By Jordon Bond, Associate, Osler, Hoskin & Harcourt LLP

A recent decision from the Ontario Superior Court of Justice reviews the statutory franchisee-to-franchisee resale exemption, which relieves a franchisor from the obligation to provide a disclosure document to a prospective franchisee in the context of a sale of a franchise by a franchisee. In 1901709 Ontario Inc. et al. v. Dakin News Systems Inc., 2022 ONSC 6008 (“Dakin”), the plaintiff franchisee, 1901709 Ontario Inc. (the “Franchisee”), sought to rescind its franchise agreement on the basis that Dakin News Systems Inc. (the “Franchisor”) failed to provide a disclosure document pursuant to section 5 of the Arthur Wishart Act (Franchise Disclosure), 2000 (the “AWA”) when the Franchisee purchased the franchise from an existing franchisee. The Franchisor took the position that no disclosure was required due to the resale exemption set out in section 5(7) of the AWA, and submitted that the grant of the franchise to the Franchisee was not affected by or through the Franchisor.

The vendor, 8468168 Canada Inc. (the “Vendor”), operated an International News franchise in Toronto. The Vendor entered into an asset purchase agreement (the “Sale Agreement”) for the sale of the franchise to the Franchisee in November of 2013. The sale was conditional on the Franchisor’s approval of the Franchisee, and the landlord, Dakin West Inc. (“Dakin West”), an affiliate of the Franchisor, consenting to an assignment of the sublease.

As part of the approval process, the Franchisor imposed a six-step procedure on the Vendor, which included: (i) requesting a copy of the Sale Agreement; (ii) obtaining certain background information on the Franchisee, including a mortgage statement, current credit card balances, and a completed franchise application; (iii) requesting a certified document from the Vendor showing total gross sales for the last 12 months of the franchise; (iv) requiring the Franchisee to obtain a Bulk Sales Act clearance certificate from the Vendor; and (vi) requiring the Franchisee’s lawyer to retain a holdback on the purchase price to cover future rental adjustments pursuant to the sublease.

Additionally, the Franchisee was required to enter into a new franchise agreement and sublease. Finally, the Franchisee was required to pay a transfer fee of $1,000 and an initial inventory fee of $20,000. The court noted that this initial inventory fee was payable despite the purchase of existing inventory by the Franchisee from the Vendor, and the Vendor having previously paid to the Franchisor an initial inventory fee of the same amount.

The Franchisee started operating the franchise in March of 2014. In July of 2014, the Franchisor notified the Franchisee that the franchise system was rebranding, and the Franchisee would need to pay $75,000 as a result. The Franchisor advised the Franchisee that the refurbishment was a condition of the Franchisee renewing its agreements, despite the Vendor having already pre-paid the renewal fee. This seemed to sour the relationship and, in May of 2015, the Franchisee served its notice of rescission on the basis it had not received a disclosure document from the Franchisor prior to purchasing the franchise.

The AWA provides that a franchisor is not required to provide a disclosure document in the context of a grant of a franchise by a franchisee if, among other conditions, the grant is not effected by or through the franchisor. In this case, the court held that the Franchisor was unable to rely on the resale exemption because the Franchisor affected the grant of the franchise through its six-step approval procedure. Accordingly, the Franchisee was entitled to rescind the franchise agreement and claim damages of $85,100. The court acknowledged that the Franchisor made efforts to distance itself from the transaction by avoiding direct communication with the Franchisee during the sales process. However, the court ultimately determined that the transaction was in pith and substance the grant of a new franchise by the Franchisor to the Franchisee, as opposed to a genuine assignment by the Vendor to the Franchisee. The court noted that every aspect of the transfer was controlled by the Franchisor.

The court also considered whether there were any “franchisor’s associates” who would be held jointly and severally liable to the Franchisee under the AWA. The court held that the principal and sole indirect shareholder of both the Franchisor and Dakin West, Mr. Davis, was a franchisor’s associate. The court also found Dakin West, the sub-tenant with whom the Franchisee entered into a sublease, was also a franchisor’s associate. However, the court found that an employee involved in implementing the Franchisor’s approval process, Mr. Smagaren, was not a franchisor’s associate. The court stated that the legislation is not intended to capture employees of the franchisor. However, the court acknowledged that a different conclusion may have been reached had Mr. Smagaren been an independent contractor of the Franchisor instead of an employee.

Dakin underscores the importance of a franchisor taking a “hands-off” approach when relying on the resale exemption. While franchisors have the right to approve a proposed franchisee and collect a transfer fee, the more a franchisor becomes involved in structuring the terms of the transfer, the greater the risk that the franchisor will be taken outside of the resale exemption. Finally, the court in Dakin clarifies the scope of the definition of “franchisor’s associate” under the AWA by confirming employees are not captured but leaves the door open to imposing liability on a similarly situated independent contractor.