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Advising the purchaser of a franchise business

|Written By David Sterns
Advising the purchaser of a franchise business

Franchise law has undergone important changes in the past decade which affect the way lawyers must approach the task of advising a client on the purchase of a franchise. While it is not necessary to be a specialist in franchise law to advise a potential purchaser, it is necessary to have a basic understanding of the law and to be on the lookout for red flags that could prejudice the client and lead to a negligence claim against the reviewing lawyer.

Initial question

Is the client looking to buy a franchise from the franchisor or from an existing franchisee on a resale? The comments which follow apply where the client is buying directly from the franchisor or where the franchisor is actively involved in the resale by a franchisee.

Begin with disclosure document

The review of a proposed franchise purchase in these circumstances begins with the disclosure document.

Ontario’sArthur Wishart Act (Franchise Disclosure), 2000 requires a franchisor to provide a prospective franchisee with a disclosure document at least 14 days before the franchisee signs any agreement that relates to a franchise (including a deposit agreement). The contents of a disclosure document are prescribed by the AWA and its main regulation 58/100. These provisions are not overly detailed or technical and should be consulted whenever a lawyer is asked to review a disclosure document.

It is a common mistake to assume that all franchisors selling franchises in Ontario have proper pre-contractual disclosure practices in place. Even some “name brand” franchisors do not comply with the disclosure requirements.

This is often based on ignorance of Ontario law or the mistaken belief that a U.S.-based disclosure document will pass muster as a disclosure document under Ontario law, when the courts have stated in 1518628 Ontario Inc. v. Tutor Time Learning Centres LLC that it will not.

In other cases, franchisors try to circumvent the disclosure requirement by claiming that they are not franchisors under the AWA. However, the definition of a franchise under Ontario law is very broad and captures most relationships involving the granting of a licence, some level of operational control, and the payment of money by the licensee.

A lawyer reviewing the disclosure document should be aware of the following requirements:

•    The disclosure document must be a single, bound document, delivered to the franchisee at one time. Piecemeal disclosure is not permitted. The reviewing lawyer should insist that the client bring to the consultation the entire disclosure document, in its original state (i.e. not separated into envelopes, scanned into multiple pdfs, or haphazardly photocopied).

•    The disclosure document must contain a certificate signed by at least two persons who are officers or directors (or a single officer or director if the franchisor does not have more than one) attesting to the accuracy and completeness of the contents. The failure to include a signed certificate is fatal to the disclosure document and means that the franchisee has an ironclad right of rescission exercisable within two years of entering into the franchise agreement.

•    The disclosure document must contain copies of all agreements related to the franchise. This includes not only the franchise agreement itself, but any sublease (and head-lease if the franchisee is bound to comply with the head-lease), general security agreement, and personal guarantee. In short, any agreement which the franchisee will be asked to sign or comply with on closing must be included in the disclosure document.

•    The disclosure document must contain all material facts related to the purchase of the franchise. The term “material fact” is defined broadly as: any information about the business, operations, capital or control of the franchisor . . . or about the franchise system, that would reasonably be expected to have a significant effect on the value or price of the franchise to be granted or the decision to acquire the franchise.” The onus to disclose material facts is high and yet many franchisors neglect to include them in their disclosure documents.

•    Subject to certain exceptions, the franchisor must include its financial statements on an audited or review engagement standard. At least one court decision, Sovereignty Investment Holdings Inc. v. 9127-6907 Quebec Inc., has stated that the failure to include proper financial statements in the disclosure document gives the franchise the right of rescission.

This is not a complete list of all possible disclosure-related defects. For instance, a proper document may be negated by other documents relating to the franchise given to the franchisee outside of the disclosure document.

Franchisors sometimes give out “information packages” containing information which contradicts the disclosure document without realizing that this contravenes the requirement that all pre-contractual disclosure be contained in a single disclosure document delivered at one time.

Likewise, earnings claims made on the back of a napkin or in an e-mail to the prospective franchisee are also prohibited but are still commonplace. All earnings claims by a franchisor or its associate must be included in the disclosure document, and must contain certain statements prescribed by s. 6(3) of the regulation.

Each case is different and must be assessed in light of the requirements of the AWA and the regulation. The reviewing lawyer should keep in mind that the courts have been very stringent in insisting on proper disclosure by franchisors.

What to do in the case of improper or incomplete disclosure

When a prospective franchisee has not received proper disclosure, the reviewing lawyer should clearly state this in its reporting letter. If the franchisee wishes to proceed with the purchase of the franchise without proper disclosure, the reviewing lawyer should inform the client in the reporting letter that it may have a right to rescind the franchise agreement and to obtain a return of its investment.

The client does not waive its right of rescission by proceeding with the purchase without proper disclosure. Failure to advise the client of this important remedy could give rise to a negligence claim.

The right to rescind may be exercised by serving a notice of rescission under the AWA either within 60 days of receiving the disclosure document (s. 6(1)), or within two years of signing the franchise agreement if no disclosure document was provided (s. 6(2)).

The 60-day deadline applies where the franchisor delivers the disclosure document less than 14 days before the franchisee signs the franchise agreement or where the contents of the disclosure document do not meet the legal requirements of the AWA.

The two-year deadline applies if no disclosure document is provided or if the disclosure document is materially deficient in the sense that one of the required elements of a disclosure document is missing, such as a signed certificate.

Conclusion

The harsh reality is that some franchises have a failure rate as high as or even higher than non-franchised businesses. When the franchised business fails, the results are often catastrophic for the franchisee. The legal advice provided by the reviewing lawyer will come under close scrutiny, particularly if the franchisee misses the rescission window because it was unaware of its rights.

The reviewing lawyer is expected to know the essential elements of disclosure.  His or her conduct may be measured against this standard of care even where the client is determined to proceed with the deal regardless of the advice, or only asks for quick or informal advice from the reviewing lawyer.

Lawyers should allocate sufficient time and charge a sufficient fee to permit a proper document review and reporting to the client. Otherwise, they should decline the retainer.

David Sterns is a litigation partner at the firm of Sotos LLP, which focuses on franchising, licensing, and distribution law.

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