In two recent decisions, the Ontario Courts have made it clear that franchisors cannot rely on technical defences to avoid the rescission remedy available in section 6(2) of the Arthur Wishart Act (Franchise Disclosure), 2000 (the Act). In both cases, the Courts permitted the plaintiffs to rescind agreements because the franchisors had not provided a disclosure document, giving short shrift to the technical defences raised by the franchisors.
In the first case, Grill It Up argued that the Act did not apply because the purported franchisee had refused to sign the draft franchise agreement (he had signed an asset purchase agreement). Rejecting this technical defence, the Court held that the transaction was in substance a franchise transaction and permitted rescission.
In the second case, Springdale Pizza argued that it met the technical requirements of sections 5(7)(a) and 8(a) of the Act and was exempt from providing a disclosure document to a prospective franchisee who purchased an existing franchise. Rejecting this defence, the Court held that the exemption is narrow and that Springdale Pizza had been sufficiently involved in the sale that it was obliged to provide a disclosure document.
As a result, franchisors must carefully consider the very real risk of a franchisee rescinding the agreement and claiming compensation if the franchisor chooses not to provide a disclosure document to a prospective franchisee, including in the resale context.
Grill It Up: The Act Applies to an Asset Purchase Transaction
In 1706228 Ontario Ltd. v. Grill It Up Holdings Inc., 2011 ONSC 2735, the Court held that the asset purchase transaction was a franchise transaction even though the prospective franchisee refused to sign the franchise agreement. In the Court’s view, the substance of the transaction trumped the technicalities.
The plaintiffs (Mr. Fang) invested money to build a Grill It Up restaurant. Mr. Fang and the defendants (Grill It Up) entered into several agreements, including an asset purchase agreement, a sub-lease, and a licence agreement permitting use of trademarks. Mr. Fang refused to sign the draft franchise agreement (as it contained more onerous financial obligations than he had agreed to), and the parties proceeded towards closing without it. Before closing, the relationship fell apart.
Mr. Fang sued for return of his deposits, out-of-pocket expenses and lost income. He argued that the transaction was a franchise transaction subject to the Act and that he was permitted to rescind the transaction because Grill It Up had not provided a disclosure document. Grill It Up argued that it was not a franchise transaction because Mr. Fang refused to sign the franchise agreement.
The Court reviewed the definition of “franchise” in section 1 of the Act and held that the transaction was a franchise, relying on the following facts:
- the parties understood that they were entering a franchise relationship;
- the transaction was structured like a typical franchise, including that Grill It Up entered into a head lease for the location and a sub-lease with Mr. Fang;
- Grill It Up described the relationship as a franchise to Mr. Fang;
- the licence agreement required Mr. Fang to pay a royalty;
- Grill It Up provided a menu, trademark “special sauces”, and a list of designated (but perhaps not mandatory) suppliers;
- Grill It Up granted Mr. Fang the right to sell food that was “substantially associated with” the Grill It Up trademarks and name (which is one part of the Act’s definition of “franchise”); and
- Grill It Up offered “significant assistance” regarding store design, equipment, location, training and branding (which is another part of the Act’s definition of “franchise”).
The Court held that Mr. Fang’s refusal to sign the franchise agreement was not relevant because the right to disclosure arises before a franchise agreement is signed and the Act began to protect Mr. Fang as soon as he paid his first deposit.
Finally, the Court dismissed Grill It Up’s technical argument that Mr. Fang was not entitled to rescind the transaction because the Notice of Rescission was not delivered in accordance with section 6(3) of the Act.
Springdale Pizza: The Exemptions from Disclosure Obligations are Narrow
In 2189205 Ontario Inc. v. Springdale Pizza Depot Ltd., 2011 ONCA 467, the Court of Appeal considered a franchisor’s disclosure obligations in the franchise resale context and narrowly interpreted the exemption from such obligations. The Court held that a franchisor would only be exempt from providing a disclosure document to the purchasing franchisee if the franchisor did nothing more than merely exercise its rights to consent to the transfer.
Franchisors’ obligations to disclose are set out in section 5 of the Act. Franchisors are exempt from this obligation if (among other things) “the grant of the franchise is not effected by or through the franchisor” (paragraph 5(7)(a)(iv) of the Act). Subsection 5(8) clarifies that a grant is not effected by or through a franchisor merely because the franchisor has the right to approve the grant or because the franchise agreement contemplates a transfer fee.
In Springdale Pizza, the franchisor argued that the grant was not effected by or through it. The Court of Appeal disagreed, relying on several facts that show how limited the franchisor’s role must be if the franchisor wants to be exempt from disclosure obligations in the resale context.
First, the Court noted that Springdale Pizza admitted that “[a]ll of the parties of this action negotiated together to bring about the sale of [the vendor’s business] to [the purchaser] and for [the purchaser] to become a franchisee of Springdale as a result”. Based on existing cases, this admission supported the Court’s conclusion that Springdale Pizza was actively involved in the sale. (See MAA Diners Inc. v. 3 for 1 Pizza & Wings (Canada) Inc., 2003 CanLII 10615.)
Similarly, Springdale Pizza required the purchaser to sign an acknowledgement that the purchaser did not rely on Springdale Pizza in confirming, substantiating or reporting the sales figures of the business. This undertaking was neither signed by the vendor nor contemplated by the franchise agreement and fell within the existing cases as support for the conclusion that the franchisor was actively involved in the transaction. (See 1518628 Ontario Inc. v. Tutor Time Learning Centres, LCC, 2006 CanLII 25276.)
More problematically, the vendor’s franchise agreement said that the franchisor’s consent was conditional on the purchaser executing the then-current franchise agreement and related documents, undertaking to bring the franchise immediately into conformity with the then-current Retail Marketing Plan. Regardless, the Court held that the franchisee need only sign related documents that had been signed by the vendor. Because the vendor had not signed an undertaking of car wrapping, the franchisor’s requirement that the purchasing franchise do so, even though it was contemplated by the vendor’s franchise agreement and was necessary to bring the franchise into compliance with the then-current Retail Marketing Plan, supported the Court’s conclusion that the franchisor was actively involved in the sale.
With this restrictive approach, a Court might even conclude that a franchisor cannot require a prospective franchisee to sign a new form of franchise agreement.
Most problematically, the Court also relied on the following facts:
- (as often happens) the purchaser contacted Springdale Pizza’s head office and it directed the purchaser to the vendor;
- (as usually happens) the agreement of purchase and sale required the prospective franchisee to obtain Springdale Pizza’s consent and thus deal directly with Springdale Pizza; and
- (as always happens) Springdale Pizza had detailed financial information about all franchisees. It seems that mere possession of the information was a fact that made Springdale Pizza actively involved in the sale.
The Court noted that “[i]t may be that any of these individual circumstances would not have been enough” to support the Court’s conclusion that the grant was effected through the franchisor. However, as one or more of these facts will be present in the majority of franchise transfers, franchisors must very carefully consider whether to take the risk of not providing a disclosure document.
Franchisors Must Abide by the Remedial Spirit of the Act
In both of these cases, the Courts rejected the technical defences advanced by franchisors and ordered rescission of the transactions as well as damages. These decisions are consistent with the trend of franchisee-friendly decisions as well as the remedial purpose of the Act. Franchisors should continue to take the obligation to disclose seriously and should ensure that their procedures for interacting with prospective franchisees comply with the remedial spirit driving the Courts’ interpretation of the Act.