Burnett v. Cuts serves as an important reminder to franchisors - in particular American franchisors operating in Canadian provinces with franchise disclosure legislation - of the significant risks of failing to provide proper disclosure to prospective franchisees and of keeping franchisees and prospective franchisees “in the dark.”
Burnett, the president of the plaintiff corporation, and the U.S. franchisor of the Cuts Fitness for Men franchise system entered into negotiations regarding a Canadian master franchise license to expand the Cuts Fitness system to the provinces of Ontario, New Brunswick, Newfoundland, Nova Scotia and Prince Edward Island.
Under Ontario’s franchise disclosure legislation, the Arthur Wishart Act (the Act), franchisors are required to provide prospective franchisees with a disclosure document not less than 14 days before the earlier of the signing by the prospective franchisee of the franchise agreement or any other agreement relating to the franchise or the payment of any consideration relating to the franchise (such as a franchise fee).
During negotiations, the franchisor provided the plaintiffs with a Uniform Franchise Offering Circular (a UFOC), the form of franchise disclosure document which was at that time required under United States franchise disclosure laws, now the Franchise Disclosure Document. The franchisor subsequently provided the plaintiffs with a draft disclosure document.
Following delivery of the draft disclosure document, the plaintiffs and the franchisor entered into a letter of intent (the LOI) setting out the terms under which the franchisor would grant master franchise rights to the plaintiffs in Ontario.
After entering into the LOI and prior to signing a master franchise agreement, the plaintiffs paid US$100,000 in franchise fees to the franchisor and commenced selling Cuts Fitness franchises in Canada. Although the parties were operating as if the plaintiffs were already master franchisees, no final disclosure document had been delivered and the master franchise agreement had not been signed.
Approximately six months after the parties entered into the LOI, the franchisor delivered a purported disclosure document which was deficient in a number of ways. Following receipt of that purported disclosure document, the plaintiffs signed the master franchise agreement. After the agreement was signed, the franchisor stopped communicating with the plaintiffs and ignored their requests for information and assistance. The plaintiffs learned that the franchisor was preoccupied with dealing with the failure of its U.S. franchise system and developing another brand. The plaintiffs rescinded the master franchise agreement, and, when the franchisor refused to reimburse the plaintiffs for the franchise fees and their operating losses, the plaintiffs commenced an action for rescission and damages for breach of the duty of fair dealing.
Deficient disclosure is no disclosure at all
Under Ontario franchise disclosure law, there are two types of situations that may give a franchisee the right to rescind a franchise agreement. Generally, if a franchisor does not provide a complete or accurate disclosure document, the franchisee has 60 days from the date the disclosure document is provided to the franchisee to rescind the franchise agreement. If a franchisor does not provide a disclosure document at all, the franchisee has up to two years from the date of signing the franchise agreement to rescind the franchise agreement. However, a number of recent decisions by Ontario courts have made it clear that even if a franchisor has provided a disclosure document, in circumstances where that disclosure document does not contain certain information and documents that are required under the Act, it is equivalent to the franchisor not providing a disclosure document at all. In those cases, the franchisee has up to two years from the date of signing the franchise agreement to rescind the franchise agreement. Burnett v. Cuts is the most recent in that growing list of cases where deficient disclosure has been found to be equivalent to no disclosure. Justice Whitaker found that the purported disclosure document was so deficient that it was as if no disclosure had been provided, and accordingly, the plaintiffs were entitled to rescind the master franchise agreement and recover the franchise fees they had paid and the operating losses they incurred. In particular, His Honour noted that the delivery of a UFOC does not meet a franchisor’s disclosure obligations in Ontario.
The court highlighted several critical deficiencies by the franchisor, including that the disclosure document:
- was delivered after the execution of the LOI. As noted above, the Act requires delivery of a disclosure document at least 14 days before the signing of an agreement relating to a franchise;
- was delivered in piecemeal fashion. The Act requires that a disclosure document be provided as one document (including all of the required contents) at one time;
- did not have any financial statements. The Act requires that a disclosure document include an audited financial statement for the most recently completed fiscal year of the franchisor’s operations, unless an exemption applies;
- did not include copies of all proposed franchise agreements and other agreements relating to the franchise to be signed by the plaintiff, as required by the Act; and
- was delivered to the plaintiff by email, which is not permitted under the Act.
Additionally, Justice Whitaker highlighted the franchisor’s failure to include in the disclosure document a signed and dated certificate certifying that the disclosure document contained no untrue information, representations or statements and includes every material fact, financial statement, statement and other information required by the Act. His Honour referred to earlier decisions of the Ontario and Alberta Courts of Appeal in which failure to provide a signed certificate in and of itself was held to be fatal to disclosure and therefore gave rise to a two-year rescission remedy.
Separate damages Awarded for breach of duty of fair dealing
Burnett v. Cuts is also significant as the third Ontario case (following Salah v. Timothy’s Coffees and 1159607 Ontario Inc. v. Country Style Food Services) in which separate damages for a franchisor’s breach of its duty of fair dealing under the Act have been awarded (in addition to damages awarded to compensate a franchisee for losses arising from deficient disclosure). In addition to the damages awarded to reimburse the franchisees for the franchise fees they paid and the losses they incurred, Justice Whitaker awarded the plaintiffs $25,000 for the franchisor’s failure to disclose the true state of affairs of the franchise system, and in particular the fact that it was in a state of rapid decline, and for failing to respond to the plaintiffs’ reasonable requests for information and assistance after the LOI was signed and franchise fees paid.
Burnett v. Cuts serves as another warning to franchisors of the importance of the substance of disclosure as well as the form of disclosure required under the Act, and the consequences of withholding information from franchisees. Burnett v. Cuts also underscores that franchisors and franchisees who sign a letter of intent prior to entering into a franchise agreement will be subject to the same duty of good faith and fair dealing as when they execute a franchise agreement.
In addition to total damages of approximately $201,000, Justice Whitaker awarded the plaintiffs $70,000 in costs. Franchisors who face significant exposure for deficient disclosure and/or other clear breaches of the Act should carefully weigh the costs and benefits of litigating claims by franchisees and should evaluate the benefits of settling those claims before trial to avoid a significant adverse costs awarded as in Burnett v. Cuts.
Finally, it is important to note that although Burnett v. Cuts was an action commenced in Ontario for rescission of the master franchise agreement under the provisions of the Ontario’s franchise disclosure legislation, the defendant franchisor was required to provide similar disclosure relating to the franchise operations in New Brunswick and Prince Edward Island. Currently, four Canadian provinces (Ontario, Alberta, New Brunswick and Prince Edward Island) have franchise disclosure legislation in effect. Manitoba’s The Franchises Act comes into force on October 1, 2012.