Authors: Ben Hanuka and Robert Jones, Law Works P.C.
In 1777453 Alberta Ltd. v. Got Mold Disaster Recovery Services Inc., an April 23, 2019, decision of the Alberta Court of Queen’s Bench, the court, sitting on an assessment hearing, found that a franchisee in the mold remediation industry that was entitled to a franchise cancellation (in Ontario, British Columbia, and other provinces, a “rescission”), suffered no “net losses”.
The court determined that the principals of the franchisee company overcharged it significantly for their professional services, which made up the bulk of the franchisee’s claim for net losses. In addition, because the franchisee continued to operate a mold remediation business independently after cancelling its franchise agreement, the court was wary about granting a “windfall” to the franchisee.
The applicant, 1777453 Alberta Ltd. (“177”), was a franchisee in the Got Mold Disaster Recovery Services franchise system. Carl McKay, James Scharfl and James Zolkavich were the principals of 177, and provided professional services to the company.
The respondent, Got Mold Disaster Recovery Services Inc. (“Got Mold”), is a franchisor that specializes in mold remediation in Western Canada.
On October 21, 2013, Got Mold and 177 signed a franchise agreement. On February 25, 2015, 177 delivered a Notice of Cancellation to Got Mold under section 13 of Alberta’s Franchises Act.
After sending the Notice of Cancellation, 177 de-branded and continued to operate as a mold remediation services company using the name “MSZ Restoration and Contracting”.
177 brought an action and a motion for summary judgment for cancellation of the franchise agreement with Got Mold. Before the hearing of the summary judgment motion, the parties consented to an Order that 177 was entitled to cancellation, and that the parties would only dispute what compensation, if any, 177 was entitled to. In addition, Got Mold agreed not to pursue claims against Messrs. McKay, Scharfl and Zolkavich.
Definition and evaluation of 177’s “net losses”
Section 14(2) of Alberta’s Franchises Act requires a franchisee to prove that it incurred “net losses” in “acquiring, setting up and operating the franchised business” as a condition of receiving compensation for the cancellation of a franchise agreement.
Based on the Alberta requirement to prove a “net loss” (which is different from the rescission compensation regime in Ontario, British Columbia, and other provinces, where proving a net loss is not required), the court started with the premise that a franchisee under Alberta’s Franchises Act is not entitled to receive a “windfall” as a result of cancelling its franchise agreement. It relied on the Court of Appeal of Alberta decision in Hi Hotel and found that the cancellation compensation regime was not intended to give a franchisee a windfall by allowing it to “obtain resources from a franchisor, and then use those resources to enter into competition with the franchisor”.
The court held that, if after delivering a Notice of Cancellation, a franchisee sets up a similar business using methods, training and experience that it developed from its franchisor, then the profits earned from that business should be factored into any “net losses” that a franchisee incurred in the original franchised business. The court reasoned that a calculation of “net losses” that only accounted for financial expenditures could amount to a “windfall” if the franchisee continued to operate a business in the same industry after cancelling its franchise agreement.
As a result, the court applied a discount because Messrs. McKay, Scharfl and Zolkavich continued to offer mold remediation services under the name of “MSZ Restoration and Contracting”. In other words, the court found that the continued operation of the mold remediation business was based on the know-how that 177 acquired in the course of its franchise relationship with Got Mold.
As another ground of challenging 177’s alleged net losses, Got Mold attacked 177’s expenditures as above-market and overstated. The court held that expenditures must have been actually incurred by the franchisee and must be objectively reasonable. They must also be offset against revenues to get an accurate figure of profitability.
The court found that, when comparing the expenditures that 177 claimed for management fees, accounting expenses and advertising costs against the rates that Got Mold paid for these services during the same period, 177’s expenditures were significantly overstated. In other words, Messrs. McKay, Scharfl, and Zolkavich invoiced 177 for their services at above-market rates. The court discounted 177’s net losses significantly to account for this discrepancy, because these amounts were not recoverable from Got Mold. For these reasons, the court concluded that 177 did not suffer a net loss in acquiring, setting up and operating its Got Mold franchised business.
Got Mold appears to have taken a strategic approach to the litigation, by focusing its resources on disputing 177’s “net losses”, instead of its liability for cancellation of the franchise agreement. Although Got Mold was technically liable for cancellation of the franchise agreement, it was nevertheless successful in the case, for all intents and purposes, because 177 recovered no damages.
The future profitability reasoning did not figure prominently in the court’s “net loss” analysis because it rejected most of 177’s expenditures as not objectively reasonable. However, the future profitability reasoning is an avenue of defence open to a franchisor, where a franchisee de-brands after cancelling its franchise agreement and continues to operate a similar business.
It should be noted that Alberta’s franchise legislation is different from the compensation regime in Ontario as a result of rescission/cancellation. While Alberta’s regime is based on a “net loss” calculation, Ontario’s regime provides for compensation even where no “net losses” have been incurred. In 2189205 Ontario Inc. v. Springdale Pizza Depot Ltd., the Court of Appeal for Ontario affirmed that a franchisee can be compensated for its expenditures for royalties, equipment and inventory, amongst other things, independent of any losses. Similarly, in 2122994 Ontario Inc. v. Lettieri, the Court of Appeal for Ontario confirmed that the Arthur Wishart Act is not a net loss regime: in other words, a franchisee does not have to prove a net loss to be entitled to compensation for rescission.
About the future profitability reasoning, while Ontario’s franchise legislation is different in this respect, it does not prevent a franchisor in Ontario from bringing a counterclaim or otherwise seeking compensation from a franchisee for causes of action such as misappropriation of confidential information, etc.
For more information about Law Works’ expertise and how we may be able to help you, please contact Ben Hanuka at email@example.com or by phone in Ontario at (855) 978-5293 and in British Columbia at (604) 262-1711.