By: Ben Hanuka, Law Works
Editor: Rebecca Colley, Law Works
Based on recent court decisions, if your FDD does not contain these 5 key elements, it is probably legally void.
Franchisors with operations in Ontario or elsewhere in Canada will be wise to take note of a trio of recent decisions from the Court of Appeal for Ontario (the highest court in Ontario) about franchise rescission law. All three decisions upheld rescissions in favour of franchisees because of defective franchise disclosure documents (FDDs). In the decisions, the Court of Appeal solidified and further developed franchise rescission grounds. The court not only confirmed established rescission grounds, it also expanded the elements that must be contained in a FDD for it to be legally valid, and who is liable to compensate the franchisee for rescission.
While these are Ontario decisions, they are likely to impact similar court cases in other provinces that have franchise legislation in place (British Columbia, Alberta, Manitoba, New Brunswick, and PEI) since the wording of the legislation is very similar (almost identical in many cases) and most franchise rescission cases emanate from Ontario.
Franchisors who do not have a legally compliant FDD can suffer devastating financial and reputation repercussions. Based on these three decisions and previous court decisions over the years, there are 5 key elements that must be contained in an FDD, or else it will likely be held to be legally invalid (these are of course not the only legal requirements of an FDD, of which there are many; rather these are 5 categories of fundamental requirements).
1. A signed franchisor’s certificate
A valid FDD must contain a franchisor’s certificate signed by the franchisor’s officer or director. If the franchisor has two or more officers or directors, the certificate must be signed by at least two of them.
By signing the franchisor’s certificate, the officers or directors are attesting that the entire FDD (in Ontario):
- contains no untrue information, representations or statements, and
- includes every “material fact”, financial statement, and other statements and information required by franchise legislation (in Ontario, it is the Arthur Wishart Act (Franchise Disclosure), 2000).
Based on the three recent court decisions, the officers and directors who sign the franchisor’s certificate are personally liable along with the franchisor company for all rescission damages to the franchisee. The importance of this cannot be overemphasized. Personal liability for rescission damages typically runs in the several hundreds of thousands of dollars for just one standard QSR location. For relatively smaller franchisors, a few rescission claims can spell significant financial hardship, and, in some cases, the end of business.
In various court decisions, the courts have ruled that an FDD was invalid, and as a result granted a rescission of the franchise purchase, based on these failures:
- the franchisor’s certificate was missing;
- the franchisor’s certificate was unsigned, and
- franchisor’s certificate was signed by someone other than the required officer or director.
2. Franchisor’s financial statements for its last fiscal year-end
The FDD must contain the franchisor’s full financial statements for its most recently completed year-end (there are some exceptions to this rule based on when the FDD was given out). The financial statements must be prepared on a “review-engagement” accounting standard at a minimum. This is a higher standard than what is required of private companies for income tax purposes, but a lower standard than a full audit.
These financials must contain all critical information about the franchise system’s assets and liabilities, and must include the formal notes to the financial statements that discuss the financial health of the franchise system. The financial statements must also contain a formal cover letter from the accountant who prepared them, certifying that they were prepared at least on a “review-engagement” basis.
Courts have ruled an FDD to be invalid (thus granting rescission) because of the franchisor’s failure to comply with the financial statements requirements in these circumstances:
- failure to provide valid financial statements of the franchisor;
- failure to comply with at least review-engagement standards, and
- providing stale-dated financials.
3. Disclosure in one piece, at one time
The franchisor must provide prospective franchisees with an FDD that is contained in one piece, given at one time. Under franchise legislation in Canadian provinces, the information that a franchisor discloses to a prospective franchisee in the sale phase must not:
- be disclosed over time (e.g., over several months);
- be fragmented in “piecemeal” (when information is provided in a series of separate documents), and
- exclude any agreement that the franchisee is required to sign.
Courts have nullified an FDD in the following circumstances:
- the franchisor disclosed information over several months instead of in one document, at one time;
- the franchisor delivered amended schedules and a sublease after already delivering the FDD, and
- the documentation provided to the franchisees was not collected in a single document nor was it delivered at the same time.
4. Disclosure of “material facts” about the lease and the location
If the franchised business involves a leased location, the franchisor must disclose all material facts about the lease and location of that franchised business.
Under franchise legislation, a material fact includes a wide array of information about the business and the franchise system which would reasonably be expected to have a significant effect on the value of the franchise or the franchisee’s decision to buy it. In the context of a lease and location, courts have nullified an FDD when franchisors failed to disclose the following information which the courts deemed to constitute a material fact:
- the fact that there was an existing head lease (and failure to include a copy of it in the FDD);
- the fact that the franchisor had already negotiated the lease and its terms (and failure to disclose those terms);
- the fact that the lease agreement prohibited the franchisee from backing out of the lease, and
- the fact that the type of retail location that the franchisee was buying was an untested retail concept in that franchise system.
5. Material facts about store financials on a resale
If a franchisor is reselling a store to a new franchisee, the FDD must disclose all material facts about the specific franchised business that is being resold (in addition to all other material facts about the franchisor and the franchise system).
Courts have nullified an FDD when franchisors failed to disclose the following information which they ruled constituted a material fact in a resale:
- the financial history of the business;
- prior owner’s store sales.
Safeguard your franchise system against one or more potential rescission claims
The best way to protect a franchise system and its officers and directors against potentially severe financial and reputational liabilities is to ensure that the franchisor’s FDD meets at least these five key elements (in addition to numerous other legal requirements that an FDD must meet). If the FDD does not comply with these requirements, and the limitation period for a notice of rescission has not expired, franchisees have a right to make a rescission claim that can result in:
- court awards that can reach hundreds of thousands of dollars of liability per franchisee;
- significant harm to the reputation and goodwill of the franchisor and the franchise system, and
- reputational harm to other franchisees in the system.
Franchisors will be wise to carefully assess whether their FDD is legally compliant, particularly in light of the recent trio of Court of Appeal decisions.