Ontario Court Considers Franchise Disclosure Obligations When Right of First Refusal is Triggered

A recent decision of the Superior Court of Justice, 3574423 Canada Inc. v. Baton Rouge Restaurants Inc., provides guidance on statutory disclosure obligations in situations when the right of first refusal (ROFR) over a new location is triggered. Two lessons emerge from this decision:  

  1. The statutory remedies for deficient disclosure under the Arthur Wishart Act (Act) are only available to prospective franchisees that actually go through with the transaction and sign an agreement relating to the franchise.  An existing franchisee with a right of first refusal must actually exercise that right and sign an agreement in respect of the new location to claim statutory remedies for disclosure deficiencies relating to the deal.  
  2. The additional franchise exemption in the Act, which exempts franchisors from disclosure obligations to existing franchisees who acquire a second location, can apply even where the second location is of a different size than the original franchise and is located in a different type of market area. In this decision, the size of the exclusive territory was not regarded as a difference affecting the operational and financial relationship between the franchisee and franchisor.

Background Facts

This dispute arose when an existing franchisee was presented with the opportunity to acquire a second franchise from its franchisor.

In 1999, the franchisee opened the first franchise in a large metropolitan market. As part of the franchise agreement, the franchisee enjoyed a right of first refusal over a second franchise location in the market area and the area directly surrounding it.

In 2000, the franchisor made available to the franchisee the opportunity to acquire a second restaurant in a suburban market north of the city. At the time, the disclosure requirements under the Act had not yet come into force. The franchisee expressed interest in acquiring the new franchise; however, due to the landlord’s inability to obtain certain approvals and permits, the opportunity lapsed.

Two other restaurants opened in the area surrounding the metropolitan market in 2000. On both occasions, the franchisor notified the franchisee of the opportunity in accordance with the ROFR and each time, the franchisee declined. The franchisor also had the franchisee sign a waiver on both occasions that amended the franchise agreement to preserve the ROFR for the franchisee to use in the event that a subsequent opportunity presented itself.

In 2001, after the disclosure requirements of the Act came into force, the initial 2000 opportunity resurfaced in the north suburban market and was presented to the franchisee. After due consideration, the franchisee drafted, signed and sent a waiver to the franchisor indicating it was passing on the opportunity, without prejudice to its ROFR for the next available opportunity. The franchisor wrote back, acknowledging that the franchisee had declined the opportunity but advising that there would be no further extension of the ROFR. The north suburban location was later acquired by another party.

A dispute later arose, with the franchisee alleging, among other things, that the franchisor made oral representations to the effect that it would continue to enjoy the ROFR. The franchisee commenced an action against the franchisor alleging inter alia, a breach of the disclosure obligations under the Act, which it asserted arose when the north suburban opportunity was presented for the second time in 2001.

The franchisee made a number of other arguments, as well. However, this comment will focus on the statutory disclosure component of the case.

Triggering Liability for Inadequate Disclosure

Although the franchisee operated an existing franchise in 2001, it asserted that it was a "prospective franchisee" in relation to a new franchise in the north suburban market under the Act.

Section 5(1) of the Act imposes an obligation on franchisors to deliver a disclosure document to a "prospective franchisee," "not less than 14 days before the earlier of: (a) the signing by the prospective franchisee of the franchise agreement or any other agreement relating to the franchise; and (b) the payment of any consideration by or on behalf of the prospective franchisee to the franchisor or franchisor’s associate relating to the franchise."

The franchisee argued that the signed written document waiving its right of first refusal, in conjunction with the alleged oral representations regarding a future right of first refusal, had the legal effect of "amending" the original franchise agreement between the two parties such that the franchisee continued to enjoy its ROFR over the next franchise location in the Greater Toronto Area. On that basis, the franchisee took the position that it had signed an "agreement relating to the franchise" within the meaning of section 5(1) and thus had the right to a disclosure document.

The Court disagreed. While the disclosure obligations under section 5 are owed to "prospective franchisees," the Court held that the remedies found in sections 6 and 7 are only available once a prospective franchisee changes its legal position and becomes a franchisee. The Court made clear that "liability only attaches to inadequate disclosure if a prospective franchisee becomes a franchisee by signing the franchise agreement or any other agreement relating to the franchise."

The Meaning of "Any Other Agreement Relating to the Franchise" in section 5(1)(a)

The Court went on to clarify the meaning of the phrase "any other agreement relating to the franchise" in section 5(1)(a). According to the Court, that phrase refers to an agreement between the franchisor and an actual franchisee. If the prospective franchisee does not become a franchisee, there can be no agreement relating to the franchise. Moreover, an agreement relating to the franchise refers to ancillary documents signed by the franchisee such as an indemnity agreement, a general security agreement or a sub-lease.

Of course, prudent franchisors should always comply with section 5 disclosure requirements when dealing with prospective franchisees. There is no reason for a franchisor to expose itself to the risk of the Act's extraordinary remedies in the event the prospective franchisee becomes a franchisee.

First Judicial Consideration of the "Additional Franchise" Exemption in section 5(7)(c)

Although it was not necessary for the determination of the claim, the Court analyzed the "additional franchise" exemption in section 5(7)(c) of the Act. This case is the first case where this exemption has been judicially considered.

The "additional franchise" exemption relieves a franchisor from its obligation to deliver a disclosure document under section 5 when: (i) the additional franchise is substantially the same as the existing franchise; and (ii) there has been no material change since the existing franchise agreement was struck or the latest renewal or extension was effected.

There was no material change in the operation of the franchise system since the franchisee’s entrance and, therefore, the section 5(7)(c) exemption would have applied in the event the north market opportunity had triggered any liability under the disclosure provision of the Act. Moreover, the Court held that a difference in the size of franchise territories was not a material difference because it did not affect the financial or operational arrangements between the parties. The Court also held that the fact that the additional franchise agreement did not contain a right of first refusal, (like the original one did) did not make the two locations "substantially" different.