To find the right franchisee and safeguard your brand, it’s critical that, as a franchisor, you have a strategy that you can put into practice to help you identify your future franchisee partners.  This article will help you identify the right franchisees for your specific system, and provides practical advice about how to assess if a prospective franchisee has what it takes to succeed in your system.

1. Business experience. Franchisees are essentially small business owners.  Prior experience operating a business, even if it’s a business type different than the franchise business they may operate, will help to set a franchisee up for success.  Remember, your new franchisee is going to have a lot of learning to do when they are onboarded to the system:  learning your system standards, understanding your brand values and how those are expressed in your daily operations, and any specific or special skills that may be necessary to operate their franchise business.  A franchisee with an understanding of small business fundamentals, such as basic accounting, budgeting, cash flow management, reporting, sales, marketing and hiring and management of employees is already one step ahead.  Franchisees with no business experience may be completely overwhelmed if, at the same time they are completing their system training, and also have to learn everything about operating a business.

2. Alignment with brand values, mission, and culture. “Fit” is going to mean something different to every franchise system, but it’s one of the most important things that franchisors need to consider in evaluating potential franchisees.  A prospective franchisee who otherwise “ticks all the boxes” but has a fundamentally different view of your brand, or of the system and its overall goals and direction is, at best, unlikely to succeed and, at worst, may create significant problems for you and the system, in general.  What’s the best way to identify the elusive “right fit?”  Here are some practical tips:

• Your initial screening and application processes should include at least some questions that directly address your brand’s values and mission. For example, ask some questions about why they are interested in your brand, in particular, and why they think they are right for the system.
• In interviewing a franchisee candidate, ask historical, behaviour-based questions that will help to reveal their personal characteristics and qualities. For instance, if one of your brand values is customer satisfaction, ask them to give you a specific example of a time in their past when a customer satisfaction issue arose, what it was, how they handled the situation, and what the result was.  These types of questions and answers will likely be very helpful to you in assessing whether the franchisee candidate is the person you’re looking for.  Past experience is often the best indicator of future performance.
• You may want to hold a discovery day or other workshop where the prospective franchisee can learn about your brand and also interact with existing franchisees. Not only will the franchisee learn about whether your system is right for them, but you can observe the candidate and assess whether you think they are right for the brand.  For instance, do they seem excited about your brand?  Do they seem engaged?  Do they get along with existing franchisees?  Are they asking good questions?  Your existing franchisees may also be able to provide you with insight on whether the candidate is compatible with your brand.
• You may wish to conduct reference checks. You might speak to previous employers, business partners or colleagues to gain insights into the candidate’s abilities and alignment with your brand values.  Another good idea is to check publicly available sources (a “Google” search, social media feeds, etc.) to see whether the franchisee candidate has a public presence and, if so, whether it reveals anything about them that is in conflict with your brand.
• You may wish to employ good profiling technology and related services. There are services available that will identify the qualities and characteristics of the most successful franchisees currently in your system, and then analyze franchisee candidates to determine whether or not they possess these same qualities.

3. Sufficient financial resources. No matter how much business experience a candidate may have, or how much they seem to fit into your brand’s culture, that franchisee is virtually certain to fail if the franchisee doesn’t have sufficient financial resources to operate.  A new unit that opens and then rapidly closes may harm the reputation of the brand, as may a unit that opens and then has to cut hours or reduce staff to stay afloat.  Franchisors should set clear financial criteria for prospective franchisees.  In particular, franchisors should ensure that prospective franchisees have a sufficient amount of unencumbered liquid assets to meet initial capital expenses, and sufficient initial operating capital to sustain the business until it is able to generate adequate profit.  The creditworthiness of the franchisee’s principal should also be explored.

4. Ambition and dedication. What are the franchisee’s expectations around business ownership and operation?  Do they intend to personally devote their full time and attention to the franchise business?  Do they understand that opening a new business, even a franchise business with excellent franchisor support, can be hard work?  Or do they think that, because the business is a franchise business, it will essentially “run itself”?  Do they believe they can just “hire a manager” to perform all business functions?  It’s important to assess a candidate’s expectations around these important issues.  Most franchise systems require franchisees to devote their full time and attention to the franchise business.  Individuals who understand this from the outset, and are keen to work hard to build a great business, are best placed to achieve success.

5. Understanding of the franchise relationship. While many franchisees are ambitious, want to be “their own boss”, and often have an entrepreneurial spirit, it’s very important for a prospective franchisee to understand the role of a franchisee within a franchise system.  A franchisor should assess whether a candidate understands that a franchisee will need to carefully follow the franchisor’s standards, methods of operation, management techniques, and business practices.  Success as a franchisee depends on the successful execution of these existing practices and standards.  The reputation of the system also depends, in part, on franchisee compliance with system standards.  For example, while it may be that restaurant franchisees can source individual items for prices lower than those offered by a franchisor’s approved suppliers, buying supplies only from approved suppliers is important to ensure consistency across the brand, manage health risks from food-borne illnesses, and achieve overall lower supply costs that are the result of volume discounts and product bundling.  Those candidates looking to “innovate” or “improve” upon the system need to understand, from the beginning, that their aspirations may not be compatible with the role of a franchisee.  It’s important for franchisors to explain to franchisee candidates the role of the franchisor, the role of the franchisee, and how their different functions work together to create the conditions for system success.

6. The right attitude and realistic expectations. It’s critical that the franchisee candidate has the right mindset.  Misalignments between expectations and reality is a recipe for unhappy franchisees and negative brand publicity.  A candidate should have genuine enthusiasm and passion for being a franchisee in your system, and understand what they can achieve with a franchise business.  It’s important that the franchisee candidate have a realistic understanding of the potential profitability of the franchise business.  In particular, it may be a red flag if a franchisee seems interested only in how much money they can make.  Franchisors who elect to directly provide financial information to franchisees must be very careful to do so in accordance with relevant franchise legislation.  Providing earnings claims or historical financial information in the wrong way may lead to significant claims against franchisors in future.

At Sotos LLP, we assist restaurateurs in determining whether to franchise their systems and guide them through the various stages of development and maturity. We also assist franchisors in every aspect of their sales processes. The author can be reached at aboudreau@sotos.ca.

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Nearly every franchise system includes a franchise marketing and promotion fund, often referred to as an “ad fund.” Typically, an ad fund operates as follows: individual units are obliged to contribute a specific percentage of their revenue to the ad fund, and the franchisor utilizes these funds for advertising and promotional activities to benefit the overall system and brand.

Ad funds serve as a potent tool for fostering system growth and expansion. They create a pool of funds for promotional endeavours that might otherwise be financially burdensome for either the franchisor or individual franchisees to undertake independently. In addition, initiatives funded by the ad fund contribute to maintaining consistent and brand-aligned messaging, as they are centrally coordinated by the franchisor.

However, ad funds can also become a focal point for discontented and divisive franchisees to unite around. Dissatisfied franchisees may join forces to raise concerns – real or “strategic” – regarding the management or administration of the ad fund. Even if these grievances lack merit, they can consume valuable time and resources for franchisors. Moreover, they can sow discord within the franchise system and among franchisees. In the most extreme scenarios, franchisees may unite and utilize their collective resources to initiate and maintain vexatious lawsuits concerning the ad fund, which can result in significant expenses and protracted legal battles for the franchisor.

This article aims to provide guidance on ad fund best practices and to highlight essential considerations for franchisors in creating and managing their ad funds.  Implementing these practices and thinking about these issues can help franchisors avoid the most common potential ad fund pitfalls.

1. Consider what geographic area the advertising fund will cover, and whether franchisees will have additional local marketing obligations

Prior to establishing its ad fund, a franchisor should think carefully about the geographic area the fund will cover. Should the ad fund be national in scope, and responsible for promoting the brand across the country, or should there be multiple regional funds to account for Canada’s size and the distinctness of its many regions?  Or should there be both a national fund and various regional funds? A franchisor should consider these questions in light of the nature of its brand and operations and the current market conditions. Are there important local or regional differences that the franchisor wants to address in its marketing efforts?  Or is it better to focus on a single advertising strategy Canada-wide?

A franchisor should also determine whether franchisees will be required to invest in a local ad fund geared towards promoting their local markets (over and above their obligation to contribute to the franchisor’s national fund), and/or whether they must individually meet certain self-directed local marketing spend minimums.  Making advertising a joint responsibility, by requiring individual unit spend minimums, can be an effective way to preempt complaints about the franchisor’s advertising strategy and decisions.  As discussed in more detail, below, franchisors that opt to require franchisees to participate in marketing should ensure there is appropriate franchisor oversight over the content of such marketing initiatives.  Franchisors should implement a tracking, approval, and reporting system to ensure that franchisees’ marketing efforts align with system standards, and that individual franchisees achieve minimum marketing spend requirements.

2. Management and reporting considerations: creating a special purpose “ad fund” entity, preserving the right records, and reporting to the franchisees

With very few exceptions, it’s generally advisable that the franchisor set up and manage the ad fund as a separate entity within the franchise system.  A general best practice is to incorporate a separate corporate entity whose sole purpose is to be responsible for all matters relating to the ad fund.  Ad fund contributions should not generally be co-mingled with other funds.  Instead, they should be maintained in a separate account in the name of the special-purpose entity that the franchisor has created for management of the ad fund.  While it is technically not improper to deposit ad fund monies into a mixed purpose account, such practice can create significant practical difficulties relating to tracing funds in the event the franchisor receives a demand to account for its use of ad fund monies.  To that end, any transfers in or out of the ad fund account should be properly memorialized.  Original source documentation relating to ad fund expenditures (for instance, invoices from third party marketing services providers) should be organized and preserved for a reasonable period, in accordance with the franchisor’s document retention policies.

A franchisor should maintain accurate financial records detailing contributions to and expenses drawn from the ad fund.  Such financial records should be distinct from those kept by the franchisor as part of its overall business operations.

A franchisor should consider whether it will provide franchisees with some degree of financial reporting relating to the revenue and expenses of the ad fund.  For example, will the franchisor provide regular financial reports to the franchisees about the ad fund?  Or will such reports be provided only in response to franchisee requests?  In any case, a franchisor should make sure it adheres to whatever reporting requirements it may put in place, as failure to do so can provide a pretext for disgruntled franchisees to stir up trouble.

The franchisor will also want to carefully consider the type of financial information it wants to make available to the franchisees in relation to the ad fund.  Will the franchisor provide financial statements, which may require the franchisor to engage external accountants to prepare?  Or, more commonly, will the franchisor provide only a statement of income and expenses, summarizing the revenue and expenses of the ad fund in a particular fiscal period?  In either case, it is generally recommended that franchisors provide such summary financial information to franchisees, rather than access to all source documents relating to the ad fund (for instance, general ledgers, invoices and other information relating to the financial activities of the ad fund).

3. Consider whether all franchisees will benefit equally from, and contribute equally to, the advertising fund, and specify if that is not the case

As a fundamental matter, a franchisor should carefully consider which entities will contribute to the ad fund, how the quantum of such contributions shall be calculated, and what use may be made of the funds.  For instance, is there any obligation for the franchisor to make ad fund contributions and, if not but the franchisor nonetheless contributes to the ad fund, how will such contributions be accounted for and used?  Will corporate and franchisor-owned stores be required to contribute?  What about stores that operate seasonally, or operate in a format that is different from the majority of stores in the system (kiosks, food trucks, special venue stores, ghost kitchens, etc.)  Will all franchisees contribute equally to the ad fund in accordance with a prescribed formula?

Is it fair for all units to pay the same ad fund fees if some units are only operating for a portion of the year?  The answer to this question is not always clear or straightforward.  Sometimes, units with reduced hours or seasonal units are in a prominent location, for instance, major sporting venues or pop-ups during special events, and have the potential to greatly increase brand awareness and attract new customers to existing units operating in traditional formats in the future.  Are these special location units creating goodwill for other franchisees to enjoy, or are they trading off the goodwill that other franchisees have created?

In addition to these considerations, a franchisor should specifically outline whether rebates, marketing allowances, and other amounts received by the franchisor will be contributed to the ad fund or retained by the franchisor for its own use.

Addressing these matters clearly, in both the franchise disclosure document and in the franchise agreement, can help to ensure that the ad fund is administered in a manner that franchisees perceive as transparent and fair.

4. Clearly define the key terms of the ad fund, including how much franchisees are required to contribute, the mediums and content of advertising that are permissible, whether the ad fund will be administered internally and/or externally, and who will pay for ad fund’s administrative expenses

While franchisors generally have a great deal of discretion as to how ad fund monies should be spent, it is important that the scope of this discretion is clearly communicated to the franchisees to avoid accusations of “unfairness” later.  It’s important to preserve the franchisor’s ability to spend the ad fund as it sees fit.  This might mean applying ad fund monies towards assisting troubled regions, or towards initiatives that seek to have the system enter new markets.

A franchisor should consider how the monies it collects for the ad fund will be apportioned, and whether franchisees can expect the ad fund to devote a proportional amount of the collected funds to specific markets or regions. Many franchisors will explicitly state in their franchise agreement that the ad fund has been created for the benefit of the system as a whole, and that franchisees should not expect that ad fund spend will benefit individual units on a proportionate or equal basis relative to their contributions or other franchisees.

To avoid potential disputes, a franchisor should address in specific detail the following considerations when structuring its ad fund:

• What amounts will franchisees be required to contribute? The franchisor should clearly define the amount that franchisees will be required to pay into the ad fund, the frequency with which they will contribute to the fund, and how the contribution will be paid to the franchisor. A franchisor should consider whether the franchisees will be required to make payments in pre-determined amounts, or whether their ongoing contributions will be determined by way of a formula based on their gross revenues or another metric.
• What media and content may the ad fund employ? A franchisor should ensure it reserves the right to employ any and all types of content and mediums of advertising (including television, radio, online, social media, etc.) for the fund as part of its activities.
• Will the ad fund rely on third-party advertising agencies, an in-house advertising department, or a combination of both to carry out its activities? A franchisor should consider whether the ad fund will be administered internally or externally, or through a combination of both. Expenses incurred by a franchisor in directly administering the fund, including direct expenses such as printing and ad placement, and indirect expenses such as salaries and head office rent, may be properly chargeable to the ad fund. When considering what and how much to charge to the ad fund, a franchisor should make a commonsense determination as to whether there is a nexus between the expenses it has incurred and whether these expenses furthered the objectives of the ad fund. Additionally, the quantum of the allocation should be proportional to the expense incurred by the franchisor and assessed reasonably. For instance, if one quarter of the franchisor’s head office space is dedicated to offices for internal marketing personnel, it may be appropriate to charge one quarter of the franchisor’s head office occupancy costs to the ad fund.
• Will the ad fund be used for purposes other than traditional marketing of the system and brand? There are a variety of promotional-related activities in which franchisors are increasingly required to engage. For instance, increased reliance on social media means that, sometimes, a franchisor must engage in reputational “damage control” or respond to negative comments on social media.  What about the cost of administering customer surveys across all or part of the system?  Franchisors should consider whether the ad fund provisions of their franchise agreements permit them to charge the cost of these activities to the ad fund. Ultimately, the franchisor should thoughtfully consider all uses or potential uses of the ad fund monies.

Finally, a franchisor should reserve the right to change and amend the rules relating to its use of ad fund monies, as necessary, to keep up with new advertising mediums and technologies, and to ensure the best possible use is being made of ad fund dollars.

5. Decide who will manage the fund, who will be responsible for its decision making, and whether there will be a franchisee advisory council.

Prior to forming the ad fund, a franchisor should carefully consider who will operate and administer the fund, and whether an advisory committee should be established to oversee and make suggestions as to the ad fund’s activities. In a majority of cases, the franchisor (or an affiliate of the franchisor) will be responsible for administering the fund and crafting the message and media to be employed in its advertising. Such centralized leadership allows the franchisor to broadcast a consistent message to potential consumers regarding its brand and products.

Some franchisors also establish franchisee advertising and marketing advisory councils, which bring together franchisees to make recommendations as to how the ad fund should carry out its activities. Most such councils are limited to making only non-binding recommendations.  However, engaging franchisees can allow franchisors to tap into franchisees’ valuable on-the-ground knowledge.  In addition, involving franchisees in the operations of the ad fund heightens transparency which can, in turn, preempt potential ad fund disputes.

6. Consider how much leeway individual franchisees will have to undertake their own advertising

One of the key advantages of franchising is establishing a common brand which can provide customers with a consistent experience. In establishing an ad fund, a franchisor can ensure that all advertising it produces is consistent with the brand’s policies, standards and image. A franchisor should carefully consider whether there is a place in its system for individual franchisees to undertake their own advertising at a local level, and whether there should be controls on the form and content of such local advertising. A franchisor should consider whether local advertising directed by individual franchisees would complement or conflict with national and regional advertising undertaken by the system’s ad fund.

A franchisor should be especially wary when it comes to a franchisee’s use of social media to promote its franchised business. Social media content and messages can spread quickly and easily.  A franchisor should be sure to clearly delineate the system’s policies on social media usage and content.  Franchisors should also ensure they have effective mechanisms to step in when and if a franchisee’s advertising is inappropriate or inconsistent with the brand.

7. Consider how the franchisor’s disclosure will be affected by the establishment of, or the reservation of the right to establish, an advertising fund

A franchisor should ensure that its franchise disclosure document fully discloses the material specifics of the ad fund it has established and its use of funds, as required by franchise legislation.

If particular franchisees are required to contribute different amounts to the ad fund, the franchisor should consider how widespread these variations are across its system, and whether knowledge of these variations is information that would be material to a decision by a prospective franchisee to acquire a franchise.

Conclusion

A well-managed ad fund, which pools contributions from franchisees, can be a valuable asset and a competitive advantage for a franchise system. However, the process of developing and administering such a fund can be complex. It is important to engage professional advisors throughout all stages of the ad fund’s lifecycle to ensure legal compliance and alignment with the system’s best interests.

At Sotos LLP, we specialize in assisting both emerging and established franchisors in navigating these complexities. Our expertise includes designing systems that adhere to best practices and crafting agreements and disclosure documents tailored to each franchise system’s unique needs.  We also have substantial experience in defending against ad fund-related claims. No matter the system or the issue, Sotos LLP is here to support and guide franchisors in optimizing their ad funds for success.

Adrienne Boudreau, Sotos LLP

Adrienne is a partner with Sotos LLP in Toronto, Canada’s leading franchise law firm. She has been recognized by Chambers Canada, LEXPERT, Who’s Who Legal, and Best Lawyers in Canada as a leading Canadian franchise law practitioner. Adrienne can be reached directly at 416.572.7321 or aboudreau@sotos.ca.

John Yiokaris, Sotos LLP

John Yiokaris is a partner with Sotos LLP in Toronto, Canada’s leading franchise law firm. He has been recognized by Chambers Canada, LEXPERT, Who’s Who Legal, Lexology, and Best Lawyers in Canada as a leading Canadian franchise law practitioner. John can be reached directly at 416.977.3998 or jyiokaris@sotos.ca.

Jason Brisebois, Sotos LLP

Jason Brisebois is a senior associate with Sotos LLP in Toronto, Canada’s leading franchise law firm. He has been recognized by Best Lawyers in Canada in the Ones to Watch category. Jason can be reached directly at 416.572.7323 or jbrisebois@sotos.ca.

The post Franchise Advertising Funds: A Blueprint for Success and Pitfall Prevention appeared first on Sotos LLP.

Since the regulatory framework in Ontario places the OCS in the middle of the supply chain, the Program cannot fully circumvent the OCS or be structured as a direct pass-through from LP to Retailer.  However, the Program does allow Retailers and Licensed Producers to develop relationships and interact directly. The Program will also allow some Retailers to carry unique product offerings, as compared to their competitors, and will also allow LPs to provide branded products that feature the Retailer’s brand.  LPs will have to work with the OCS to ensure that any obligations they have to Retailers are met, determine the product quantity needed, and ensure that the proper inventory method is used.

In connection with the introduction of the Program, the Alcohol and Gaming Commission of Ontario (the “AGCO”) has updated its standards regarding the provision of inducements from LPs to Retailers. A guidance document, Inducement Rules for Licensed Cannabis Retailers, was released to clarify the changes to the AGCO’s Registrar’s Standards for Cannabis Retail.[2] The changes detail the continued general rule against material inducements, but also highlight new exceptions to this rule. This article will review these new exceptions including with regard to the practice of “white labelling.”

Rule Against Material Inducements

The Registrar’s Standards for Cannabis Retail (the “Standards”) prohibit Retailers from entering into agreements with LPs and their representatives for items, benefits, payments, or services in exchange for the promotion or increased sale of a particular product by the Retailer or its employees.[3] In other words, LPs are prohibited from approaching Retailers and offering them any incentives to promote that LP’s product over other products sold by the Retailer. An example of this would be a Retailer entering into an agreement with an LP whereby the Retailer agrees to promote and increase sales of that LP’s product in exchange for exclusive product features. The provision of exclusive product features would be considered a material inducement by the AGCO and, as such, would be prohibited.

Other prohibited activities or inducements include: the sale of in-store or online advertising space; the provision of cannabis samples for sensory display purposes; the provision of fixtures or physical assets; the provision of items essential to the operation of the business; sales incentives; cash or rebates; travel or accommodation for education or training; and monetary compensation for education or training.[4]

The Exceptions to the Rule:

While the AGCO’s general rule prohibits the provision of material inducements by LPs to Retailers, a few important exceptions do exist, the most important of those being (1) the allowance of items, benefits, or services of nominal value, and (2) the allowance of “white-labelling”.

• Items, Benefits, or Services of Nominal Value:

Retailers may enter into agreements with LPs or their representatives for items, benefits, or services of nominal value. Nominal value items are defined as those of inconsequential value (unlike the prohibited financial and material inducements). The AGCO has not prescribed a specific monetary value above which an item would not be considered “nominal”.  Instead, the AGCO has advised that it will consider the following factors in determining whether the benefit or item would be considered nominal;

• Would a licensee be likely to change their behaviour toward an LP or the LP’s product after receiving the item, benefit, or service?
• Are the items, benefits, or services valued at an amount that would defray the Retailer’s operational costs?
• How many items, benefits, or services have been provided over what period of time? [5]

Retailers should consider these questions when entering into any type of agreement with an LP to ensure that they are not receiving inducements that might be considered material and would, therefore, be prohibited by the Regulations.

• Items, Benefits, and Services Related to Education or Training:

Retailers may accept items, benefits, or services from LPs that are related to education or training. This may include education or training sessions or materials, meals and refreshments during the education or training, and cannabis product samples directly related to education or training. [6]

• Ownership Interest and Franchise Agreements:

Retailers and LPs are permitted to enter into financing, leasing, and franchise agreements. A copy of any such agreement must be disclosed to and approved by the AGCO.  All agreements must comply with the Cannabis License Act, 2018 (CLA)[7] and the Standards. Note that the AGCO will not provide any commentary or explanation regarding its decision to accept or reject a proposed agreement.  As such, it is important that Retailers familiarize themselves with the Standards.

• Store Brand Cannabis Products (White Labelling)

Agreements between Retailers and LPs for store-branded cannabis products (also known as white labels, private labels, and in-house/house brands) are also permitted (“White Label Agreements”).  White Label Agreements allow Retailers to partner with LPs to develop products that include that Retailer’s specific brand. This involves Retailers entering into contractual agreements with LPs for the manufacture and sale of products that are specifically branded for that retail store.[8]  These types of agreements are subject to the same review process by the AGCO as mentioned above.  Retailers should be aware that any branded products will remain available for any other retailer to purchase on the OCS’ “flow-through catalogue,” provided they are part of the Program.

While these agreements are permitted, the AGCO does place certain constraints on their contents.  Retailers and LPs should be cognizant of these rules before entering into any such agreement and seeking AGCO approval.  In particular, White Label Agreements must not:

• Define the amount of product from the LP or its affiliates that must be offered for sale by the Retailer;
• Require a defined amount of display space at the retail space to be dedicated to products from the LP or its affiliates;
• Provide merchandising, marketing, or promotional activities to the LP or its affiliates; or
• Restrict the LP’s ability to have its products sold at other retail stores, or the Retailer’s ability to sell products produced by other LPs (or their affiliates). [9]

White Label Agreements and the Program are intended to benefit smaller LPs and Retailers, as they will enable the OCS to offer more products to Retailers, including products that have a short shelf life or are slower-moving.  It is important that Retailers and LPs monitor how the industry reacts to these changes. White Label Agreements also allow Retailers to further differentiate themselves from their competitors and to build brand loyalty and awareness.

Key Takeaways:

Given the rapid evolution of the cannabis industry, Retailers and LPs alike need to ensure they are familiar with and current on industry developments. The introduction of the OCS’s flow-through program and subsequent changes to the relevant regulations regarding material inducements are two such developments.  Both provide additional growth opportunities for LPs and Retailers but also present a minefield of potential pitfalls if the rules are not properly understood.  Becoming well-versed in the OCS’s Program and the AGCO’s rules regarding material inducements is crucial for Retailers and LPs who want to be able to avail themselves of these new opportunities without costly hiccups.

Anna Thompson-Amadei, Sotos LLP

Anna is an associate with Sotos LLP in Toronto, Canada’s largest franchise law firm. She is the head of the firm’s cannabis practice area. Please contact Anna at 416.572.7322 or athompson-amadei@sotos.ca if you would like to discuss this or any other topic relating to the operation of your business.

Don Houston, Sotos LLP

Don is one of our articling students for the 2022-2023 term.

[1] Brown, David. “Ontario’s New Flow-Through Model and Product Call Timeline, Comes with Pros and Cons, Says Producers and Retailers.” Stratcann September 1, 2021. https://stratcann.com/insight/ontarios-new-flow-through-model-and-product-call-timeline-comes-with-pros-and-cons-say-producers-and-retailers/
[2] Brown, David. “Ontario Chamber of Commerce Concerned with Province’s Plan to Ban In-House Cannabis Brands and Products” Stratcann March 4, 2022 https://stratcann.com/news/ontario-chamber-of-commerce-concerned-with-provinces-plan-to-ban-in-house-cannabis-brands-and-products/
[3] “Cannabis Retail Regulation Guide” Alcohol and Gaming Commission of Ontario https://www.agco.ca/book/export/html/19736
[4] “ Guidance Document- Inducements Rules for Licensed Cannabis Retailers” Alcohol and Gaming Commission of Ontario https://www.agco.ca/guidance-document-inducements-rules-licensed-cannabis-retailers
[5] Ibid
[6] Ibid
[7] Cannabis Licence Act, 2018, S.O 2018, C.12, SCHED 2.
[8] Maurer, Matt, “The “Return” of White-Labelling is a win-win-win for LPs, Retailers, and Consumers” Grow Opportunity. June 1, 2012.      https://growthopportunity,ca/legal-matters-2/?utm_source=rss&utm_medium=rss&utm_campagin=legal-matters-2
[9] Supra, note 4

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The facts are straightforward.

270[2] entered into agreements with Lightbox for the operation of two retail cannabis stores under the “Dutch Love” brand.  Under the agreements, Lightbox was required to operate both stores on a day-to-day basis. 270 was never involved in the operation or direct management of the stores.

In December 2021, 270 delivered two notices of rescission to Lightbox pursuant to the Wishart Act.[3]  270 took the position that it was a franchisee of the “Dutch Love” franchise system, and it did not receive the required disclosure.  Lightbox disputed that the businesses were franchises.[4]

Upon delivering the notices of rescission, 270 jointly rebranded both stores.  It stopped using the “Dutch Love” marks, and began operations under its own brand, “Roll N Rock Cannabis.”

Lightbox commenced an action against 270 and brought a motion for an injunction.  It sought to prevent 270 from “owning and/or operating a ‘Roll N Rock Cannabis’ retail store or any other cannabis retail store, other than a ‘Dutch Love’ branded store.”  Lightbox also sought to restrain 270 from using the marks and “operating methods” associated with the Dutch Love brand.  This included a long list of prohibitions, including requiring 270 to no longer use the services of certain third-party suppliers (such as the global HR software company ADP) and not displaying certain items in-store, including “potted plants”.

The Court dismissed Lightbox’s motion after a preliminary assessment of the evidentiary record, and did not need to consider the three-part test that is standard on injunction motions.

First, the Court found no right capable of enforcement.  There was “no evidence whatsoever of any agreement between the parties that 270 would refrain from the ownership or operation of another cannabis retail brand at either of the store locations in question or at all.”  In fact, the Court noted that the order Lightbox wanted it to make would be contrary to certain express terms of the agreements, which allowed 270 to transition its operations to another cannabis brand.

Second, the Court found Lightbox had failed to lead any evidence to support its claim that 270 had misused any confidential information or operating methods.  In fact, one of Lightbox’s affiants bluntly admitted that many of the resources needed to understand the cannabis business can be found publicly online.

The following lessons can be learned from this case:

1. An injunction remains an extraordinary remedy that must be grounded in pre-existing contractual rights. The Court will not enforce rights for which the parties never bargained. The Court will not find that a restrictive covenant is an implied term in the parties’ agreements, particularly where that implied term would contradict the express terms of the contract.
2. Allegations must be supported by adequate evidence. Evidence in support of injunctive relief must be clear, cogent, and detailed. Any proprietary information or methods must be clearly identified, and the existence of such interests and methods must be established by the evidentiary record.  Vague allegations will not be sufficient to support a claim for injunctive relief.
3. Whether the injunction is mandatory or prohibitive may be determined by evaluating the result of the proposed order. Lightbox argued on the motion that the injunction sought was prohibitive. 270 agreed that while the order was phrased as a prohibition, its practical effect was that 270 had no choice but to perform its positive obligations under the agreements.  Essentially, that 270 would have to operate as a “Dutch Love” or cease operations entirely.   The Court agreed with 270.  It concluded that because the result of the order would be to restore the status quo, the relief sought was mandatory in nature.  Had the Court been required to consider the three-part test for an injunction, Lightbox would have had to meet the more demanding strong prima face case standard.
4. An “ill-conceived” motion is not sufficient grounds for an elevated costs award. Although the Court agreed with 270 that Lightbox’s motion was “ill-conceived and as well unsupported by a proper evidentiary record relating to the relief sought” it found this was not a sufficient basis to increase the costs awarded to 270 on the motion. 270 was awarded partial indemnity costs, payable within 30 days.[5]

Adrienne Boudreau, Sotos LLP

Adrienne is a partner at Sotos LLP.  Her practice focuses on all areas of commercial litigation with an emphasis on franchise litigation.  Adrienne can be reached directly at 416-572-7321 or aboudreau@sotos.ca.

[1] 2022 ONSC 1873 (CanLII).
[2] Sotos LLP was counsel to 270 on this motion.
[3] Arthur Wishart Act (Franchise Disclosure), 2000, SO 2000, c 3.
[4] The parties agreed that the Court did not need to determine whether they were in a franchise relationship in order to fully adjudicate the issues on the motion.
[5] 2022 ONSC 2999 (CanLII).

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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

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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.

In response to the COVID-19 pandemic, provincial governments across the country have declared states of emergency and issued orders for the mandatory closure of “non-essential” businesses to the public.

On March 23, 2020, the Ontario government made such an order under the Emergency Management and Civil Protection Act[1] (the “Act”). The order revealed a list of businesses that were deemed “essential” and would therefore be permitted to remain open. To the delight of cannabis advocates and enthusiasts, the list of businesses included recreational cannabis stores. However, following the subsequent release of grave projections by health professional about the potential impacts of the COVID-19 crisis[2], the government changed course and on April 3, 2020, released a reduced list of essential businesses which no longer included cannabis stores[3]. The effect of the revised order was that all cannabis stores in Ontario were required to close for business as of 11:59 PM on Saturday, April 4, 2020 for a period of at least 14 days.

While the government’s order required non-essential businesses to close their physical store premises to the public (to promote social distancing), it did not prevent them from offering products and services online or via home delivery; however, under the Ontario Cannabis Retail Corporation Act, the government-run retailer, the Ontario Cannabis Store (OCS),  has the exclusive right in Ontario to sell cannabis online[4]. For that reason, the government’s order forced privately-owned retailers to temporarily cease operating, thereby fueling speculation that the black market for cannabis would fill the void.

Less than one week later on April 7, 2020, and following an outcry from industry participants, the provincial government issued yet another emergency order under the Act, this time permitting cannabis retailers to offer curbside pick-up and delivery services to consumers for a 14-day period.[5] Under the order, retailers are required to keep their stores closed, and are constrained by the following rules relating to pick-up and delivery:

• Pick-up must take place at an “outdoor area in close proximity to the retail store” (i.e. customers cannot enter the store premises);
• Products may only be sold, picked up, and delivered between the hours of 9 a.m. and 11 p.m. (i.e. no midnight orders!);
• Delivery must be to a “residential address” (i.e. no deliveries to the office);
• For pick-up orders, the individual who placed the order must be the one who picks it up; and
• Payment cannot be in cash (only online and telephone orders are permitted).

Ontario’s Premier, Doug Ford, had initially cited the concerns of mental health and addiction experts who claimed it was critical to keep certain businesses open to the public that supplied substances on which the public may be dependant. While cannabis stores were ultimately deemed not to be essential, and were therefore forced to close their doors, they have been temporarily permitted to offer products via the alternative sales channels of home delivery and curbside pick-up. Nothing has changed for patients with medical prescriptions for cannabis who will continue to be able to fill their orders directly with licensed cannabis producers online and receive their products by mail.

In another boost for the industry, on April 5, 2020, the federal government announced a $40-billion credit program under which cannabis businesses would be eligible to apply for funding from the Business Development Bank of Canada to offset the devastating financial impacts the pandemic has had on their businesses[6].

Sotos LLP helps clients navigate the complexities of doing business in the cannabis sector. As the COVID-19 outbreak continues to evolve rapidly, members of our team will remain available to assist you with any legal questions you may have.

[1]             Order Under Subsection 7.0.2 (4) – Closure Of Places Of Non-Essential Businesses, O Reg 82/20, Schedule 2, available online: https://www.ontario.ca/laws/regulation/200082.

[2]             “Canada: Ontario warned to expect 15,000 deaths from coronavirus”, The Guardian (April 3, 2020), online: https://www.theguardian.com/world/2020/apr/03/ontario-canada-coronavirus-warned-to-expect-15000-deaths.

[3]             Government of Ontario, “List of Essential Workplaces”, available online: https://www.ontario.ca/page/list-essential-workplaces.

[4]             Ontario Cannabis Retail Corporation Act, 2017, S.O. 2017, c. 26, Sched. 2, s 2(1)(a), available online: https://www.ontario.ca/laws/statute/17o26#top.

[5]             Order Under Subsection 7.0.2 (4) Of The Emergency Management and Civil Protection Act – Pick Up And Delivery Of Cannabis, O. Reg. 128/20, available online https://www.ontario.ca/laws/regulation/r20128.

[6]             “Bars, cannabis sector eligible for $40-billion credit program from government bank”, The Globe and Mail (April 5, 2020), online: https://www.theglobeandmail.com/canada/article-bars-cannabis-sector-eligible-for-40-billion-credit-program-from/

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Likely having learned from its past mistakes, the government’s new lottery will add 50 new stores this year (compared to the 25 stores currently permitted to operate in Ontario), with 8 licences to be allocated to First Nations. The remaining 42 stores will be allocated geographically: for example, the City of Toronto is its own “region” and will have 13 out of the 50 new stores.

Another major difference is in the application process and requirements: unlike the first lottery which merely required payment of a $75 application fee and completion of an application form, applicants in the new lottery have a number of prerequisites to meet before their applications will be considered. In order to be eligible, applicants must have secured a site for their proposed store and a letter from a bank confirming they have the ability to access $250,000 in cash. They must also obtain a stand-by letter of credit for $50,000 within 5 days of being selected. Due to this onerous criteria, there is no doubt that lottery entrants this time around will be sophisticated applicants who are well capitalized rather than the “mom-and-pop” applicants who dominated the first lottery.

Applicants must also “exercise control” over the cannabis retail business, a requirement that leaves open the possibility of licence holders entering into licensing or franchising arrangements with established brands, provided the agreements underlying those deals are carefully drafted by qualified professionals. Franchising is a business model in which a brand owner (the franchisor) gives an independent business owner (the franchisee) a right to sell products under its trademark in exchange for payments, such as royalties or licensing fees. We witnessed many such deals in the first lottery when licensed cannabis producers (LPs) and established brand owners offered the use of their trademarks, systems, and methods to license holders, many of whom lacked experience in both retail operations and cannabis. Licensing deals have also been popular in the industry because the regulations under Ontario’s Cannabis Licence Act prohibit LPs and their affiliates from owning a stake of more than 9.9% in any corporation that owns a retail store, hence the rise in creative solutions by LPs to get around this restriction.

The application process closed on August 9, 2019, and winners will be announced on August 20, 2019. Successful applicants must be in possession of their retail premises by no later than October 1, 2019. Demand is bound to be high for retail licences, especially in light of the upcoming federal cannabis regulations which will permit the production and sale of cannabis edibles, extracts, and topicals. Those regulations come into force on October 17, 2019.

Sotos LLP assists LPs, franchisors and licensors, and retail licence applicants to secure their space in the burgeoning cannabis industry.

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Provincial securities regulators in Alberta, British Columbia, Ontario and Quebec conducted a review of the disclosure of 70 publicly-listed cannabis companies with varying levels of involvement in the industry and with operations in different countries. The most significant takeaways relate to licensed cannabis producers (or “LPs”).

Source: CSA Staff Notice 51-357 Staff Review of Reporting Issuers in the Cannabis Industry

There are two key takeaways from the recent CSA staff notice:

• All of the LPs needed to improve their fair value and fair value related disclosure
• 71% of LPs did not separately disclose all fair value amounts included in the profit and loss statement

Companies involved in agricultural activities (such as LPs) are required under IAS 41 to measure living plants, or biological assets, at their fair value. As a result, LPs place a value on their crop while it’s still growing or waiting to be sold, reporting the unrealized, non-cash change gains (or losses).

Since cannabis production is currently growing at a faster rate than sales, and the fair value of those plants is being recognized long before any sales take place, LPs can end up reporting massive gross profit margins. Canopy Growth Corp., the world’s largest cannabis company, reported a gross profit margin of 97% (according to IAS 41 reporting standards) for 2017.[1] By way of comparison, Apple Inc. reported a gross margin of 38% in 2017.[2]

In addition to the complexity faced by investors in deciphering fair value generally, the CSA found that fair value adjustments were often embedded in costs of goods sold rather than being broken out into a separate line item. The CSA found that unrealized (and realized) gains/losses resulting from fair value changes should be disclosed separately so that investors can understand the actual cost of sales, excluding any impact from fair value adjustments.

Even with perfect disclosure, ordinary investors will likely struggle to understand the financials of LPs. Since the CSA found that all LPs need to improve their disclosure relating to fair value adjustments, investors are being placed at a significant disadvantage.

Sotos LLP is at the forefront of this budding industry, working with emerging and established retailers and franchisors to help them grow their brands. If you are considering entry into the cannabis industry, start by retaining qualified and experienced legal counsel to assist you in navigating the landscape.

[1] Without accounting for fair value changes, Canopy Growth Corp.’s gross margin would have been 66%. https://www.newswire.ca/news-releases/canopy-growth-corporation-reports-fourth-quarter-and-fiscal-year-2018-financial-results-driving-readiness-for-the-canadian-recreational-cannabis-market-686663871.html

[2] https://www.apple.com/newsroom/pdfs/fy17-q4/Q4FY17ConsolidatedFinancialStatements.pdf

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Despite this initial restriction on participants in the grocery industry, some of the world’s major food and beverage brands have already announced their plans to develop edibles in concert with Canada’s largest licensed cannabis producers: alcohol giant Constellation Brands recently invested billions of dollars in Ontario-based Canopy Growth; Molson Coors Canada announced a joint venture with Quebec-based Hydropothecary; and Coca-Cola is reportedly in talks with Aurora Cannabis to develop beverages infused with cannabidiol (a.k.a. CBD – the non-psychoactive element of the cannabis plant). CBD has been touted for its ability to provide natural health benefits, including pain relief. Beyond the more traditional association with cannabis of “getting high”, the food and beverage industry is jumping at opportunities to develop cannabis products that compete not only with alcohol, but with health and therapeutic products that are commonly found on the shelves in grocery aisles and health food stores.

These early indications of a budding edibles industry begs the question of how and when the government will permit such recreational products to be marketed and sold in groceries, pharmacies, and other bricks and mortar businesses.  Canada’s dominant pharmacy franchise, Shoppers Drug Mart, recently obtained a license from Health Canada allowing it to dispense medical cannabis directly to patients in-store (medical cannabis is currently only legally available through the government’s strictly regulated e-commerce system). This development, along with the upcoming launch of the private retail network that will be permitted to distribute cannabis directly to consumers, will result in a flood of new food-grade products and other edibles on store shelves. Once the government announces its plan for regulating edibles, we can also expect added interest from the food manufacturing, restaurant and hospitality industries in promoting and offering these products to their patrons.

The general decline in users smoking cannabis (owing to its negative health impacts) combined with the growth in research and development initiatives for legal edibles will bring about a new and unprecedented era for the grocery and hospitality industries and their consumers, although not without its legal complexities, uncertainties, and challenges.

Sotos LLP works with emerging and established franchisors and retailers in a variety of industries to help them grow their brands within the confines of the law. If you are considering entry into the cannabis industry, start by retaining qualified and experienced legal counsel to assist you with the expansion of your business.

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