By: Law Works
A rescission claim is a statutory remedy that allows a franchisee to cancel the entire franchise purchase transaction and exit the franchise system with compensation for their entire investment and losses, even for payments to vendors and contractors. If successful, a rescission claim can pose potentially devastating financial and reputational risk for franchisors and franchise systems. This article outlines the requirements that a franchisee must satisfy to make a valid rescission claim, what a franchisee may be entitled to, the key issues that impact the success of such a claim, the franchisor’s potential defences and the awarding of damages.
What are the overall requirements for making a franchise rescission claim?
There are two key requirements for a franchisee to seek a rescission claim:
- the franchisor did not deliver a franchise disclosure document (known as an “FDD”), or delivered one that is significantly non-compliant, to the franchisee before signing a franchise or related agreement, and
- the franchisee delivered a notice of rescission within the 2-year limitation period.
What constitutes a legally compliant FDD?
A franchisor has delivered a valid FDD if – generally – it is one document, delivered at one time, and if it contains all these fundamental components:
- franchisor’s certificate (signed as required);
- full financial statements for the franchisor’s most recent year-end, prepared on at least a review-engagement basis;
- copies of all agreements the franchisees are required to sign;
- all material facts about the franchisor, the franchise system and the location, and
- all other prescribed information (setup costs, system-wide franchisees lists including terminated franchisees, etc.).
The strength of the rescission claim will be assessed based on these components. If the franchisee has sufficient evidence that the franchisor made a significant disclosure error or omission, there can be a legitimate dispute that could result in rescission decision and the awarding of damages to the franchisee.
What is the 2-year limitation period?
When no FDD (or compliant FDD) has been provided, a franchisee’s limitation period to deliver a notice of rescission is two years from the date of the franchise agreement. After the limitation period has expired, this remedy is no longer available to the franchisee.
The franchisor must respond to the notice of rescission within sixty days. If no agreement is reached by the two sides, and depending on the dispute resolution requirements in the franchise agreement, the franchisee can then move ahead with commencing a legal claim for rescission, which can potentially require mediation or arbitration, or both.
What damages can the franchisee be entitled to?
If the rescission claim is successful, the franchisee may be entitled to compensation in the following three categories:
- all franchise fees and royalties paid;
- the cost of all equipment (e.g., freezers, computers/POS systems) and leaseholds (e.g., fixtures like countertops, renovation or building costs) for the franchised store or location, and
- all other losses incurred in purchasing, setting up and operating the franchised business.
- Franchise Fees and Royalties
Franchise fees and royalties are documents in payments to the franchisor.
- Equipment and Leaseholds
The costs of equipment and leaseholds may have been paid to the franchisor or to third party vendors or contractors – either way they can generally be supported by contracts and payment receipts.
However, if the franchisee wants to keep operating the location as an independent location, and assuming there is no dispute about the franchisee’s right to do so after rescission, it is arguable that the franchisee should not be entitled to claim the cost of equipment (except for proprietary equipment that may need to be returned) and leasehold improvements.
A claim can also include the cost of inventory on hand.
- All other losses – generally
This third category traditionally gives the franchisor more negotiating room if there are issues about under-reported revenues or if the claimed expenses are unreasonably high.
If the franchisee was profitable, it may not be able to claim any damages in this category.
Other than the reasonableness of the claimed expenses, the franchisee must have receipts to back up all claimed expenses.
Proving and validating the reasonableness of expenses may require each side to retain a forensic accountant to provide a report about the expenses, particularly if the dispute is headed to court or arbitration. The judge or arbitrator will weigh both forensic experts’ testimonies about the reasonableness of the franchisee’s claimed expenses and damages.
In a recent franchise rescission dispute in Ontario, the trial judge substantially reduced the amount of the franchisees’ rescission award, from a claim over several hundred thousand dollars to just over $80,000, because the franchisees failed to produce legitimate receipts to backup many of their claimed expenses. Their forensic expert relied on an Excel balance sheet that the franchisees prepared themselves, without showing backup documents.
- All other losses – rent
With respect to claims for rent, in most cases the franchisee will have paid rent directly to the landlord, even if the franchisee is a subtenant of the franchisor under the lease and sublease. In this situation, rent falls under the expenses category (and will need to be subtracted against revenues). In a minority of cases, where the franchisee has paid rent directly the franchisor, the franchisee can claim that amount of the rent like franchise fees and royalties – directly.
- All other losses – franchisee’s salary
A franchisee may also be entitled to claim unpaid salary as an owner/operator if the franchisee was involved in the operation of the business but had not been paid a salary. The franchisee may be entitled to claim a reasonable manager’s salary.
What is the impact of a non-competition restriction?
Even in the face of a rescission claim, it may be possible for a franchisor to enforce non-competition restrictions against the franchisee. This remedy may be available to a franchisor even in a rescission claim. Depending on the provisions in the franchise agreement, it may also include ownership of the customer list.
What happens if the franchisee was in default of the franchise agreement?
If the franchisee who makes a rescission claim has stopped paying royalties or is otherwise in default of their obligations under franchise agreement, the franchisor may be able to terminate the franchise agreement, get control of the franchised business, sell it, and use the proceeds from the sale to offset the rescission damages claimed by the franchisee.
Conclusion
When a franchisee claims a rescission of their franchise agreement, it opens up a complex and potentially high-stakes legal process that can significantly impact both the franchisor and franchisee. The criteria for a valid franchise rescission claim revolve around whether the franchisor provided a legally compliant FDD and whether the franchisee is within the 2-year limitation period.
A successful rescission claim can lead to compensation for the franchisee, including the reimbursement of franchise fees, equipment costs, leaseholds, and other incurred expenses.
Ultimately, franchise rescission claims are intricate legal matters with significant financial and operational implications for all parties involved. It is important for all parties to seek legal counsel and thoroughly understand their rights and responsibilities to navigate this process effectively.
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This article is provided for general information purposes only and is not intended to provide legal advice. Parties in a business dispute should obtain legal advice from a knowledgeable franchise lawyer.
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