When compiling a disclosure document, franchisors are faced with an uncomfortable dilemma: disclose too little and risk a costly lawsuit resulting from inadequate disclosure. The rigorous disclosure requirements enacted by franchise laws in several Canadian provinces have increased the risks of incorrectly drawing the line on disclosure, and even those provinces without specific franchise laws are coming to demand more disclosure and transparency from franchisors.
It would be tempting to advise franchisors to find a balance in their approach to disclosure. In an ideal world, franchisors could reveal just enough information to inform potential franchisees while safeguarding the internal knowledge they have worked so hard to build up. But such advice would mischaracterize the uncompromising nature of the laws on franchise disclosure. The law has not left a happy medium for franchise disclosure whether or not a provincial franchise statute is in effect.
Material Facts and More
In Ontario, the Arthur Wishart Act (Franchise Disclosure) leaves no room for a Goldilocks solution to disclosure. The Act plainly states that in addition to a litany of specifically prescribed corporate and financial information, franchisors must also reveal “all material facts” to prospective franchisees, which must be current as of the date disclosure is provided. This range of information will then allow franchisees to make fully informed decisions on whether to pursue a franchise.
The Act’s definition of material facts is frustratingly vague and broad in scope. As defined, “material facts” include:
[A]ny information about the business, operations, capital or control of the franchisor or franchisor’s associate, 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 Ontario courts are still grappling with exactly what sort of information constitutes a material fact, but the consensus is that material facts include a vast scope of information that could potentially impact a franchisee’s decision to invest. As a result, franchise lawyers are treading with great caution and taking an extremely broad approach when assisting franchisors in preparing their disclosure documents to ensure compliance with the law.
While the “all material facts” requirement is specific to Ontario, failure to provide pertinent information to franchisees could lead to accusations of misrepresentation in all provinces, whether or not they have specific franchise legislation in place. A franchisor who fails to disclose material facts is largely treated by the courts with the same disdain as a franchisor that deliberately distorts material facts. Both are considered actionable misrepresentations at common law. So franchisors across the country should take careful note of the obligation to disclose, and how it might conflict with their desire to protect their information.
A further challenge to providing disclosure that meets the requirements of the Act is that a disclosure document must be presented as a single cohesive document. It is now standard procedure for franchisees to be provided with all relevant ancillary documents at the time the disclosure document is provided (all bound together as one document), such as the head-lease between the landlord and the franchisor. The head-lease is likely to be ripe with material facts that may impact the terms under which the franchisee operates its business on the premises. A recent court case in Ontario upheld that failing to disclose the renewal and expiration terms of a head lease was tantamount to providing the franchisee with no disclosure whatsoever.
Providing the head-lease itself may seem like a safe means of ensuring that these material facts are provided to the franchisee, but it does not ensure that the relevant material facts are provided in the disclosure document itself. In complying with the obligation to disclose all “material facts”, a franchisor should conduct a careful review of the head-lease, and the material facts of relevance to the franchisee should be listed clearly as a separate section of the disclosure document.
To the dismay of franchisors who give out disclosure documents, it is now quite common to see entire operations manuals, or extracts from them, disclosed to individuals who have expressed an interest in the franchise system, but have not made any substantive commitment to becoming franchisees. Given the availability of disclosure documents, and the potentially sensitive trade information they contain, franchisors may decide to keep certain information off the public record. However, the relative ease of bringing an action for inadequate disclosure, at least in Ontario and the other provinces with franchise legislation, should serve as a significant deterrent and a constant reminder of the risks of keeping material facts hidden.
The internet has enhanced the free flow of disclosure documents. To receive a disclosure document, the potential franchisee must generally sign a receipt confirming that the disclosure document was provided and that it will be kept private. In reality, once a disclosure document is provided, it is entirely out of the franchisor’s control. In the United States, a network of franchisee-friendly websites and message boards freely distribute franchise disclosure documents and court documents which are uploaded by users. The spread of such sites to Canada, and the rapid exchange of Canadian disclosure documents, is likely to be imminent. These websites may make franchisors uncomfortable by easing access to potentially sensitive trade information, but the corresponding potential to expose inadequate disclosure on a large scale poses an even greater risk. It is yet to be seen, but the day may come when franchisees and their counsel surf these sites in the hopes of locating an exit strategy.
Even without access to disclosure documents over the internet, anyone with a bit of time and some passing knowledge of the legal system could get a hold of an array of current disclosure documents. Once a disclosure document becomes an issue in a legal proceeding, a copy with be filed with the court and publically available for anyone to read or copy. If a lawsuit proceeds to trial, the disclosure document will have the further exposure of being dissected and analyzed by each party’s lawyer and the judge. At this point, the sensitivity attached to any material facts will be less a priority than ensuring that the disclosure document is compliant with the law.
Concerns about the sensitivity of disclosure documents are not entirely new, even though the pressure to disclose has been increasing in recent years. When disputes arise between franchisees and franchisors, it is not uncommon for one side to request a confidentiality order from the court, which would seal the information brought forward by the parties and keep it off the public record.
A typical confidentiality order limits access to all documents produced in the proceedings, including the disclosure documents and financial information. Access is limited to the parties’ lawyers, the court staff, and potentially one or two experts retained as part of the case. While they are effective in instances where they are granted, confidentiality orders cover only a small fraction of franchise disputes that end up before the courts. Confidentiality orders are generally reserved for the largest and most complex of franchise disputes, where the court will be scrutinizing every iota of the franchisor’s documentation. The standard for obtaining a confidentiality order is set deliberately high by the courts, and a typical dispute over the adequacy of a franchisor’s disclosure document is unlikely to meet the standard necessary to obtain a confidentiality order.
Furthermore, confidentiality orders depend upon the whims of the legal system, and the arguments of counsel. Obtaining a confidentiality order requires a costly motion before the court, and they are never guaranteed. Franchisors simply cannot count on confidentiality orders to limit access to sensitive information in the event a dispute does end up before the courts.
It is understandable that franchisors do not want to hold an open house with their sensitive and proprietary information. Small compromises seem to have become standard practice, such as disclosing only the table of contents of an operations manual rather than the entire contents of the manual. Despite their understandable reluctance to broaden the scope of disclosure, franchisors must also consider the dire consequences of failing to disclose anything that might be considered a material fact.
A leading Ontario franchise case states that the franchisor has a “rigorous duty to disclose all material facts as well as protect the franchisee from entering into such agreements without having all relevant information”. This may be counterintuitive to franchisors, who view franchisees as independent agents making their own investment decisions, but the duty of franchisors to protect franchisees is an integral part of their disclosure obligations. Any suggestion that material facts were willfully obscured by franchisors will be treated harshly by the courts, and franchisees will continue to have access to a set of drastic remedies.
The free-flow of disclosure documents, and the increasing awareness of franchise lawsuits, will only see increasing pressure on franchisors to disclose. There is no option for franchisors to disclose “just enough” of their material facts, as franchisees, their counsel, and the applicable laws have all established an uncompromising standard for franchise disclosure. At the end of the day, franchisors must have open and frank discussions with their counsel in determining how best to comply with all of their disclosure obligations. Franchisors who prepare their disclosure documents without considering these issues and obtaining sound legal advice run the risk of defending lawsuits over their failure to properly meet their disclosure obligations.
This article originally appeared in The Franchise Voice magazine.