By: Ben Hanuka, Law Works
Editor: Rebecca Colley, Law Works
In addition to the fundamental disclosure requirements, such as franchisor’s financials and a signed franchisor’s certificate, a failure to disclose all “material facts” in a Franchise Disclosure Document is one of the most common disclosure errors that Canadian franchisors make.
A complete FDD contains all material facts and a specific section about the location being franchised or resold. Under provincial franchise legislation, a “material fact” includes a wide array of information about the business and capital of the franchisor and its associates, as well as the franchise system, that would reasonably be expected to have a significant effect on the value of the franchise or the franchisee’s decision to buy it.
The magnitude of the risk to franchisors whose FDDs contain disclosure failures can be enormous. Court awards in successful rescission claims made by franchisees can reach hundreds of thousands of dollars of liability per franchisee. They can also bring significant harm to the reputation and goodwill of the franchisor and the franchise system, as well as reputational harm to other franchisees in the system.
Lease Specific Information
A franchisor should provide its franchise lawyer will all lease and related documents (if a lease exists at the time), and a full history of that lease. The following are examples of lease disclosure errors that have resulted in a successful rescission claim:
- failure to disclose a negotiated lease agreement or its terms (2611707 Ontario Inc. v. Freshly Squeezed Franchise, 2022);
- failure to disclose a lease agreement where the franchise agreement did not allow the franchisees to back out of the lease (2611707 Ontario Inc. v. Freshly Squeezed Franchise, 2022);
- not sharing the head lease and associated costs with the franchisees (6792341 Canada Inc. v. Dollar It Limited, 2009; 2364562 Ontario Ltd. v. Yogurtworld Enterprises Inc. 2021).
The history of the lease is also of potential importance. For example:
- has the franchisor taken over a lease of a former franchisee?
- have there been amendments to the head lease since it was originally signed?
- have landlords changed?
Site Specific Information (not just the lease…)
A franchisor should have intimate knowledge about the site in question. They should provide the franchise lawyer with all information that can reasonably impact the value of the location or a prospective franchisee’s decision to enter into the franchise agreement for that location. The rescission and associated risks will far outweighed the legal and administrative cost of going through this process. Put another way, the initial cost savings of not doing this can backfire down the road. Key information that should be disclosed may include the following:
- The history of the location (if it is an existing plaza/building): what business operated there most recently and why did it close? If the previous business was in the same segment or industry, that would likely constitute material fact.
- If the location is a conversion from an independent or another franchised operation, what are the particulars about the closure? Also potentially relevant is information about the asset purchase agreement.
- If the location is in a shopping centre, any information that the franchisor has about an anchor store that is about to close or relocate elsewhere, or alternatively upcoming new operations in the plaza, can constitute material facts.
- Any knowledge the franchisor has about upcoming construction in the area that can negatively impact sales at the location in the near term (e.g. a new condo project, road closure). For example, even though a new office tower can mean a lot of new customers in the future, it can also be a serious disruption in the near term that threatens the success of the franchise business.
- If the franchise location is a resale, the courts are moving in the direction of requiring a franchisor to obtain and disclose the sales revenue information of the location.
- Also on a resale, if major renovations are or will likely soon be required to the location, that will constitute a material fact.
- Reasonably accurate information about the cost of construction or conversion. Where a location has already been identified, the FDD should contain a reasonably specific range of the turnkey cost.
Another disclosure consideration is whether the nature of the proposed location is different from the existing locations in the franchise system. In a recent rescission decision, the court awarded damages to a franchisee because the disclosure document failed to disclose that the location was an untested retail concept – the first non-mall location in the system (2611707 Ontario Inc. v. Freshly Squeezed Franchise, 2022).
Industry Specific Information
A franchisor has extensive knowledge of its industry. The competitive environment is important for potential franchisees to understand. The following are some types of information that should be disclosed in the FDD:
- New government regulations or programs that can impact the future success of the location.
- In a highly regulated industry (such as day care, for example) the FDD should disclose the complexities and hurdles that the franchisees may face in locating a suitable site, obtaining all required licences from all levels of government, how long that will realistically take and how it can potentially affect the opening of a new location.
Prospective franchisees are often new to the industry (and often to any business), while the franchisor is expected to have the resources, experience and business sophistication to understand, identify and disclose all material facts to prospective franchisees.
A legally compliant FDD will not only meet all the requirements on a checklist, it will give prospective franchisees the information they need about the franchisor, the franchise system, the location, its history and the industry to give them a realistic understanding of the process, cost and risks of setting up and operating franchise business; ultimately, to enable prospective franchisees to make an informed investment decision.
To reduce the risk of a rescission claim, a franchisor should devote the time, effort and resources to share this critical information with the franchise lawyer when preparing or updating an FDD. An experienced franchise lawyer can identify some of this information by conducting due diligence investigation online, but a great deal of the specific information and documents can only come from the franchisor client who has intimate knowledge about the site, lease, the industry, etc. Although customizing each FDD for the site in question means more legal fees upfront, taking this necessary preventative action can mitigate the risk of future rescission claims down the road that could negatively impact the finances and reputation of the franchisors and the franchise system.