Canada: Ontario Court Imposes New Disclosure Requirement Prohibiting The Common Practice Of Determining Location After Signing A Franchise Agreement

A recent decision of the Ontario Superior Court of Justice will have drastic effects on the business of franchisors who follow the common practice of granting franchises for locations yet to be determined.

In Raibex Canada Ltd. v ASWR Franchising Corp. (Raibex), the defendant franchisor was found liable for rescission under section 6(2) of the Arthur Wishart Act (Wishart Act) for failing to disclose a copy of the head lease and location-specific development costs for the franchise, despite the fact that the location was to be determined after the franchise agreement was signed pursuant to a location selection process set out in the franchise agreement.1

In her decision Justice Matheson states:

If it is simply impossible to make proper disclosure because material facts are not yet known, then the franchisor is not yet ready to deliver the statutorily required disclosure document. The franchisor must wait – it does not get excused from its statutory obligations.2

This decision creates an unprecedented expansion of disclosure obligations under the Wishart Act. Justice Matheson found, essentially, that the delivery of a disclosure document and the execution of a franchise agreement prior to determining the location of the franchise is "premature" since all material facts are not yet known. This introduces a new timing requirement for disclosure and the execution of franchise agreements that is not set out in the Wishart Act and has not been imposed by courts prior to this case.

In addition, Justice Matheson's decision does not differentiate between situations where the franchisor assumes the head lease and those where franchisees enter into leases directly.

In principle, the Raibex decision leads to the perplexing conclusion that a franchisee could choose to rescind when disclosure is made and the franchise agreement signed before other types of site-specific facts, which may not even be lease related, are known. Given the myriad variables that any particular site may have, this would leave franchisors with the never-ending question of determining at what point enough material facts are known that it is "ready to deliver" disclosure.

All franchisors are cautioned to take note of this decision in considering the timing and content of disclosure to franchisees while the decision is under appeal, regardless of whether their practice involves subleasing the premises or not.

Overview

The plaintiff franchisee, Raibex Canada Ltd. (Raibex) and its individual principals, moved for summary judgment on their rescission claim in respect of their "AllStar Wings & Ribs" franchise. After a few months of operating the franchise, the franchisee's claim was commenced in response to the impending termination of the franchise agreement due to the franchisee's failure to pay over $200,000 owing for rent and amounts owed to contractors for the development of the restaurant. The defendants, ASWR Franchising Corp. (AllStar), its related entities and principals, moved for the entire action, including the franchisee's claims under sections 3 and 7 of the Wishart Act to be dismissed and for judgment on its own breach of contract claim arising from the termination of the franchise agreement. Aside from the quantification of damages, Justice Matheson resolved the entire action on summary judgment, granting the rescission claim and dismissing the plaintiffs' claims under sections 3 and 7.

Rescission

The plaintiffs' rescission claim was based on a number of alleged deficiencies in the Franchise Disclosure Document (FDD) provided to the plaintiffs including:

a) Failure to include a copy of the head lease;

b) Failure to disclose adequate estimates for the development costs of the franchise;

c) Deficiencies in the disclosure certificate, which was signed by the sole officer and director of the franchisor; and

d) Failure to deliver the FDD as one document at one time.

Justice Matheson found that Raibex was entitled to rescind the franchise agreement on the basis that the FDD failed to include (a) a copy of the head lease for the location or (b) sufficient disclosure with respect to the estimated development costs of the location.

Lease

Following common and long established practice, the location in this case was not determined until after the franchise agreement was signed. As such, the FDD did not and could not have included a copy of the head lease, although the form of sublease and location selection process under the franchise agreement were both disclosed.

Notably, under the location selection process outlined in the franchise agreement, the franchisee could have opted to terminate the franchise agreement and receive a refund of the franchise fee if it was not satisfied with any locations available after 120 days from execution. This option was not exercised. The plaintiffs were deeply involved in the selection process, including reviewing and approving the specific lease terms prior to AllStar entering into the head lease. Leaving aside the argument that the lease could not have been a material fact at the time of disclosure because it was not then known, the franchisee had actual knowledge of and approved the terms of the head lease, the very fact which was said to be missing from the FDD.

Justice Matheson acknowledged that the practice of determining a location after signing a franchise agreement "may not be unusual", but nonetheless found that it gave rise to a material deficiency in this case. Justice Matheson based her finding on what she described as the potential for franchisors to abuse prospective franchisees by disclosing "prematurely" and thus avoiding the requirement to disclose material facts which are not yet known. Paradoxically, however, Justice Matheson found there was no evidence of any such "abuse" by AllStar in this case.

Development Cost

Justice Matheson also found that the estimates provided in the FDD for development costs were materially deficient. The FDD described two different methods of building a franchise – a "shell" where the location is built from scratch and a "conversion" where an existing restaurant is refurbished into an AllStar franchise. The FDD provided estimates for the higher cost shell and noted that pursuing a conversion may offer certain savings on those costs which are ultimately dependent on the location selected. As a result, Justice Matheson found that the FDD failed to include any estimates relevant to the conversion build pursued by the plaintiffs. Justice Matheson again characterized this deficiency as resulting from "premature" disclosure before AllStar was in a position to estimate costs sufficiently specific to developing the location selected by the franchisee. This was despite the fact that the plaintiffs' actual costs were within the range estimated in the FDD for a shell.

Certificate

The plaintiffs' arguments regarding the sufficiency of the disclosure certificate were rejected. The certificate was signed by the sole officer and director of the franchisor. The plaintiffs claimed that two other individuals were also required to sign the certificate.

One was a former officer and director who had resigned from his position several years prior to the delivery of the FDD. Due to the inadvertence of AllStar's previous corporate counsel, the resignation was not recorded on AllStar's corporate filings with the Ontario government until after the Franchise Agreement was signed, creating a presumption that the former director was still a director. The presumption was found to be rebutted by AllStar through evidence from the former director and the former counsel. The second individual, who was acting as an independent consultant at the time but later became an officer and director well after the franchise agreement was signed, was not found to be a de facto director at the relevant time, as alleged. Finally, the plaintiffs' argument that the sole officer and director who did sign had improperly signed on behalf of AllStar and not "in his personal capacity" was also rejected on the basis that the Wishart Act does not prescribe the form in which a director or officer must sign a certificate.

Franchisor's Associates

The plaintiffs alleged that three related corporations, ASWR Developments Inc. (ASWR Developments), Hellenic International Holdings Inc. (Hellenic) and Leontian Holdings Inc. (Leontian) as well as the actual director and the alleged de facto director were "franchisor's associates" who should all be jointly and severally liable for rescission damages under the Wishart Act. ASWR Developments is an affiliate of AllStar which enters into head leases and sub-leases to franchisees. Hellenic and Leontian are related entities controlled by the sole officer and director of the franchisor, and have no direct relationship with franchisees.

Only ASWR Developments and the actual sole director and officer of AllStar were found to be franchisor's associates. Justice Matheson found that Hellenic and Leontian had no relationship with franchisees and could not be franchisor's associates and that the alleged de facto director had no "control relationship" with AllStar sufficient to make him a franchisor's associate.

AllStar's Cross-Motion

Justice Matheson found in favour of the defendants on their cross-motion to dismiss the plaintiffs' section 7 misrepresentation and section 3 duty of good faith claims, finding the plaintiffs' failure to "put their best foot forward" by seriously contesting either of these claims in the face of the defendants' summary judgment motion was fatal. The remainder of the cross-motion, which related to breach of contract and amounts owing due to the termination, were rendered moot by the finding of rescission and were not decided.

Key Take-Aways From the Decision

The Raibex decision threatens to jeopardize the common and longstanding practice in Canadian franchising of granting a franchise where the location has yet to be determined. Following this practice, after disclosure is made and the franchise agreement signed, the franchisor and franchisee will scout out and select a location that is agreeable to both. In most cases, a lease and sublease are then signed and the parties go about their business. There are strong business reasons for this practice. A franchisor would not want to take on the liability of a long term lease without knowing that a franchise for that location was going to be granted and that a franchisee was going to take the location. The prospect of this is fully enshrined in most franchise agreements and forecasted in most disclosure documents. Franchisees who sign franchise agreements in this context do so with full knowledge that they are agreeing to become a franchisee at a time when no location exists. Usually, the franchisee is contractually entitled to opt out if a location is not found within a certain period of time.

Until the decision in Raibex, this practice was well accepted, time tested and seemingly compliant with the Wishart Act. The Raibex decision changes all of this.

Raibex creates, for the first time, a new requirement under the Wishart Act with respect to the timing of disclosure and entering into a franchise agreement. According to Raibex, all material facts relevant to the location (which at the time of disclosure are often unknown), such as the head lease and specific development costs related to the location, must be known before proper disclosure can be made and a franchise agreement can be signed. The decision concludes that, by entering into a franchise agreement before the location is known, a franchisor will have committed an "egregious" violation of the disclosure requirements under the Wishart Act entitling the franchisee to rescind within two years. This is a sweeping change. While Justice Matheson states that she does not rule out proper disclosure being made in situations where a location is determined post-agreement, it is almost impossible to conceive of a situation where this would be possible given the implications of Raibex.

It is noteworthy that Justice Matheson does not make any distinction between situations, like in Raibex, where the franchisor assumes the head lease and subleases locations to franchisees and where the franchisee is responsible for entering into a lease directly with the landlord. Justice Matheson states in her decision, "to suggest that the head lease is not material is absurd. The terms of the lease [...] are a critical component of franchise disclosure."3 From this, it may be inferred that, following Raibex, a lease will always be material for disclosure purposes regardless of whether the franchisor is subleasing the location to the franchisee or not.

From a common sense perspective, it seems straight forward that a potentially material fact that is not and cannot become known until after the franchise agreement is signed should not be considered a material fact for the purpose of disclosure. Faced with the disclosure that a location will not be selected until after the franchise agreement is signed, the franchisee, as an independent businessperson, is free to knowingly elect to become a franchisee and submit to the site selection mechanism in the franchise agreement, or alternatively, choose to forego or defer signing the franchise agreement. Oddly, the fact that the franchisee was aware that there was no lease at the time the franchise agreement was executed, and that it had the choice after execution of the franchise agreement whether to proceed, or not based on the suitability of the location to be determined, was not relevant to the court's analysis.

Furthermore, when the contract in question specifically outlines the activity that is to take place (i.e. the identification of a location) the franchisee is specifically afforded the good faith and fair dealing protections that section 3 of the Wishart Act provides in the performance and enforcement of that provision. The franchisor must act in accordance with reasonable commercial standards in and throughout the site selection process. The franchisee is not left without any statutory protections. In fact, it is exactly the contrary. How then can it be said that the franchisor is being "excused from its statutory obligations" when it delivers disclosure before the location is known as Justice Matheson suggests? 

The Raibex decision will be appealed by the franchisor. While under appeal, franchisors that grant franchises for locations to be determined should consider the implications of the decision and consult with their legal advisors when making disclosure and granting franchises.

Footnotes

1 2016 ONSC 5575, http://canlii.ca/t/gts4v [Raibex].

2 Raibex, supra, at para. 78.

3 Raibex, supra, at para. 70.

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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Authors
Christopher Horkins
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