Franchisees Closing Down: Problems With Getting Help

Well-known brands in the Canadian food and related retail industry are common these days; practically the norm.  Stores are typically owned and operated by franchisees who are unsophisticated and inexperienced at operating a small business.  Surprisingly, a large number of Canadian franchisors, i.e., the owners of the franchise system, are undercapitalized startups, with no meaningful levels of management experience or ability to provide genuine training or support to their franchisees.  In stark contrast with what unsuspecting would-be franchisees expect, many of these startup franchisors are themselves relatively unsophisticated and inexperienced.

From anecdotal evidence, it appears that startup franchise systems have a large percentage of failing franchised units.  When a franchisee closes down its doors with a partial or total loss of investment, it often represents a loss of a lifetime’s worth of savings and family assets, and typically ends in the franchisee’s financial ruin.

The protection of franchisees does not end with the creation of rescission and other statutory remedies recently made available in some Canadian provinces, though these represent fundamental advances in franchisees’ rights and their access to justice.  Despite their far-reaching effects, these can be of little practical value if franchisees are unable or unwilling to pursue them.

Franchisees often face a myriad of interrelated legal and business problems when faced with a business failure.  Much like in the broader consumer arena where a family breakdown has been documented to often lead to related legal problems in a cluster, in the franchise sphere, a failed business often creates a need for various other legal and related aspects.  Some of the multitude of inter-disciplinary services include: accounting, financial advice, real estate evaluation and brokerage services, loan financing, and franchise consulting.

When a franchisee finds himself operating a distressed business and starts seeking redress, the “cost of entry” to the legal market is high.  Whereas at the outset, the average prospective franchisee would typically raise the necessary financing for the purchase and setup of the franchised business by mortgaging his personal assets, by the time the business is in distress, the franchisee is financially strapped, having invested most or virtually all of his personal assets in the purchase and operation of the business.

A recognition that the average Canadian franchisee is often a consumer is key to the removal of barriers to access to justice in franchising.  The issue here is not necessarily the cost, but rather the lack of access to the complex suite of professional services that are required at the time of distress; an integrated and coordinated service.  Not being able to access this sort of a coordinated approach, franchisees simply give up on all these services.  Many fail to even recognize that they require these services.

The level of information typically contained in Canadian franchise disclosure documents often provides little by way of genuine material information about all the risks associated with the business to be sold to the prospective franchisee, including what it will take for the particular prospective franchisee to successfully operate the business

And there is much more to the problem than mere information asymmetry, or leveling the information playing field. No reasonable disclosure of information could in itself remove all barriers to access to justice.

For example, pursuing a claim for rescission often requires a significant undertaking by a franchisee. Factors such as litigation delay, fighting against franchisors which generally have greater financial wherewithal than franchisees, and incurring the expense of lost time off work, are only a few reasons why franchisees are reluctant to pursue a rescission claim.

Listed below are some of the multitude of legal practice areas in which services are typically required to address issues raised by a business in distress – even though many franchisees who operate businesses in distress refrain from seeking out these services.  It should be noted that even where a franchisee pursues a rescission claim, one or more of the services listed below are nevertheless required; for example, as a matter of mitigation of damages.

• Rescission claim: This is a franchisee’s statutory claim against a franchisor and its associates.  The following are the legal services involved in launching and marshaling such a claim:
  • Initial due diligence investigation about the identity and liability of all  franchisor and franchisor’s associates parties under the AWA;
  • Preparing the form of notice of rescission and ensuring its adequate  service as require under the AWA;
  • Pursuing the claim for rescission and damages in an adjudicative process,  be it in court or arbitration.
• Insolvency of start-up franchisors: Franchised businesses are often operated by inexperienced and under-capitalized start-up franchisors.  A typical rescission claim against a start-up franchisor in an amount of between $250,000 and $500,000 will almost certainly threaten to push it into insolvency.  Pushing the franchisor into bankruptcy would likely not benefit the franchisee.  Pursuing a claim for rescission in the face of a startup franchisor’s threat of insolvency requires strategic negotiation strategy and execution by legal counsel that is almost certainly beyond the abilities of even sophisticated franchisees.
• Franchisor’s claim of contractual default against the franchisee: Claims by the franchisor for other failures, including the franchisee’s failure to comply with ongoing payment obligations to the franchisor under the franchise agreement, such as royalties and advertising fund fees.
• Separation of assets with the franchisor: When the franchisee plans to continue operating a new, non-franchised, business that is similar to the current franchised business in distress, assuming no restrictive covenant prevents the franchisee from doing so, a franchisee may require assistance with negotiating a separation of assets with the franchisor, such as client list, equipment, chattels, etc.
• CRA deemed trust claims: Statutory lien claims by the Canada Revenue Agency against the assets of the businesses for HST and other taxes owing, which otherwise prevent the sale or windup of the business.
• Landlord’s claim against franchisee and/or franchisor: A breach of the lease agreement and a claim by the landlord as a result.
• Bank and other secured creditors: Claims by secured creditors against the franchisee and the assets of the franchised business, as well as personal claims against the franchisee or its principals under personal guarantees that are provided in favour of the bank or other secured creditors.
• Trade creditors: Claims by trade creditors.

Due to the general lack of organizational experience and financial literacy of the average Ontario franchisee, these aspects are often mismanaged by a franchisee.  A franchisee who otherwise has a valid rescission or other damages claim does not necessarily meet the required test to prove damages in a court action.

Existing common law legal tests with respect to damages require a plaintiff to prove damages on a balance of probabilities.  Yet, a typical franchisee operating a business in distress and lacking adequate financial literacy will often not have his financial statements, income tax returns and other tax filings adequately in place or up to date.  The law draws an adverse inference against franchisees, even penalizes them, if they choose to come to court with these outstanding financial issues.

Knowledge of legal and financial issues affecting the business problems and the available strategies in dealing with them will enable the franchisee of a business in distress to have much better access to justice, in the sense of knowing what services to seek out, at what time during the business life cycle and with respect to which issues.

For justice to be accessible to the average Canadian franchisee, in essence a consumer-turned-franchisee, relevant information needs to be accessible and available, and the manner in which some professional services are delivered need to be reconfigured.  Issues relating to access to justice for Canadians engaged in franchising should deal with means to enablefranchisees to seek remedies when their franchised businesses are in distress.

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