Disclosing Franchisors with Clarity
In late 2016, the “AllStar Decision” created great uncertainty for franchisors and franchise practitioners alike. This uncertainty surrounded the process for providing disclosure as required under the Arthur Wishart Act, (Franchise Disclosure), 2000 (the “AWA”) to prospective franchisees in situations where no location for the franchise had yet been selected. Thankfully, on January 25, 2018, the Court of Appeal released its decision in Raibex Canada Ltd. v. ASWR Franchising Corp. and brought order and clarity back to the franchise industry by allowing the franchisor’s appeal and dismissing the franchisee’s claim for rescission.
The franchisor, ASWR Franchising Corp., granted Raibex Canada Ltd. the right to acquire and operate an AllStar Wings and Ribs franchise in Mississauga. Often franchisees will sign franchise agreements and be free to find a location on their own or work in collaboration with the franchisor to select a location, either signing a head lease directly with a landlord or a sublease with the franchisor. In this case, the franchisor was to sign the head lease with the landlord and sublease the premises to the franchisee.
The franchisee in this case intended to find an existing restaurant and convert it to an AllStar Wings and Ribs franchise. The disclosure document provided cost estimates for constructing a new location from a shell but not for converting an existing restaurant to an AllStar Wings and Ribs franchise.
The franchisee was granted rescission of the franchise agreement based on section 6(2) of the AWA, which provides that a franchisee may within two years of signing a franchise agreement, walk away from the franchise and receive full reimbursement of its costs if disclosure was never received. Over time, case law has developed to provide that in certain cases, even where a franchisee has received disclosure, the two-year rescission remedy is still available if the disclosure is considered so deficient that it is as if no disclosure had been provided at all.
The franchisee in this case claimed that the disclosure provided fell into this fatally deficient category as it did not disclose a copy of the head lease for the premises (which did not yet exist) and did not provide conversion estimates for the location. When a location was subsequently selected, the lease required a $120,000 deposit. Additionally, the conversion cost exceeded $1 million. The franchisee sought rescission of the franchise agreement on these grounds and was successful.
The lower court held that it was premature for the franchisor to have disclosed to the franchisee without a head lease, as this amounted to an omission of a material fact. It did not matter that this material fact did not yet exist, and was therefore not yet known to the franchisor – and so began the uncertainty.
As a result, franchisors have faced practical issues such as having to convince landlords to offer them locations without a formal lease until the franchisee could be found, or failing this, having to sign leases without a franchisee in line for that particular location.
Franchise practitioners have had to grapple with creative ways to balance their clients’ needs to sell franchises by providing disclosure to prospects, with this impossibly onerous new disclosure requirement of waiting to disclose until you know everything.
The Court of Appeal
On the rescission issue, the Court of Appeal reiterated that when seeking the two-year rescission remedy, it must be clear that the franchisee was deprived of the ability to make a fully informed decision considering both the language of the disclosure document and the franchise agreement.
In this particular case, the franchisee was not deprived of that ability. With respect to the lease, the franchisee knew that no location had been selected. Additionally, the franchise agreement provided that (a) the franchisee and franchisor would work collaboratively to find a location with the franchisee to be actively involved in site selection, and (b) if a location had not been selected within 120 days of signing, the franchisee could terminate the franchise agreement and receive a refund of its initial fee, less the franchisor’s reasonable expenses. Therefore, once the franchisee learned of the $120,000 deposit, it had the ability to reject the location or terminate the franchise agreement. Instead, the franchisee urged the franchisor to sign the lease. The Court of Appeal called these safeguards a “complete answer” to the claim that the failure to disclose the head lease amounted to fatal disclosure giving rise to the two-year rescission right.
With respect to the conversion estimate, the Court of Appeal held that the franchisee was effectively put on notice of the potential costs and risks associated with a conversion location and was therefore not deprived of its ability to make a fully informed decision. The disclosure document provided:
1. Cost estimates for developing an All Stars franchise from a shell;
2. A warning that cost estimates could vary greatly from site to site; and
3. A warning and recommendation that the franchisee maintain a significant contingency reserve.
Franchisors can now safely return to the practice of disclosing to prospective franchisees without first having secured a location for that franchisee and disclosing a head lease. Locations may be selected after the franchisee signs the franchise agreement, either by the franchisee alone with the franchisor’s approval (or not), or in collaboration with the franchisor. Given the Court of Appeal’s reasoning based on the existence of site selection safeguards and risk warnings in the disclosure document, franchisors are wise to provide franchisees with an opt out in the case that a location is not found within a reasonable time and to advise prospective franchisees of the uncertainties associated with build out and/or renovation costs.