Business Law Notes

FANCHISE DISCLOSURE: TOP 10 MISTAKES

  ()

The following is part of a series of short articles to assist individuals and companies who are contemplating franchising their business.

The Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”) requires franchisors to provide a disclosure document to any potential franchisee at least 14 days before any monies are paid or any agreements are assigned in respect of the franchise. The purpose of disclosure is to have the franchise candidate make an informed decision as to whether or not to invest in the franchise by having all material information presented to him or her beforehand. On the face of it, this sounds simple enough. However, when you consider that any errors in disclosure may lead to a right of the franchisee to cancel the agreement and obtain a refund of all monies invested, or a lawsuit personally against any of the principals of the franchisor who sign the disclosure document, extra care is required to ensure accuracy and compliance with the Act and its regulations. Based on our experiences, the following are some of the common errors committed by franchisors in preparing a disclosure document and in meeting their obligations under the Act.

  1. Deposit & Confidentiality Agreements
    The former practices of most franchisors to have franchise candidates sign a confidentiality agreement and pay a deposit at the outset of the application process is no longer permissible. “Franchise agreement” is broadly defined under the Act as “any” agreement that relates to a franchise. Therefore, a confidentiality agreement may be captured within this definition, and delivery of a disclosure document and expiry of the 14-day period would be necessary before its execution.
  2. Incomplete Disclosure
    The Act requires that the disclosure document contain “all” materials facts, which, in turn, is defined as any information about the business, the franchisor, or the franchise system that may reasonably be expected to effect the price of the franchise or the decision to acquire it. Although the regulations to the Act set out certain information that must be disclosed by the franchisor, compliance by the franchisor with the regulations alone may not be enough to meet the requirement of disclosure of “all” material facts. For example, if the franchisor has knowledge that a competitor will open a competing location in close proximity to the franchise, it should disclose this fact even if such disclosure is specifically not required under the regulations.
  3. Inaccurate Information regarding Directors & Officers
    The disclosure document focuses not only on the franchisor and the franchise system, but also upon its directors and officers. Accordingly, it is a requirement under the regulations that the disclosure document include a brief description of the prior relevant business experience of these individuals, as well as their involvement in any findings of a court for fraud, misrepresentation, unfair or deceptive business practices, or a violation of any law that regulates franchises. The franchisor must also disclose if a director or officer was involved in any bankruptcy or insolvency proceedings either personally or when he or she was a director or officer of a corporation. It would therefore be prudent of a franchisor to make the necessary inquiries of its directors and officers to obtain written confirmation of these matters.
  4. Improper Financial Statements
    Whether the franchisor is a public or private company, it must include a copy of its financial statements with its disclosure document. To comply with the Act, the statements must also be either audited or prepared with the review and reporting standards applicable to review engagements set out in the Canadian Institute of Chartered Accountants Handbook. This may, in turn, require franchisors to change the accounting standards by which financial statements may have been previously prepared. If statements for the recently completed fiscal year have not yet been prepared, the franchisor may include statements from the previous fiscal year but only if 6 months has not passed from its fiscal year end.
  5. Underestimated Development Costs
    While a franchisor may be tempted to intentionally state lower estimated costs to establish the franchise and to make it more attractive to potential franchisees, doing so may expose itself to a claim for misrepresentation from a franchisee if such estimates have no basis in reality. Given the franchisor’s expertise in developing and managing its concept, a franchise candidate will likely be relying upon the franchisor to prepare its business plan and budget. Any estimate of these costs should take into account, as much as possible, any foreseeable contingencies that may arise and if necessary, state the estimated costs as a range as opposed to a fixed number.
  6. Unintended Earnings Projection
    Most franchisors may be loathed to provide any earnings projections to potential franchisees for fear of litigation if the franchisee does not achieve these projections. That being said, a franchisor who does not wish to make such projections must be careful not to indirectly or unintentionally make these claims when describing the advertising fund in the disclosure document. If the franchisor maintains an advertising fund, the regulations to the Act require the franchisor to state the “projected amount of the contribution” to the fund. By doing so, however, it is simply a mathematical exercise to calculate the franchisor’s projected revenues on average for each location. To the extent that the franchisor does not make earnings projections, it is better off to state that it cannot project the contribution to the fund since it is a function of revenues for each franchise which are beyond its control.
  7. Incomplete List of Former Franchisees
    While most franchisors properly list information of former franchisees in Ontario who may have been terminated or not renewed on expiration, they often forget to list franchisees who may have sold their franchise and are no longer in the system. Franchisors must ensure that these former franchises are also included in the list of former franchises.
  8. Improper Delivery of Disclosure
    The Act requires that the disclosure document be delivered personally or by registered mail to the franchise candidate. With the advances in electronic commerce, some franchisors have taken the liberty of delivering these documents electronically by way of email. Although this may certainly be the wave of the future in franchising, the Act and its regulations do not currently permit the delivery of disclosure documents in this manner and a franchisor should continue to deliver hard copy versions of the disclosure until the legislation is amended to permit these other forms of delivery.
  9. No Proof of Delivery
    Considering how critical timing of delivery is to the franchisor’s compliance with the Act, it is surprising that some franchisors do not obtain written confirmation from its franchise candidate regarding the date that the disclosure document was received. General practice should be that the franchisee candidate’s corporation (if known) and all of the individuals expected to execute the franchise agreement should sign an acknowledgment confirming the date of receipt of the disclosure.
  10. Changes to Documents Not Reflected in Disclosure
    There is an ongoing debate within the franchise community whether a franchisor has to disclose any changes to the documents which are insisted on by a candidate. Obviously, the franchisee would have notice of these changes having made the request for them. However, to the extent that the franchisor is making a further change to the agreements as a result of a change granted to the franchisee, it may be interpreted that the franchisee does not have notice of this change and a statement of material change would be required setting out these changes.

Conclusion
Ensuring that the disclosure document is accurate and complies with the Act is critical to defending any purported claim by a disgruntled franchisee. Successfully defending these claims also means not having to list them in future disclosure documents causing further embarrassment.

Editors: 416-368-0582
416-368-0491

Updated: November, 2006