Ontario Court Finds that Material Omission in Franchise Disclosure Document Provides Only 60-Day Rescission Right
In a significant recent decision, the Ontario Superior Court of Justice granted partial summary judgment in Caffé Demetre v. 2249027 Ontario Inc. the first franchise rescission claim to be decided since the new summary judgment test was set down by the Supreme Court of Canada in Hryniak v. Mauldin. The case is one of the first in which an Ontario court was prepared to find that a franchisee was restricted to a 60-day rescission claim, even though the franchise disclosure document lacked a material fact. The case also demonstrates that claims for statutory rescission for alleged defects in franchise disclosure documents contrary to the Arthur Wishart Act (Franchise Disclosure) (Act) and the parallel provisions in the franchise legislation in Alberta, Manitoba, New Brunswick and P.E.I. can be resolved using the newly expanded scope of summary judgment.
In Caffé Demetre, the franchisor commenced an action against one of its franchisees after the franchisee had failed to respond to various notices of default and had started a competing business under a different name in the franchise location. In turn, the franchisee served a notice of rescission of the franchise agreement and counterclaimed against the franchisor. The franchisee relied on section 6(2) of the Act, which provides for rescission within two years if "the franchisor never provided the disclosure document." The franchisee alleged that the disclosure document failed to disclose "all material facts" about the franchise as required by section 5(4) of the Act, in such a manner that it could not be considered a disclosure document at all.
Specifically, the franchisee claimed that the franchisor failed to disclose (1) that it was involved in litigation with a former franchisee at the same location, which had started a competing business, Spin Desserts, 7.5 kilometres away; (2) that it would implement a new tipping out policy that prohibited franchisees from taking a share of their employees’ tips; (3) that it would implement a new policy requiring the owner principal of each franchise to assume sole responsibility for making ice cream on site; and (4) that it would require the franchisee to undertake remodelling and renovations.
The franchisor brought a motion for partial summary judgment in respect of the franchisee’s rescission claims under the Act.
Alleged Deficiencies in the Disclosure Document
The Court first considered the four alleged deficiencies in the disclosure, as follows:
(1) Failure to disclose litigation against Spin Desserts: The Court noted that although the litigation was not commenced until one month after the disclosure document was delivered, it was clear from the franchisor’s emails that it was contemplated at the time of disclosure. However, the litigation did not represent a potential liability to franchisees; it was simply a proactive measure taken to protect the intellectual property of the operation as a whole because the competitor was allegedly using the franchise’s recipes. Moreover, the competitor’s location was such that it would not affect the franchisee’s sales in any way. The Court noted that, therefore, it was "difficult to see how the existence of this litigation could have a significant effect on the price to be paid by the franchisee, as required by the definition of ‘material fact.’" However, the Court held this particular litigation should have been disclosed in the disclosure document as a material fact. This finding is difficult to reconcile with the Ontario Regulation, which only requires disclosure of certain litigation brought against the franchisor.
(2) The tip out policy: The new policy, which prohibited employers from retaining a portion of the tips collected by their employees, arose as a result of provincial legislation in August 2012 – that is, 14 months after the disclosure document had been delivered. There was no evidence it was contemplated at the time the disclosure document was delivered, and as a result could not constitute a material fact.
(3) The ice cream manufacturing policy: The policy requiring owner principals of the franchises to assume sole responsibility for ice cream production came about 20 months after the disclosure document was delivered, and thus could not be considered a material fact that should have been disclosed.
(4) Remodelling and renovations: In August 2012, the franchisor inspected its locations’ state of repair, appearance and cleanliness and provided the franchisee with a list of items that needed to be corrected, in accordance with its rights under the franchise agreement. The franchisee refused to do any of this work. The Court held, once again, that this issue could not be said to constitute a material fact as it arose 14 months after the disclosure document was delivered. Moreover, the franchise purchase agreement that the franchisee entered into with the previous owner required the previous owner to bring the store up to date, and the franchisee had taken no steps to require the previous owner to make any improvements. Even if renovations had been required in 2011 when the disclosure document had been delivered, that could not constitute a material fact because the cost would have been borne by the previous owner – it would have been cost-neutral to the franchisee.
The Court concluded that only the Spin Desserts litigation could constitute a material fact. While this finding is arguably open to question given the clear wording of the regulation dealing with the disclosure requirement for litigation, the Court made an important finding as to the consequence of the franchisor’s failure to disclose this material fact. According to the Court, since there was no basis for inferring that the litigation could have any economic impact on the franchisee’s operation, and because the issue was simply what the Court termed a "content deficiency," it gave rise to only a 60-day (rather than two-year) rescission right. According to the Court, only if there are "stark and material" deficiencies in the disclosure, may a court conclude that this amounts to no disclosure at all:
[A] content deficiency only gives rise to rescission rights under s. 6(1) [60 days]. It is only where there are stark and material deficiencies in the disclosure document that a court may conclude that it amounts to no disclosure at all [leading to a two-year rescission right]. The sweeping remedy of rescission is restricted to "instances of a complete failure to provide a disclosure document."
The Court granted partial summary judgment dismissing the rescission claim. The material before the Court consisted of various documents, the pleadings of the defendants and uncontested facts and admissions made by the franchisee on his cross-examination; the facts were essentially not in dispute. On this basis, Justice Heeney held "that the summary judgment process provides me with the evidence required to fairly and justly adjudicate this portion of the dispute in a timely, affordable and proportionate procedure."
Importantly, the motion sought only to dismiss the franchisee’s counterclaim for rescission, because the parties had agreed that a trial would be required to address the remaining issues. The Court considered whether it was cost-effective to engage in a partial summary judgment when both parties acknowledged that a trial would still be required, and concluded that if the rescission issue was resolved it would increase the chance that a lengthy trial might be avoided.
The Court reaffirmed the first principle that the appropriate frame of reference for the consideration of alleged deficiencies in a franchise disclosure document is the time the disclosure document is delivered. Subject to material changes that occur before the signing of the franchise agreement or the payment of consideration, issues that arise after the fact cannot constitute material facts that were omitted from the disclosure documents.
Most importantly, this case is part of the evolution of the distinction between deficiencies sufficient to warrant rescission under s. 6(1) (within 60 days) and s. 6(2) (within two years). The Court’s reasoning in this case suggests that material facts that must be disclosed for completeness, but would not likely have an effect on the price to be paid for the franchise or the franchisee’s sales (such as the Spin Desserts litigation in this case), may not be sufficient to provide a two-year rescission remedy. This should provide some comfort to franchisors, although we will await a more definitive statement on this issue from the Court of Appeal when it is faced with a similar issue.