Ontario Court Affirms That Faulty Financial Disclosure is a “Fatal Flaw”, Entitling the Franchisee to Rescind

The Ontario Superior Court of Justice has affirmed that (i) franchisors must disclose to their prospective franchisees financial statements that provide a “complete, accurate, and current financial picture” of the franchisor and that (ii) a franchisor’s failure to provide compliant financial statements constitutes a “fatal flaw” in the franchisor’s disclosure, entitling any franchisee who received that flawed disclosure to rescind its franchise agreement up to two years from when the agreement was entered into.

In Moonable Right Ltd. et al v. Canadian Ice Cream Company Inc. et al., Justice Parghi granted the former franchisee of the defendants’ Marble Slab franchise system nearly half a million dollars in rescission damages after the franchisor failed to provide the plaintiffs with the franchisor’s current financial statements.

The Facts

In February 2021, the plaintiff was considering whether to invest in becoming a Marble Slab franchisee. The franchisor defendant provided the plaintiff with a financial disclosure document, as required by Ontario’s franchise legislation, the Arthur Wishart Act (the “Wishart Act”). As was also required by the Wishart Act, the disclosure document included the franchisor’s financial statements; however, the financial statements provided were for the franchisor’s fiscal year ending 2019 – more than two years old by the time the disclosure document was provided to the plaintiff.

The franchisee elected to become a Marble Slab franchisee and operated a Marble Slab franchise for less than a year, from June 2022 to January 2023. After operating the business at a continuous loss, the franchisee delivered a rescission notice and stopped operating the store in January 2023.

When the franchisor disputed the franchisee’s entitlement to rescind, the franchisee commenced a lawsuit to recover the franchisee’s rescission losses. In the meantime, the franchisee continued to service the small business loan it had obtained to finance its purchase of the franchise and continued to pay rent to its landlord for many months following the franchisee’s delivery of its rescission notice.

The franchisor eventually installed a new franchisee to take over the tenancy and operate as a new Marble Slab franchisee. With the franchisee’s cooperation, the franchisor bought the former franchisee’s equipment from that franchisee’s lender and sold that equipment to the new franchisee.

In the franchisee’s lawsuit, the franchisee sued the franchisor for a declaration that the franchisee’s rescission was valid and for rescission damages of nearly half a million dollars, including the franchisee’s losses incurred following its rescission. The franchisor countersued, claiming that the franchisee’s rescission was unlawful and that the franchisee had, instead, abandoned the franchise in breach of the franchise agreement.

The Decision

Justice Parghi agreed with the franchisee that it was entitled to have rescinded its franchise agreement up to two years from when it had entered into the franchise agreement. The Court held that the franchisee’s entitlement to rescind arose out of the fact that the financial statements it had been provided by the franchisor were older than what was permitted under the Wishart Act.

Stale Financial Statements Are a Fatal Flaw in Disclosure

The Wishart Act requires of the franchisor to disclose financial statements for the franchisor’s most recently completed fiscal year (or, if a financial statement for the franchisor’s most recently completed fiscal year has not yet been prepared as of the date of disclosure and a “grace period” of 180 days has not yet passed, the franchisor may disclose financial statements for the year previous to the most recently completed fiscal year).

When the Marble Slab franchisor provided disclosure to the plaintiff franchisee in February 2021, the franchisor was therefore required to include in its disclosure document financial statements for its most recently completed fiscal year, being January 2021, or, if those were not yet available, then it was required to disclose financial statements for its fiscal year ending January 2020.

Instead, the franchisor disclosed financial statements for its fiscal year ending January 2019.

The Court followed previous appellate authority in recognizing that the disclosure of stale financial statements constitutes what has been described as a “fatal flaw” in the disclosure; a fatal flaw is a disclosure defect that is so material that, if present, is regarded by the courts as if no disclosure at all was provided to the franchisee.

Interestingly, Justice Parghi asked in obiter (rhetorically) whether a categorical separation of disclosure flaws into “fatal” and “non-fatal” ones can be “properly reconciled with the case-by-case approach” previously mandated by the Court of Appeal.

Her Honour nonetheless found that the stale financial statements disclosed by the Marble Slab franchisor were a fatal flaw that, in and of itself, entitled the franchisee to rescind; she went on to find, however, that even if the stale financial statements were not a fatal flaw, or if the categorical approach were not the correct one, she would nonetheless have found in favour of the plaintiff.

In reaching that conclusion, she relied on evidence that the franchisor’s financial statements for the fiscal year ending 2020, which had not been disclosed to the franchisee, demonstrated that Marble Slab’s financial situation had deteriorated significantly when compared with the financial situation depicted in the 2019 financial statements that had been disclosed. As the Court noted, the 2020 financial statements were already available to the franchisor by the time it provided disclosure to the franchisee in February 2021. The franchisor’s deteriorating financial condition meant that “the out-of-date financial statements provided to the plaintiffs prevented them from obtaining a complete, accurate, and current financial picture.”

The Court declared Marble Slab’s principal, Cameron Inglis, to be a “franchisor’s associate”, which is a person so closely connected to the franchisor that it becomes co-liable with the franchisor under the Wishart Act for the franchisee’s rescission claim.

Damages

The Court awarded the franchisee $482,043 in damages, payable both by the Marble Slab franchisor and its principal. In its analysis of the franchisee’s damages, the Court made the significant finding that the franchisee’s damages incurred following rescission were properly recoverable, rejecting the franchisor’s argument that rescission damages crystallize as of the moment of rescission.

The Court’s Rejection of the Franchisor’s Other Arguments

The Court rejected all of the franchisor’s arguments.

The franchisor had argued that the franchisee must have been content with the disclosure provided and could not have felt deceived by it, given that he built the restaurant, negotiated the lease, personally guaranteed the loan, and even indicated a wish to expand to a second location in August 2022. In rejecting that argument, Justice Parghi reiterated the well-established proposition that the legal test concerning the sufficiency of the disclosure provided is an objective one that does not depend on the conduct of any franchisee, but that instead is concerned only with the adequacy of the disclosure itself.

Justice Parghi also rejected the franchisor’s argument that a franchisee is under an obligation to mitigate its rescission losses.

Finally, Justice Parghi also summarily dismissed the franchisor’s counterclaim, noting that such counterclaims are consistently dismissed when a franchisee’s rescission is upheld.

Key Takeaways

This decision serves as a sober reminder to franchisors that the disclosure of stale financial statements is a fatal flaw in a franchisor’s disclosure obligation, effectively entitling the franchisee to an automatic right of rescission up to two years from when the franchise agreement was entered into.

Franchisors should accordingly verify that the financial statement they are disclosing are sufficiently recent to comply with the legislative requirements. Franchisees should preserve a copy of the disclosure document provided to them and records of any payments and losses they incur in the operation of their business, including those incurred after delivery of a rescission notice.

Franchisors and franchisees who find themselves involved in a rescission claim – and their counsel - should appreciate that the Marble Slab decision has also expressly confirmed important principles concerning rescission damages that were previously only obliquely referred to in earlier court decisions:

a franchisee’s post-rescission losses are recoverable; and
franchisees are not under any duty to mitigate their rescission losses, unlike other plaintiffs seeking damages arising from the breach of non-franchise contracts.

Note: Idan Erez and Karine Bédard of Sotos LLP acted for the franchisee in this case.

How Sotos Can Help

Whether you are a franchisee concerned about the adequacy of the disclosure you received or a franchisor responding to a rescission claim, understanding your legal position is essential. Sotos LLP advises on franchise disclosure obligations and represents franchisors and franchisees in disputes involving rescission and related claims.

For advice on the sufficiency of a franchise disclosure document, potential rescission rights or liability arising from a rescission notice, contact Idan Erez at ierez@sotos.ca or 416-572-7314.

About the Author

Idan Erez is a partner at Sotos LLP whose litigation practice focuses on franchise and commercial disputes. Idan is currently serving as Chair of the Ontario Bar Association’s Franchise Law Section and is recognised by Best Lawyers in Canada for Franchise Law and by Franchise Times as a “Legal Eagle”.