Canada: Franchisor Disclosure Obligations When A Franchisee Resells Its Franchise

Last Updated: April 21 2016
Article by Jonathan Mesiano-Crookston and Andrea Wong

While many franchisors are aware that they have disclosure obligations when granting a franchise to a prospective franchisee, many forget that they have the same disclosure obligations where a franchisee is selling their franchise to another franchisee, unless the franchisor does no more than provide their reasonable consent (or not) to the prospective purchaser and accept a stipulated or reasonable fee for their costs in so doing.

Section 5 of the Arthur Wishart Act (Franchise Disclosure), 2000, SO 2000, c 3 (the "Wishart Act") requires a franchisor who is "granting" a franchise to a prospective franchisee to provide that person with a disclosure document at least 14 days before they signs any agreement relating to the franchise, or pay any franchise-related consideration.  The disclosure requirement is intended to rectify the informational imbalance between franchisor and franchisee, thereby ensuring that prospective franchisees are able to make an informed decision about purchasing a franchise.

Subsection 5(7) of the Wishart Act sets out the exemptions to this disclosure requirement, one of which applies when a franchisee transfers its franchise to another franchisee without the franchisor's extensive involvement.  As set out in subsection 5(7)(a) of the Wishart Act, the disclosure requirement does not apply to:

(a) the grant of a franchise by a franchisee if,

(i) the franchisee is not the franchisor, an associate of the franchisor or a director, officer or employee of the franchisor or of the franchisor's associate,

(ii) the grant of the franchise is for the franchisee's own account,

(iii) in the case of a master franchise, the entire franchise is granted, and

(iv) the grant of the franchise is not effected by or through the franchisor.

 

Subsections 5(7)(a)(i) to (iv) are conjunctive: all four conditions must be met before a franchisor may claim an exemption from the disclosure requirement.  Furthermore, cases have held that franchisors bear the burden of proving these four elements (MAA Diners Inc v 3 for 1 Pizza & Wings (Canada) Inc, 2003 CanLII 10615 (Ont SCJ), at para. 26).  In fact, other cases have also pointed out that section 12 of the Wishart Act provides that "the burden of proving an exemption or an exclusion from a requirement or provision is on the person claiming it", and franchisors therefore bear the burden of proving any grant-related exemption from the disclosure requirement on which they intend to rely.

The Court of Appeal has held that the exemptions to disclosure set out in 5(7)(a)(iv) and 5(8) ought to be narrowly construed (2189205 Ontario Inc v Springdale Pizza Depot Ltd, 2011 ONCA 467 at para. 32).

Four elements

Subsections 5(7)(a)(i) ensures that the grant does not flow from the franchisor or any related party, and (ii) ensures that the grant is an arm's-length transaction.  Subsection 5(7)(a)(iv) captures any involvement of the franchisor in the grant and, typically, the most challenging aspect of claiming a grant-related exemption is ensuring that the grant in question has not been "effected by or through the franchisor."  Indirect involvement of the franchisor is also captured (2189205 Ontario Inc v Springdale Pizza Depot Ltd, 2011 ONCA 467, at para. 41).

While the Wishart Act provides little guidance as to what constitutes a "grant", in subsection 5(8) it does clarify that a grant 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; or where a transfer fee must be paid to the franchisor in an amount set out in the franchise agreement or in an amount that does not exceed the reasonable actual costs incurred by the franchisor to process the grant.

Approving the grant should be a relatively uninvolved process that "is akin to a tenant assigning a lease and the landlord consenting to the assignment" (MAA Diners Inc v 3 for 1 Pizza & Wings (Canada) Inc, 2003 CanLII 10615 (Ont SCJ) at para 26).

Jurisprudence

Beyond the express language of subsections 5(7)(a)(iv) and 5(8), the courts have progressively identified a growing list of circumstances that trigger the disclosure requirement due to sufficient involvement of the franchisor. Numerous cases evince the courts' characteristically narrow interpretation of the "grant" exemption.

For example, in 2189205 Ontario Inc v Springdale Pizza Depot Ltd, 2011 ONCA 467, the Ontario Court of Appeal found "a number of circumstances" that cumulatively signified that the franchisor had brought about, or caused, the resale.  These included that the franchisor had directed the new franchisee to the vendor and participated in negotiations relating to the sale. The agreement of purchase and sale required the new franchisee to obtain the franchisor's consent, which required direct contact with the franchisor. Finally, as a condition of its consent, the franchisor had also required the new franchisee to sign two additional documents that had not been signed by the vendor, including an acknowledgement that there was no reliance by the new franchisee on any financial representations by the franchisor. Although the franchisor's involvement had not risen to the level of acting as the vendor in the resale, the evidence revealed that the franchisor had done more than remain passive and could therefore not rely on the resale exemption.

Similarly, in MAA Diners Inc v 3 for 1 Pizza & Wings (Canada) Inc, 2003 CanLII 10615 (Ont Sup Ct), the court found that the grant in question was effected by or through the franchisor because of its active role with the new franchisee. The franchisor's operations manager prepared all contractual documents, provided the bill of sale and the sublease, and testified that he had been asked to "facilitate or manage the transaction" with the new franchisee. All meetings between the parties were held at the franchisor's office. The relationship between the franchisor and the new franchisee precluded the franchisor from claiming an exemption from the disclosure requirement.

A franchisor relying on the grant-related exemption cannot impose conditions on the new franchisee that go beyond the specific requirements of the franchise agreement.  In 1518628 Ontario Inc v Tutor Time Learning Centres, LCC, 2006 CanLII 25276 (Ont SCJ), the new franchisee was a corporation controlled by a single principal that had entered into a share purchase agreement with the vendor. The franchise agreement enumerated conditions for the franchisor's consent to a transfer. In addition to the new franchisee's compliance with these conditions, the franchisor also required the principal's spouse to sign a personal guarantee and to assume all personal obligations set out in the franchise agreement. Although this was standard practice for the franchisor, Cumming J found that the franchisor's exercise of the power "to require a non-officer, non-shareholder spouse to in effect become a co-franchisee [was] not merely engaging in the relatively passive act of approval of the transfer of the franchise as between the parties." This requirement exceeded the franchisor's "right, exercisable on reasonable grounds, to approve or disapprove the grant," as contemplated by section 5(8) of the Wishart Act, and therefore characterized the transfer as having been effected by or through the franchisor.

In 2147191 Ontario Inc v Springdale Pizza Depot Ltd, 2014 ONSC 3442, Myers J observed that "the exemption will apply when a franchisor merely passively exercises its consent rights and no more." The franchisor in this case exceeded the passive exercise of its rights by meeting with the new franchisee three times personally, even though the franchise agreement stipulated that the vendor was responsible for obtaining the franchisor's consent to an assignment. Further, the franchisor required the new franchisee to provide an acknowledgement that it had not relied on any sales figures obtained from the franchisor. The acknowledgement restricted any future ability to bring misrepresentation claims under section 7 of the Wishart Act, which constituted valuable consideration surpassing the transfer fee allowed by section 5(8).

As the cases demonstrate, franchisors should be wary of the exemptions from the disclosure requirement, all of which are narrowly defined and construed by courts. In Salah v Timothy's Coffees of the World Inc, 2010 ONCA 673, Winkler CJO noted that the Wishart Act "is intended to redress the imbalance of power as between franchisor and franchisee" and "to provide a remedy for abuses stemming from this imbalance." Given the remedial nature of the Wishart Act, courts must "err on the side of disclosure" and hold franchisors to the disclosure requirement as soon as the imbalance of power between franchisor and franchisee becomes a factor in a franchise-related transaction (2147191 Ontario Inc v Springdale Pizza Depot Ltd, 2014 ONSC 3442 at para. 18).

Overall, franchisors ought to be careful not to play any role in a resale situation beyond approving the grant or accepting a transfer fee.  If they want to play such a role, as for example when they want new forms of agreements signed, they should be prepared to make disclosure in compliance with section 5 of the Wishart Act.

[Originally published in the OBA Franchise Section newsletter, late 2015]

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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