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Key Developments Impacting Franchising – 2014 in Review

This week’s post, the second in our four-part series, focuses on three cases of consequence, the Caffe Demetre, Springdale Pizza and Delimark decisions.  Each of these cases represents a significant development in the law relating to franchise disclosure and provides important takeaways for franchisors.   


Caffe Demetre Franchising Corp. v. 2249027 Ontario Inc. and Waqar Khan[1]

The Caffe Demetre decision involved the resale of an existing franchised business.  Approximately two years after purchasing the franchise from the then-existing operator, the franchisee sought to rescind the franchise agreement pursuant to Section 6(2) of the Arthur Wishart Act (Franchise Disclosure), 2000[2] (the “AWA”) on the basis that the franchisor’s disclosure document omitted four material facts:

  1. the fact that the franchisor was contemplating litigation against a former franchisee of the system;
  2. the fact that the franchisor was contemplating the implementation of a system-wide tip-out policy;
  3. the fact that the franchisor was contemplating the implementation of a system-wide ice cream production policy; and
  4. the fact that the franchisee would be required to upgrade the premises during the term of the franchise agreement.

The court held that the implementation of the tip out policy, the implementation of the ice cream manufacturing policy, and the renovation requirement did not constitute “material facts”[3] within the meaning of the AWA, as each arose more than one year after the franchisee signed the franchise agreement.  The court did find, however, that the contemplated litigation was a material fact requiring disclosure.  The basis for the court’s determination in this regard is somewhat unclear, as the court was unable to “see how the existence of [the] litigation could have a significant effect on the price to be paid by the franchisee, as required by the definition of “material fact””.[4]  Notwithstanding this acknowledgment, the court held that the existence of the litigation ought to have been disclosed.

The court then went on to consider whether this particular omission entitled the franchisee to a two-year period of rescission and ultimately concluded that the omission, being a “content deficiency”, only gave rise to a 60-day rescission period.  The two-year rescission period, the court noted, is available only where there are “stark and material” deficiencies in the disclosure document such that a court may conclude that it amounts to no disclosure at all.[5]  The facts of this case did not support such a finding.

SIGNIFICANCE

This decision represents a welcome shift in the courts’ interpretation of Sections 6(1) and 6(2) of the AWA and suggests that the omission of a material fact from an otherwise compliant disclosure document will not necessarily entitle a franchisee to a two-year period of rescission.  Franchisors are still encouraged, however, to ensure that their disclosure documents contain any and all facts which may be considered by a prospective franchisee to be material.


2147191 Ontario Inc. v. Springdale Pizza Depot Ltd.[6]

The Springdale decision also involved the resale of an existing franchised business.  The franchisee sought to rescind the franchise agreement pursuant to Section 6(2) of the AWA on the basis that the franchisor failed to deliver a disclosure document.  The franchisor, relying on Section 5(7) of the AWA, took the position that it was exempt from the disclosure obligation.

Section 5(7)(a) of the AWA relieves a franchisor of its disclosure obligation where an existing franchisee sells the franchise for the franchisee’s own account and the grant is not effected by or through the franchisor.  Section 5(8) of the AWA clarifies that a grant is not effected by or through the franchisor merely because: (a) the franchisor has a right, exercisable on reasonable grounds, to approve or disapprove the grant; or (b) a transfer fee must be paid to the franchisor. 

The court rejected the franchisor’s defence, finding that the franchisor’s involvement in the transfer process went well beyond approving the transfer and collecting a transfer fee.  In arriving at this conclusion, the court emphasized the following:

  1. the purchase agreement was conditional for a period of 10 days on the purchaser obtaining the franchisor’s approval to the transfer;
  2. the franchisor met with the franchisee three times prior to signing the franchise agreement; and
  3. the franchisor required that the franchisee acknowledge, in writing, that the franchisee was not relying on any representations made by the franchisor regarding the sales figures of the business. 

SIGNIFICANCE

The Springdale decision serves as a reminder that Ontario courts interpret disclosure exemptions narrowly and that the resale exemption, in particular, should be relied upon only where the franchisor’s involvement in the transfer process is clearly limited to approving the transfer and collecting a fee pursuant to the terms of the existing franchise agreement.  Where a franchisor’s involvement extends beyond these acts, disclosure must be provided.   


2237310 Ontario Inc. v. 2264145 Ontario Inc.[7]

In the Delimark decision, the franchisee sought to rescind the franchise agreement pursuant to Section 6(2) of the AWA, citing numerous deficiencies in the franchisor’s disclosure document.  The court held that the franchisee was entitled to a two-year period of rescission on the basis that the purported disclosure document:

  1. did not contain financial statements for the franchisor’s most recently completed fiscal year;
  2. did not contain a certificate signed by the directors or officers of the franchisor;
  3. did not contain a copy of all agreements relating to the franchise, including various transactional documents relating to the franchisee’s purchase; and
  4. was delivered in a piecemeal fashion.

Additionally, the court found that the franchisor failed to disclose any information relating to the lease for the premises, including a copy of the head lease and sublease, both of which were finalized prior to the franchisee signing the franchise agreement.  With respect to this particular deficiency, the franchisor took the position that it could not be expected to disclose information or agreements which did not exist at the time the disclosure document was delivered.  The court rejected this argument, stating that to accept such a submission “would be to create a potentially large lacuna in the disclosure system: it would be easy for a franchisor to pare down its disclosure obligations on the basis that certain material or information was simply not available at the time the disclosure document was prepared”.[8]  The correct approach, the court affirmed, is for the franchisor to disclose additional material information or documents that become available during the disclosure period within a fresh disclosure document or a statement of material change. 

SIGNIFICANCE

Where material information or documents become available after the franchisor issues a disclosure document, but before the prospective franchisee signs a franchise agreement or any agreement relating to the franchise or pays any consideration to the franchisor or its associate in relation to the franchise, the franchisor must disclose the document or information to the prospective franchisee within a fresh disclosure document or a statement of material change.  This decision is particularly significant because it affirms that a statement of material change, a document originally intended solely for the disclosure of adverse material changes, may be used to disclose information or documents which did not exist, or were not available, at the time the disclosure document was delivered.


For questions about how these cases of consequence may impact your disclosure process, please contact a member of our Franchise Law group.  For Part One of our series, click here.

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[1] 2014 ONSC 2133 [Caffe Demetre].

[2] S.O. 2000, c. 3 [AWA].

[3] Section 1(1) of the AWA defines “material fact” as including “any information about the business, operations, capital or control of the franchisor or the 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”.

[4] Caffe Demetre, supra note 1 ¶ 26.

[5] Caffe Demetre, supra note 1 ¶ 41.

[6] 2014 ONSC 3442 [Springdale].

[7] 2014 ONSC 4370 [Delimark].

[8] Delimark, supra note 7 ¶ 37.