Published on October 21, 2011
Posted in: Blog
Knowing whether or not you can safely rely on an exemption to franchise disclosure can have multimillion dollar implications. A recent decision of the Ontario Court of Appeal is the first to consider the short duration disclosure exemption and provides much needed clarity for franchisors hoping to avoid the hefty costs associated with Ontario disclosure obligations.
The case involved a rescission claim by a franchisee operating a gas station under the franchisor’s Sunoco brand name. The franchisee had entered into a franchise agreement with the franchisor for a one year term, with no option to renew. The franchisor later merged with Petro-Canada and, following the merger, wrote the franchisee extending the franchise agreement for an indefinite period, on a month-tomonth basis.
A few months later, the franchisor again wrote the franchisee enclosing a termination letter and offering a transition payment in exchange for the franchisee agreeing to operate until August 2010, some 21 months following the entering into of the initial one year agreement. The franchisee rejected the offer, claiming the right to rescind the agreement and seeking a return of all payments made to the franchisor since entering into the franchise agreement on the basis that it was never provided a disclosure document.
The franchisor disputed the rescission claim relying on the short duration disclosure exemption. This exemption provides that disclosure is not required if: (i) the franchise agreement is not valid for longer than one year; and (ii) does not involve the payment of a non-refundable franchise fee. The franchisor argued that it was not required to provide the franchisee with a disclosure document as the franchise agreement met both requirements of the exemption.
The Superior Court of Justice agreed with the franchisor, holding that both requirements of the exemption had been met and the franchisee was therefore not entitled to rescind the franchise agreement. The Ontario Court of Appeal upheld the decision.
In considering the first requirement, the court agreed with the motion judge that the franchise agreement was only valid for one year as that was “the time frame during which the franchisee [was] bound to certain rights and obligations.” Notwithstanding that the first requirement refers to the validity of a franchise agreement, the court’s focus was on the stated term of the agreement as it was during this period that the franchisee could not walk away from the franchise.
The court further held that the month-to-month extension did not make the franchise agreement valid for longer than one year as this reasoning would, in the words of the motion judge, “make conduct illegal that was proper when it occurred.” Put another way, it would penalize a franchisor based on events which occurred in the future and could not have been known at the time of signing the franchise agreement.
Notable also was the court’s treatment of the indemnity and confidentiality provisions of the franchise agreement. Although both provisions survived termination or expiration, the court found that the survival did not extend the term of the franchise agreement as these provisions only came into effect upon the franchise agreement being terminated or expiring. A terminated or expired agreement, in the eyes of the court, could not be considered valid for the purpose of the exemption.
Turning to the second requirement, that is, no non-refundable franchise fee, the court again upheld the finding of the motion judge that a franchisee fee had not been paid. Specifically, the court found that the royalty payments required of the franchisee did not fall within the scope of “franchise fee.” In reaching this conclusion, the court stated that “a franchise fee is in the nature of a fee paid for the right to become a franchisee. It does not include royalties or payments for goods and services.” A franchise fee, then, is a sort of “initiation-like” fee, and because there was no such fee in the franchise agreement, the exemption applied.
What can franchisors and franchisees take away from this decision? In determining the validity period of a franchise agreement the courts will look to the intention of the parties at the time of signing the franchise agreement. Where parties do not contemplate an extension beyond one year at the outset, a subsequent agreement to extend will not operate retroactively so as to require disclosure, and will not bar a franchisor from relying on the exemption. Furthermore, while not extending to royalty fees, the definition of “franchise fee” remains quite broad and can include such fees as non-refundable deposits or any payment to enter the system other than payments for goods and services. Franchisors hoping to rely on the exemption must therefore ensure no such fee is obtained from a prospective franchise, either directly or indirectly.
Despite the outcome of this decision, the short duration disclosure exemption remains very narrow and will only apply in rare circumstances. If you are a franchisor seeking to rely on a disclosure exemption, you will be well served to obtain legal advice in advance of entering into a franchise agreement with a prospective franchisee.
Sotos LLP represented the franchisee in this decision. For more information on the case contact David Sterns or Allan D.J. Dick.