Franchising a restaurant concept goes through fairly identifiable stages, from “birth” to “emerging” to “growth” to “maturity” and, potentially, to “exit”. Each stage brings with it new challenges and new opportunities. This article explores the typical characteristics of each stage.

Stage 1 – Birth

Most restaurant concepts are not started in anticipation of future growth by franchising. Some, however, are. Irrespective of the original intention for the concept, the birth stage for a restaurant franchise system must have the following characteristics:

• a name that holds prospects for obtaining a registered trademark;
• a unit that not only generates profit, but sufficient profit such that, if operated as a franchised business, it would continue to be profitable in the face of the added expenses that a franchisee would be required to pay to the franchisor (and possibly others); and
• a “system”. A “system” includes all or some of the following components—a distinctive look and feel to the restaurant design, an optimal footprint, proximity to a welcoming customer base, a recommended or fixed equipment list, a methodology for preparation and service and an intended brand image.

The birth stage is also when the would-be franchisor must first understand the legalities and regulatory environment affecting franchise sales and franchise relationships. To that end, where statutorily required, the “system” must also include a form of disclosure document, a franchise agreement and a whole range of potential ancillary agreements to provide to prospective franchisees.

Supplementary issues for consideration at the birth stage include whether the restaurant franchisor intends to supply certain core products to its prospective franchisees and the logistics of doing so, as well as whether it intends to sell units with sites in hand or before sites have been identified. These decisions may change over time.

With these attributes in hand and determinations made, the franchisor can begin to sell franchises.

Stage 2 – Emerging

An emerging system begins with the first franchisee and, from this author’s perspective, continues until the system reaches such a size that the franchisor has created independent value in itself as a franchising company. Hallmarks of value include, among other things:

• a stream of royalties and other payments coming in the door from franchisees;
• receipt of rebates from suppliers; and
• recognition of the brand outside of the trading area of the individual units.

The emerging stage may last for the first ten to twenty units.

From an administrative perspective, during the emerging stage, franchisors begin to evolve from an initial group of all-purpose personnel into an organization with specialized subgroups in charge of various discrete tasks, such as site selection, franchisee sales, menu development, product input selection, compliance, marketing and training. This organizational division will continue from the emerging stage through to maturity.

In addition, with respect to the issues of site buildout and location control, restaurant franchisors often make the important decisions at this stage of their growth whether they will take direct leases for locations or whether they will require franchisees to do so, and what role they will play in the build out of units, including the possibility of doing the construction themselves.

Stage 3 – Growth

In the growth stage, a franchisor is operating a recognized franchise system. Among other things, this translates into:

• the franchisor’s ability to access capital as desired to hire further staff, expand extra-provincially or internationally and to pursue other development strategies. In connection with this, the franchisor has also retained research and development personnel tasked with evaluating what modifications the system may need to adapt the concept to new markets, if necessary;
• the capacity to bring in-house certain activities which may have been previously outsourced (g., marketing, sales, legal, site selection);
• increased market knowledge (g., about the system’s customer base and the attributes of successful franchisees);
• well-established supply chains and rebate agreements;
• a developed philosophy around unit transfers;
• at least one wholesale review of the franchisor’s original agreements to reflect the evolving realities and needs of the system; and
• reliable franchisor profits.

In Canada, the growth phase may include up to forty units, give or take. This milestone may require anywhere from five to ten years to achieve depending on the success of the concept.

Given the length of operations typically required to reach this stage, franchisors at this level of growth also start to face renewals and extensions of franchise agreements, renovation requirements and possibly unit transfers and franchisee-successors. Leases are coming up for renewal and new rents must be negotiated or arbitrated. While the system’s branding may need a refresh, its social media profile, messaging and identity are well-cemented in its markets.

Finally, the franchisor is in a better position to operate locations in the event it needs to terminate a franchise. To that end, in all likelihood, the system has experienced disputes, the creation of franchisee advisory boards and potentially a franchisee association, multi-unit operators, terminations, take backs and re-sales.

Stage 4 – Maturity

At the maturity stage, the sky is the limit in terms of system growth. Units are sold and developed at the rate that the system can handle, subject to what markets are available and feasible in light of supply chain issues, competition and the interest and ability of the franchisor to be in and service those markets.

At this stage, most founders are considering one or more of the following as next steps:

• bringing in professional management;
• bringing in private equity;
• acquiring other systems;
• making an initial public offering;
• internal succession;
• merging with other systems; and
• potentially selling the system in whole or in part to other investors.

Stage 5 – Exit

A thorough discussion of the options available to founders of a mature system seeking an exit is beyond the scope of this article. Suffice it to say that throughout the life cycle of a franchise system that achieves maturity, its founders will become well-acquainted with the available exit strategies and will undoubtedly be giving consideration to what they may want to do eventually.

Two brief points ought to be mentioned:

• early identification of a founder’s long-term goals is critical, particularly when those goals are to eventually exit the system. In that case, the sooner the founder can tailor the characteristics of their system to be most conducive to their proposed exit strategy, the better; and
• as part of the franchisor’s strategic planning session, which is customarily held at least annually (and which also ought to include risk assessments and risk management planning and implementation), the agenda should include discussion of the potential or designed exit plan.

Conclusion

The trajectory of a restaurant franchise’s development is linear, moving from the first stage to the next, and so on. While this article has explored the typical characteristics of each stage, it is important to note that:

• the unit count in each phase may vary from system to system;
• the length of time it takes each system to move from stage to stage will vary; and
• some characteristics of a particular stage may be realized sooner in the lifecycle of a franchise system or later than what is described above.

Ultimately, how fast and how well a franchisor moves from stage to stage will typically turn on the franchisor’s level of sophistication, the demand for franchises and by the levels of satisfaction and growth of its franchisees.

Allan Dick, Sotos LLP

At Sotos LLP, we have assisted franchisors at all stages of growth. We help franchisors accelerate their development by introducing best practices to contribute to their success. Please contact the author at adjdick@sotos.ca or 416-805-8989 if you are interested in franchising or if you are looking for experienced counsel dedicated to your success to assist you with the development of your system.

The post The Stages of Restaurant Franchising appeared first on Sotos LLP.

1. The consuming public likes the offering;
2. Optimal locations have been secured; and
3. The franchisees are the right franchisees for the system.

This article focuses on the last factor.

Typically speaking, restaurant franchisors, like all franchisors, promote their systems to prospective franchisees principally on the basis that their systems are attractive business investments. In so doing, they seek to bring in financially viable prospects to help grow their brand. Likewise, a major factor in any prospective franchisee’s decision to invest in a particular system is the anticipated return on their investment.

While these are important considerations, as a result of this focus, what is sometimes overlooked by both sides during the sales process is whether, apart from meeting the franchisor’s financial requirements, a prospective franchisee has what it takes to be a successful operator in that particular system. This does a disservice both to franchisors and to prospective franchisees.

That is, once the franchise is granted, and assuming a good location is secured, the success or failure of the franchise will generally come down to how the franchisee operates their business. When a good operator is selected, they will generate positive returns for both the franchisee and the franchisor, enhance the brand’s reputation within its community and build cohesiveness within the system. Conversely, when a poor operator joins the system, they will typically be unprofitable, they may test the limits of the system and, through substandard operations, spoil the brand’s reputation amongst consumers and prospective franchisees.

Given this, when evaluating prospective franchisees, franchisors must look to more than just the typical qualification criteria of the prospect’s financial means to purchase a unit, whether the prospect has time to operate the restaurant and whether they can pass the franchisor’s training program.

Consider the following six questions when selecting your next franchisee.

1. What does it mean to properly qualify a franchisee financially?

Whether a prospective franchisee can purchase a restaurant with a small business loan should not be considered the qualifying financial baseline for purchasing a franchise. Rather, prospective franchisees should have significant available cash capital to sustain losses for at least the initial 12 months, notwithstanding the common provision in franchise agreements that they have resources to cover 3 months of operating costs.

Against that backdrop, it is critical that franchisors appreciate the harm that may be caused to their system when a franchisee struggles to operate financially. First, these operators are the first to cut costs, buy outside of the system, cut staffing levels or hours of operation, complain about profitability, and deflect their attention away from the basics of operating a good restaurant as designed by the system to try to avoid the costs of system compliance.

2. Is the prospective franchisee customer and employee driven?

Good restaurant franchising assumes the public likes the offering. It is the franchisee’s responsibility to execute the system, which means hiring, training and retaining the best staff, and understanding the best employment practices. Similarly, they need to be customer-friendly and actually enjoy interacting with their customers. Training franchisees in these aspects of the business is no substitute for seeing proof of these characteristics in a prospective franchisee’s application.  Have they successfully hired, trained and managed staff in the past? Have they had experience in sales and customer service?  Do they love these aspects of the business?

3. Has the prospective franchisee developed an exciting local store marketing plan?

Regardless of a franchisor’s marketing initiatives, most small local businesses thrive when their owners are part of the community they serve and have smart marketing plans to attract that community. A franchisee, and not the franchisor, should be the expert in the local market to be served by the business. Given this, prospective franchisees should be encouraged to develop and present detailed and thoughtful local marketing plans and proposed budgets, together with a demonstration of their personal commitment to the community, during the qualification period.

4. Does the prospective franchisee possess the same qualities as existing successful franchisees?

Franchisors, with or without the use of available third-party resources, must be able to identify the key qualities of their most successful franchisees and administer testing to prospects to measure how they stack up to the system’s gold standards of franchisee success.  Such testing should be a feature of every franchisor’s qualification process.

For example, one universally valued quality amongst franchisees is ambition. They must be driven to grow their businesses and be driven to invest in more units. Although space limitations prevent a discussion here of the challenges with multi-unit franchising and whether limits should apply to how large a franchisee should be permitted to grow, having successful multi-unit franchisees should be the goal of every system.  It is therefore, critical for a franchisor to know a prospective franchisee’s ambitions for purchasing a franchise and to assess their ability to achieve those goals.  Psychological assessment tools are available to assist with the analysis.

5. Does the prospective franchisee understand that operating a restaurant is hard?

The qualification process must reveal whether the prospect has a real understanding of what it takes to operate a restaurant and how that can impact their life and the lives of their family members. For example, most franchise agreements require a franchisee to devote their “full time and attention” to the business. In the usual case, that requires both operational management and management oversight on all other aspects of the business. While managers can be trained to perform these functions, franchised restaurant management works best when it is conducted hands-on by the owner. Moreover, given that franchisees incur significant fees that they would not otherwise incur if they were independent (e.g. royalties), these additional costs impact a franchisee’s ability to hire managers. Because of this, franchisees must be personally dedicated to the business and have the support of their families. These qualifications can be assessed in a properly designed and executed interview process.

6. Does the prospective franchisee understand the respective roles of the franchisor and franchisee?

This is an overlooked aspect of the selection process. Franchisors and franchisees perform different roles in a successful franchise system. Many prospective franchisees do not know, appreciate, and most importantly, accept these differences.

Franchisees’ primary roles are to execute at a high level the franchisor’s system. From time to time, there is a place for franchisors to tap into their franchisees’ experience and obtain the franchisees’ input to help improve the system. Lessons from the trenches can always be learned. On a day-to-day basis, however, it is the franchisee’s responsibility to trust in and execute the system it chose to join to the best of its ability and to work cooperatively with the franchisor in that regard. To that end, lawyers and business advisors who work for prospective franchisees to provide professional advice in the course of the prospect making the decision to invest in a franchise should be providing their clients with this understanding and helping them to assess whether the role of a franchisee is something they are willing and well-suited to perform. Rarely, however, is this done.  Because many restaurant franchise systems provide little room for franchisees to be “entrepreneurial”, it is critical that a franchisor be able to assess accurately whether a prospective franchisee is better suited to own or operate its own business rather than to own and operate a franchised business.

Selecting the wrong franchisee can be seriously detrimental to a franchise system.  Poor franchisees take up a disproportionate amount of management time. They are more likely to try to get out of their agreements or to advance claims against their franchisor. In provinces, like Ontario, where there are franchise disclosure laws, the identity and contact number for each franchisee is listed in the disclosure document. Given this, if other prospects decide to call existing franchisees during the sale process to learn more about the system, they may well get in touch with a poor performing franchisee who might be inclined to speak ill of the franchisor and the brand. Poor franchisees will also generate negative online reviews which have consequences for the entire system. In addition, when an otherwise good location is operated by a poor franchisee, this can lead to the permanent poor performance of the location even when it is subsequently taken over by a new franchisee.

It is hoped that from this discussion, franchisors will look past a prospective franchisee’s mere ability to purchase a unit and do the work necessary to determine if the prospect is a good candidate to be a key piece in the short, medium and long-term success of the franchise system.

Allan Dick, Sotos LLP

At Sotos LLP, we assist restauranteurs in determining whether to franchise their systems and provide aspiring franchisors with the guidance necessary to establish their systems and lead them through their various stages of development and maturity.  We also assist franchisors in every aspect of their sales processes.The author can be reached at adjdick@sotos.ca or 416-805-8989.

The post How to Select the Right Franchisee for your Restaurant Franchise System appeared first on Sotos LLP.

Against that backdrop, while the use of written employment contracts has never been the norm for the restaurant industry, it is argued here that these businesses can utilize these contracts to help address various of the unique labour challenges now faced by the industry.  For businesses that already use written employment contracts, it is recommended that those contracts be reviewed to address their current enforceability as a result of recent court decisions.

Basic principles and considerations applicable to employment contracts

Before discussing the specific content of written employment contracts, it is useful to review some basic principles and considerations applicable to all employment contracts:

1. in order for these contracts to be valid, they must be entered into before the employee starts their employment;
2. if an employee does not have a contract, one can be presented to them for required acceptance at the time of any proposed promotion or proposed new benefit, such as a raise in pay, or bonus;
3. if an employee does have an employment contract, depending on its terms, a new one can be presented to them for required acceptance at the time of any proposed promotion or proposed new benefit;
4. employees are not required to obtain legal advice before entering into an agreement; however, as a best practice, they should be encouraged to do so, or at least given a reasonable opportunity to do so;
5. in some provinces, (such as Ontario) employees cannot be bound to post-termination non-competition covenants. In Ontario, this restriction generally applies to all non-senior executive positions;
6. many employers use employment contracts to limit the amount of common law notice they must give to an employee when they want to terminate the employee for reasons other than for cause. The industry has typically not resorted to written contracts as this is usually not a serious concern for restaurateurs. To that end, most employees are not employed long enough by the same employer for this to matter much; employees who are let go can easily mitigate their damages in markets such as this, and the amounts in issue are not particularly significant for most employers. Nevertheless, many written employment contracts which have been in use contain termination provisions that the courts have invalidated.  These provisions need to be reviewed and updated where possible. More about this below.

Employment contracts provide flexibility

The fundamental benefit of an employment contract is to give the employer flexibility in how the employee can be employed. By way of a few typical scenarios demonstrating the need for such flexibility, in many restaurants these days, managers are increasingly needed to work the floor, the bar, and the kitchen. Without provision for this flexibility in an employment contract, a manager might claim to be constructively dismissed if, for example, they are required to fill the role of a dishwasher for any extended period of time. Similar concerns may arise for an employer with various locations that require its employees to work at different locations as directed by the employer. To the extent this possibility was not set out in an employment contract, depending on the degree of hardship involved in attending multiple business sites, an employee may have grounds to resist such direction. As another common example, consider also the need for the ability to vary or increase an employee’s scheduled working hours, or location where they work, with little notice to respond to issues arising from staff shortages.

The content of employment contracts

While a review of the full range of potential content in a written employment contract for use in the restaurant industry is beyond the scope of this article, the following list touches on a number of key provisions for consideration by an employer when drafting such agreements:

1. Bonuses/ profit-sharing – A written employment contract can address with much certainty how any bonus or profit-sharing entitlement will work. For example, it is not uncommon for the discretionary nature of any bonuses to be described in language which protects the employer and which also makes such bonuses payable only if the employee is employed at the time the benefit is stated to be payable.
2. Compliance with vaccination policies – A written employment contract can specify whether and to what extent the employee is required to comply with vaccination policies and what may or may not be required in the case of any illness or symptomatology. Whether contained in a written employment agreement or not, it is important that you obtain advice on your vaccination policies as there are human rights and accommodation issues that arise that should be addressed when formulating such policies.  Much has been written on the topic and there are divergent views.
3. Restrictive post-termination covenants – Although non-competition agreements for non-senior executives are invalid in Ontario and in many cases in other provinces, there are measures an employer can take to obtain related protections in the circumstance of a departing employee. For example, an employer can be specific as to which intellectual property it is entitled to protect and how it will do so. Those lawful protections are best set out in an employment contract, the fact of which also serves as evidence of the employer’s genuine interest in protecting its property.
4. Modification to benefits – Businesses may also want the flexibility to modify any benefits they may provide to their employees. The right to change or cancel benefits is a matter which can be included in a written employment agreement.
5. Layoff provisions – A written employment contract can also contain an express right of the employer to lay an employee off for a limited period of time without the layoff being considered a constructive dismissal at law. This is a very important consideration given the experience during the pandemic where employers were required to ask employees not to come in from time to time and for lengthy periods. Fortunately, the government also addressed this issue by regulation to support employers during the pandemic, but a properly worded contract can avoid the problem.
6. Notice requirements – A written employment contract can set out how much notice the employee may have to give if they want to quit. Subject to the minimum requirements provided for, in provincial employment standards legislation, the contract can also specify the required notice that the employer must give in a without-cause termination situation.  The parties can also agree on the circumstances in which the contract will be determined to be “frustrated” or terminated as a matter of law, for example, if the employee is unable to work for a certain extended period due to any prolonged health issues. Courts do tend to be extremely rigorous in their analysis of these provisions such that any deficiency will tend to invalidate them in favour of the employee.  The likelihood of such provisions surviving a challenge is increased if notice is not limited to minimum employment standards requirements but rather includes something more, even if less than common law notice.
7. Termination provisions – A written employment agreement is particularly useful in defining what constitutes cause for dismissal which would allow the employer to terminate the employee’s employment without any notice or pay in lieu of notice, such as in the instance of fraud, theft, or deception. Based on recent authority, dismissal for cause is viewed strictly by courts and will not be enforced unless the conduct is extremely serious as reflected by these examples.
8. Severability – A written employment contract should contain a provision that allows any provision which may be found to be unenforceable severable from the balance of the contract so that the balance remains enforceable.

An alternative to employment contracts and independent contractor agreements

As an alternative to requiring the employee to sign an employment contract, before their employment begins, an employee can instead approve a description of their prospective role which is broadly drafted to address certain of the issues identified above.  For the employer who may want to avoid the formality of a more detailed contract, this is a minimum best practice.

If a prospective worker is in fact an independent contractor and not an employee, and the business wants to ensure that the person is categorized as such, a written independent contractor agreement rather than an employment contract is strongly recommended.

There are many critical differences between employees and independent contractors, which can affect the content of a business’s written independent contractor agreement. As a few examples of these differences, independent contractors are not entitled to the various rights and protections contained in provincial employment standards legislation, such as in respect of termination rights, rights to disconnect, vacation pay, etc. It is also noted that a business is not required to withhold and remit for income tax payable by a worker or to comply with other government-required deductions where that worker is an independent contractor (as opposed to with employees).  The taxing authorities, however, will look at the substance of the arrangement to determine if employment taxation applies regardless of the way the parties have described their agreement. A mischaracterization can be costly to a business if monies are found due to the government. To that end, and without being exhaustive, critical indicia of an employment versus an independent contractor relationship include the business’s control (or lack thereof) over hours worked, the worker’s right or inability to work for multiple businesses, the full-time nature of the work, and the ability to exercise control over and provide direction to the worker.  In addition to taxing authorities, other government agencies such as labour boards and workers’ compensation can scrutinize these arrangements and decide the matter on the basis of substance over form.  Legal advice should be obtained before characterizing a relationship as that of an independent contractor.

Further incentives to utilize written employment contracts

In addition to the foregoing benefits of utilizing written employment contracts, these contracts are easy to prepare and can be drafted in a general template form applicable to every position within the restaurant, from the general manager position down to various part-time worker roles.

However, it is crucial to note that any template that was not drafted by a human resources/employment law specialist in 2022 may contain unenforceable provisions or, at worst, may be unenforceable in its totality. For example, as noted above, an employment contract that contains an unenforceable non-competition provision, but which fails to also contain a “severability” clause, may not be enforceable at all.  For businesses with employment contracts like this, it is important that they seek legal advice to determine what strategies are available to them to address this potential concern. To avoid this and other pitfalls, it is best not to use an old form of the employment contract but to obtain advice on preparing a current form reflecting up-to-date industry best practices. Furthermore, it is also highly recommended that existing employment contracts be reviewed regularly by legal professionals to ensure they remain in compliance with the law.  Courts regularly issue employment decisions, some of which can materially change the responsibilities of employers and impact the enforceability of contracts or contractual provisions.

In addition to drafting written employment contracts in response to new legal decisions and employment standards legislation, there are numerous other pieces of legislation that impact employers’ obligations to employees, including those relating to worker’s compensation, occupational health and safety matters, and human rights. Whether or not a business is preparing new employment contracts or updating existing contracts, it is always advisable for employers to proactively undertake periodic reviews of their obligations or have access to resources that update them on what they need to know when managing any sized workforce. For example, we have come across a number of Ontario restaurants that inadvertently missed recent legislative amendments which require them to make their washroom facilities available to those participating in the gig economy, such as third-party delivery drivers. With that in mind, it is recommended that employers review the Future of Work Report which can be found at www.Ontario.ca/document/future-work-Ontario to get a glimpse at where future government regulation may occur.

Allan Dick, Sotos LLP

At Sotos LLP, we assist many franchisors and other businesses in the food service and hospitality industry in handling and advising on employment-related matters affecting them and their systems.  If you have any questions relating to your workforce, please contact the author at  adjdick@sotos.ca or 416-805-8989.

The post The Case for Employment Contracts in the Restaurant Industry appeared first on Sotos LLP.

Given the significance of this juncture in the evolution of a franchise system, it is crucial that franchisors first have regard to certain fundamental initial considerations before they decide to extend beyond their national borders. With that in mind, the following are five key questions that franchisors should answer when considering international expansion for their brands:

1. Are you pushing or being pulled?

Many franchisors expand internationally as a result of a foreign national experiencing their brand during a trip abroad. The individual loves the franchisor’s concept and believes it can work in their country.

Following an expression of interest, the franchisor, enticed by the prospect of selling into a new country and earning a significant fee from the prospective master franchisee or area developer, decides to franchise their concept in a foreign country.

This scenario is an example of a franchise system being “pulled” towards international expansion. While excited to grow internationally, albeit through the initiative of others, franchisors in this situation have done little, if any, research into the details of the expansion into the target country to their own potential detriment.

In contrast to this passive expansion strategy, franchisors should instead be actively considering the prospect of international franchising when they start their growth phases. They should be dedicating time to the prospect of “pushing” their concept into international markets. Among other things, this includes conducting certain critical investigations, such as:

• Who is my competition and who owns my competition?
• What are the local laws?
• In what way will my system need to be adapted to account for local preferences?
• How will my supply chain work?
• Is growing internationally the best use of my available resources?

2. Do you appreciate the potential impact on your intellectual property?

Most franchisors begin franchising with a trademark which they have either registered or have made an application to register with an opinion of its likely registrability.

It is critical to ensure that a franchisor’s trademark is protected in the country they are looking to expand into. That is, if a franchisor gives up the use of its trademark to third parties, for example to a master franchisor or unit franchisees, it needs to understand the chances of that trademark being unrecoverable to them at law or in practice if there is a breach of their intellectual property rights contained in their initial agreements.

In too many cases, franchisors only get one chance to get this right. Practically speaking, the loss of control over their own brand will mean that no second chance will be possible.

3. What is the best way to expand?

Franchisors typically expand internationally through master franchising or area development agreements, though often by way of a new legal franchisor entity to address tax and liability considerations. Each model has its pros and cons for international expansion.

Errors are often made choosing which model to utilize without the franchisor first appreciating the business issues associated with each. For instance, international franchising can be a very “skinny” model for the master franchisee. It must operate an entire franchise system with a fraction of the fees that the master franchisor receives when it operates its own national system.

This model can place a great deal of financial pressure on the master franchisee which can lead to failure. Getting the economic balance right between the franchisor and its international partners is critical for long-term success. Both sides need to win. If either loses, the whole effort is likely to fail.

The vast majority of the largest international franchisors are American-based. There are many resources and dedicated experts in international franchising available which have developed from that market. Moreover, most international practitioners have a tight network of reliable, capable colleagues across the globe that know the ropes and can guide a franchisor focused on international expansion to success. Given this, there is no reason for a franchisor looking to expand internationally to reinvent the wheel.

Picking the right first country to expand into is an important decision to be made. For instance, for Americans, coming to Canada may be a logical first start to international franchising. The reverse however might not be the case.

4. Do you know your partners?

Choosing any foreign partner, whether as a master franchisee, area developer or unit franchisee, is always more challenging than selecting a partner in one’s own country. For example, language and cultural differences can raise obvious concerns. Some franchisors look for their international partners to be the experts in their country that will do all the leg work while the franchisor simply provides the name and the system. Similarly, some franchisors off-load the responsibility of creating local legal agreements to their international partners.

Time must be taken to know your prospective international partner(s), to assess their capabilities, resources and competing interests, and to learn from them and with them. Doing so will naturally increase the likelihood of securing a partner with greater experience, knowledge, local expertise and possession of valuable assets (for example, they may operate a portfolio of brands or control critical real estate).

It is also essential that local legal counsel be engaged to negotiate the transaction and ensure compliance with any local laws affecting the proposed agreement or relationship. Franchisors can use experienced counsel in their own countries to work with external foreign counsel to assist in the process and help the franchisor navigate through the issues.

5. Are you prepared to stay involved?

The commitment to international franchising requires more than the decision to do so and a resulting agreement with an international partner. It is critical for franchisors to remain hands-on in these foreign markets regardless of the expansion model they follow.

For example, most international deals contain quotas and expectations on the local partners in respect of the growth of the brand in their jurisdictions; however, these are frequently not met. It is imperative for a franchisor to stay connected, stay involved, provide support, watch for signs of trouble and know what it is looking for in the market.

It is a commonly stated rule of thumb that it takes five years of focused research and planning to maximize the chances of success in international franchising.

Franchisors can apply many of the lessons they learned when growing locally, regionally and nationally to an expansion beyond their national borders. Fortunately, international franchising is now a well-developed model and there are professionals dedicated to this aspect of the franchising industry.

As Canada’s largest franchising law group, Sotos LLP has assisted many international franchisors in their efforts to come to Canada and in taking Canadian brands international. The firm has developed a large network of local experts in many countries with whom the firm members have worked in helping to guide all manners of international franchising to success.

This article was originally published in the Global Franchise Magazine.

The post The Fundamental Initial Considerations for International Franchising appeared first on Sotos LLP.

Fundamental to these strategies is the selection of a name and identifying logo(s) that can be protected. Once selected, from an intellectual property perspective, a business’ name and logo(s) must be protected from those who may intentionally or unintentionally usurp the value of these critical assets for themselves.

In 2019, Canada overhauled its system for the registration of trademarks and as a result, the Canadian Trademarks Office has been flooded with applications. Combined with the impact of the pandemic affecting the ability of the office to process these applications and the influx of cannabis-related applications resulting from the legalization of cannabis, the time it’s taking to get trademark approval has more than tripled, with waits of three years or more to be expected.

The changes to Canada’s trademark regime provided a tremendous opportunity for people to register trademarks that they may have no intention of ever using for themselves. Prior to the recent changes, an applicant would not be able to have a trademark registered unless it was using its mark. Now, the only basis on which they will be denied their applications is if there is already a user of the trademark in Canada or if the trademark being applied for does not meet the qualifications for a trademark to be registered as specified by the legislation.

As a result, Canadian businesses engaged in foodservice and hospitality, or thinking of entering the industry, should ensure they have undertaken, or should undertake, the following measures:

Review their existing registered trademarks. It’s critical that the goods and services encompassed by their original applications were comprehensive and reflect today’s actual use and any contemplated future use. Additional coverage using the “Nice” [named after the city in France] system of classification introduced in 2019 is essential to cover any missing existing uses and even possible prospective uses. The Nice classification was intended to bring the Canadian system in line with the vast majority of the world and allows registrations in Canada to have more global reach. In respect of existing uses that are not captured by the existing registered trademark and prospective uses, a search should be undertaken to determine if any business has been using or has applied for registration for the use of the trademark in respect of such use.

Conduct regular monitoring of the trademarks’ database to uncover any possible infringing applications (or registrations). These should be addressed immediately. The new laws permit a possible form of early intervention rather than the previous requirement to await the advertisement of an application in order to oppose it (which now takes place some 18 months or so after the initial trademark application has been filed). This applies to a business’ registered and unregistered trademarks. Apart from intervening through the Trademarks Office, early communications to cause the would-be infringer to cease and desist from its efforts need to be considered and likely undertaken without delay.

In addition, it’s critical to understand the significance and exposure of applying for a new trademark where use has not yet occurred. By applying to register a trademark which is not yet in use, a business gains the advantage that, once registered, the protection as a registered trademark dates back to the date of application. On the downside, by applying for the registration of a trademark that is not yet in use, a business will be providing notice to the world of its intended trademark and the uses to which it intends for it to be put. In some instances, an application to register may also provide competitors with an early indication of any new product or service that the applicant may be planning to offer.

Trolling for Trademarks
People who troll the trademarks database can find applications for trademarks and research for themselves whether they are in use or not. Aggressive trolls might then seek to use the very trademark that has been applied for before it is used. What are the rights of the person who has applied for the trademark in that situation?

In a recent court decision, our firm secured an injunction to prevent a third party from using a trademark which a would-be franchisor had applied to use and which it had incorporated into its franchise-system design in which it was deeply investing to launch. The injunction had been opposed on the basis that the opponent was already “first to use,” allegedly both prior to the application to register being made and subsequently (but of course prior to the application being granted). The opponent asserted that it had the right to use the trademark given that the application had not yet been granted even if its claim of prior use was not accepted.

If we ignore the factual findings of the court, which did not accept that the opponent had in fact used the proposed trademark prior to the date of application, the court agreed with the position of our client that the party applying where there had not been demonstrated use prior to the date of application, was entitled to protection for the trademark it had applied for even prior to the application being granted. As a result, and as the client was able to prove that it was suffering irreparable harm, the court enjoined the opponent’s use of the proposed trademark requiring the opponent to take down its signs, change its menus and remove references to the trademark from its online presence and all social-media accounts pending the trial of the action. Third-party delivery apps have respected the court order. The opponent is seeking the court’s permission to appeal this result. In the meantime, the message remains that its crucial that brand owners look to protect their existing brands and those which it may potentially look to develop. Legal advice should be sought to strategize the best means of protecting unregistered trademarks for which trademark applications will be filed particularly where those marks are not yet in use. For those currently using marks which have not been registered, they should seek to file trademark applications to protect their rights in those marks and obtain registration status.

Challenges & Opportunities
The new Canadian trademarks regime presents a host of opportunities and challenges. Given the importance of branding and marketing to any business looking to expand, particularly by way of franchising, it is crucial that such business conduct a health check on the security of its intellectual property assets. It should further ensure that it has an effective program in place for the ongoing protection of its registered and unregistered existing trademarks and prospective marks.

The concerns set out in this article apply equally to foreign franchisors and other businesses which may be contemplating expanding into Canada. Such businesses should be applying to have their marks registered in Canada as soon as possible. Prior to the recent changes to Canada’s trademark regime, registration would not be granted unless the foreign applicant had started using the mark. But that is no longer the case. We’ve experienced instances where a foreign franchisor or other business which has finally decided to enter the Canadian market is surprised to discover that someone else has already registered their mark(s) in association with the same goods and services.

Potential franchisees will be reluctant to invest in any franchise system that does not have registered trademarks or which has not applied to register its marks with a strong likelihood that such applications will be approved by the Trademarks Office. Potential investors will require business to demonstrate that it has good title to those trademarks.

A business that believes that its registered or unregistered trademarks have been infringed have a variety of legal recourses available to them depending on the nature of the marks, whether they are registered or unregistered and the nature and degree of infringement. Apart from such legal remedies, experienced legal counsel may be able to recommend and seek interim relief to those affected by trolls and other unauthorized users of a business’ intellectual property. Given the changes to Canada’s trademark regime as outlined above, we have experienced a significant increase in the amount of work directed to the prevention of trolling and unauthorized uses of registered and unregistered trademarks.

Allan Dick, Sotos LLP

Sotos LLP assists many franchisors in the design of their systems. Many of the aforementioned leasing considerations are also applicable to single-unit or multiple-unit non-franchised restaurant operations. If you have any questions about your leases or land control issues, please contact the author at adjdick@sotos.ca or 416-805-8989.

The post The new Canadian trademarks regime presents a host of opportunities and challenges appeared first on Sotos LLP.

In the franchising context, one fundamental decision that a would-be restaurant franchisor makes is who will hold the lease for the business. There are typically four options: the franchisor; the franchisee; an affiliate of the franchisor, which holds leases for the entire system and sublets premises to its franchisees; or a single-purpose affiliate of the franchisor that holds an individual lease, which it sublets to a particular franchisee.

There are traditional considerations, pro and con, impacting franchisors’ decisions for the land-control aspect of the design of their systems. These considerations are re-examined below in light of the approaching endemic.

Direct or indirect franchisor control
Franchisors looking to maximize control over their franchisees’ premises typically enter into leases directly or through either a leasing affiliate or single-purpose affiliate. In situations where the franchisee may be terminated or abandon the system, having land control is useful because it prevents the franchisee from remaining in possession of the premises and operating from a location previously affiliated with the system. In these circumstances, land control also helps to minimize the likelihood a franchisor will need to sue to enforce any applicable covenant not to compete.

Landlords may require franchisors to provide an indemnity, or limited indemnity in duration or amount, if they are prepared to accept a franchisor’s affiliate as the tenant because these affiliates, typically speaking, are mere holding companies with no meaningful covenant to offer themselves. In this scenario, it’s the franchisor or its affiliate who is directly responsible for fulfilling the tenant’s obligations under the lease. To that end, franchisors often face the situation of funding rental payments when they terminate a franchisee’s sub-lease, pending their ability to re-franchise the location.

In the age of an endemic, this strategy of holding leases, whether directly or indirectly, can create tremendous financial hardship on a franchisor where the sub-tenant franchisee may not itself be able to maintain its payments under its sub-lease and any franchisee indemnifier does not have the wherewithal to make good on any indemnity given under a sub-lease/franchise agreement.

Franchisee Control

The immediate reaction to the potential financial burden on a franchisor resulting from holding leases, whether directly or indirectly, is to instead require franchisees to lease their premises directly from their landlords. The decision to have franchisees lease directly as a matter of system design is not a standalone decision, but involves several other critical decisions:

• Is the franchisee or the franchisor primarily responsible for seeking out suitable premises and negotiating the lease?
• Is the franchisee or the franchisor responsible for the build-out of the premises?
• Who will receive any tenant allowance which may be available to the tenant?

Leaving these considerations aside, allowing franchisees to lease premises directly from a landlord creates the following dynamics:

• The franchisee will have the primary relationship with the landlord. The franchisee may not have the necessary gravitas or skill to negotiate with its landlord during an endemic;
• There is a greater likelihood of a default occurring if the franchisee cannot sustain its rents with no, or limited, business;
• If the franchisee is seeking to terminate its obligations with its franchisor, it will have control at first instance of its location and may have a positive relationship with its landlord who may support a de-identification;
• A franchisee may be behind in their obligations for some time before the franchisor becomes aware of the default; and
• It may be more difficult for the franchisor to negotiate for its receipt of tenant allowances or inducements.

The experience from this endemic has overwhelmingly suggested that franchisors need to design their systems with the least exposure to lease liabilities and cross-defaults under their leases as possible. Funds that must be paid to landlords are needed for other purposes — innovation, franchisee support, wage support for key employees and maintaining corporate locations. Paying rent on closed or partially open locations can create a significant risk to the health and future of a franchise system very quickly.

Assuming the endemic is here to stay, with the prospects of future variants and renewed partial or total closures, along with the unpredictability of government-support programs, the choices for franchisors on the matter of land control are narrowing. At this time, franchise systems should approach land control with the following design features:

• Franchisees should be responsible for finding locations within the territory agreed to, subject to the franchisor’s approval. If suitable locations are not found within a specified period, franchisees should be entitled to a return of the initial franchise fees, in whole or in part;
• Franchisors should provide guidance to franchisees on lease terms, and should either consider providing franchisees with an approved form of a letter of intent to be utilized by franchisees or take responsibility for the negotiation of the letter of intent and lease on behalf of the franchisees;
• Franchisors should be entitled to approve the form of an offer to lease and lease, which the franchisee intends to enter into if they have not undertaken the negotiations themselves;
• Franchisees will take the ultimate responsibility for the terms of any offer to lease or lease they enter into;
• Franchisors should require franchisees as a term for their approval that they be given the following rights:

1. To notice by the landlord if a breach of the lease occurs;
2. to have the lease conveyed to the franchisor upon a termination of the franchise agreement;
3. To have time to re-franchise upon a conveyance of the location and, during that intervening period, to be “dark” if necessary;
4. To occupy the location under the franchise agreement in the event of a large group of defaults by a franchisee and to operate the business for the account of the parties as set out in the franchise agreement;
5. To receive any tenant allowances to support construction;
6. To control the construction at the franchisee’s expense;
7. To take security over the tenant’s assets (to the extent permitted by any loan which a franchisee may need to procure to support the construction and store opening); and
8. To act as the franchisee’s agent for an additional fee to negotiate with the landlord where necessary.

These guidelines require a great deal of understanding on the part of franchisors and significantly impact the drafting of the default agreements utilized within the system.

Lease Terms

Franchisors will want to pay particular attention to the following matters if they allow their franchisees to lease their premises directly.

Force Majeure: As a result of the pandemic, most landlords and franchisors re-visited the wording of the force majeure/unavoidable-delay provisions of their leases and other agreements. For a franchisor, to the extent possible, it will not want the tenant to be paying rent if the tenant is not receiving revenues of any significance or governmental assistance. More specifically, the franchisor will want to ensure that these provisions, which would suspend the tenant’s obligations to perform, include government lockdowns, whether formal or informal, and specifically do not require the tenant to pay rent during this time.

Use Clause: Franchisors should confirm that the use clauses in their leases are limited to the activities of operating the system’s business but allow for sufficient flexibility to permit them to modify the business as they may need to.

Insurance: Franchisors will want to ensure that the franchisee/tenant is carrying sufficient and appropriate business-interruption insurance.

Formal Lease: If the franchisors’ entitlements are to be more specifically included in the formal lease rather than the offer to lease, they will not want their franchisees taking possession of the premises under the franchise agreements until the subject lease is fully executed.

Landlord’s Work/Tenant’s Work: Whether in an offer to lease or lease, franchisors should ensure that they have approved all work that is expected to be performed by the landlord and the tenant. A franchisor’s form of letter of intent that its franchisees either utilize or are guided by should include these provisions.

Land control is one of the most difficult pieces of franchise system design that a franchisor must understand, appreciate and gain expertise in. The decisions made around land control and the execution of these decisions can make the difference between system success and failure during a pandemic/endemic.

Allan Dick, Sotos LLP

Sotos LLP assists many franchisors in the design of their systems. Many of the aforementioned leasing considerations are also applicable to single unit or multiple unit non-franchised restaurant operations. If you have any questions about your leases or land control issues, please contact the author at adjdick@sotos.ca or 416-805-8989.

The post An endemic can impact land-control decisions for restaurant operators appeared first on Sotos LLP.

On August 30, 2021, the Court of Appeal for Ontario released its decision in 2161907 Alberta Ltd. v. 11180673 Canada Inc (“Tokyo Smoke”).^[1]

This decision re-affirms previously established principles relating to contractual interpretation and the duty of good faith in long-term relationship contracts, which we previously discussed in our post “Wastech and the Franchising Context”.

While the Supreme Court of Canada’s landmark 2014 decision in Bhasin v Hrynew established good faith contractual performance as a “general organizing principle” of the common law of contract, the precise boundaries of this duty of good faith have thus far been difficult to practically define.

Helpfully, Tokyo Smoke provides some guidance on the type of conduct required for a finding of a breach of the duty of good faith in relation to the termination of an agreement.

Summary of Facts

2161907 Alberta Ltd. (“216” or “licensor”) holds the Ontario rights to the “Tokyo Smoke” cannabis brand and licenses it to various retail operators. 11180673 Canada Inc. (“111” or “licensee”) won a cannabis retail operator license in an August 2019 allocation lottery by the Alcohol and Gaming Commission of Ontario (“AGCO”).

In November 2019, 111 and AGCO entered into a License Agreement for the use of the Tokyo Smoke brand and an accompanying Sublease, whereby 111 rented the retail premises from 216 for the operation of a cannabis store. 216 offered 111 funding for start-up costs, including funds for the monthly rent of $105,409.03, and an approximately $2 million inducement to open under the Tokyo Smoke banner (the “Branding Fee”).

On June 1, 2020, two days before opening, a dispute arose over rent. 216 indicated that it would not be paying 111’s June rent. In turn, 111’s principal advised 216 that he would be laying off employees and not opening the store as planned if the rent issue was not resolved.

216 took the position that 111’s threat to cease business operations was an Event of Default under the License Agreement and terminated the parties’ relationship. On June 2, 2020, 216 pulled its staff from the store premises and delivered Notices of Default to 111.

On June 3, 2020, 111 opened the store despite the delivery of the Notices of Default. 216 subsequently delivered a Cease and Desist Notice to 111, but 111 took the position that it was not in default of the parties’ License Agreement and continued to operate the store.

Accordingly, 216 brought an application seeking a declaration that 111 had breached their various agreements, that the Branding Fee was not payable, and that 111 must vacate the store premises.

111 brought a counter-application seeking payment of the Branding Fee, and a declaration that 216 had wrongfully terminated the License Agreement and breached its duty of good faith in the performance and enforcement of the parties’ contractual relations.

Procedural History

Justice Gilmore of the Ontario Superior Court of Justice dismissed 216’s application, holding that 216’s termination of the License Agreement was not valid and ordering 216 to pay the Branding Fee.

Upon examining the surrounding context and interactions between the parties, the Court found that 216 had no valid reason to terminate its agreements with 111, as no breach of the Licence Agreement had occurred. 111’s principal’s communication to the effect that he would not be opening the store and would be laying off staff was not an Event of Default under the License Agreement, but merely “an emotional response to being given incorrect information at a critical time”.

Further, the Court held that 216’s termination of the agreements was done in bad faith. The Court found that, based on 216’s representative’s admission in cross-examination that on the morning of June 2, 2020, 216 was looking for a way to end the relationship with 111, 216 had “pounced” on the statement made by 111 as a way to terminate the relationship and avoid paying the Branding Fee. Therefore, 216’s termination of the agreements was not done in good faith.  The issue of 111’s damages for the breach was to be left to be addressed at a later date.

216 appealed to the Ontario Court of Appeal. Among other things, it argued that the application judge erred in finding that 216’s termination of the License Agreement was invalid, and that 216 had breached the duty of good faith in contractual performance to 111.

The Ontario Court of Appeal Decision

The Ontario Court of Appeal allowed the appeal in part. It upheld the application judge’s finding of breach of contract by 216 for wrongfully terminating its License Agreement with its licensee, 111, but it overturned the finding of bad faith conduct on the part of 216.

Breach of Contract Findings

Justice Rouleau, writing for the Court of Appeal, held that the application judge’s interpretation and application of the parties’ contractual terms were owed deference on appeal, and found that there was no basis to interfere with Her Honour’s findings.

While the Court of Appeal accepted that the 111’s communications were, on their face, a threat not to open, nevertheless, the Court did not apply a literal approach to the License Agreement and rejected this possible interpretation of the License Agreement.^[2] Rather, the Court of Appeal endorsed the interpretation of the License Agreement made by the application judge that would require the threat to be objectively credible in order to trigger a default under the agreement.^[3]

In adopting this interpretation, the Court of Appeal emphasized that the application judge’s finding that the licensee’s emotional response did not constitute a threat for the purposes of meeting the requirements of the parties’ Event of Default termination clause was drawn from Her Honour’s “objective assessment of the parties’ exchanges in light of the language of the agreement and the factual context”.^[4] Thus, the Court of Appeal affirmed that determining whether the threat was objectively credible required this type of contextual analysis.

Upon reviewing the factual matrix[5], the Court of Appeal held that it was clearly reasonable for the application judge to find that 111’s statements did not meet the requirements of an Event of Default under the parties’ License Agreement.

Bad Faith Findings

Beginning at paragraph 40 of the reported decision, the Court of Appeal conducted its analysis of the application judge’s finding that 216 breached its duty of good faith to 111.

The Court of Appeal ultimately found that 216 did not act in bad faith, because it simply misunderstood its rights and acted on its mistaken belief in its rights when it wrongfully terminated the License Agreement.  While 216’s basis for terminating the License Agreement ultimately proved invalid in law, its position on termination was not so unreasonable, malicious, or inconsiderate of 111’s legitimate contractual interests as to constitute bad faith.

In conducting this analysis, the Court of Appeal considered and rejected four potential sources of bad faith conduct by 216:^[6] (i) that 216 knowingly misled 111; (ii) that 216 “pounced” on a default that it did not believe had occurred; (iii) that 216 sought to evade payment of the Branding Fee in bad faith; and (iv) that 216 seized upon a breach of its own making.

• 216 knowingly misled 111

Critical to the Court of Appeal’s finding that there was no bad faith conduct by 216 was the fact 216 was not found to have acted dishonestly^[7], capriciously^[8] or in a way that was so inconsiderate of 111’s legitimate contractual interests as to constitute bad faith.^[9] 216’s basis for terminating the License Agreement was not manufactured or concocted, it simply believed that 111’s purported threat was a breach it could act on.^[10]

Thus, although the Court of Appeal accepted that 216 had misled or misinformed 111, it did not find bad faith conduct because 216 had not “knowingly mislead” 111 about its intention with respect to the Branding Fee or the deferral of rent.^[11] 216 did not lie to 111 at any point, but simply changed positions given new information.

• 216 “pounced” on a default

In determining whether 216’s actions in “pouncing” on the alleged default by its licensee constituted bad faith, at paragraph 63 of Tokyo Smoke, the Court of Appeal described the type of conduct that would make “pouncing” on a default bad faith conduct:

…The breach he ultimately invoked was based on 216’s understanding that the threat was the type of threat contemplated by paragraph 26(c). That interpretation was wrong but, absent a finding that it was a position manufactured to achieve 216’s objective of ending the relationship, an unreasonable position, or a position taken capriciously or arbitrarily, it constitutes an error and no more.

Thus, the Court of Appeal concluded that 216’s erroneous belief that the circumstances gave rise to a right of termination does not amount to bad faith, regardless of 216’s underlying desire to end its relationship with 111. The termination right was part of the parties’ bargain and reflected the licensor’s legitimate interest in protecting its brand.

• 216 sought to evade payment of the Branding Fee in bad faith

The Court of Appeal also considered the argument that 216 had an improper motive for terminating the License Agreement, which reason constituted bad faith conduct. In paragraph 66, it re-affirmed the principle that “a party has a duty not to evade its contractual obligations in bad faith. As a result, a party that manufactures an artificial reason to terminate a contract in order to avoid future payment obligations would likely be found to have acted in bad faith.”^[12]

Here, 216’s alleged improper motive was to avoid the payment of the Branding Fee to 111. However, the Court of Appeal held that since the application judge did not reject the evidence of 216 that it was not seeking to evade that payment,^[13] there was no bad faith conduct. 216 did not manufacture an artificial reason to avoid paying the Branding Fee but believed its termination of the Licensing Agreement was justified. The fact that termination releases a party from making a significant payment does not amount to bad faith, even where a court later finds that the termination was invalid.

• 216 seized upon a breach of its own making

Lastly, the Court of Appeal considered whether the doctrine of invoking a breach of its own making as set out in the Supreme Court of Canada decision of Mason v. Freedman^[14] applied. The doctrine stipulates that a party should not be permitted to evade its contractual obligation by seizing upon the consequences of its own mistake.^[15]

In considering the doctrine, the Court of Appeal concluded that, unlike Mason, there was no deliberate attempt by 216 to create the conditions giving rise to 216’s right of termination. 216 misinterpreted the parties’ agreement when it made the statements that triggered 111’s “threats”, which 216 in turn perceived as an event of default.^[16] Thus, the doctrine did not apply.

Key Takeaways 

Tokyo Smoke reaffirms that the conduct of the parties under an ongoing relationship contract must be viewed in context and that a contextual analysis is necessary to determine both the parties’ rights and obligations under the contract, as well as whether a breach of such rights did in fact occur.^[17]

Tokyo Smoke also establishes that:

• A finding of bad faith is not required for a determination of breach of contract: A breach of the duty of good faith is not a condition precedent to a finding that a party wrongfully enforced the termination provision in a long-term relationship contract. A party can be found to be in breach of an agreement in the absence of bad faith conduct.
  Although the Court of Appeal in Tokyo Smoke overturned the application judge’s finding that there was a breach of the duty of good faith, the Court of Appeal did not overturn the finding of a breach of the License Agreement and found that the conduct of the licensor was “quite simply a case of breach of contract”.^[18]

• The duty of good faith does not prevent a party from exercising its contractual discretion to terminate an agreement: A party is not prevented from exercising a valid right of termination simply because it desires to end a relationship, and “pounces” on what it views as an opportunity to do so.
• The duty not to evade contractual obligations in bad faith is breached when a party intentionally creates the circumstances it relies on to terminate the agreement: When a party manufactures an artificial reason to terminate a contract in order to avoid future obligations, it will likely be found to have acted in bad faith. Similarly, a deliberate attempt to create the conditions to trigger the other contracting party’s contractual default is a hallmark of bad faith.

Implications for Franchising

In the six Canadian provinces that have franchise legislation[19], parties to a franchise agreement owe each other a duty of fair dealing in the performance and enforcement of the franchise agreement.  In each of these provinces except Alberta, the fair dealing obligation is said to include the duty of good faith.  As such, these common law standards of what the duty of good faith entails are informative in understanding the statutory duty of fair dealing.  In addition, however, the duty of fair dealing is said to include the duty to act in accordance with reasonable commercial standards.  The demonstration of such standards may, in fact, further inform the duty of fair dealing and any “reasonableness” aspects of the good faith obligation.

At the lower court level in Tokyo Smoke, the parties argued whether the license agreement at issue was a “franchise agreement” as defined by Ontario’s franchise legislation, Arthur Wishart Act (Franchise Disclosure), 2000.[20] The court declined to determine the issue as the license agreement at issue contained a provision which expressly included an obligation on the parties to act in good faith in its performance.  The issue was not addressed further in the Court of Appeal.

It is unfortunate that the court did not address the issue of whether the license agreement was in fact a franchise agreement within the meaning of the legislation.  If the case, however, did not invoke any issues of reasonable commercial standards, then it is likely that the outcome of the decision would not have been different, whether the court was assessing the good faith obligation or the statutory fair dealing obligation.

Franchisors are well-advised to consider their franchise agreements and to include provisions which will define for the parties the nature and scope of their obligations and the purposes for which any contractual discretion is being retained.

At Sotos LLP, our lawyers regularly advise our franchising and licensing clients on matters relating to the preparation of and the performance and enforcement of their agreements.  Please contact the writer at 416-572-7306 if you wish to discuss the implications of evolving law of fair dealing and good faith to your business.

[1] 2021 ONCA 590 (“Tokyo Smoke”).
[2] Tokyo Smoke at paras 30-31.
[3]Tokyo Smoke at para 31.
[4] Tokyo Smoke at para 38.
[5] The context was that, prior to the alleged default, 216 wrongly advised 111 that it had no obligation to advance any further monies to it under the parties’ agreement, which would have left 111 unable to pay its rent and employees for the June opening month of operations. It was after receiving this wrong information from 216, that 111 made its “threat” to not open the store and lay off its employees, which “threat” was the default that 216 subsequently relied on to terminate the License Agreement between the parties. 111 correctly believed that 216 had breached their agreement by refusing to provide this funding and was consequently unsure whether the store would open in the face of an unexpected funding shortfall.
[6] Tokyo Smoke at para 48.
[7] Tokyo Smoke at para 57.
[8] Tokyo Smoke at para 59.
[9] Tokyo Smoke at para 58.
[10] Tokyo Smoke at para 58.
[11] Tokyo Smoke at para 50-51.
[12]Tokyo Smoke at para 66.
[13] Tokyo Smoke at para 68.
[14] [1958] S.C.R. 483 (“Mason”).
[15] Tokyo Smoke at para 69.
[16] Tokyo Smoke at para 71.
[17] Tokyo Smoke at para 32.
[18] Tokyo Smoke at para 71.
[19] Ontario, Alberta, British Columbia, New Brunswick, Manitoba, and Prince Edward Island.
[20] S.O. 200, c.3

The post Tokyo Smoke and the Threshold Required to Establish Bad Faith appeared first on Sotos LLP.

Not surprisingly, start-up and developing franchisors do not usually possess all of the management talent they need to fulfill all of these functions in-house.  As such, it is common for start-up and developing franchisors to purchase the services they require – legal, accounting, sales, marketing, real estate brokers and other consultants on a as needed basis.  Similarly, the founders often remain the only formal members of the board of directors.  They may be heavily reliant on organizations such as their national franchise association and other providers of continuous education for programming so they can learn general strategies and best practices.  People experienced in the industry do not typically want to join nascent board of directors because of liability concerns.

It is strongly recommended that franchisors from their earliest days establish for themselves an advisory board which can provide guidance in the development, oversight and accomplishment of strategic plans.

An advisory board is a collection of industry expertise which ownership is not likely to possess itself.  The franchisee principals would retain an individual to act as the Advisory Board Chair and assist the principals on the selection and recruitment of board members based on the skill sets that are not available in-house to the principals.

An advisory board is to be contrasted with a franchisee advisory council which the franchisor may also come to have.  A franchisee advisory council is a committee typically made up of franchisees selected by the franchisor and franchisor management personnel who discuss issues relating to the operation of the franchise system of concern to the franchisees or for the discussion and implementation of potential changes to the system.

An advisory board should be made up of up to six individuals to ensure full membership meeting attendance is regular.  The board would meet to assist the principals to establish their short, medium and long term strategic plans.  They would provide advice to the principals on action plans to accomplish the strategies.  They would remain available between meetings to address any particular issue that may arise in their areas of specialty.  The principals remain accountable to the advisory board.  The board may be used to interview key prospective members of the management team as the needs arise to hire and as resources warrant the hiring of in-house expertise.

Advisory board members do not have the same exposure to liability as do formal directors.  Their appointments are generally at will.  They are often paid a flat fee to attend meetings.  Key in-house personnel may be asked to make appearances at or make presentations to the advisory board from time to time.  The advisory board owes no legal duty to the franchisor per se; it serves only in a strategy advisory capacity to the principals.  Membership expertise at the advisory board level may change from time to time as the franchisor evolves.

Advisory board members are expected to bring to the table substantial industry and franchising expertise.  They are expected to take a keen interest in the overall performance of the franchisor.  They are expected to have excellent contacts to be able to provide recommendations for whatever services or resources the franchisor may require in the operation of its business.

As examples, many franchisors are often in need of capital at various stages of growth.  An advisory board with a strong finance representative should be able to assist in the planning for when such requirements will arise and the options and contacts for securing capital.  Similarly, an advisory board can assist in the development of a crisis management plan and assist if a crisis occurs.  An advisory board can plan for and assist the principals in determining potential exit scenarios or assist in identifying the need for and options for system change.

The end result is that a franchisor has access to experts that work together as a single team at every stage of development to assist the franchisor’s principals in the development of their franchise system.  These individuals may not be financially invested in the franchisor but critically they can be expected to be emotionally invested in the franchisor dedicated to providing value to the achievement of franchisor success.

At Sotos LLP, our team of lawyers have significant experience in the restaurant and hospitality industry working with many franchisors from start ups to mature system having hundreds of units in Canada.  We are often called upon to assist franchisors in their strategic planning including to assist in the creation and maintenance of franchisor advisory boards.  The writer can be contacted at adjdick@sotosllp.com if you are interested in discussing how an advisory board can assist your business.

Allan D.J. Dick, Sotos LLP

Allan is a partner at Sotos LLP and sector leader of the firm’s Restaurants practice area. Allan is a trusted primary advisor to many top franchisors, with more than three decades practising law in the franchising, licensing and distribution industry. Allan has been recognized by Chambers Canada, Canadian Legal LEXPERT Directory, Who’s Who Legal, and Best Lawyers in Canada as a leading Canadian franchise law practitioner.

This article was originally published by Foodservice and Hospitality magazine in March 2021 issue. 

The post Franchisor Advisory Boards – Why Every Franchisor Should Have One appeared first on Sotos LLP.

The decision to grant a franchise which is basically a permission given by the owner of a system involving intellectual property rights which it owns to another is highly personal. Franchisors carefully consider each franchise candidate before deciding whether to grant this permission to represent its brand to the public.

As well, the franchise agreement is for a term of years. This permission is not for a lifetime. The term may vary and may contain renewal options but at some point the right to operate the business will end. At the end of that term, the franchisee’s permission to operate ends and the franchisor gets the business back on terms contained in the agreement. The franchisee may be entitled to receive nothing at the end of its years of hard work. At the end of the term, the franchisor is free to re-sell the very same business which at that time may be much more valuable on account of the franchisee’s efforts.

The term “churning”  refers to a franchisor orchestrating the premature end of franchise agreement usually due to alleged franchisee defaults so as to repeatedly re-sell the same businesses.  This term does not apply to repeated acts of terminating one agreement and refranchising even where the same business may have failed repeatedly in successive hands.

As a result, franchised businesses are not bought and re-sold like any other businesses.

Franchisees must appreciate from the time they are contemplating purchasing a franchise that the value of the business they will be building up does not belong to them alone. The franchisor has a genuine interest in at least part of that value when the franchisee is considering a possible re-sale. Franchisors can rightfully attribute part of that value to the overall success of the franchisor’s efforts to build the brand.

The drafting of the provisions of the franchise agreement relating to how, when and if a franchisee can sell its business should not be an exercise in adopting boilerplate. Each franchisor should carefully consider the options available to it for its control rights on transfers. Similarly, franchisees must understand the degree to which their franchisor can control a decision to sell before they buy. In many cases, the adage that all a franchisee is buying is a job when it purchases a franchise may be more or less applicable depending on these re-sale controls.

In the same vein, franchisors often have first rights to buy the business if the franchisee wants to sell the business or even if it receives a bona fide offer from a third party for the business. Again, franchisor buy-back rights should not be seen as boilerplate. Franchisors should carefully consider the choices available to them when their franchise agreements are being drafted.

Franchise re-sale provisions often contain language which permits the franchisor to exercise a great deal of discretion when considering a requested transfer. In other instances, the terms may be very specific. If, for instance, the agreement contains language that says that the franchisee must do certain things to obtain the franchisor’s consent, even if those requirements seem harsh, outside of the provisions being unconscionable as a matter of law, the franchisee will need to abide by them. However, if the franchisor has reserved for itself discretionary rights relating to the requested consent, the franchisor may exercise that consent usually in its “sole and absolute” discretion which is a language commonly written into franchise agreements to describe this discretion.

“Sole and absolute discretion” however does not allow a franchisor to make decisions capriciously or arbitrarily when deciding whether to exercise a discretion it may have. It must act honestly at a minimum as a matter of good faith which is a legal requirement implied in and applicable to the performance and enforcement of every contract. In the six Canadian provinces that have franchise legislation, including Ontario, the franchisor must also act in accordance with “reasonable commercial standards” when exercising discretionary rights even if that discretion may be exercised solely and absolutely.

If a franchisor withholds its consent improperly, the franchisee may have a right to sue or arbitrate over this decision depending on the dispute resolution provisions of the agreement. It might even try to get an order or award forcing the franchisor to grant its consent. However, by the time a franchisee can get before a judge or arbitrator chances are it would have lost its purchaser.

A franchised business subject to a ten year contractual term and no renewal rights may by year seven of the agreement be generating healthy profits for the franchisee. But in considering the re-sale value of the business at that time, the franchisee must appreciate that it only has three years of operating time left as a matter of contract. Who will pay how much for the right to operate a business for only three years? Franchisees and franchisors may negotiate at that point how they may share the pie of the proposed sale price if the franchisor will agree to grant a new or extended term to the purchaser.

Often, on a re-sale, the purchaser may be required to enter into the franchisor’s then current form of franchise agreement as a consent condition. Franchisees will want to know what that new form contains as that may also have some relevance to business value.

Franchise agreements usually also require the franchisee to pay a fee and potentially the franchisor’s legal costs in addition to a fee as part of the franchisor’s consideration of and involvement in the transfer. Franchise agreements may even control the form and manner in which a franchisee may be allowed to list the business for sale. As the listing can impact the brand, this is an understandable requirement. Listing without first getting approval may be an act of default.

For a franchisor which is re-selling a formerly franchised business where the franchise agreement has been terminated, it is necessary for the franchisor to have title to the assets of the former business. This is usually obtained by one of or a combination of techniques. Franchise agreements should give the franchisor the right on termination to acquire the assets free and clear of any encumbrances at some specified value or means of determining that value less any amounts which the franchisee owes to the franchisor. If the assets are subject to registered security from financing obtained by the franchisee, this becomes a difficult provision to enforce practically. The franchisor typically must deal with the franchisee’s secured lender to purchase the security or the assets and add that amount to the franchisee’s debt. As the franchisee might owe the government for unpaid taxes or employee remittance obligations, these assets may also be subject to a government’s likely unregistered priority claim. Efforts must be made to determine the amount of any such debt.

The franchisor should also have its own security in place to allow it to realize on the assets. The issue with a franchisor acting on its security is that it must exercise its secured rights as required by law which may make self dealing problematic.

Franchisors must at least have the right to operate the business using the assets (without assuming unwanted liabilities) while these issues are sorted out. The resolution may include cooperation from the franchisee.

Every franchisor should understand what it needs to go through to be able to re-sell a formerly franchised business to a new franchisee including the practicalities involved in the choices to be made when structuring the franchise agreement and security arrangements in the first place.

Lastly, in those provinces with franchise legislation, a franchisor needs to decide whether it needs to provide statutory disclosure to the purchaser. When selling for its own account, it must give that disclosure. When the sale is by the franchisee, unless all the franchisor is doing is giving its consent and not getting involved otherwise in the transaction, then there may be a statutory exemption from the requirement to disclose available to it. That exemption is quite narrow and most franchisors involve themselves in the transaction enough such that they must give disclosure to the purchaser. The failure to disclose or to disclose properly where required can be exceptionally punitive to a franchisor. The purchaser may have a right to get out of the franchise agreement within two years of acquiring the business and have its investment and other payments/losses refunded to it. Disclosure on a re-sale is not the same as selling a new unit. A franchisor is well advised to seek out experienced counsel to assist with the manner of re-sale disclosure.

In summary, the re-sale of a franchised business involves many different and specialized considerations from a usual sale of a business transaction. Those involved in franchising, from franchisors, franchisees, business brokers, and counsel must fully understand these differences and proceed accordingly.

At Sotos LLP, we have acted for hundreds of franchisors in every sector of franchising designing their system re-sale processes for more than 40 years. We have acted as counsel to franchisors and franchisees in innumerable re-sale transactions to ensure franchised businesses are properly re-sold and have acted as litigation counsel when they have not.

Please contact the writer at adjdick@sotosllp.com or Peter Viitre at pviitre@sotosllp.com to discuss best practices related to the re-selling of franchised businesses.

The post Franchise Re-sales- Everything You Need To Know appeared first on Sotos LLP.

The main difference between a ghost kitchen and a virtual restaurant is that the latter is usually associated with a restaurant or franchise system using existing kitchens in existing bricks and mortar restaurants to produce and promote products for delivery only through delivery apps under a brand not associated with the restaurant itself.  By contrast, ghost kitchens tend to be brands which rent the use of facilities which are established for the production of virtual brands.  Ghost kitchens may produce multiple brands for the same owner utilizing similar ingredients but packaged in completely different ways.  Ghost kitchens can also be utilized by more than one organization at one time in shared facilities.

Ghost kitchens are an excellent way for a new chef or an existing brand to test out new concepts or new items without making the investment into a brick and mortar location.  They are somewhat restrictive in that they can only offer limited geographical coverage.  An operation may therefore need to utilize several ghost kitchens in various locations to get necessary delivery coverage beyond a small geographical area.

There are a number of legal considerations involved in the creation and operation of ghost kitchens and virtual restaurants which are highlighted in this article.

1. Names/Lease Use Clauses

Although ghost kitchens and virtual restaurants typically have no visible signage and are not promoted in the same way typical restaurants are promoted, a name is no less important to a ghost kitchen or virtual restaurant than for any restaurant.  The same attention must be paid when selecting a name as with a full-scale restaurant.  Trademarking considerations including the trademark rights of others must be taken into account.

A second important consideration for the brand owner is to ensure that it can operate using its chosen name out of its designated location.  If an existing restaurant is being used as a virtual restaurant to promote a virtual brand, the lease must permit the general use of take-out or delivery and must not be restrictive to a particular brand.  Consideration must also be given in these circumstances to whether there are any exclusive use obligations contained in a lease which might restrict what products can be sold out of a virtual restaurant.

2. Reservations of Rights

If a franchisor or franchisor-related entity is establishing a ghost kitchen, it must ensure that its rights to operate have been reserved in the franchise agreements utilized in the franchisor’s system.  Franchisor virtual brands may operate out of franchised locations in an exclusive or non-exclusive franchised territory.  They may combine menu items from existing concepts or serve as testing grounds for products which may or may not be introduced into the mainstream system.

Where such rights may not be expressly reserved, a franchisor or franchisor-related entity will need to consider whether the sale by it of new items typically sold by its franchisees in the franchise system may breach its contractual obligations or offend its statutory fair dealing obligations to any affected franchisee.

Care must be taken to ensure that the establishment and operation of ghost kitchens by franchisors do not have the effect of cannibalizing franchisee business so as to derail the traditional franchised businesses.  System advertising funds must also not be improperly used to benefit the franchisor’s business where no reasonable benefit accrues to the franchisees.  Franchisors may want to consider offering ghost kitchen outlets to a nearest franchisee similar to the practice of offering underdeveloped territories to the nearest franchisee for use as a satellite store.  Such practices avoid the appearance and the potential fact of the franchisor competing with its own franchisees.

Where franchisors require franchisees to utilize their kitchens or ghost kitchens for the production of new items for a virtual brand, it is important that franchisees understand the limits of what interest they may have in the brand and menu items themselves.  The ability of a franchisor to require the franchisee to discontinue the production and sale of the menu items must be communicated to the franchisee clearly as must be the franchisor or its related entity’s ability to offer the same menu items through an alternative system at the same time or subsequently.

3. Disclosure

The existence of such businesses will also need to be disclosed as a matter of statutory franchise disclosure where such disclosure laws exist.  This disclosure alerts a prospective franchisee to the possibility that its menu items may be sold in non-franchised locations either by the franchisor or a franchisor-related entity within its trading area or even more generally.

4. License Rights

If any entity related to a franchisor establishes a virtual brand where it is intended that such production will be sold by franchisees out of their kitchens, they will want to ensure that the proper licensing rights exist between the related entities that would permit the franchisor to sub-license the right to create the new items to its franchisees to be sold by the franchisees under their franchise agreements.

5. Liability/Insurance/Trade Secrets

For a ghost kitchen brand, it is necessary to consider liability and insurance issues if kitchens are being shared by various operators in a commissary situation.  The brand owner will also want to ensure that its new items are protected from other users of the commissary from a trade secret perspective.  Users of ghost kitchens will also want to ensure that the facilities they are using are properly zoned and licensed and adhering to the highest levels of food safety standards.

6. Proprietary Apps

An important initiative in recent years has been the development of proprietary apps for take-out and delivery purposes.  Many restaurant concepts were motivated to develop their own apps for three specific reasons:

1. to reduce the cost of providing delivery services which have produced marginal profitability at best given the cost of using third-party providers;
2. to allow for more uniformity in the pricing of menu items which has often had to be higher when the same items are available through third party providers;
3. to permit for the collection and utilization of customer data and the development of loyalty programs.

There is an opportunity for virtual brands to share collected information.  Users of proprietary apps will need to agree through the terms of use of the apps to the collection and sharing of any personal identifying information.

The development of ghost kitchen and virtual restaurant businesses have received a tremendous boost during the current pandemic.  If some predictions are correct that the increase in the use of delivery systems for meals will be part of the new normal even if the pandemic subsides, it can be expected that these businesses will continue to develop and flourish.  As with all new businesses, we are seeing new forms of agreements and contractual provisions and the development of insurance products to address the legal issues they raise.

Allan D.J. Dick, Sotos LLP

Allan is the co-managing partner of Sotos LLP and sector leader of the firm’s Restaurants practice area. Allan is a trusted primary advisor to many top franchisors, with more than three decades practising law in the franchising, licensing and distribution industry. Allan has been recognized by Chambers Canada, Canadian Legal LEXPERT Directory, Who’s Who Legal, and Best Lawyers in Canada as a leading Canadian franchise law practitioner. He can be reached at adjdick@sotosllp.com or by cell at 416.805.8989.

This article was originally published by Foodservice and Hospitality magazine in August 2020 issue. 

The post Ghost Kitchens and Virtual Restaurants: Legal Considerations appeared first on Sotos LLP.