[author: Frank Zaid]
Part II: Best Practices in Franchise Agreement and Disclosure Document Preparation
In our March 2012 Franchise Review we completed the first part of our two-part commentary on important developments we have seen in franchise agreement and franchise disclosure document preparation in the past few years. We commented on some of the most common problems seen in recent years in the preparation and/or enforcement of franchise agreements (including collateral documents). This article addresses additional common problems with the preparation and validity of franchise disclosure documents.
Franchise Disclosure Document Deficiencies
Form and Content of Disclosure Documents
Using the province of Ontario, as an example, the actual content of a franchise disclosure document is set out in the Arthur Wishart Act (Franchise Disclosure), 2000 (the Act), and the regulations to the Act (the Regulations). Under section 5(4) of the Act, a disclosure document must contain:
all material facts (a defined term);
material facts prescribed in the Regulations;
financial statements prescribed in the Regulations;
copies of all proposed franchise agreements and other agreements relating to the franchise to be executed by the prospective franchisee;
statements prescribed in the Regulations for the purposes of assisting the prospective franchisee in making informed investment decisions; and
other information and copies of documents as prescribed (none prescribed to date).
In conjunction with these requirements, section 5(6) of the Act requires that all information in a disclosure document should be accurately, clearly and concisely set out.
Recent cases in Ontario and other provinces with franchise disclosure legislation have determined a pattern among the courts in terms of the consequences of noncompliance with the form and content requirements of franchise disclosure documents. Generally, the courts have taken a strict view on non-compliance, usually finding in favour of a franchisee when there are deficiencies in the content of disclosure documents, or when a franchisor fails to comply with the technical requirements of the legislation. The courts have stated that the main purpose of the obligation imposed upon a franchisor to make full and accurate disclosure is to allow a prospective franchisee to make an informed decision about investing in the franchise opportunity. For example, in one leading case, the court identified four deficiencies in a disclosure document provided to the franchisee, any one of which was fatal to compliant disclosure:
failure to include financial statements in accordance with the regulations;
failure to include a statement specifying the basis for earnings projections provided in the disclosure document;
failure to provide disclosure in a single document at one time; and
the absence of a signed certificate of disclosure as required by section 7 of the regulations.
Failure to comply with any one of these requirements, according to the Court, precluded a perspective franchisee from making an informed investment decision.
In a leading case in Alberta, confirmed by the Court of Appeal, the Court held that the lack of a signed and dated certificate of disclosure was sufficient to establish that the franchisor failed to provide a disclosure document to the franchisee.
In a recent case in Ontario, the Court noted that the disclosure document provided by the franchisor did not include a copy of the lease for the premises under which the franchisee was the sub-tenant. The Court determined that the failure to provide a copy of the sublease as well as information regarding the franchisor’s affiliate which was the tenant under the lease was equivalent to failure to disclose all material facts, leading to the conclusion that the franchisor had failed to provide a disclosure document at all.
Failure to include financial statements in a disclosure document as prescribed under section 5(4)(b) of the Regulations will be fatal to a franchisor. Subject to limited exemptions, every disclosure document must include audited financial statements for the most recently completed fiscal year of the franchisor’s operations, prepared in accordance with Canadian general accepted accounting principles (GAAP) that are at least equivalent to those set out in the Canadian Institute of Chartered Accountants (CICA) Handbook, or financial statements for the most recently completed fiscal year of the franchisor’s operations, prepared in accordance with GAAP that are at least equivalent to the review and reporting standards applicable to review engagements set out in the CICA Handbook.
If 180 days have not passed since the end of the most recently completed fiscal year and financial statements have not been prepared and reported for that year, the disclosure document must include financial statements for the previous fiscal year prepared in accordance with these requirements. If the franchisor has operated for less than one fiscal year or if 180 days have not passed since the end of the first fiscal year of operations and financial statements for that year have not been prepared, the disclosure document must include the opening balance sheet for the franchisor.
Franchisors may not include internally prepared financial statements or financial statements prepared in another jurisdiction whose standards are not equivalent to the CICA standards.
The Act requires that a disclosure document contain prescribed material facts, as well as any other material facts relevant to the particular franchise being offered. As demonstrated by some recent cases, courts in Ontario seem to expect franchisors to comply strictly with the disclosure requirements of the Act and ensure that all material information relevant to the franchise being offered is included within the disclosure document. While a generic standard form disclosure document will often fit the disclosure requirements relative to a new franchise, a standard form for a new franchise may not satisfy the requirements for a renewal or a transfer of an existing franchise or the acquisition of a corporate unit, as disclosure must be relevant to the particular franchise in question. Therefore, it has become the recommended practice in Ontario as well as in the other provinces which have franchise legislation that a disclosure document be customized to the particular franchise in question.
Execution of a Franchise Agreement
The Act requires the delivery of a disclosure document to a prospective franchisee. Delivery of the disclosure document must take place at least 14 days prior to the execution of a franchise agreement or the payment of any consideration relating to the franchise. The term “franchise agreement” is defined as any agreement signed by the franchisee and relating to the franchise. Accordingly, the first executed agreement may not necessarily be a franchise agreement, but may take the form of some other ancillary document entered into between the parties. In a recent case, the Ontario Superior Court of Justice determined that the definition of a “franchise” under the Act addresses the substance of the relationship and not whether the parties executed a document referred to as a “franchise agreement.” The Court found that the parties dealings constituted a franchise transaction because the characteristics of the relationship met the meaning of the term “franchise” under the Act, and ordered the franchisor to return a deposit received from a prospective franchisee and to pay damages for an aborted transaction to purchase the restaurant from the franchisor due to the fact that the franchisor had never delivered a disclosure document to the franchisee.
In one recent case, the same Court determined that an option agreement did not constitute a franchise agreement for the purposes of disclosure, and in another recent decision, the Court determined that a short letter agreement setting out specific terms of a renewal of a franchise constituted an actual franchise agreement for the purposes of disclosure, thereby allowing the franchisee to rescind the transaction as the letter agreement was executed more than two years prior to delivery of a disclosure document.
Accordingly, franchisors must be certain that they prepare and deliver a disclosure document at least 14 days prior to the execution of any form of agreement which might constitute an agreement between the parties relating to the franchise, regardless of whether that document takes the precise form of a franchise agreement or deals with the usual business and legal terms contained in a standard form of franchise agreement.
One of the most controversial and frequently contested disclosure document requirements under the Regulations pertains to disclosure of certain information if the franchisor provides earnings projections or financial performance information to a prospective franchisee. If an earnings projection is made by the franchisor, the disclosure document must include a statement specifying the reasonable basis for the projection, the assumptions underlying the projection and the place where substantiating information is available for inspection by the franchisee. Earnings projections made on the internet or in the media, or through some other means of communication, are not regulated differently in Ontario than other financial representations. There is no definition in the Act of what is meant by or what is included in the term “earnings projection.”
In a leading case, a franchisee was granted rescission of a franchise agreement on the basis that the disclosure document did not comply with the Act. Among other noncompliant items, the disclosure document contained earnings projections with the required principal assumptions underlying the projections, but no location was identified where substantiating information could be reviewed by the prospective franchisee. The Court found that the franchisee was unable to make an informed assessment of the credibility of the financial information even though the information was highly relevant to the prospective franchisee’s investment decision. The Court held that the franchisor had failed to deliver a disclosure document because of four fundamental deficiencies but noted that each of them, including the failure to provide the necessary information pertaining to the earnings projections, on its own, was sufficient to find that the franchisor had not delivered a proper disclosure document.
Franchisors must carefully consider whether the information they provide about the franchsie could be construed as an earnings projection, in which case the information must be included in the disclosure document.
While we have dealt with only some of the most serious areas of potential franchise disclosure document deficiencies, there are many more that could be discussed, and many more that will undoubtedly be considered by the courts in the future. In most of these cases, the problems arise because the franchisors do not keep themselves informed of ongoing developments, fail to take action when informed, or do not have adequate systems in place to ensure that the information required included in a disclosure document is in fact included and properly disclosed. The consequences of failure to comply with the disclosure document requirements of the Act and the Regulations can be enormous; particularly if a class proceeding is commenced alleging non-compliance on behalf of an identifiable group of franchisees.
Franchisors must ensure that they are thoroughly familiar with and regularly updated on the disclosure document requirements of Canadian franchise legislation. They must also appreciate that most courts will grant them little leeway when there has not been complete or near-complete compliance with disclosure document requirements. Most importantly, they must realize that the consequences of noncompliance can be extremely costly to the reputation of the franchisor, its ability to sell franchises, and its financial stability.
When it comes to franchise legal compliance, proper attention to compliance with the form, content, maintenance and delivery of disclosure documents should be at the top of the list of best practices by franchisors in Canada.