The Dangers of Dabbling In Franchise Law

Franchise Law is a trap for the unwary lawyer. Given the broad definition of “franchise” under franchise legislation, an unwary lawyer may not identify that a commercial transaction is in substance a “franchise”, which may then impose a disclosure obligation on the party deemed to be a “franchisor”.  Secondly, the preparation of a valid disclosure document, and the circumstances in which a disclosure document must be delivered, are increasingly complex. The consequences of getting it wrong can be significant, not only to the public, the client, and to various individuals related to the client, but also for the lawyer. According to LawPRO’s most recent statistics the average dollar value of a negligence claim against lawyers in franchise matters was approximately five (5) times the claim value in almost every other area of law. 

Franchise legislation in Canada

In Ontario, as well as in five (soon to be six) other Canadian provinces[1], the respective rights and obligations of franchisors and franchisees are in part governed by the Arthur Wishart Act (Franchise Disclosure), 2000[2] (the “Wishart Act”).   The main policy goals of the Wishart Act are to: (a) provide prospective franchisees with the information they need to make an informed decision about purchasing a franchise; and (b) create a commercial framework that governs the relationship of the parties. The Wishart Act, and other provincial franchise legislation, is remedial and is akin to consumer protection legislation, enacted to rectify a perceived imbalance of power favouring the franchisor.  The courts have generally given it a liberal interpretation.  

Under the Wishart Act, the term “franchise” is broadly defined.   Lawyers need to look at the substance of the business relationship to determine whether it is a “franchise”.  Just because an agreement is described by another name, does not mean it is not a “franchise” agreement and therefore subject to the Wishart Act.  There are, however, certain relationships which are excluded from the application of the Wishart Act. 

As part of achieving the first policy goal, a franchisor must provide a franchise disclosure document (FDD) to each prospective franchisee no later than 14 days before the earlier of the franchisee:

1. signing the franchise agreement or any other agreement relating to the franchise, or
2. paying any consideration relating to the franchise (i.e., collectively, signs or pays).

The FDD is to be certified by two directors or officers of the franchisor (unless the franchisor has only one person serving as director and officer) as true and complete and must contain the following:

1. all material facts[3], including material facts as prescribed by the regulations;
2. financial statements as prescribed;
3. copies of all proposed agreements;
4. the prescribed statements (these are found at the beginning of the disclosure document); and
5. other information and copies of documents as prescribed.

The disclosure process begins when a franchisor provides a prospective franchisee with the FDD and ends when the prospective franchisee signs the franchise agreement. The time between those two events must be at least 14 days but could continue for additional weeks or months. If during the intervening period there are any “material changes”[4] to the information provided or that should have been provided in the FDD, the franchisor must deliver a statement of material change to the prospective franchisee as soon as practicable after the material change has occurred, but in any event before the prospective franchisee signs or pays.  There are, as well, a variety of circumstances exempting a franchisor from its obligation to provide a prospective franchisee with an FDD.

The Wishart Act provides that a franchisee may rescind the franchise agreement no later than: 

1.           60 days after receiving the FDD if:

1. the franchisor fails to provide the FDD, or statement of material change within the time requirements.  This includes a situation in which an intermediate step is taken by a prospective franchisee (i.e., the payment of a deposit or the signing of a letter of intent) and who does not receive a disclosure document until after having taken this step; or
2. the contents of the FDD do not meet the requirements of the Wishart Act but are otherwise not so deficient to permit the franchisee a two (2) year right of rescission (referenced in item 2 below). 

2.           2 years after signing if:

1. the franchisor never provided an FDD; or
2. the FDD was so deficient it constitutes non-disclosure i.e. as if the franchisor never provided an FDD. 

Judicial interpretation of the Wishart Act and of provincial franchise legislation by other provincial courts, has resulted in holding franchisors to a relatively high standard of disclosure to ensure that the franchisee “can make a properly informed decision about whether or not to invest in a franchise.”   Examples of this standard include granting a franchisee the right to rescind in the circumstances in which: (a) the franchisor: (i) failed to include a certificate in the appropriate form signed, and dated, by the required number of officers or directors of the franchisor; (ii) failed to provide financial statements as required; or provided stale dated (not current) financial statements, or financial statements which did not contain proper notes; (iii) failed to provide a statement of material change in circumstances where it was required; (b) provided a disclosure document in successive stages and not as one document at one time; (c) did not include copies all agreements that the prospective franchisee was required to sign, in the disclosure document; and (d) the franchised business was the first of its type (i.e. outside of a shopping mall) in the franchisors’ system.

In the event of a rescission, the Wishart Act requires that the franchisee be placed back in the same position as if the franchisee never signed the franchise agreement.  This requires that the franchisor, and those parties deemed to be a franchisor’s associate, within sixty days of the effective date of the rescission, to:

(i)           refund to the franchisee any money received from or on behalf of the franchisee, other than money for inventory, supplies, or equipment;

(ii)          purchase from the franchisee any inventory that the franchisee had purchased pursuant to the franchise agreement and remaining at the effective date of rescission, at a price equal to the purchase price paid by the franchisee;

(iii)         purchase from the franchisee any supplies and equipment that the franchisee had purchased pursuant to the franchise agreement, at a price equal to the purchase price paid by the franchisee; and

(iv)         compensate the franchisee for any losses that the franchisee incurred in acquiring, setting up and operating the franchise, less the amounts set out in (i) to (iii).

The result is that a franchisor, and those individuals who are deemed to be franchisor’s associates, can be liable for hundreds of thousands of dollars in damages. 

As well, if a franchisee suffers a loss because of a misrepresentation[5] contained in the FDD or a statement of material change, or because of the franchisor’s failure to comply with the requirements of Wishart Act, the franchisee has a right of action for damages. In respect of both the foregoing losses there is personal liability involved for a broad category of individuals. 

Why a Lawyer Should Not Dabble in Franchise Law

The Wishart Act is a trap for the unwary lawyer.  This trap presents itself in one of two ways:

1. The failure to appreciate that the commercial relationship is a “franchise” under the Wishart Act which then imposes on the party granting the rights (the franchisor) the obligation to provide an FDD.
2. The failure of the franchisor to provide an FDD that meets the obligations set forth in the Wishart Act, whether because the lawyer believed an exemption was available when it was not, or the FDD was deficient.

The manifestation of the trap depends on the type of franchise client the lawyer has.A lawyer may be liable for negligence to:

1. A franchisee, if the franchisee either did not receive an FDD, or received a non-compliant FDD, and the lawyer did not advise the franchisee of their right to:

 

1. rescind, resulting in the franchisee missing the opportunity to rescind its franchise agreement within the time provided under the Wishart Act; or

 

2. commence legal proceedings for a misrepresentation or failure to comply with the provisions of the Wishart Act. 

2. A franchisor, if the franchisee subsequently rescinds its franchise agreement and claims rescission damages from the franchisor, who then claims against its (former) lawyer for negligence and indemnification for the post-rescission damages claim, if the lawyer:  

     a. did not advise the franchisor client of its obligation under the Wishart Act to provide a compliant FDD to a prospective franchisee.  This could arise because the lawyer:

 

1. did not advise the franchisor client that the commercial relationship between the parties to the agreement was a “franchise” under the Wishart Act;

 

2. advised the franchisor client that an exemption from the application of the Wishart Act was available when it was not, or

 

3. advised the franchisor client that an exemption from the delivery of an FDD was available when it was not.

 

2. prepared an FDD for its franchisor client that failed to comply with the requirements of the Wishart Act; or

 

3. failed to instruct the franchisor client of the importance of updating the FDD on an as required basis to include all “material facts”, including those “material facts” prescribed by the regulations. 

There are a number of consequences arising from a lawyer not properly advising a franchise client of their rights and/or obligations under the Wishart Act.  First, is the failure to serve the public interest, and the resulting economic loss.  For the franchisee they may not have been afforded the opportunity to make an informed decision.  They may have lost their investment entirely or find themselves mired in litigation in an effort to recover compensation.  For the franchisor and a broad category of individuals who have personal liability, it is the realization that for the sake of a franchise fee, they now have an obligation to compensate the franchisee for rescission damages which can total hundreds of thousands of dollars.

Secondly, these decisions generate case law adverse to franchisors, which creates a more difficult legal environment, and serves to undermine the overall level of trust and confidence franchisors hope to establish and maintain for the Canadian franchise industry.

Finally, it could result in a finding of negligence against the lawyer and exposure for damages. Most often when the lawyer finds that their advice to a franchise client was negligent, the damages have already been suffered and cannot be rectified. It is for these reasons that lawyers should not dabble in franchise law.

Learn more by attending the OBA's upcoming program, What You Didn’t Know You Need to Know About Franchise Law: A Two-Part Primer.

About the author

David Kornhauser, MBA, LL.B., is a partner at Loopstra Nixon LLP

 

Any article or other information or content expressed or made available in this Section is that of the respective author(s) and not of the OBA.