A ‘dose of pragmatism’ from Court of Appeal

By Peter Dillon for AdvocateDaily.com

Ontario’s Court of Appeal released its much-anticipated decision in this case on Jan. 25, 2018. I say much-anticipated because the summary judgement decision of Justice Wendy M. Matheson of the Superior Court of Justice had thrown the proverbial wrench into the works of most franchisors.

Distilled version of the facts

The franchise prospect received a disclosure package that was delivered as a single document, at one time, in a timely fashion (at least 14 days prior to executing the franchise agreement or receiving any payment). The disclosure document:

1. did not specify a location for the prospective franchisee’s restaurant;
2. included a draft sublease, which indicated that the franchisee was obliged to accept all terms in the head lease negotiated by the franchisor and the landlord of the proposed restaurant;
3. did not contain a draft of that head lease;
4. provided an estimate of development costs to develop the restaurant from a shell;
5. indicated that the cost to convert a pre-existing restaurant to a branded restaurant was highly site-specific, although in the franchisor’s experience, these costs had been significantly lower than the cost of building from a shell;
6. cautioned that significant cost overruns could occur during a conversion due to infrastructure deficiencies that remain undetectable until reconstruction commences;
7. stated that the franchisor had no reasonable means of estimating or predicting conversion costs with any certainty; and,
8. recommended that the franchisee maintain a “significant contingency reserve.”

The franchise agreement did not specify a site for the prospective restaurant, nor a territory. The territory was to be “reasonably determined by the franchisor.” The agreement required the parties to “use their reasonable best efforts to find a suitable location for the [restaurant] acceptable to the franchisor.”

The franchise agreement also provided that if the franchisor failed to negotiate a lease for a suitable location within 120 days of the agreement being signed, the franchisee was entitled to terminate the agreement upon 20 days’ notice and receive a release and refund of all amounts paid to the franchisor, less any costs and expenses reasonably incurred by the franchisor in connection with the granting of the franchise.

Following execution of the franchise agreement, the franchisor and franchisee located a mutually acceptable location in Mississauga, available for lease and conversion. The franchisor’s affiliate signed the head lease and sublet the property to the franchisee. The head lease required a steep initial deposit of approximately $120,000.

Prior to signing the sublease, the franchisee had been informed of the hefty deposit requirement but had not received a copy of the executed head lease. The franchisee consented to the deposit condition and asked the franchisor to “please accept [the lease], we want this deal to be done ASAP.”

Construction of the restaurant was substantially completed at a cost exceeding $1 million. This amount fell within the range specified in the disclosure document for construction from a shell. However, this location had been developed through conversion and as noted, no cost range had been provided in the disclosure document for the development of a conversion location.

Upon completion of construction, the franchisor asked the franchisee to pay a variety of unpaid construction invoices and the $120,000 deposit required under the head lease. The franchisee refused and served a notice of rescission. The franchisor refused to accept the notice of rescission, terminated the franchise agreement, and assumed control of the outlet.

Decision of the motion judge

The motion judge declared that the franchise agreement had been validly rescinded and awarded damages in favour of the franchisee in an amount of $1.28 million.

She found that the disclosure document did not contain “all material facts” as required by section 5(4) of the Arthur Wishart Act, for two reasons. First, the disclosure document did not include the terms of the head lease by which the franchisee would be bound. Second, although the disclosure document outlined the estimated costs for developing the restaurant from a “shell,” it did not provide cost estimates for converting an existing restaurant to its own brand.

In the motion judge’s view, the franchisor could not be excused from its obligation to disclose these facts simply because they were not known to both parties when the franchise agreement was signed. She stated, “until the franchisor is prepared to make proper disclosure of all material facts, it must wait — it does not get excused from its statutory obligations.”

To hold otherwise, in her view, would allow franchisors to make disclosure at a premature stage and avoid the Act’s rigorous disclosure requirements, undermining the purpose of the legislation. She held that the franchisor’s breach of its disclosure obligations was “egregious” and contained “stark and material deficiencies” with respect to the franchisee’s lease obligations and estimated development costs.

Implications of the summary judgment decision

The practical implications of the summary judgment decision were enormous and negative to franchisors (and, I would argue, to franchising generally — including franchisees). Many systems operate on the basis that the documentation will be signed, whereupon the parties set out to find a mutually agreeable location. To prevent this from happening would be a huge impediment to the growth of most systems.

It also places an unfair burden on franchisors, who typically complete the franchise sales process and then engage in lease negotiations, without the fear of being “left at the altar” by a prospect who develops cold feet, leaving the franchisor holding a lease and location, with no franchisee to operate it. Finally, it amounted to a judicial imposition of terms that simply do not exist anywhere in the Act. There is nothing that prohibits using a form of “generic” disclosure, with the parties then mutually agreeing on location and other development decisions (note, however, that this decision does not relieve franchisors from the obligation to provide “site-specific” disclosure in accordance with the requirements of this decision.

The Court of Appeal weighs in

The franchisor argued that the decision of the motion court judge was unsupported by authority, inconsistent with the text of the Act, and was commercially unreasonable. The Court of Appeal agreed.

The court started its analysis by distinguishing between section 6(1), which provides for disclosure within 60 days of late or deficient disclosure, which must occur within 60 days of receipt of the disclosure document, and a rescission in accordance with subsection 6(2), where the franchisor never provides disclosure, which must occur within two years after entering into the franchise agreement. The court cited a prior decision in support of the proposition that the right of rescission under subsection 6(2) was an “extraordinary remedy.”

In this case, of course, the franchisor had provided a disclosure document. In such circumstances, for a franchisee to succeed with his rescission claim, the purported disclosure document must be so deficient as to effectively amount to a complete lack of disclosure. As the court previously stated in this case: “a document does not become a disclosure document … just because it is called a disclosure document.”

Whether deficiencies in the disclosure document were so serious as to amount to no disclosure for purposes of the Act must be determined on the facts of each case. The court referenced several of its prior decisions in which it described the required degree of deficiency in several ways, including “materially deficient,” “serious noncompliance,” “fundamentally inadequate and deficient disclosure,” and “stark and material deficiencies.” Whatever terminology is employed, the court found that the inquiry into whether disclosure deficiencies are such that they justify rescission ultimately focuses on whether the franchisee has been “effectively deprived … of the opportunity to make an informed [investment] decision,” as cited in this case.

Dealing with the issue of the failing to include a copy of the head lease as part of the disclosure document, the Court of Appeal found that the motion judge’s failure to consider the terms of the franchise agreement entered into between the parties constituted “an inextricable error of law.”

In this case, all parties involved knew that the proposed restaurant location had not been selected, and agreed that the franchisor and the franchisee would work collaboratively to select the site. These provisions were incorporated into the franchise agreement in a variety of locations. The franchise agreement contemplated the active participation of the franchisee in the selection of the location and provided the franchisee with an opt-out right in the event that they did not favour the proposed site or found any provision of the head lease to be unacceptable.

In the circumstances where the franchisee had these contractual protections, the absence of the head lease information at the time of entering into the franchise agreement “had little impact on the franchisee’s ability to make an informed investment decision.” As noted, the franchisee participated actively in the site selection and was aware of the quantum of the rent deposit upon which he later sought to base his rescission claim. In those circumstances, the court found that he did not have a valid basis to rescind.

With respect to the conversion cost estimates, the court found that the lengthy and detailed provisions in the disclosure document ought to have put the prospect on notice as to the potential risks associated with pursuing a conversion opportunity by providing:

1. cost estimates for developing a branded restaurant;
2. a strongly worded warning that the cost estimates associated with a conversion could vary greatly from site to site; and
3. a warning to the franchisee to maintain a significant contingency reserve.

For these reasons, the Court of Appeal found that the motion judge’s conclusion that the disclosure document amounted to “no disclosure at all” could not be supported.

The court concluded by awarding the costs of the trial and of the appeal to the franchisor — damages in the amount of $110,000 representing unpaid construction invoices, and payment of the rent deposit of $119,000, adjusted for any financial benefit the franchisor derived from operating in the restaurant for the duration of the lease.

Key takeaways and best practices

Decisions of the Court of Appeal that are favourable to franchisors are relatively few. While the recent decision represents a definite “win” for commercial reasonableness and a measured interpretation of the Act, its limitations should be borne in mind by franchisors and their counsel.

First, the case does stand for the proposition that “premature disclosure” by itself does not exist as a prohibited practice under the Act. This means that signing a franchise agreement or accepting payments after making compliant disclosure — i.e. disclosure based on what the franchisor knows at the time of disclosure — is OK.

Second, don’t lose sight of the fact that the decision does not affect the extremely onerous obligation of site-specific disclosure created by the Court of Appeal in this decision.

Third, the decision does not in any way limit the requirement to disclose “all material facts.” The risks of that open-ended regime still exist.

Fourth, and on a similar note, this decision was based upon the two-year right of rescission under subsection 6(2) of the Act. The court expressly stated that the results might have been different had the rescission claim been brought within 60 days of disclosure, based on “deficient disclosure” under ss. 6(1).

Fifth, personal liability of signatories to disclosure documents remains, underlining the extreme care that must be devoted to compliance with the franchisor’s disclosure obligations.

Sixth, franchisors and their counsel should undertake a close review of their franchise agreement to ensure that strong and clear contractual terms exist with respect to any circumstances about which full disclosure at the time of signing the franchise agreement — such as site selection — cannot be made. Strong wording of the franchise agreement in the recent case likely saved the day for the franchisor.

Seventh, strong and clear risk warnings in the franchisor’s disclosure document dealing with situations — such as site development — where risk exists and precise numbers can’t be provided, are essential.

Eighth, the court did not decide the issue of whether signature of the certificate of disclosure by the franchisor only — and not by individual officers or directors — was compliant. Best practice may therefore dictate that certificates of disclosure be signed by the signatories in their individual capacities. The signatories need to be reminded of their personal liability should the franchisor be unable to satisfy the full amount of a rescission claim.

And so, celebrations should likely be limited to a good bottle of prosecco. Save the champagne for now.