In 2013, I was fortunate to attend both the Canadian Franchise Association (“CFA”) and the International Bar Association/International Franchise Association (“IBA/IFA”) annual conventions and to speak at both the CFA and IBA/IFA legal days.
Both conventions confirmed that franchising is rebounding from the recession in both the United States and Canada. In addition to domestic franchising, there is a strong and growing interest in franchising across the border to and from each country, but with many differences from the methods used in the past.
Master Franchising versus Direct Unit Franchising
A decade ago, before the passage of most of the Canadian provincial franchise laws, it was most common to use master franchising for cross-border expansion. Now, most Canadian franchisors sell unit franchises directly into the United States, and vice versa. One exception is that master franchising into the province of Quebec is still common due to the necessity to adapt the system for language and cultural issues.
This change is not solely due to the convergence of franchise disclosure laws and other legal issues. There is also a perceived convergence of technology, and a globalization of marketing, that makes local adaptations easier than in the past.
A master franchise agreement grants the master franchisee the right to either subfranchise or to act as an agent for the franchisor in a territory. Subfranchising has generally fallen out of favor in U.S. domestic franchising, due in part to legal compliance costs, but it is still the method of choice for most outbound franchising from the United States, except as to Anglophone Canada.
One advantage of master franchising is that the master franchisee is responsible to localize the system to the local country, province, state, or market. A master franchisee is also responsible for organizing local marketing. However, the royalty revenue is shared between the franchisor and the master franchisee. More and more franchisors are not willing to share royalties in order to have a master franchisee adapt the system or to organize marketing in the territory in cross-border franchising between the United States and Anglophone Canada.
Five provinces in Canada have passed franchise laws (four of these in the past decade): Alberta, Manitoba, New Brunswick, Ontario, and Prince Edward Island. British Columbia is also considering franchise disclosure legislation. The CFA recommends that its franchisor members use a franchise disclosure document (“FDD”) throughout Canada.
In the United States, the Federal Trade Commission (“FTC”) requires the use of an FDD in all 50 states and in all U.S. territories. The U.S. FDD form was updated, and made more lengthy and complex, in 2008. It now averages over 50 pages, not including exhibits, which is longer than any FDD in any other country. For example, disclosure of rebates and other payments from suppliers is more detailed in the United States than in Canada. Also, U.S. franchisors must generally attach audited financial statements, and Canadian franchisors may not need a full audit. Also, the FTC and the states formally approved electronic disclosure using an electronic FDD, which is not yet specifically approved in some Canadian provinces.
Additional U.S. Requirements: U.S. state registration and notice filing requirements exist in approximately 18 states (depending on exemptions that might be available), a requirement that does not exist anywhere in Canada. This adds delay and expense that Canadian franchisors entering the United States often underestimate. For example, state examiners will often prohibit a Canadian franchisor from using financial performance representations unless they have units in the United States, and will often require that averages consist of most or all units. The U.S. FDD remains longer and more detailed than the FDD required by any Canadian province, including U.S. GAAP audited financial statements. The U.S. states may require filing of marketing material and salesperson and broker forms, impound or deferral of initial franchise fees, unaudited interim financial statements, and statement of franchisor’s use of funds from initial fees, and other requirements that do not exist in Canada. The U.S. franchise relationship laws may govern franchise termination, non-renewal, transfer, supply issues, territory protection, non-discrimination, and good faith and fair dealing, in much more detail than in Canadian legislation.
Additional Canadian Requirements: While both Canada and the United States require “evergreen” disclosure of the prescribed information, plus additional “material facts,” plus disclosure of “material changes,” the process of updating disclosures is more formal in Canada, because each FDD must include a signed and dated certificate of disclosure by one or more officers of the franchisor. The case law is strict about this requirement. Therefore, Canadian franchisors are generally advised by their Canadian counsel to review and update the FDD prior to each disclosure delivery, to tailor the FDD to the specific grant, and to disclose material changes in a separate signed and dated material change document. In addition, French language requirements relating to the province of Quebec requiring extensive translations are a factor that many U.S. franchisors underestimate.
Conventional wisdom says that the legal environment for business in the United States is more litigious than Canada. As to litigation, in the province of Quebec, a landmark case involving Dunkin’ Donut was decided in 2012. A Quebec court determined that Dunkin’ Donuts must take steps to protect its brand and to protect franchisees from competition. The Quebec court awarded a $16.4 million judgment for a group of franchisees against Dunkin’ Donuts, representing all business losses suffered by the Quebec franchisee plaintiffs over the entire length of the franchise. Many Canadian and U.S. franchisors are concerned about this decision. Canadian franchise lawyers are advising caution for franchisors considering entry into Quebec. Some U.S. franchise lawyers are advising that the case should give pause to any American franchisor considering entry into Canada.
In Ontario, there have been many cases holding franchisors liable for failure to disclose material facts, even beyond what exists in the FDD, and liable unless the franchisor constantly updates the FDD. Because case law defining “material fact” and “material change” is far from conclusive, franchisors must take a facts-and-circumstances approach, with little bright-line guidance, when preparing disclosures to be provided before a franchise sale.
I conducted an informal poll of about 50 Canadian franchise lawyers attending the CFA Legal Day in February 2013 in Toronto. When asked whether the Canadian franchise legal environment was trending toward becoming as litigious as in the United States, about half of the attendees raised their hands.
In contrast, in the United States franchise litigation has diminished in the past five years, according to an informal poll of franchise lawyers conducted in February 2013. The reasons for the decrease include: lack of new franchise laws for more than a decade, a trend toward ADR (arbitration and mediation), and the economic downturn beginning in 2008. Also, the regulatory climate for franchising has improved in some ways. For example, the U.S. Supreme Court decision in Leegin Creative Leather Products v. PSKS, Inc. (2007) allows franchisors to set franchisee prices if the activity does not substantially impair competition, thereby allowing franchisors to engage in national price promotions (subject to state laws).
Other Differences: There are still many differences between the United States and Canadian markets. The franchise agreements and manuals and procedures still should be customized to comply with the local laws. For example, there are general differences in laws governing many areas of business between the United States and Canada. The two countries have different laws regarding language, packaging, labeling, product liability and insurance, advertising, contests, weights and measures, privacy and personal data protection, and others that may change how the business operates at the franchisee level. Cases in the United States have set aside one-sided arbitration clauses. There is a movement toward short concise plain-English franchise agreements in the United States.
The operations and training must also be customized and localized for business conditions and competition. There may be differences still in sources of inventory, supplies and equipment, and market conditions for leases may differ. And the competitive conditions may be different locally and nationally.
We can learn from the franchise experience and legal environment in other countries. For example, one of the lessons that U.S. franchisors should take from Canadian franchising is to try to keep the FDD up to date with material information for each disclosure and each location. If complying with each other’s laws across the border is not feasible even with the help of local counsel, the franchisor should consider master franchising instead of unit franchising.