By: Law Works
Small to medium-sized franchisors may be unaware of the significant risk that their standard disclosure and sale process does not comply with their franchise disclosure obligations (in provinces that have franchise disclosure statutes – Ontario, British Columbia, Alberta, Manitoba, New Brunswick and PEI).
For the most part, the information in many disclosure documents appears on a quick review to be good. A franchisor may have worked with a lawyer several years before to create a disclosure document that met the disclosure requirements at the time.
We frequently find that growing small and mid-sized franchisors rely on an outdated disclosure process that puts them at significant risk of non-compliance and rescission. Often, there are combinations of problems, such as:
- an outdated document,
- failure to include all documents and information in one package at one time, and
- failure to include location-specific information and omitting all material facts.
The risks of rescission and the damages that flow from rescission is significant for franchisors who use a flawed disclosure process. Successful rescission claims by franchisees can be financially devastating to the franchise system, its officers and could even be damaging to other franchisees in the system.
A review of the disclosure process by an experienced franchise lawyer can reduce a franchisor’s risk by identifying flaws in their disclosure process.
Franchisors should also consider taking corrective action with franchisees who did not receive proper disclosure, to avoid potential rescission claims.
This article examines five common oversights in the disclosure process that small to medium-sized franchisors should assess to mitigate their rescission risk.
1. Accidental piecemeal disclosure
Franchisors recruiting new franchisees often disclose information to prospective franchisees before or after they provide the disclosure document. It may be that the franchisor hired a lawyer to draft a disclosure document years earlier, and rather than “tamper” with the document, the franchisor distributes new information to prospective franchisees in separate documents. These documents might even contradict information that was in the disclosure document.
This can be a brochure selling the benefits of the franchise system, spreadsheets with sales projections, or an offer to lease that the prospective franchisee needs to sign. If information is disclosed over several months, and separate from the disclosure document, recent franchisees who signed a franchise agreement within the past two years may be able to seek rescission.
This information must be contained in the disclosure document and disclosed in one document at one time. The following are some case examples.
- A café franchisor that provided a franchisee with amended schedules and a sublease at a later date than the disclosure document.
- An auto repair franchisor that provided parts of a disclosure document to a franchisee in piecemeal (Mendoza v. Active Tire & Auto Centre Inc., 2017).
2. Providing documents that may be considered “earnings projections”
Sometime franchisors provide prospective franchisees with revenue projections or financial historical information during the sales process. Even if it is an informal document with rough estimates of typical sales, the courts and some franchise legislation in Canada deem this financial information to constitute “earning projections”.
Earning projections must not only be contained in the disclosure document, they must also include a host of information required by franchise legislation with, among other things, the basis for the information, the assumptions underlying the information and a location where supporting information may be inspected.
The following are some case examples.
- A restaurant franchisor’s representative showed an earnings projection table to the franchisee in a meeting before the parties signed the franchise agreement. The court held that the franchisor’s omission of earnings projections and the required underlying information from the disclosure document entitled the franchisees to a rescission of their franchise purchase.
- A court ruled in favour of a dessert franchisee whose franchisor’s directors shared misleading earning projections.
3. Omission of site-specific information
Many franchisors have franchise disclosure packages that disclose fairly good information about the franchise system, but they do not disclose information and all material facts about the specific location. The franchisor should have intimate knowledge about the location in question and must disclose to a prospective franchisee all material facts within its knowledge. This includes:
- information about the actual franchised business (e.g., if it is a conversion from an independent or another franchised operation), as well as particulars about any previous closures or asset purchases;
- if applicable, the history of the location (e.g., prior businesses operating in that unit, whether they were in the same industry and why they closed);
- information about the location (e.g., if an anchor store in the plaza will be closing, upcoming major construction in the area, competition in the area, etc.), and
- a history of the lease that includes all lease renewals up to the current time.
Depending on the circumstances of each case, this information likely constitutes “material fact” under franchise legislation because it could reasonably impact a prospective franchisee’s decision to enter into the franchise agreement for that location or the financial cost and financial obligations that the prospective franchisee is required to incur.
The following are two case examples where a rescission claim was successful.
- A juice franchise where the franchisor did not disclose that the site was the very first non-mall location in the franchise system and as such was an untested retail concept.
- A discount retail franchise where the franchisor failed to provide the franchisee with a copy of the head lease and the name of the franchisor’s leasing associate (6792341 Canada Inc. v. Dollar It Limited, 2009).
4. Omission of prior sales revenue and renovation requirements for a resale location
In a resale, a franchisor has an obligation to disclose a store’s recent sales revenues, regardless of whether the prospective franchisee did obtain, or could have obtained, this information directly from the seller.
In a recent case against a restaurant franchise, the franchisor failed to include the location’s sales information in the disclosure document that it provided to a franchisee. (The franchisor delivered the sales information after the fact in a separate email.)
If major renovations are needed, or may be required soon, the cost of construction or conversion must be disclosed in the disclosure document. A recent case example involved a convenience store franchise where new franchisees purchased their store from the previous franchisee on a resale. The new franchisees learned that the franchisor was requiring them to renovate the store premises as a condition of renewing the franchise term and sought a rescission of their purchase against the franchisor and its affiliates.
5. Omission of information about third party financing
Sometimes franchisors are involved in providing financing to prospective franchisee to secure the funds to purchase the franchised business, whether by facilitating the financing through a third party, or by being involved in the financing through its own affiliate.
If the franchisor is involved in the financing, whether by facilitating the financing or by extending financing through its affiliate, depending on the circumstances of the case, the disclosure document should contain information about the identity of the financing company, its relationship to the franchisor, the terms and conditions of the financing, whether any benefit or other financial consideration flows to the franchisor, and copy of all financing and loan agreements.
Repairing Disclosure Errors and Mitigating Rescission Risk
Once the franchisor, usually with the help of an experienced franchise lawyer, identifies errors and omissions in the disclosure process, they can consider strategies recommended by the franchise lawyer to mitigate rescission risks. This can include updating parts of the disclosure document or adding new sections to it.
If there is a franchise sale in progress, there may be a need to deliver corrected and updated information through a statement of material change, or through an overhauled disclosure document, to account for information already delivered to prospective franchisees who are in the queue for a franchise purchase. Depending on the circumstances and the extent of the disclosure issues that require repair, whether with prospective franchisees in the queue, or existing franchisees, these situations may require additional legal remedies, such as a settlement.
Assessing the franchise disclosure process and implementing necessary repair can be critical to the viability and growth of the franchise system going forward. An experienced franchise lawyer can identify and repair errors and omissions that a franchisor may not be aware of, to reduce the risk of facing rescission claims by franchisees. Franchise legal counsel can help safeguard the franchise system by helping to prevent potential financial and legal turmoil, protecting the integrity of your franchise systems, and ultimately contributing to the growth and success of your franchise businesses.
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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