By Paul Gemmink
One of the major concerns for a potential buyer of an existing franchise is whether or not all of the information provided by the franchisee is correct. Some franchisors have been reluctant to make any comment to a potential buyer about the sales by the existing franchisee, the related costs or the market, since doing so would open it to claims by the purchaser.
Recently, however, the Ontario Court of Appeal released a decision that is likely to provide additional strength to buyers of existing franchises in that province when they attempt to obtain information from franchisors.
The decision should also motivate franchisors to strongly consider becoming more actively involved in the entire franchise resale process. Such franchisor involvement can only be of benefit to potential purchasers of existing franchises.
In the decision, the court of appeal agreed with a lower court judge who had ruled a franchisee was able to (a) terminate its franchise agreement a few months after it purchased the corresponding franchise from the former franchisee and (b) sue the franchisor for its losses.
The court of appeal agreed with these two actions because (a) the business had turned out not to be what the old franchisee had said it was and (b) the franchisor was sufficiently involved in the transaction that it should have provided a disclosure statement for the new purchaser, but it had not done so.
The Arthur Wishart Act (Franchise Disclosure), 2000 (“the Act”) is the Ontario legislation that deals with the duty of fair dealing between parties to a franchise agreement. Subject to some exemptions, one of which is the ‘resale exemption’ that was raised by the franchisor in this case, the Act requires a franchisor to provide a disclosure document to a prospective franchisee and, if material changes are made before the franchise agreement is signed, a statement of material change.
These documents are to be provided not less than 14 days before the earlier of (a) the prospective franchisee signing the franchise agreement or (b) the prospective franchisee paying the franchisor and thus purchasing the franchise.
Within certain time periods, a franchisee can terminate the agreement without penalty or obligation and can sue the franchisor for losses if that franchisor failed to provide the disclosure statement—at all or within the proper time frame—or if the disclosure statement did not set out everything required under the Act.
The need for disclosure
In its decision, the court of appeal agreed the franchisee had the right to terminate the franchise agreement and to start the lawsuit against the franchisor, even though the franchisor had not provided the disclosure agreement because, with the resale exemption, it felt it did not need to. The exemption in question states the franchisor does not need to provide a disclosure document if “the grant of the franchise is not effected by or through the franchisor.” Indeed, many franchisors do not provide disclosure to purchasers based on the resale exemption.
As stated by the judge in the case, the franchisor’s argument was that:
“. . . in the context of a primary franchise sale, the franchisee must place heavy reliance on the disclosure document provided by the franchisor to assess the potential financial viability of the franchise. On the other hand, the prospective franchisee in a franchise resale market is better positioned to make an informed decision concerning whether to invest in a franchise. The prospective franchisee in this second scenario has the opportunity to observe the franchisee as a business, discuss the business with the incumbent franchisee and review business records.”
Essentially, the position taken by the franchisor was that if the business was not as good as the old franchisee said it was, the new franchisee could not therefore terminate the franchise agreement; and the new franchisee’s claim for damages would be restricted to one against the old franchisee, even though the franchisor had not provided a disclosure document on the resale.
While the judge agreed with the basic premise of the franchisor’s argument, he ruled that the Act limits the role a franchisor may play in a resale to rely on the exemption and avoid its obligation to provide a disclosure document. He ruled there were substantial limitations on the meaning of the phrase, “the grant of the franchise is not effected by or through the franchisor.”
Specifically, the major problems for the franchisor were:
- the amount of involvement it had in the transaction;
- its knowledge of the finances of the franchise; and
- its requirement of the franchisee to sign two new documents in addition to the existing franchise agreement.