Franchise Legal: Deal-Making and Franchise Disclosure Law

By Mike Melvin | Originally published in the Spring 2019 issue of The Franchise Voice

Franchise deal-making and franchise disclosure often do not fit neatly together. A proposed franchise deal may go through several iterations before it closes and the final deal may look quite different than the deal that was initially proposed. There may be changes to the scope of the deal, changes in the composition of a proposed franchisee investor group, amendments to the franchise agreement and other standard documents, preparation of new non-standard agreements and new information may come to light that was not available at the time the franchisor’s disclosure document was given.

To the extent that these and other developments give rise to “material facts” or “material changes” within the meaning of provincial franchise legislation, they must be properly disclosed in order to limit the franchisor’s risk of a statutory rescission claim. This article is intended to provide a basic primer for franchisors in spotting material information as it arises and in properly disclosing it.

Presumably, most franchisors are familiar with the basic disclosure requirements in the six provinces that currently have franchise legislation (i.e., NB, PE, ON, MB, AB and BC). In each of these provinces, the franchisor must deliver a franchise disclosure document to the prospective franchisee not less that 14 days before any money changes hands or any agreements are signed.[1] If, after delivery of the franchise disclosure document, but before the deal closes, one or more “material changes” occur, the franchisor is required to deliver a written statement of material change to update the disclosure document as soon as practicable after the change occurs. Understanding this updating process is crucial in order to ensure that deal-related changes are properly disclosed.

As its name indicates, a statement of material change is properly used to disclose “material changes”. A “material change” is defined in virtually identical terms in the provincial franchise statutes of all six franchise-regulating provinces. Two elements of the “material change” definition are especially relevant when determining the correct means of updating disclosure: (1) material changes relate only to changes; and (2) material changes are changes that “would reasonably be expected to have a significant adverse effect on the value or price of the franchise to be granted or on the decision to acquire the franchise”. On a plain language reading of the definition, material information that was known at the time the franchise disclosure document was given but which was, for whatever reason, omitted from the disclosure document, does not meet the definition of a “material change” because it is not a “change”. In the author’s view, the prudent course of action in dealing with such disclosure deficiencies is for the franchisor to issue a replacement franchise disclosure document, rather than statement of material change.

While some changes will clearly be adverse, others will have no discernable adverse aspect and some will have a mixed character, i.e., they will be adverse, or potentially adverse, in some, but not necessarily all, respects. Thus the question arises whether all changes that arise in the course of negotiating a deal are “material changes” that may be properly disclosed in a statement of material change.

As of the date of writing, the law on this point is not entirely settled and different franchise lawyers may reasonably hold different views on this question. However, at least one court has indicated that statements of material change can be used to disclose changes of a mixed (i.e., not solely adverse) character. In the case of 2337310 Ontario Inc. v. 2264145 Ontario Inc., 2014 CarswellOnt 10076, 2014 ONSC 4370, 243 A.C.W.S. (3d) 333 (“DeliMark”), the Ontario Superior Court of Justice considered a scenario in which the head lease and related sublease for the franchisee’s premises were not in existence at the time the initial franchise disclosure document was delivered, but became available prior to the franchise deal closing. The franchisor argued that it could not have been expected to disclose information that was not known at the time the franchise disclosure document was delivered. The Court stated at paragraph 39 of its decision:

“In my view, the correct approach…is to impose upon the franchisor an obligation to provide an updated disclosure statement (or, at the very least, a written statement of material change) when additional material information or documents become available or come into existence.”

While this statement was not integral to the Court’s ruling in that case, and therefore it is not considered to be binding precedent, it suggests that courts will accept that disclosure has been properly updated via statement of material change, even where the relevant information is not of a solely adverse character.

Taking the above discussion into account, the sample fact pattern below illustrates some common deal-related developments that necessitate additional disclosure and the application of the franchise updating principles discussed above.

Fact Pattern:

A franchisor proposes to enter into a franchise agreement with a new franchisee. The terms of the proposed franchise agreement require that any shareholder owning more than 10% of the shares in the franchise must sign the franchise agreement as a guarantor. In preparation for closing the deal, the franchisor delivers a disclosure document before any location or lease has been secured and before the territory has been determined. Although the disclosure document does not include information regarding the lease or territory, it is otherwise compliant. After the disclosure document is given, but before deal closes;

  1. landlord and franchisor finalize a lease for the franchisee to sign as tenant;

 

  1. parties agree on boundaries of the territory;

 

  1. After persistent requests, and worries that the franchisee is getting cold feet, franchisor has its accountant prepare a pro forma financial statement for the franchisee, based on the financial results of its corporate stores for the last three fiscal years; and

 

  1. the principal of the franchisee advises the franchisor that his father-in-law will provide some of the financing for the deal and will be a “silent” investor in the new franchise, holding 49% of the shares in the franchisee corporation.

 

The following are the author’s recommended approaches to updating disclosure in response to the above-noted developments (the number of each solution is the same as the number of the corresponding problem above):

 

  1. A copy of the lease and a summary of the material lease terms should be disclosed to the franchisee via a statement of material change. While the case law regarding lease disclosure has developed with respect to head lease and sublease arrangements [2], it the author’s view that the same disclosure obligation will be applicable in cases where the franchisor negotiates a lease for the franchisee to sign directly with the landlord. In such cases, the franchisor still has both an informational advantage over the franchisee and a highly material influence over the final lease terms, as it does when it negotiates a head lease.

 

  1. The description of the territory should be disclosed to the franchisee via a statement of material change. Disclosure of a description of the territory is mandatory in Ontario and Alberta[3]. In contrast, a description of the territory is not mandatory in Prince Edward Island.[4] In New Brunswick, Manitoba and British Columbia the franchisor may satisfy its disclosure obligations regarding territory by disclosing “the manner in which and the person by whom the exclusive territory [or, in BC, the franchisees’ rights to the territory] will be determined”.[5] Notwithstanding that disclosing a territory description is not mandatory in PE, NB, MB or BC, the author’s view is that if the boundaries of the territory become known before a deal in these provinces closes, it is prudent to disclose a description of the territory in a statement of material change.

 

  1. The new pro forma should be disclosed via a statement of material change. The pro forma is an “earnings projection” (“earnings claim” in Alberta) and/or an “estimate of operating costs” under franchise legislation. Accordingly, when it discloses the pro forma, the franchisor must be certain to include all of the substantiating information that is required to accompany an earnings projection or estimate of operating costs by the regulations under provincial franchise legislation. The required substantiating information varies from province to province, in some cases materially. Failing to include all of the required substantiating information has been held in several cases to be a “material deficiency” in disclosure.[6]

 

  1. An updated franchise disclosure document must be provided to the franchisee principal’s father-in-law. Even if he will not be actively involved in the operation of the franchise, the terms of the agreement require that, as a 49% shareholder, he is required to sign the franchise agreement as a guarantor. This signing requirement makes him a “prospective franchisee” within the meaning of franchise legislation and triggers a disclosure obligation, as reflected in the case law[7].

 

The examples above illustrate only a small sample of the sorts of issues that may arise in the course of franchise deal-making. Far more complicated developments, and corresponding disclosure problems, are possible. However, it is hoped that the background discussion and examples provided will help to better attune franchisors to the sorts of deal-related information that require additional disclosure. As always, franchisors are strongly advised to consult with experienced franchise counsel in determining when and how to update disclosure.

 

ABOUT THE AUTHOR
Mike Melvin is a corporate-commercial law partner in the Fredericton office of McInnes Cooper. His primary practice areas are franchise, trademark and technology law. Mike is recognized as a leading lawyer in the area of franchise law in The Canadian Legal Lexpert® Directory and as a leader in his field in the Chambers Canada 2018 Guide. Mike is an active member of the Canadian Franchise Association’s Legal and Legislative Affairs Committee and frequently writes and speaks on legal matters affecting franchising.

[1] In NB, PE, MB, AB and BC it is permissible to enter into a certain type of confidentiality agreement or a site selection agreement before disclosure has been given. Moreover, in MB, AB and BC it is permissible for the franchisor to accept a fully-refundable deposit before disclosure has been given, provided the deposit is subject to certain prescribed conditions. Amendments to the Arthur Wishart Act (Franchise Disclosure), 2000, SO 2000, c 3, allowing for such pre-disclosure agreements and deposits in Ontario have been passed but, as of the date of writing, not yet proclaimed in force.

[2] See 6792341 Canada Inc. v. Dollar It Ltd., 2009 ONCA 385, 2009 CarswellOnt 385; 2337310 Ontario Inc. v. 2264145 Ontario Inc., 2014 ONSC 4370, 2014 CarswellOnt 10076; 2122994 Ontario Inc. v. Lettieri, 2016 ONSC 6209, 2016 CarswellOnt 15839; and Raibex Canada Ltd. v. ASWR Franchising Corp., 2018 ONCA 62, 2018 CarswellOnt 694, reversing 2016 ONSC 5575, 2016 CarswellOnt 14638.

[3] O. Reg 581/00 – General, Part II, s. 12; Alberta Regulation 240/1995 – Franchises Regulation, Schedule 1, s. 18.

[4] See Franchises Act Regulations, Schedule 1, Part 3, s. 11.

[5] See Disclosure Document Regulation, NB Reg 2010-92, Schedule A, Part 3, s. 12(1)(a); Franchises Regulation, Man Reg 29/2012, Schedule A, Part 2, s. 18(1)(a); and Franchises Regulation, BC Reg 238/2016, Schedule – Disclosure Document Requirements, Part 1, s. 18(1)(a)(i).

[6] See Sovereignty Investment Holdings Inc. v. 9127-6907 Quebec Inc., 2008 CarswellOnt 6547 (SCJ); Essa v Mediterranean Franchise Inc., 2016 ABQB 178; Apblouin Imports Ltd. v. Global Diaper Services Inc., 2013 ONSC 2592, 2013 CarswellOnt 5190; and Giroux et al. v. 1073355 Ont. Ltd. et al, 2018 ONSC 143, 2018 CarswellOnt 44; see also 2212886 Ontario Inc. v. Obsidian Group Inc., 2017 ONSC 1643, 2017 CarswellOnt 4130, which, although reversed on procedural/evidentiary grounds on appeal in 2018 ONCA 670, 2018 CarswellOnt 12272, also supports the proposition that failure to properly disclose and substantiate earnings projections is a fatal disclosure flaw.

[7] Walden v. 887985 Alberta Ltd., [2005] OJ. No. 257, 2005 CarswellOnt 251 (ONSC); See also 1518628 Ontario Inc. v. Tutor Time Learning Centres LLC, [2006] OJ No. 3011, 2006 CarswellOnt 4593 (ONSC) and Essa v Mediterranean Franchise Inc., supra, note 6.

Disclaimer
The opinions or viewpoints expressed herein do not necessarily reflect those of the Canadian Franchise Association (CFA). Where materials and content were prepared by persons and/or entities other than the CFA, the said other persons and/or entities are solely responsible for their content. The information provided herein is intended only as general information that may or may not reflect the most current developments. The mention of particular companies or individuals does not represent an endorsement by the CFA. Information on legal matters should not be construed as legal advice. Although professionals may prepare these materials or be quoted in them, this information should not be used as a substitute for professional services. If legal or other professional advice is required, the services of a professional should be sought.