October 24, 2011

Disclosure documents and franchise resales: what franchisors should know

Earlier this summer, our firm won an important decision in the Ontario Court of Appeal. This decision reinforces best practices for franchisors that provide disclosure documents to franchisees that purchase existing franchises from other franchisees. At issue was the interpretation of an exemption from giving a disclosure document under the Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”).

Prior to being heard by the Court of Appeal, the lower court declared that a former Pizza Depot franchisee that had purchased its franchisee from a previous franchisee had validly rescinded its franchise agreement since it never received a disclosure document and so, the franchisor was liable to pay damages to it as required by the Act. The franchisor took the position that it wasn’t obligated to provide any disclosure document since it was exempted from doing so. The franchisor appealed the lower court’s decision arguing that the lower court had erred in its interpretation and application of a certain exemption to providing a disclosure document, specifically, Sections 5(7)(a)(iv) and 5(8) of the Act.

By way of background, Section 5(7)(a)(iv) of the Act provides that a franchisor does not need to provide a prospective franchisee with its disclosure document where the “grant of the franchise is not effected by or through the franchisor”. Section 5(8) of the Act states, in part, that a grant of a franchise is not “effected by or through a franchisor” merely because the franchisor has a “right, exercisable on reasonable grounds, to approve or disapprove the grant.”

The franchisor argued that it played no role in the sales process or in arranging the agreement of purchase and sale between the franchisee who sold its franchise (the vendor franchisee) and the franchisee that eventually rescinded its franchise agreement (the rescinding franchisee). Accordingly, the franchisor claimed that it was exempt from providing disclosure in this resale situation pursuant to Section 5(7)(a)(iv) of the Act. However, the Court of Appeal disagreed with the franchisor.

The Court reminded the parties of an earlier Court of Appeal decision in Salah v. Timothy’s Coffees of the World Inc. where the court observed that the purpose of the Act is “to redress the imbalance of power as between franchisor and franchisee” and to “provide a remedy for abuses stemming from this imbalance.” With this in mind, the Court of Appeal accepted our arguments that exemptions from the duty of disclosure in the Act are to be “narrowly construed” in order to advance the purpose of the Act which is to protect franchisees. Using those parameters as a guideline, the Court of Appeal found the following facts:

  • the franchisor had directed the rescinding franchisee to this particular business;
  • the franchisor had some involvement in the negotiations for the agreement of purchase and sale of the assets of the business between the vendor franchisee and the rescinding franchisee. To use the words of the Court, the franchisor “was not merely a passive participant in this resale”;
  • the agreement of purchase and sale required the rescinding franchisee (not the vendor franchisee as is typically the case) to obtain the consent of the franchisor and thus deal directly with the franchisor; and
  • the franchisor required the execution of certain documents by the rescinding franchisee that the vendor franchisee had not been required to sign.

All of these circumstances, taken together, supported the lower court’s decision that the resale was brought about or caused to happen by or through the franchisor. Further, the Court of Appeal held that the franchisor went beyond the passive role of merely exercising its rights to approve the resale of the franchise business within the meaning of Section 5(8) of the Act. Accordingly, the rescinding franchisee had the right to rescind and the franchisor was liable to pay damages to the rescinding franchisee.

The courts have now signaled that franchisors must be very careful in relying upon the exemptions from having to provide a disclosure document. Not only will the courts narrowly construe any exemptions to disclosure, they will take a hard look at the facts surrounding the franchisor’s involvement in the resale process. In reviewing the resale process, the courts will look at both the franchisor’s role in facilitating any transaction and the requirements that the franchisor asked the parties to fulfill. Moreover, when it comes to resales, franchisors will also need to weigh the risks involved in relying upon an exemption to disclosure document against providing a site specific disclosure document. In light of this very important decision, franchisors should seek legal advice before they try to take advantage of any of the exemptions to the disclosure document under the Act.