Best Practices in Franchise Agreement and Disclosure Document Preparation
[author: Frank Zaid]
For our first newsletter of 2012, we thought it might be timely to look back at the many developments we have seen in franchise agreement and franchise disclosure document preparation in the past few years. Specifically, and especially for U.S.-based franchisors coming to Canada, we have noticed a number of common problems that have been tested by our courts or that simply create serious impediments to the enforceability of franchise agreements or the validity of disclosure documents. While this article could go into detail on a very comprehensive list of issues, we will split the article into two parts, limiting our comments to five of the most common problems we have seen in recent years in the preparation and/or enforcement of franchise agreements (which includes collateral documents) in the first part, and in the preparation and validity of franchise disclosure documents in the second part, and our recommendations for best practices in these areas.
Franchise Agreement Deficiencies
1. Non-Competition Covenants
Our courts continue to be very diligent in applying well-established principles when considering the enforceability of non-competition covenants against franchisees following termination, expiration or transfer of a franchise. The principles are quite straightforward: (i) the covenant must be reasonable both in the interest of the parties and the public; (ii) the covenant must be certain and unambiguous in respect of the activities being restrained; and (iii) the covenant must be reasonable in respect of its reach, especially regarding territory and time.
When applying these principles, Canadian courts will not generally enforce a “blue-pencil” non-competition covenant which attempts to direct the court to select a territory or distance that it considers reasonable from a list of alternatives. Also, a court will not enforce a covenant which does not define the prohibited activities in specific language: covenants which address “similar” or “competing” activities will generally not be enforced. In addition, covenants which address future products or services in which the franchisor may be involved will also not likely be enforced. And, finally, covenants which attempt to restrain individuals who are not parties to the agreement will not generally be enforceable against such parties, although they may be enforceable against the party who is the franchisee.
The clear direction for best practices for drafting enforceable non-competition covenants is for franchisors to be fully aware of the most recent developments in the courts, and not to assume that covenants which may be enforceable in a country outside Canada, especially in the U.S., will be enforceable in Canada. A bit of expert Canadian advice will possibly mitigate or eliminate a very costly proceeding later on.
2. Renewals or Transfers
We have seen a continuing stream of difficulties faced by franchisors who try to enforce provisions in their franchise agreements dealing with renewals or transfers. While many of these situations are very fact specific, there seems to be a general trend on the part of franchisors to require that renewing or resale franchisees must enter into “the then current form of franchise agreement and ancillary documents.” Clearly the intent is to be able to allow a franchisor to require a renewing or resale franchisee to execute the franchisor's current form of agreement which in many cases will contain new provisions dealing with system changes, new standards, and new provisions to counteract adverse judicial decisions, by way of example, but some new forms of agreement will contain major changes like different financial terms, reduced or eliminated territory, shortened renewal terms, more stringent default clauses, or enhanced restrictions on transfers. While our courts will generally enforce clauses which require a renewing or transferring franchisee to enter into a then current form of agreement, the courts will be vigilant in requiring the franchisor to establish what the then current form of agreement is, and whether the ability of the franchisor to impose a materially different form of agreement will be in compliance with the common law or statutory duty of fair dealing which requires the franchisor to act in good faith and in accordance with reasonable commercial standards.
Best practices in this area suggest that a franchisor be communicative to its franchisees when contemplating and introducing a new form of agreement that it intends to use in the future on renewals and transfers. A suggested form of communication may also include a summary of material changes from the form being changed, and give reasonable time for introduction of the new form. Then the franchisor must ensure that it has documented evidence to establish that the new form of agreement is actually being used in practice, whether by way of new disclosure documents or by way of executed franchise agreements. Failure to follow these practices may result in a court refusing to enforce a proposed new current form of agreement, and requiring the franchisor to revert to its old form.
Many franchisors in product or service industries that operate from fixed locations require that their franchisees execute leases or subleases directly with the franchisor or affiliates of the franchisor that own the locations or lease them directly from landlords. By doing so the franchisor will be able to control possession of the premises and, in particular, to gain access to the premises in the event of default, termination or resale. A variation of this practice is to require the franchisee to enter into a conditional assignment of lease with the landlord permitting the franchisor to assume tenancy in the event of default, termination or resale, under specific conditions.
While all of these techniques will work well for a franchisor wishing to regain possession of the premises in the event of a franchisee termination or resale, they do not provide the most effective assistance for a franchisor wishing to take occupation of the premises on a default under the franchise agreement unless they also contain provisions giving the franchisor landlord/tenant rights. This is most easily accomplished by providing in the franchise agreement that a default under the franchise agreement is considered to be a default under the lease or sublease, and vice versa, and that in the case of such default the franchisor is entitled to exercise rights available under landlord/tenant or commercial tenancy legislation allowing the franchisor to repossess the premises as if the franchisee had defaulted under the lease or sublease. Absent these provisions, a franchisor will be unable to repossess the premises if the franchisee defaults under the franchise agreement without terminating the agreement. Unfortunately, we often see leases or subleases prepared by real estate lawyers with little knowledge of franchise law which do not include the necessary cross-default clauses and real estate remedies.
4. The Electronic Age
Twelve years ago lawyers worried about the possibility of defects in franchise agreements dealing with possible defects arising out of the year 2000. Since then there has been a rapid explosion of electronic media, the internet, e-mail communications, franchisor intranets, and now social media. Older franchise agreements do not address these subjects, and often prevent a franchisor from introducing new standards and specifications relating to use of the internet, intranets, e-mail communications, and social media.
However, if a franchise agreement contains a well-drafted system change provision it is possible for a franchisor to introduce these changes by way of policies or system standards or specifications. In so doing, a franchisor must not lose sight of the fact that the duty of fair dealing will apply to require that the changes are in accordance with reasonable commercial standards, are not unreasonable, and not exercised in the franchisor's sole discretion without regard to the rights of its franchisees. As soon as it is possible for the franchisor to amend its standard form of franchise agreement, these subjects must be written into the franchise agreement itself to reflect the franchisor’s requirements concerning electronic communications.
5. Operations Manuals
Almost very franchisor and their respective franchise agreements utilize operations manuals for setting forth the standards, specifications, rules and regulations regarding the operation of the franchise system. However, what is often missing is a proper and thorough description of the term “Manual” so as to allow the franchisor various means of communicating changes, amendments, withdrawals and inclusions in or to the manual. The term “Manual” should be broadly described to include actual manuals by their titles, additional manuals, bulletins, policies, directives and communications, whether written or retained electronically. Further, while older franchise agreements refer to written supplements or amendments, more current franchise agreements refer to an electronic form of operations manual retained on the franchisor's intranet, with changes being communicated by e-mail. With a comprehensive definition, and the right to make changes electronically, a franchisor can obtain a significant degree of flexibility to allow system changes without running the risk of contravening its rights under the franchise agreement or contravening the duty of fair dealing.
And one more serious closing comment on the subject of manuals. While most franchise agreements refer to manuals and their use in setting forth system standards, we have seen on a few occasions the worst of possible mistakes on this subject – franchisors who either have no manuals or whose manuals are hopelessly outdated. If a franchisor commits to regulate its system standards through the use of manuals, a franchisee, or worse, as group or class of franchisees, will no doubt have an argument that the franchisor is in breach of its agreement or in fact in fundamental breach by not providing the very backbone of a franchise system. While slightly less egregious, a franchisor who does not update its manual for a significant period of time, or at all, may also be facing a similar claim from its franchisees. Suffice it to say that franchisors who intend to use manuals must devote appropriate time and attention to their preparation, and their updating, and must ensure that they communicate the contents of their manuals and updates to their franchisees on a timely basis.
While we have only dealt with some serious areas of potential franchisee agreement deficiencies, there are many more that could be discussed. However, in these and most other cases the problems arise not because of an ill intention on the part of franchisors, but more because of franchisors do not keep themselves informed of ongoing developments, fail to take action when informed, or simply do not recognize that prioritizing regular updates and reviews of their franchise documents can lead to serious consequences in the future. A little attention now can pay big dividends down the road.
Stay tuned for our discussion about similar challenges relating to the preparation and use of franchise disclosure documents in our next issue of the Osler Franchise Law Review.
Best Practices – When is a Fact “Material”?
[authors: Andraya Frith and Michelle Malecki]
Canadian franchise laws require that all “material facts” relating to the franchise be included in a franchise disclosure document. In addition, any “material change” that has occurred after initial disclosure must also be disclosed to the prospective franchisee as soon as practicable and before the signing of the franchise agreement or the payment of any consideration relating to the franchise.
What is or is not a material fact or material change is often a difficult question to answer. “Material fact” is defined non-exhaustively in Ontario’s franchise legislation, and although the provincial regulations list specific items to be disclosed, this list may not cover all material facts. For that reason, what constitutes a material fact or material change must be determined on a case by case basis.
What is a Material Fact?
In Ontario, for example, “material fact” includes any information about the business, operations, capital or control of the franchisor or franchisor’s associate, or about the franchise system, that would reasonably be expected to have a significant effect on the value or price of the franchise to be granted or the decision to acquire the franchise. The definition of “material fact” only requires that the information have a “significant” effect as opposed to the higher threshold of a “material” effect or a “substantial” effect on the value or price of the franchise or the decision to acquire the franchise. Given that there is little case law analyzing the definition of “material fact,” franchisors may wish to adopt a conservative approach, and if a fact could possibly be considered material, it should be disclosed.
What is a Material Change?
In Ontario, for example, a “material change” means a change in the business, operations, capital or control of the franchisor or franchisor’s associate, a change in the franchise system or a prescribed change, that would reasonably be expected to have a significant adverse effect on the value or price of the franchise to be granted or on the decision to acquire the franchise. Positive changes do not trigger the obligation to provide a statement of material change. A change is only material if it is reasonably expected to have a significant adverse effect. If in the course of the sales and disclosure process, new information develops that falls within the definition of a “material change,” this new information must be disclosed to prospective franchisees by providing them with a statement of material change. In addition to disclosing material changes, many franchisors also use a statement of material change to provide prospective franchisees with site-specific information that was not available at the time of initial disclosure.
How to Determine if Information is “Material”
When deciding whether a particular piece of information is a “material fact” or “material change,” franchisors should first consider whether the fact or change falls within the categories of information covered by the definition of “material fact” or “material change.” If so, franchisors should further consider whether the fact or change could reasonably have a significant effect on the value or price of the franchise or the prospective franchisee’s decision to purchase the franchise (in the case of a material change this effect must be adverse or negative). When performing this analysis, franchisors must exercise reasonable judgment, and weigh the likely significance of the information from the prospective franchisee’s point of view. If the answer to both of these questions is yes, this fact or change is material and must be disclosed. If not, the franchisor is not required to disclose this fact or change.
A franchisor should also consider whether its sales team intends to use or provide this information to a prospective franchisee during the franchise sales and disclosure process. If the answer to this question is yes, this information is likely important, regardless of whether it has a positive or negative impact, and will likely constitute a “material fact” that should be disclosed.
Examples of “Material Facts”
The following list provides some examples of information that may be considered a “material fact” or “material change” in the franchise law context beyond the scope of the required disclosure set out in the regulations:
The franchisor’s decision to significantly alter the brand image of the franchise system;
The franchisor’s decision to expand into a new channel of trade which may impact the traditional franchise delivery model (e.g., online business, kiosks, etc.);
Significant changes in the franchisor’s financial situation, such as the sale of the franchisor;
Information known by the franchisor about a specific location including prior closures, bankruptcies, or store failures in that location.
This list of examples provided above provides only a small subset of the types of information that might be considered to be a material fact or material change. The analysis for any specific franchisor must be performed on a case by case basis and franchisors should focus on identifying and evaluating information not currently included in its disclosure document. If the legal or business team has any reasonable doubt about whether an item of information should be disclosed, that information should be thoroughly discussed by the franchisor’s management and employees involved in the disclosure process, because collective judgment will greatly assist in determining materiality. If consensus cannot be reached, the safe approach is to disclose the information.