, extent and consequences of that investigation are matters for counsel’s good judgment having regard to all of the circumstances, including the applicable professional rules of conduct.
Finally, counsel should ensure that his or her name or the firm name does not appear in the disclosure document except, perhaps, as authorized agent to accept service (unless, of course, counsel is deliberately ‘expertising’ part of the disclosure document). If counsel is retained to ‘expertise’ part of the disclosure document and agrees to do so, then counsel’s engagement letter should clearly state that the client must obtain counsel’s separate, written consent to the use of counsel’s (or the firm’s) name in the disclosure document before the client may use the document in connection with offering franchises. Any such written consent should also state that consent will be automatically revoked should any amendment be made to the disclosure document without counsel’s prior written consent.
 Alberta: Franchises Act, R.S.A. 2000, c.F-23 (the “Alberta Act”) and A. Reg. 240/95 (the “Alberta Regulation”); New Brunswick: Franchises Act, S.N.B. 2007, c. F-23.5 (the “New Brunswick Act” – the province is still finalizing its disclosure regulations); Ontario: Arthur Wishart Act (Franchise Disclosure), 2000, S.O. 2000, c.3 (the “Ontario Act”) and O. Reg. 581/00 (the “Ontario Regulation”); Prince Edward Island: Franchises Act, S.P.E.I. 2005, c. 36 (the “PEI Act”) and EC2006-232 (the “PEI Regulation”).
 This is a dangerous choice because of the complexity of the legislation, its many ambiguities (especially in the Regulation), and the personal liability which the legislation imposes on the franchisor, on anyone else who is involved in marketing or granting the franchise, and on anyone who signs the disclosure document.
 The franchise legislation of each province is complex and often ambiguous, and therefore at the very best our summary can only approximate its disclosure requirements. If ever a question arises the reader is cautioned to consult the legislation itself (and, if necessary, counsel who regularly practices in the franchise disclosure area), not our summary of it in this Paper.
 Ontario Act: 5(4) and Ontario Regulation: 2 to 6. See 1(1) of the Act for the definition of “material fact”, and 6 of the Regulation for the deemed material facts. Because the definition in 1(1) uses the word “includes” rather than “means”, many franchisors will have to disclose information unrelated to the business, operations, capital or control of the franchisor, the franchisor’s associate or the franchise system. Consider, for example, a situation where an affiliate of the franchisor, who is not the “franchisor’s associate” (because it is not involved in marketing or granting the franchises, nor in supplying the franchisor’s system), operates a competing franchise system under a different trade-mark. Note that Ontario Regulation: 2(1)(viii) and 6(1)(14) do not require disclosure of this obviously material information.
 Ontario Act: 5(6). This section together with 5(4)(a) and the definitions of “material fact” and “misrepresentation” effectively require a franchisor to provide full, true and plain disclosure of all material facts relating to the franchise being offered; this is equivalent to the standard for disclosure under provincial securities legislation: see, for example, 1(1) and 56(1) of the Ontario Securities Act, R.S.O. 2000, c.S-5.
 Ontario Act: 5(5). In this Paper we use the term “disclosure document” for both a s.5(1) disclosure document and a s.5(5) statement of material change, except where it is necessary to distinguish between these two types of document.
 “Often the securities lawyer’s advice is conclusive as to when, whether and how disclosure is to be made, but this power is not enough to make the securities lawyer accountable or liable to shareholders or the investing public by reason only of the public company’s failure to comply with a disclosure obligation, unless, of course, the lawyer’s advice is formalized in an opinion addressed to, or relied upon by, shareholders.” (Victor P. Alboini, Due Diligence and the role of the Securities Lawyer, 6 C.B.L.J. 241 at 268.)
 There is nothing wrong with using a “plain vanilla” disclosure document coupled with a province-specific addendum or wrap-around, as long as the result is both clear and concise (a wrap-around is a compound document that sandwiches the “plain vanilla.” disclosure document between
 Ontario Act: 6(1). This is a virtually useless remedy, since it usually takes more than 60 days for a prospective franchisee simply to consult with legal and financial advisors and negotiate changes to the franchise contracts.
 New Brunswick and PEI Acts: 7(1)(b) and (c); Ontario Act: 7(1)(c) and (d). See 1(1) of these Acts for the definition of “franchisor’s associate”, 1(1) of the New Brunswick and PEI Acts and 7(1)(c) of the Ontario Act for the definition of “franchisor’s broker”.
 Counsel’s mere participation in the preparation of a disclosure document does not result in counsel being considered to have ‘expertised’ the document: Escott v. BarChris Construction Corporation, 283 F. Supp. 544 (1971).
 One can think of many circumstances where counsel may have (foolishly) represented the adequacy of the disclosure document to the franchisee outside that document, and of course counsel will be liable to the franchisee for that.
 This common-law ‘due diligence’ defence mirrors the similar statutory defence in Alberta Act: 10(3) and New Brunswick and PEI Acts: 7(5)(e). The Ontario Act does not provide such a statutory defence.
 That standard will obviously vary between communities, but since you are a member of the community attending this Conference (or at least are reading this Paper), you will be held to the high end of the spectrum.
 The Alberta, Ontario and PEI Regulations all require the disclosure document to state the names, addresses and telephone numbers of at least the 20 franchisees in or closest to the province, or of all franchisee if there are fewer than 20. These Acts also require the disclosure document to state the names,, last known addresses and telephone numbers of all former franchisees in the province who left the franchise system within the franchisor’s most recently completed fiscal year.
 The profit derived from royalties and other continuing payments made by franchisees compensates the franchisor for providing continuing support and maintaining the franchise system, and should not be considered as “proceeds of offering”.
 Which counsel will not give (we hope) before he or she has seen the amendment. This automatic revoking of consent may allow counsel to raise a common law defence of “disclosure given without my knowledge or consent”: see the statutory equivalent in Alberta Act: 10(1)(a) and New Brunswick, Ontario and PEI Acts:7(5)(a).