Advice & TipsAsk an ExpertJuly/August 2021

Q. As a franchisee, what should I have in my legal tool kit before embarking on a new franchise opportunity?

A: Most franchisees get a crash course in franchise law as a fringe benefit of purchasing a franchise.  Counsel will gleefully dissect the franchise disclosure document (FDD), advise on the finer elements of the franchise agreement, and pontificate on the meaning of “material facts,” the duty of good faith, and the right of rescission. Here, I will dive deeper and provide franchisees with a useful tool kit of core principles that govern the relationship between franchisors and franchisees.

Is it a franchise?

Promoters will go to great lengths to assert that their business is not a franchise in order to avoid the costs of franchise compliance and issuing FDDs. However, any business which, under a written agreement, grants a person the right to conduct a business, using the other person’s trademark, and in which the other person exercises significant control over the business or provides significant assistance, is a franchise. Substance trumps form, and the courts will find a franchise if these elements exist.

Piecemeal disclosure is no disclosure

An FDD must be delivered in one document, at one time. For example, franchisors cannot provide pro forma income statements in one meeting, the franchise agreement in another, and then the investment costs in another, even if the prospective franchisee receives, in the aggregate, all information required by law.

Strike one, you’re out

A franchisor’s failure to disclose in its FDD financial statements from the most recently completed fiscal year in audited or review engagement format (subject to a 180-day grace period), is fatal to the FDD and can entitle a franchisee to a two-year rescission period commencing on the date of the franchise agreement. Notice to reader and internally prepared financial statements are a critical deficiency.    Failure of a franchisor to have two of its officers and directors sign and date the FDD certificate (unless there is only one officer and director) is also a critical deficiency which will invalidate the FDD and open the two-year rescission window.

No ‘cookie-cutter’ FDDs

Franchisors can no longer issue “generic,” one-size-fits-all FDDs. These must be tailored to the specific opportunity. Costs must reflect the format (new build, turnkey, conversion, kiosk, etc.), and the franchisor must disclose site information, revenue information, and, if it is a head tenant, lease information pertinent to the site. Failure to do so can result in a deficient FDD. Franchisors can, however, supplement the original, properly prepared FDD with statements of material change to disclose new information (such as a head lease, sublease, and costs) arising after the original FDD is provided.

RELATED: What to Have in Your Franchisee Legal Tool Kit (VIDEO)

Keep the faith

Franchisors owe franchisees a duty of good faith and fair dealing in the performance and enforcement of the franchise agreement. In exercising discretion, a franchisor must consider the franchisee’s interests, but is not required to put those ahead of the franchise as a whole. Franchisors must act in good faith, absent ulterior motive, and in a commercially reasonable manner.

Please release me  

Franchisees cannot be asked to contract out of, or release a franchisor, from its statutory obligations.  The law protects franchisees by invalidating any purported waiver or release by a franchisee of these rights. For example, an agreement by a franchisee to waive a franchisor’s disclosure obligations, or release the franchisor from any rescission claim, is invalid. The exception to this rule is where a franchisee agrees to release known statutory claims against the franchisor (e.g., a rescission claim), for valuable consideration, and with the oversight of lawyers.

(No) right of renewal

Once the term and all renewal terms in a franchise agreement have expired, the franchisor has no implied, or good faith obligation, to renew the agreement. The courts will not read into a contract terms that do not exist. Franchisees must ensure that their agreement contains meaningful renewal rights in their favour or risk losing the right to continue to operate their franchise.

Ch, ch, changin’   

Franchises are constantly evolving, and franchisors must often make key changes to their business model. Franchisors must consider whether (i) such changes are permitted under the agreement; (ii) the changes would be so impactful as to undermine the benefit of the contract; and (iii) the imposition of the changes breaches the duty of good faith. The courts have reviewed this question and while a franchisor must consider the best interests of the system as a whole, it is not required to guarantee any benefit or level of profit to its franchisees when making system changes in good faith for legitimate business reasons.

To compete, or not to compete  

Non-competition covenants are often unenforceable as being in restraint of trade and contrary to the public interest. The party enforcing the clause must justify that it is reasonable in time and scope, and protects a valid business interest. Restrictive covenants that are vaguely drafted, are overly broad in scope, or contain material errors, will be voided by the courts. And, if the franchisor does not have a legitimate business interest to protect in the restricted territory (including the lack of any intention to expand their business to that territory), the courts may strike the clause as unenforceable.

Richard Leblanc  
Miller Thomson LLP