It’s common practice in Canada to enter into a franchise agreement before determining the location of the franchise – the franchisor and franchisee typically agree that the franchisor will use “best efforts” to find a suitable location for the business, often with the franchisee’s input and participation. Once the location is determined, it is common for the franchisor (or an associated entity) to enter into a head lease for the premises and sublease to the franchisee, which provides the franchisor with, among other things, the ability to step into the premises and take over the business if necessary.
In a recent decision with wide-ranging implications across Canada, the Ontario Superior Court has all but foreclosed this practice. In Raibex Canada Ltd. v. ASWR Franchising Corp., (2016 ONSC 5575) the court held that the franchisor failed to meet the disclosure requirements in the Arthur Wishart Act (Franchise Disclosure), (2000, S.O. 2000, c. 3) because the location of the business, and therefore the terms of the head lease, were not known and therefore could not be disclosed.
Often, franchisors do not want to take on the obligations of a head lease without having a franchisee lined up to assume those obligations. Under the court’s reasoning in Raibex, the franchisor’s statutory disclosure obligations will not be met unless it is in a position to disclose a materially complete and materially accurate form of sublease, including the provisions said to be incorporated from the head lease. Franchisors may therefore find themselves in a tough spot when negotiating head leases.
In September 2012, the defendant franchisor in Raibex provided the principal of a prospective franchisee with a Franchise Disclosure Document for an AllStar Wings and Ribs franchise in Mississauga, Ontario. The location of the franchise had not yet been determined, and so no head lease was included in the disclosure document. A draft sublease was included in the disclosure that provided that the franchisee accept all the terms, covenants, conditions and obligations in the head lease as negotiated by the franchisor and the landlord.
The Franchise Agreement was executed in November 2012. The location of the franchise – an existing restaurant space to be converted to an AllStar Wings and Ribs franchise – was determined by June 2013, and the franchisor’s development entity negotiated a head lease with the landlord. The head lease included a term requiring prepayment of five months’ rent, to be released one month per year for the first five years, together with a security deposit, for a total amount due of $120,000. Though not a party to the head lease, the franchisee “participated to some degree” in the negotiation of the head lease and was aware of the prepayment requirement. The head lease was dated September 19, 2013, and the sublease was signed October 23, 2013, though the court found that the franchisee did not receive a copy of the executed head lease until after the sublease had been executed.
The franchise opened in March 2014. In July 2014, the lessor invoiced the franchisee for the prepayment amount due under the head lease and outstanding construction costs. The franchisee refused to pay, and on July 25, 2014, served notice of rescission of the franchise agreement.
The franchisee claimed that the franchisor’s disclosure was deficient; the franchisor argued that it was impossible to disclose a head lease that did not yet exist.
The court found the franchisee was entitled to rescind the franchise agreement because the terms of the lease – comprised of both the head lease and the sublease – were critical components of franchise disclosure, and found as follows:
The focus of the AWA is on protecting the interests of franchisees. The mechanism for doing so is the imposition of rigorous disclosure requirements on franchisors and strict penalties for noncompliance. If a franchisor can make disclosure at a premature state and avoid those rigorous disclosure requirements, the purpose of the legislation is defeated.
If it is simply impossible to make proper disclosure because material facts are not yet known, then the franchisor is not yet ready to deliver the statutorily required disclosure document. The franchisor must wait – it does not get excused from its statutory obligations.
The court found it was immaterial that the franchisee knew no location had been selected at the time of disclosure, and participated in the selection of the location and the negotiation of the head lease, as the franchisee cannot waive the disclosure requirements of the AWA. If the disclosure document is materially inadequate, then statutory requirements simply have not been met.
The court also found that the franchisor’s disclosure of the potential franchisee’s costs was materially inadequate. The franchisor disclosed an “Estimate of Development Costs” in the disclosure document based on development from a “shell” premises, not the conversion of an existing restaurant space. The franchisor disclosed that the cost of converting an existing space may be significantly lower, but that the franchisor had “no reasonable means of estimating or predicting these costs with any certainty” and that costs could “vary dramatically from location to location.” The court found that this “broad disclaimer” was essentially an admission that the costs disclosure obligation in the AWA could not be met and held “[a]gain, if a location had been determined, these broad caveats based upon costs being “highly site-specific” would be unnecessary and proper disclosure would be made.”
The court found that these defects in disclosure were “egregious” and amounted to no disclosure at all. The franchisee was therefore entitled to rescind the franchise agreement.
The decision may be applied in any jurisdiction with similar statutory provisions. The B.C. Franchises Act is expected to be brought into force in early 2017.