Potential Franchisors Beware: The Powerful Statutory Rescission Remedy

As a result of the existence of Ontario’s franchise legislation (the concisely named Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”)), franchisors and franchisees are subject to statutory rights and obligations that do not exist in most other commercial contexts. The franchisor’s obligation to provide disclosure, and the consequences of failing to do so, are chief among them.

The Act and the regulation thereunder sets out a robust inventory of documents and information that franchisors must deliver to prospective franchisees by way of a disclosure document.

While the particular disclosure obligations are cumbersome and onerous, it is imperative that franchisors get it right the first time as the Act provides a franchisee with the powerful remedy to rescind the franchise agreement if disclosure is not made properly. When a franchisee is able to effectively invoke the right of rescission it serves to unwind the relationship as if the parties never entered into it in the first place. As discussed below, this can have catastrophic consequences for the franchisor.

The rescission remedy involves problematic disclosure in connection with one of two types of documents. The first is a disclosure document and the other being a statement of material change. A disclosure document is provided by the franchisor to disclose material information about the franchise, while a statement of material change discloses a change in the franchise system that may reasonably be expected to have a significant adverse effect on the price of the franchise.

A franchisee can rescind the franchise relationship in three situations: late disclosure, insufficient disclosure, or no disclosure at all.

Late Disclosure

A disclosure document must be provided to a prospective franchisee at least 14 days before whichever of the following occurs first:

• The prospective franchisee signs the franchise agreement or any other related agreements (excluding confidentiality agreements, non-disclosure agreements, and location selection agreements); or
• The prospective franchisee pays any amount to the franchisor or franchisor’s associate for the franchise (excluding a fully refundable deposit).

If there are any material changes, a franchisor must disclose the material changes before the earlier of the two events described above.

If a disclosure document is not provided at least 14 days before the earlier of these two events, or if a statement of material change is not provided by the earlier of these two events, a franchisee can rescind the franchise agreement within 60 days of receiving the disclosure document.

Insufficient Disclosure

A franchisee can also rescind a franchise agreement if the disclosure document is insufficient. A disclosure document will be deemed to be insufficient if it does not contain:

• All material facts;
• Financial statements;
• Copies of all proposed franchise agreements and other agreements to be signed by the prospective franchisee;
• Statements that assist the prospective franchisee in making an informed investment decision; and
• Other documents or statements set out in the Act’s regulations.

If a disclosure document lacks these requirements, a franchisee can rescind the franchise agreement within 60 days of receiving the disclosure document.

No Disclosure

If a franchisee was not provided with a disclosure document they can rescind the franchise relationship within two years of entering into the franchise agreement.

However, just because a document purports to be a disclosure document does not mean that it constitutes proper disclosure. For example, disclosure documents with the following deficiencies have been held by the courts to be no disclosure at all:

• No certificate of disclosure certifying that the document included every material fact and financial statement and contained nothing that was untrue;
• No audited financial statements;
• Incomplete collection of proposed franchise agreements and other agreements to be signed by the prospective franchisee; and
• The franchisor delivered parts of the disclosure document at different times.

The issue of whether deficiencies in the disclosure document fall under “insufficient disclosure” versus “no disclosure” must be determined on a case-by-case basis, with a view of all relevant circumstances relating to whether the franchisee can make a properly informed decision about whether or not to invest.

Financial Consequences of Recission

The purpose of the rescission remedy is to restore a franchisee to the position it was in before the franchisee agreement was entered into. Within 60 days of rescission of a franchise agreement, a franchisor must:

• Refund any money received from the franchisee (other than money for inventory, supplies, or equipment);
• Purchase any remaining inventory from the franchisee at a price equal to the purchase price paid by the franchisee;
• Purchase any supplies and equipment from the franchisee at a price equal to the purchase price paid by the franchisee; and
• Compensate the franchisee for any other losses that the franchisee incurred.

Clearly, the consequences of failing to comply with the Act’s disclosure requirements can be devastating for franchisors. Oftentimes when the franchisee is not doing well economically for reasons completely unrelated to the franchise system, a franchisee will look back to the disclosure it was provided at the outset and, where possible, utilize improper disclosure as a means to exit the relationship despite the fact that the franchisee would have entered into the relationship at the time in question in any event even if it had been provided with proper disclosure at the outset.

The rescission remedy is an incredibly powerful one that was given to franchisees to balance out the historical imbalance in bargaining power between franchisors and potential franchisees. It is therefore critical that franchisors understand and comply with the Act’s disclosure requirements fully, lest they be left holding the bag  up to two years later.