Half of all the Canadian provinces, Alberta, Manitoba, Ontario, New Brunswick and Prince Edward Island, now have franchise specific legislation. Thankfully, from a franchisor’s perspective, these statutes are remarkably similar. There are differences, but they tend to be more technical in nature and, with care taken, will not present significant challenges for compliance. However, there is a growing body of decided cases that are adding more than a little stress and worry for those in a franchise organization or the legal community responsible for franchise regulatory compliance.
The courts have been very clear that this type of legislation is remedial and intended to address the perceived imbalance of power in the franchisorfranchisee relationship. Some of these decisions have applied a very strict interpretation of the wording of the statutes and their regulations. As a result, even minor administrative errors can result in unexpected and costly consequences. How do you protect yourself against such consequences? The answers are: a) know the legislation thoroughly, b) understand the court interpretations of the legislation, c) stay current with new cases interpreting and applying the legislation and d) take great care in the preparation of the disclosure documents and their attachments.
This paper will outline some of the most common compliance challenges and offer some suggestions for best practices in the preparation and use of franchise disclosure documents.
Use of a Single Franchise Disclosure Document (“FDD”) for all of Canada
By complying with the most stringent requirements among the 5 statutes, it is possible to create one FDD for use in all of the provinces with franchise specific legislation. This reduces the likelihood that the wrong form will be chosen for the wrong province and simplifies the process of updating the FDD, whether for reasons of facts changing or the law evolving. Of course, if there is any reason why a franchisor would not be comfortable with complying with any of the provisions of a statute of a particular province in another province, then this approach is not appropriate.
One caution is that the costs of establishing a franchise may be different depending upon where the unit is going to be operated in Canada. As a result, that section of the Canada wide FDD, would have to be tailored for the regional differences that may exist. This, of course, may be necessary, even for regional differences within the same province, i.e. northern Ontario vs. southern Ontario.
It is not uncommon for franchisors to provide their FDD to prospective franchisees who will be operating their franchise in one of the provinces that does not have franchise legislation. The theory being that it is better to provide the same information to all potential franchisees in the system. If this is to be the practice, then it is important to bring to the attention of such prospective franchisees that the FDD was not prepared under the laws of the particular province and that its contents may not be applicable to the particular franchise. Appendix 1 of this paper is an example of a possible covering letter to be provided along with the FDD to such a prospective franchisee. Also, in these situations, no executed certificate of disclosure should be included in the FDD.
When to Disclose?
All of the provincial statutes have the same trigger events for the requirement to provide disclosure; 14 days prior to the franchisee paying any money or signing any agreement relating to the franchise. It is best to make the 14 days clear days, i.e. do not count the day the FDD was delivered and do not take money or have documents signed on the 14th day following delivery.
Who Should be Disclosed?
Where the prospective franchisee is an individual or several individuals, i.e. a partnership, then each of them should be disclosed separately. Where the prospective franchisee is an existing corporation, the safest approach is to disclose the corporation and everyone who owns shares in the prospective franchisee, although this is not strictly required by the statutes. In practice, however, this often occurs because the shareholders are also the guarantors of the franchise agreement and, based on existing case law, disclosure is required or the guarantors would have the right to rescind their guaranties for up to 2 years.
It is not uncommon for individuals to be disclosed and then they form a corporation just prior to the franchise agreement being executed. In this situation, the counsel of perfection is to disclose the new franchisee corporation and wait the 14 days. In real life, however, expectations are running high and everyone just wants to finalize the deal. If so, then the recommended course of action is to at least disclose the new corporation, even if the 14 day rule is not going to be followed. In this way, the corporate franchisee’s remedy of rescission will be extinguished after 60 days.
Delivery of the FDD
The typical way in which FDDs are delivered is personally or by registered mail. The New Brunswick statute, Manitoba statute and the PEI statute also specifically allow delivery by courier. The PEI, Manitoba and New Brunswick statutes are the only provincial statutes which permit delivery of disclosure documents electronically. Multiple requirements attach to this option however.
Even where the statute specifically permits delivery by courier, if the FDD is being delivered in this manner, it is wise to have the party effecting the delivery ask for picture ID and execute a brief affidavit as to whom they delivered the FDD. While not required by any of the provincial statutes, it is a common and highly recommended practice to have all recipients of an FDD sign and date a receipt of delivery. An exact copy of the FDD, with a copy of the signed certificate and the original receipt should be retained in the files of the franchisor.
An FDD must contain all required information and attachments delivered as one document at one time. One exception to this rule exists under the Manitoba Franchises Act which allows a franchise disclosure document to be delivered in parts at different times. In such circumstances, the date of delivery of the disclosure document is the date of the delivery of the last document.
Contents of an FDD
Much of the content of an FDD is prescribed in the regulations to the various provincial statutes. Some of the requirements are clear and uncomplicated, but others are vague or ambiguous. The following is a brief description of some of these requirements.
(a) Material Facts
Each Canadian franchise statute requires the full disclosure of all “material facts” relating to the franchise. This is a broadly defined term. The key aspect of the definition is a test as to whether or not the fact being considered for inclusion in the FDD would have a significant impact on the decision of a prospective franchisee to purchase the franchise or the price the prospective franchisee would be willing to pay. The courts have held that material facts include a wide array of information that could have a potential impact upon a prospective franchisee’s decision as to whether or not to invest in a franchise system. The conservative approach is to disclose any fact that could possibly have such results.
A challenge lies in the fact that the knowledge of the officers, directors, agents and employees of the franchisor is the knowledge of the franchisor. As a result, it is imperative that everyone who could learn of a material fact be canvassed about their knowledge each time an FDD is to be delivered. In smaller franchise organizations, this can be a challenge. In larger franchise organizations, it can be a nightmare. There are no easy solutions, but the more systematized and thorough the enquiry is of these people, the less likely that material facts will be missed. In larger franchisors, enquiries can be done more efficiently on a departmental basis.
(b) All Agreements Attached to the FDD
Each of the Canadian franchise statutes require that every agreement that a prospective franchisee is expected to sign be attached to the FDD. To be certain, even the most innocuous agreement should find its way into the FDD. This includes agreements with third parties that the franchisor requires as a condition to the grant of the franchise.
(c) Information About Officers and Directors
In franchisor corporations with a large number of officers and directors, it can be a challenge gathering all of the relevant information for disclosure. Attached as Appendix 2 is an example of a possible questionnaire for directors and officers.
(d) Financial Statements
Unless exempt from financial disclosure, every franchisor must attach its financial statements for the last completed fiscal year. However, if those financial statements have not yet been prepared, the franchisor may use the statements for the prior fiscal year up to 180 days following the end of the last fiscal year of the franchisor. The financial statements must be either audited or prepared to a review engagement standard. A new franchisor gets a break, in that it can use simply an opening balance sheet for its first fiscal year and for 180 days following the end of the first fiscal year.
While not yet determined by a court, it is likely that consolidated financial statements do not meet the requirement of the various statutes to include the financial statements of “the franchisor”.
(e) Earnings Projections
Although earnings projections are not required to be provided to prospective franchisees under the Canadian franchise statutes, if a franchisor does choose to make an earnings projection, the FDD must include a statement indicating the reasonable basis for the projection, all assumptions that substantiate the projections and the location where the underlying information is available for inspection by the prospective franchisee.
The term “earnings projection” is not defined in any of the Canadian franchise statutes, so franchisors should be cautious in ensuring that the information provided to a prospective franchisee, in an FDD or otherwise, will not be viewed as an earnings projection, unless that is the intention. A further caution lies in the fact that an earnings projection could be an oral statement made by someone in authority or ostensible authority. As a result, anyone involved in the franchise sales process should be schooled about not discussing any such matters beyond what is authorized by the franchisor. Some franchisors use a franchisee signing questionnaire to help establish what information has been conveyed to the franchisee, including any possible earnings claims. Attached as Appendix 3 is an example of such a franchisee signing questionnaire.
(f) Certificate of Disclosure
An FDD must be accompanied by an originally signed and dated certificate of the franchisor warranting that all material facts have been provided and that the information provided is true. If the franchisor has only one director or officer, it must be signed by that person. If the franchisor has more than one director or officer, it must be signed by at least two persons who are officers or directors of the franchisor. It should be noted that each individual who signs the certificate of disclosure may be held personally liable in the event that the FDD is found to be incomplete or inaccurate.
Questions have been raised as to whether or a not certificates can be signed in advance or sent for signature by someone who is a distance away, without providing those individuals with the final copy of the FDD. While the statutes do not specifically deal with this question, these are dangerous practices, as they may lead to the impeachment of the certificate once it is proven that they did not in fact review the FDD before signing the certificate. Based upon the decided case, this could render the FDD a nullity and allow the franchisee a 2 year window in which to rescind it.
(g) Policies vs. Contract Terms
There are number of disclosure items which ask for the franchisor’s policies on a specific matter, such as volume rebates and proximity of new units to existing units. It is not uncommon to read an FDD which recites the contractual provisions of the franchise agreement on these points, but states nothing about policy. There is a significant difference between the two and, if the franchisor has a policy, state it and, if the franchisor does not have such a policy, that should be stated.
(h) The Manual
There is some uncertainty under the Alberta, Ontario and PEI statutes as to whether or not the system manual or any portion of it needs to be included in an FDD. The argument for inclusion is strongest where the franchise agreement states that, “the provisions of the manual are incorporated herein by reference”. Such a disclosure requirement would be onerous and undesirable for many franchisors. The practice that has evolved is to include only the table of contents for the manual in the FDD. In Manitoba and New Brunswick this practice is specifically provided for in their regulations and presumably would be accepted as the extent of the requirement to disclose information about the system manual.
(i) Existing Franchises and Corporate Units
Across the various statutes, there are differing approaches and formulae for the disclosure of existing units in the system. In PEI, New Brunswick and Manitoba, for example, depending upon the number of existing units in the particular province, disclosure may have to be made regarding existing units in contiguous provinces. For franchisors operating in multiple provinces, this can become challenging and fraught with opportunities for mistakes. Unless there are compelling reasons to do otherwise, the best policy is to disclose in a Canadian FDD the existence of all franchised and corporate units throughout Canada.
Even after an FDD has been prepared and delivered to a prospective franchisee, the franchisor’s disclosure obligations under the applicable Canadian franchise statutes continue. There is an ongoing obligation to disclose to a prospective franchisee all “material changes” that occur after the delivery of the FDD up until the date of signing the franchise agreement.
A material change is defined in Ontario’s Arthur Wishart Act as a change in the business, operations, capital or control of the franchisor or its associate, or a change in the franchise system, that would reasonably be expected to have a significant adverse effect on the value or price of the franchise to be granted or the decision to purchase the franchise. Note that this definition is similar to the definition of a material fact; the big difference being that a fact will be a material fact whether it has an adverse or positive effect on the value of the franchise. Other Canadian franchise statutes provide similar definitions of material change.
Only the provinces of New Brunswick, Manitoba and Prince Edward Island prescribe any form or technical requirement for a notice of change, other than the notice has to be in writing. It would, however, be a good practice to use a form which complies with the regulations under the franchise statutes of these three provinces. Note that the requirements for the signatories to the statement of material change in New Brunswick and the certificate in Manitoba and PEI are the same as the requirements for FDDs, i.e. if the franchisor has more than one officer or director, then two signatures are required. It is also recommended that a written receipt of the notice of material change be obtained.
Attached as Appendix 4 is an example of a form for a statement of material change. It should be noted that the requirement to present the information in an FDD accurately, clearly and concisely applies equally to statements of material change.
The question arises about how to deal with situations where key agreements and/or facts are simply not known or available at the time the original FDD is delivered to a prospective franchisee. A good example of this is when the franchisee is disclosed before the location is selected and the lease is obtained, whether or not a franchise agreement is signed. It may be that this will be considered by a court in the future as being such a “material fact” that proper disclosure is not possible without the existence of the lease. At a minimum, the best practice is the lease should be disclosed in a statement of material change and the prospective franchisee or existing franchisee is given a reasonable opportunity to review the lease and seek professional advice.
Although the method of delivery of a statement of material change is not addressed in the Canadian franchise statutes, it would be prudent to follow the prescribed methods of delivery for the FDD, as mentioned above. Delivery of a statement of material change does not re-start the 14-day waiting period before the franchise agreement can be entered into, but a reasonable period of time should be given to allow the prospective franchisee to process the material change and consult with counsel, if desired.
Renewal and Extensions of Franchise Agreements
The provincial franchise statutes provide for an exemption from disclosure for renewals and extensions of franchise agreements. With the exception of Alberta, however, this exemption is conditional on there being no material change since the signing of the original franchise agreement or the last renewal agreement. In order to avoid the risk of a material change being found, especially because the time leading up to the renewal or extension is often considerable, with lots of changes in a franchise system, the best practice is to provide an up-to-date FDD upon each renewal and extension.
- The system’s standard FDD often needs to be adapted for renewals and extensions in, at least, the following areas:
- Change the section respecting “Costs Necessary to Establish the Franchise” to “Costs Necessary for Renewal of the Franchise” and list only the costs which may be required for renewal or extension including extension of lease, leasehold improvements, equipment updates, renewal fees, etc.
- Attach copies of all agreements the franchisee will be required to sign on renewal or extension, i.e. new franchise agreement, new lease document, guarantees, etc.
- If a new form of franchise agreement is being used on renewal or extension, modify the sections of the FDD, as necessary, which refer to the content in the franchise agreement which might have changed, i.e. royalty and advertising contribution rates, restrictions imposed on the franchisee, exclusivity of a territory, termination, further renewal, transfers, etc.
Transfers and Sales
All of the provincial statutes provide for an exemption from disclosure for the resale of a franchise by the franchisee. However, there are a number of conditions to that exemption, the most problematic being the condition that the sale not be effected “by or through the franchisor.” There is no definition of that phrase in the various statutes (although the franchisor is free to reasonably approve the buyer and take a transfer fee, subject to some restrictions) and the case law is still evolving. Add the reality that franchisors have a considerable stake in who buys the franchise and the process by which the new parties become franchisees in the system and one can see that franchisors may easily become so involved in the resale that the disclosure requirement is triggered.
The best practice is for the franchisor to simply take the position that each franchisee entering the system will receive an appropriate FDD. The system’s standard FDD would have to be modified in a number of ways, including:
- A section should be added summarizing the essential facts of the resale, including a reference to the fact that the franchisor makes no representations or warranties concerning the existing franchised business or its financial performance, unless that is the case. Provided, however, the franchisor should indicate what information it does have regarding the financial performance of the franchised business, with the added caveat that the financial information has not been verified by the franchisor, unless that is the case. This latter suggestion comes from the belief that such information would amount to a material fact.
- Make certain that all agreements the new franchisee will be required to sign are attached to the FDD, including any new franchise agreements, franchise agreements being assigned, lease agreements, guarantees, etc.
- The costs to establish the franchise should be replaced with the costs necessary to effect the purchase of the franchise.
For the sale of a corporate unit the system’s standard FDD should be provided. It is recommended that a section be added to the FDD summarizing the sale transaction and that the agreement of purchase and sale be added as a scheduled agreement to the FDD. Whether or not the franchised business being sold is owned by the franchisor or a related corporation, all relevant financial and operational information concerning the business should be disclosed as material facts.
Unlike in the United States, there is no requirement in Canada to do an annual update of the entire FDD. Rather, much of a Canadian FDD needs to be current and up-to-date each time the document is delivered to a prospective franchisee. The following is a list of certain items required in an FDD and the time frames in which they must be updated:
- Unless indicated otherwise, each item of disclo sure must be accurate and current to the date of delivery of the disclosure document. Some items of particular concern are:
e. Directors and officers who might change from time to time;
f. Costs of establishing the franchise;
g. Litigation, insolvency proceedings and administrative proceedings; and
h. List of existing franchisees.
- As soon as new financial statements are prepared for the previous fiscal year, they must replace the existing financial statements used in the franchisor’s standard form FDD. Such new financial statements must be prepared no later than 180 days following the end of the last fiscal year.
The following items relate to fiscal years:
- percentage of the fund spent on national campaigns and local advertising in the two preceding fiscal years
- percentage of the fund retained by the franchisor, the franchisor’s parent or the franchisor’s associate in the two preceding fiscal years
- projection of the amount of the franchisee’s contribution to the fund
- projection of the percentage of the fund to be spent on national or local advertising campaigns for the current fiscal year
- projection of the percentage of the fund to be retained by the franchisor, the franchisor’s parent or the franchisor’s associate in the current fiscal year
- name, last known address and telephone number for those who left the system in the last fiscal year
- reasons for the closure of each franchise during the last three fiscal years
- Advertising fund:
Franchise legislation is now a firmly established reality for the Canadian franchise marketplace. If anything changes in the future, it will most likely be the addition of other provinces to the list of those that have enacted such laws and more court cases interpreting the statutes and setting standards. Along with this reality and the court decisions to date, which have established some traps for the unwary or uneducated, franchise legislative compliance has become a challenging area of franchise practice. The right people, with the right attitudes and training, need to be put in charge of this very important task and they will have to be diligent, meticulous and knowledgeable to keep the franchisor and the system out of harm’s way.
Click here to see Appendices.