Canada: Practical Considerations For Dealing With Financially Troubled Canadian Franchisees

At some point or another, most franchisors operating in Canada will have to deal with a franchisee in financial difficulty. This article sets out a non-exhaustive checklist of questions and considerations that will assist the franchisor in formulating the appropriate strategy to address this challenge.

1. Assessing the situation

The first step in addressing the problem is a preliminary assessment of the situation. As part of this analysis, the franchisor should first identify the macro-level problems requiring resolution. These problems can include the failure of the franchisee to pay franchise fees, a "dark" (i.e. abandoned) franchise location, and even bankruptcy or creditor-initiated proceedings against the franchisee.

In examining the situation, the franchisor should also reflect on the franchisor's longer-term objectives with respect to the franchisee and the location. The franchisor may consider the degree to which its patience has been strained, and management attention distracted, by repeated defaults and difficulties with respect to the franchisee.

2. Preparation

If it appears that the franchisor will need to pursue a form of remedy against the franchisee, it is necessary to ensure that all potential courses of action are analyzed and that the proper groundwork is set. Proper preparation will include a review of the relevant documentation, as well as a clear understanding of the repercussions of certain decisions and the impact of applicable insolvency laws and procedures on the rights and remedies of both the franchisor and the franchisee. A franchisor should always consider obtaining legal advice at this stage.

The following considerations are integral to the preparation process:

A. Agreements and Contractual Rights

  1. Agreements. Before instituting any action, the franchisor should verify that all documentation is in order and properly signed by the current franchisee. Even if the franchise agreement was properly signed, the franchisor should double check whether the agreement has expired, as that may have consequences on the proposed course of action. A review of the franchise agreement is also important because the agreement may provide for certain remedies available to the franchisor.
  2. Franchise Disclosure Law Compliance. Just as importantly, the franchisor needs to determine if any actions it plans to take will be met with a franchisee's claim relating to non-compliance with any of the provincial franchise disclosure laws. If the franchisor failed to properly deliver a franchise disclosure document, then the franchisee may have a 2 year absolute right of rescission from the date the agreement was signed, in which case the franchisee's claim would often far exceed any amount owing by the franchisee. Any franchisor pursuing a defaulting franchisee should be certain they are on solid ground before taking enforcement steps.
  3. Leases. The franchisor should also review and consider their rights under any lease agreements with the franchisee. If the franchisor sub-leases to the franchisee, the franchisor should be able to control the lease. However, in a sub-lease situation, the franchisor will remain liable to the head landlord for any arrears in rent, and for continued payment of rent for the term of the lease. If there is not a sub-lease situation, the franchisor should examine whether there exists an option to assume the main lease upon termination of franchise, or whether there is a right of entry or other property rights under the franchise agreement.
  4. Security Interests. The franchisor should also consider whether it has a security interest that could be enforced against the business and assets of the franchisee as a secured creditor. Before enforcement is possible, the franchisor will need to determine what obligations the security interest secures and whether those obligations have in fact been breached. To avoid other secured creditors gaining priority, the franchisor should ensure that a financing statement been registered in the proper location at the earliest possible time.

B. Defaults

  1. Defaults. The franchisor should carefully consider the nature of the franchisee's default, as this will dictate the nature and timing of the remedies that are available to it. Events of default and the remedies available are primarily set out in the franchise agreement, although other agreements, such as leases, will include similar provisions. After identifying the default, the franchisor will need to consider whether the default is material or merely technical. Generally, a technical default will not likely allow for the same remedies as a material default; however, this determination will require a review of the terms of the franchise agreement. Finally, the franchisor should consider what operational fixes may be available. If the default can realistically be cured, the franchisee may have a contractual right to do so within a specific period of time. Where the default is cured, it is important for the franchisor to identify and address the cause of the default so that it will not be repeated.
  2. Notices. As a pre-condition to enforcement, the franchise agreement may prescribe that notices of default be issued in a specific form and according to specific timelines. It is integral that any technical notice requirements are followed to ensure the notice is valid.
  3. Course of Conduct. The franchisor should also examine its own course of conduct to determine if it has waived defaults, either expressly or by conduct. For example, a franchisor may inadvertently waive default by repeatedly failing to demand timely payment of fees.

C. Other Stakeholders

  1. Enforceability and Priority. As discussed above, the franchisor should determine whether it has a security interest. If such a security interest exists, the franchisor should further determine if it will be enforceable against third parties. Some legal analysis may be required to determine if the franchisor's security interest is in first secured position or if other deemed or registered interests take priority.
  2. Franchisee's Bank. The franchisor should be aware of any interest held by the bank. In the event that the franchisor has given the bank a comfort letter, the franchisor should review this letter to determine its contents and what obligations it imposes. The franchisor may also consider if there is a long-term business objective (i.e. expanding with a particular lending institution providing financing for all franchisees) that trumps a particular termination/enforcement situation?
  3. Landlord. The franchisor should make inquiries to determine if the rent is current, particularly where the franchisor could become liable for arrears. It will be valuable for the franchisor to have awareness of the legal rights of the landlord and also whether the landlord is cooperative.
  4. Employees, Taxes, and Suppliers. The franchisor should determine whether the franchisee has outstanding tax liabilities or liabilities to employees and suppliers. A full understanding of the franchisee's debts always places the franchisor in a better position to pursue the appropriate remedy.
  5. Guarantors. Finally, a franchisor should consider if there are any guarantors, and if so, the nature and extent of their involvement. Where a corporate franchisee lacks the assets to satisfy its obligations, guarantors become increasingly important.

D. What Laws Apply

Before any legal proceeding is commenced, the franchisor must be aware what franchise, competition, debtor/creditor, tax, insolvency, or other laws apply to the situation. The applicable law is generally set out in the franchise agreement, but jurisdictional clauses have sometimes been ousted by the court. The application of these laws may provide some surprising results, as different jurisdictions may have their own particular foibles. A further consideration is whether an agreement calls for mandatory arbitration or mediation of disputes. Such a clause may limit the franchisor's recourse by preventing a court action.

If the matter involves a franchisee bankruptcy, the franchisor should be aware of the potential reversal of certain interests in bankruptcy, and be alert to the possibility that the franchisee's trustee in bankruptcy might seek to assign the franchisee's rights without the consent of the franchisor.

Any legal analysis should take into account the historical relationship between franchisor and franchisee, as the franchisor must consider, anticipate, prepare for and be ready to rebut any defences raised by the franchisee (meritorious or otherwise). One should examine whether the franchisee has been cooperative or whether the relationship has been troubled, as any past complaints are likely to surface again.

E. Strategic Objectives and Ramifications

Outside of the legal considerations, a franchisor must decide whether it wishes to fix the problems, or simply terminate the relationship. A forbearance agreement may be appropriate if the parties wish to work together as this will allow the franchisor to continue to pursue its remedies if the problem is not rectified.

Even in situations where a default is been cured and legal action is avoided, there may be lingering issues. The franchisor should consider whether the franchisee has a complaint that has not been properly addressed, and if so, how it can be fixed. In certain cases, mediation may be appropriate, or even mandated. If a resolution will eventually require an in-depth exploration of both sides of a course of conduct or series of issues, it is often best to tackle the issue earlier, rather than later when it reappears.

Where it appears that the relationship is unsalvageable and termination is necessary, the franchisor must decide whether it wishes, or may even be obligated, to keep the premises. Other considerations come into play, such as the impact on other stakeholders, including other franchisees. The potential public relations impact should also be assessed.

Finally, the franchisor will need to address the intellectual property issues that arise from the termination of a franchise, including the use of signage, trademarks, licensed products and proprietary methods.

The above considerations are by no means exhaustive. Each franchisee situation is unique and legal advice is necessary to deal with specific situations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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