More Clarity and More Uncertainty – The Ontario Court of Appeal Weighs in on the Selling of Franchises without a Site in Hand
Published on January 26, 2018
Posted in: Allan Dick, Blog
It has been a commonplace practice for franchisors in Ontario to sell franchises to franchisees in situations where the exact location for the franchise has not yet been determined. One Ontario court cast doubt on a franchisor’s ability to do this given the franchisor’s statutory duty to deliver a disclosure document containing all material facts relating to the opportunity before the sale could be effected. That decision has been overturned by the Ontario Court of Appeal with reasons that provide further clarity to those buying and selling franchises and their advisors as to the availability of remedies for improper disclosure under Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”). Unfortunately, the reasoning of the Court will create new issues for the industry in managing the disclosure process.
In Raibex Canada Ltd. v. ASWR Franchising Corp. (“Raibex”), the prospective franchisee was considering buying an AllStar Wings and Ribs franchise. It had limited funds. There was an option to buy either a new unit to be constructed or converting an existing restaurant into a unit. The franchisor had had experience with three previous conversions. It expected that a conversion would be less expensive than building new but it could not say specifically by how much with regard to any particular site until it was chosen.
In order to proceed with selecting a site for conversion, the franchisor required the franchisee to enter into a franchise agreement.
To comply with its statutory obligation, the franchisor provided the prospective franchisee with a franchise disclosure document (the “FDD”) as required by the Act. That FDD, by its nature, could not include the head lease, as no site had yet been secured. It did confirm the form of required sublease. It was silent on the franchisor’s conversion experience.
The proposed franchise agreement was attached to the FDD. Under the agreement, the franchisee was alerted to the fact that the parties would seek out a site collectively subject to the franchisor’s approval and the franchisor would take the head lease. The prospective franchisee then signed the franchise agreement and the parties proceeded to find a location.
The site that the parties selected required the franchisor’s affiliated leasing company to pay a significant deposit which became the franchisee’s obligation upon signing the sublease. The construction costs for the site were also ultimately higher than may have been anticipated, but did not exceed the cost of building new.
The franchisee balked at paying these amounts and exercised its statutory right to rescind the franchise agreement on the basis that the FDD was tantamount to no disclosure at all, entitling it to rescind the agreement within two years of having signed the franchise agreement as provided by Section 6 (2) of the Act.
Many cases in Ontario, including at the Court of Appeal levels have considered the application of the rescission right in circumstances where a disclosure document, albeit a deficient one based on the required content as established by the Act, has been provided.
The summary judgment motion judge in Raibex found that, as there was no site in hand, it was premature to try to disclose the prospective franchisee as the FDD could not provide all the facts necessary for a prospective franchisee to make a fully informed investment decision to buy the franchise.
The motion judge allowed the franchisee to rescind, triggering the extensive remedy for rescission provided for in the Act.
The Court of Appeal disagreed, overturning the motion judge.
Interestingly, the appellate court assumed that the FDD was deficient. The question the Court said had to be answered was whether the deficiencies were serious enough to give rise to the Section 6 (2) remedy which required the document to be so deficient as to be tantamount to giving no disclosure.
The Court found that, in order for the Section 6 (2) two-year rescission remedy to be applicable, the prospective franchisee had to effectively be deprived of the opportunity to make an informed investment decision. That was the Court’s summary of all of the previous decisions which discussed the nature of the deficiencies giving rise to the remedy. In fact, many of the previous decisions assessed the sufficiency of disclosure against a standard of whether the prospective franchisee was able to make a “fully” informed investment decision. Did the Court in Raibex intend to lower the bar by only requiring the decision to be “informed” rather than “fully informed”? The Court established, in any event, that there is a difference between “imperfect” disclosure and “no” disclosure. Only the latter would give rise to the two-year remedy.
In looking at all of the circumstances, including the drafting of the franchise agreement itself, the Court found that the franchisee was not only aware of the possibility of what the conversion could cost, but that the franchisee was to be involved in the site selection and had the opportunity to back out of the deal and have its money refunded if it didn’t want to proceed with the location. This drafting was fundamental to the Court’s assessment of the sufficiency of the disclosure provided when weighed against the test to be applied.
The Court was satisfied that the franchisor’s previous experience with conversions would not have allowed it to better disclose on the issue of the cost of conversion such that it would have had an effect on the franchisee’s investment decision.
This decision is fundamental to the future of franchising in Canada’s 6 provinces with similarly-worded franchise disclosure legislation. It affirms that:
a) franchisors can enter into franchise agreements with franchisees before sites are selected, but they remain at risk;
b) disclosure may well be deficient in such instances for reasons not articulated by the Court of Appeal;
c) deficient disclosure can give rise to a 60-day rescission remedy under Section 6 (1) of the Act, which the Court of Appeal did not discuss in Raibex;
d) however, whether the franchisee can exercise the two-year right of rescission is dependent on whether the deficiencies effectively deprived the franchisee of the opportunity to make an informed investment decision from a review of all of the surrounding circumstances, including the drafting of the franchise agreement;
e) the wording of the franchise agreement and the intended process to find a site may be very material to whether the disclosure document will be sufficiently deficient to give rise to a rescission remedy; and
f) notwithstanding the absence of a rescission right, Section 7 of the Act gives rise to a claim for damages if there has been a breach of Section 5 of the Act. That breach could have been said to have occurred in Raibex given the assumption that the disclosure document was “deficient”. Had the franchisee in Raibex pursued a Section 7 claim (which the Court of Appeal found it did not), and if the deficiency was a cause of a resulting loss, the franchisee could have arguably recovered for that loss.
The Court of Appeal decision in Raibex leaves us uncertain as to how a franchise disclosure document can be drafted under circumstances where a site has not been located pre-agreement in a way that is not “deficient”. Although the Court provided excellent guidance to the future application of the rescission remedy, there continues to be uncertainty as to how compliant franchise disclosure documents can be drafted in this context.
The question still remains how a prospective franchisee can make a fully informed investment decision, or even an informed investment decision, if it does not know material terms of a head lease affecting it. Is it sufficient if it does not know because it has a right to get out of the agreement if it subsequently doesn’t like the terms? Surely, the time to assess the adequacy of the disclosure has to be the time when the franchise agreement is entered into and not based on events that arose thereafter.. In this respect, the appellate decision in Raibex is open to criticism and provides difficulties in its future application. Nevertheless, the decision is instructive and helpful and provides guidance on the test for the applicability of the Section 6 (2) two-year rescission remedy in broad circumstances and in confirming that franchises can be sold before sites are secured.
At Sotos LLP, we advise franchisors on all aspects of franchise disclosure and best sales processes for statutory compliance.