Christine Jackson and Shane Murphy
Published on October 22, 2012
Posted in: Blog
Franchisors may well be wondering what more needs to be said about disclosure, given the extensive analysis that has taken place in this and other publications in recent years. And yet, given the “draconian” nature of the rescission remedy available to franchisees if disclosure is not made properly, we at Sotos LLP are constantly grappling with novel disclosure issues for our clients. Some of these issues are worthy in our minds to be published for broader consumption. In this article, we tackle the sensitive matters of earnings projections and operations manuals.
Disclosure of earnings projections
A common belief amongst franchisors is that if they do not make earnings projections, then they do not have to disclose anything to a prospective franchisee regarding what the franchise may earn. Quite simply, this belief is open to serious debate, and a franchisor who takes a rigid approach to the disclosure of earnings projections risks winding up on the wrong side of the franchise disclosure laws.
The main consideration for most prospective franchisees when entering a franchise agreement is how much money they will make. And yet, if this is what is on everyone’s mind, it does beg the question: if a franchisor has information which it can and does utilize to provide a range of projected earnings, why should that not be considered a “material fact”?
Franchisors in Ontario must disclose “all material facts”, as defined by the Arthur Wishart Act (Franchise Disclosure), 2000 (“AWA”). A franchisor is required to provide a prospective franchisee with a disclosure document that includes certain information prescribed by the AWA and its regulation which must contain all material facts, including those prescribed by the regulation, financial statements as prescribed by the regulation, copies of all agreements relating to the franchise, statements prescribed by the regulation for the purposes of assisting a prospective franchisee in making an informed investment decision, and other information and copies of documents prescribed by the regulation. This information typically includes, but is not limited to: the business background of the franchisor; its finances; its intellectual property; its litigation, bankruptcy, and insolvency history; the expected costs associated with establishing the franchise; and all contact information for both current and former franchisees.
Section 1(1) of the AWA defines a “material fact” as follows:
“material fact” includes any information about the business, operations, capital or control of the franchisor or franchisor’s associate, or about the franchise system, that would reasonably be expected to have a significant effect on the value or price of the franchise to be granted or the decision to acquire the franchise.
Put another way, a material fact is one that would affect a prospective franchisee’s decision about whether or not to invest in a franchise and the value attributed to that investment. The term, “any information about the business, operations, capital or control of the franchisor or franchisor’s associate, or about the franchise system” is clearly broad, particularly when measured against an obviously important fact which would relate to the value of the franchise opportunity being sold.
What franchisors should know about “material facts”
It can be tempting to advise franchisors to find a balance in their approach to disclosure. In an ideal world, franchisors could reveal just enough information to inform potential franchisees while safeguarding the internal knowledge they have worked so hard to build up. However, such advice clearly mischaracterizes the uncompromising nature of the laws on franchise disclosure. The law has not left a happy medium for franchise disclosure even where there is no provincial franchise statute in effect. Given the cost of being wrong, franchise lawyers tread with great caution and take an extremely broad approach when assisting franchisors in preparing their disclosure documents to ensure compliance with the law.
Failure to provide pertinent information to franchisees can lead to accusations of misrepresentation in all provinces, whether the province has franchise legislation in place or not. A franchisor who fails to disclose material facts is largely treated by the courts with the same disdain as a franchisor that deliberately distorts material facts; both are considered actionable misrepresentations at common law. Consequently, franchisors offering franchises in any province should take careful note of what they disclose, despite the conflict with their desire to protect their information.
Considering the high stakes of disclosure, it is curious that franchisors have taken the position that earnings do not need to be disclosed if they “do not make” earnings projections. This position is likely rooted in the wording of the AWA disclosure regulation relating to earnings projections. The regulation provides that: “if an earnings projection for the franchise is provided, [the disclosure document must include] a statement specifying the reasonable basis for the projection, the assumptions underlying the projection and a location where information is available for inspection that substantiates the projection.” Accordingly, the inference which many have made is that disclosing an earnings projection is not compulsory under the AWA.
The above analysis, however, assumes that an earnings projection does not fall within the catch-all requirement to disclose “all material facts.” The proper approach is to consider on a case-by-case basis whether there is information in the possession of the franchisor that needs to be disclosed relating to prospective earnings of the franchise that would affect a decision about whether or not to invest in the franchise.
For example, consider a situation where a franchisor’s internal earnings information reveals a consistent history of losses among existing franchisees; or, where it showed profit only after the third year where a franchise agreement is to be signed for a five year term with no option to renew; or, where internal earnings data reveal consistent success in one territory but consistent losses in the territory to be acquired by the prospective franchisee. These are but a few common scenarios in which franchisors should ask themselves whether or not their internal earnings information would affect a prospective franchisee’s decision about whether to invest.
Franchisors would be well served to review their internal earnings projections and financial information with legal counsel to determine whether or not they may be considered “material facts” in certain circumstances. Counsel can guide you through what is required in disclosing such earnings projections.
Disclosure of operations manuals
Much to the dismay of franchisors, it is no longer unusual to see entire operations manuals, or extracts from them, disclosed in cases where the manual is incorporated by way of the proposed franchise agreement and contains important obligations on the part of the franchisee. Apart from what might be the sheer size of the manuals, franchisors are very concerned about disclosing their manuals to individuals who have expressed an interest in the franchise system, but have not yet made any substantive commitment to becoming franchisees and may never become franchisees.
The theory supporting the need to disclose operations manuals is that the manual is part of the franchise agreement, and no part of the franchise agreement can be executed without first being disclosed. After all, where policy and operations manuals contain important obligations on the part of the franchisees, does it not follow that a franchisee is entitled to be alerted during the disclosure process to all information and obligations that might affect the decision to buy the franchise?
Franchisors have, for the most part, accepted that the necessity of making lawful disclosure has supplanted their interests in keeping information about its system confidential, despite the practice of requiring prospective franchisees to sign receipts. To receive a disclosure document, a potential franchisee must generally sign a receipt confirming that the disclosure document was provided and that it will be kept private. In reality, once a disclosure document is provided, it is entirely out of the franchisor’s control. Since the passing of the AWA, the internet has greatly enhanced the free flow of disclosure documents.
In the United States, a network of franchisee-friendly websites and message boards freely distribute franchise disclosure documents and court documents which are uploaded by users. The spread of such sites to Canada, and the rapid exchange of Canadian disclosure documents, is likely to be imminent. These websites make franchisors uncomfortable because they provide easy access to potentially sensitive trade information for a very long time. The corresponding potential to expose inadequate disclosure on a large scale poses an even greater risk. It is yet to be seen, but the day is expected to come when franchisees and their counsel surf these sites in the hopes of locating information lawfully posted on the internet providing grounds for assessing the possible inadequacies of a franchisor’s disclosure practices.
Even without access to disclosure documents over the internet, anyone with a bit of time and passing knowledge of the legal system can get a hold of an array of current disclosure documents. Once a disclosure document becomes an issue in a legal proceeding, a copy could well be filed with the court and publically available for anyone to read or copy. Motions often include references to and enclose disclosure documents. If a lawsuit proceeds to trial, the disclosure document will have the further exposure of being dissected and analyzed by each party’s lawyer and the judge. At this point, the sensitivity attached to any material facts will be less a priority than ensuring that the disclosure document is compliant with the law, and the fact the document may become an exhibit.
Availability of Confidentiality Orders
Concerns about the sensitivity of disclosure documents are not entirely new, even though the pressure to disclose has been increasing in recent years. When disputes arise between franchisees and franchisors, it is not uncommon for one side to consider requesting a confidentiality order from the court, which would seal the information brought forward by the parties and keep it off the public record.
A typical confidentiality order limits access to all documents produced in the proceedings, including the disclosure documents and financial information. Access is limited to the parties and their lawyers, the court staff, and potentially experts retained as part of the case. While they are effective in instances where they are granted, confidentiality orders cover only a small fraction of franchise disputes that end up before the courts. The standard for obtaining a confidentiality order is set deliberately high by the courts, and a typical dispute over the adequacy of a franchisor’s disclosure document is unlikely to meet the standard necessary to obtain a confidentiality order.
Furthermore, confidentiality orders depend upon the whims of the legal system, and the arguments of counsel. Obtaining a confidentiality order may require a costly motion before the court, and it is never guaranteed. Franchisors simply cannot count on confidentiality orders to limit access to sensitive information in the event a dispute does end up before the courts. In Ontario, for instance, the parties cannot simply consent to a confidentiality order given the public’s interest in an open court process.
It is understandable that franchisors do not want to hold an open house with their sensitive and proprietary information. Small compromises seem to have become standard practice, such as disclosing only the table of contents of an operations manual rather than the entire contents of the manual, whether lawful or not (and not yet ruled upon by the courts). Despite their understandable reluctance to broaden the scope of disclosure, franchisors must also consider the dire consequences of failing to disclose anything that might be considered a material fact.
Franchisors should be guided in their decisions on what to disclose in part by the statement of the Ontario courts in 6862829 Canada Limited et al. v. Dollar It Limited et al. that a franchisor has a “rigorous duty to disclose all material facts as well as protect the franchisee from entering into such agreements without having all relevant information”. The need to actually protect a person from entering into a franchise agreement may be counterintuitive to franchisors, who view franchisees as independent agents making their own investment decisions with their own counsel and business advisors. This positive duty of franchisors to protect franchisees, however, is an integral part of franchisor’s disclosure obligations. As a result, any finding that material facts were willfully obscured by a franchisor will be treated harshly by the courts, and franchisees will continue to have access to a set of “draconian” remedies.
The free-flow of disclosure documents, and the increasing awareness of franchise lawsuits, will only see increasing pressure on franchisors to disclose. There is no option for franchisors to disclose “just enough” of their material facts, as franchisees, their counsel, and the applicable laws have all established what appears to be an uncompromising standard for franchise disclosure. At the end of the day, franchisors must have open and frank discussions with their counsel in determining how best to comply with all of their disclosure obligations. Franchisors who prepare their disclosure documents and those signing disclosure certificates and others deemed to be “franchisor’s associates” under the AWA without considering these issues and obtaining sound legal advice, including an assessment as to what are true “material facts” requiring disclosure, run the risk of defending potentially very large lawsuits over their failure to properly meet their disclosure obligations.