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Existing Franchisees with a Right of First Refusal Must Actually Exercise that Right in Order to Trigger Franchise Disclosure Obligations

Published: 02/08/2012

By Stefanie Baldassarra

The Ontario Superior Court of Justice recently dismissed a franchisee plaintiff’s action for $15 million in damages arising out of a franchisor’s alleged failure to honour a right of first refusal and adhere to its disclosure obligations under Ontario’s franchise legislation, the Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”). The court’s decision provides significant guidance on when statutory disclosure obligations arise in cases where a franchisee has a right of first refusal over a new location.

In 3574423 Canada Inc. v. Baton Rouge Restaurants Inc., the franchisee, 3574423 Canada Inc., was given the opportunity to acquire a second franchise to which it enjoyed a right of first refusal pursuant to the franchise agreement with the franchisor, Baton Rouge Restaurants Inc. In 2000, the franchisee had been given three opportunities to acquire a second franchise prior to the disclosure requirements under the Act having come into force.  On each occasion, the franchisee declined the opportunity and signed a waiver to preserve its right of first refusal in the event of a subsequent opportunity. In 2001, following the coming into force of the disclosure requirements of the Act, the opportunity for a second franchise which had previously been offered to the franchisee re-emerged. Once again, the franchisee rejected the opportunity and signed a waiver without prejudice to its right of first refusal but this time, the franchisor refused to extend the right of first refusal and the location was later obtained by another party. 

Despite the fact that the franchisee operated an existing franchise, it took the position that it was a "prospective franchisee" in relation to the second franchise.  Pursuant to section 5(1) of the Act, franchisors are required 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 waiver was an "agreement relating to the franchise" within the meaning of section 5(1), thereby triggering its right to a disclosure document.

The court rejected this argument and held that the Act provides relief to those who become franchisees, not to those who do not. In other words, 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 phrase “any other agreement relating to the franchise" refers to an agreement signed by a person who becomes an actual franchisee. Until a prospective franchisee becomes an actual franchisee, there can be no agreement relating to the franchise and therefore, no right of action based on disclosure information that was allegedly provided or not.

Although the court’s conclusion was sufficient to deal with the franchisee’s claim for damages, it further analyzed the “additional franchise” exemption contained in section 5(7)(c) of the Act, which has yet to be judicially considered. The "additional franchise" exemption relieves a franchisor from its obligation to deliver a disclosure document where (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 or the latest renewal or extension was entered into. In this case, the Court found that the difference in the size of franchise locations was not material, as it did not affect the financial or operational arrangements between the parties.

While franchisors must always be mindful of their disclosure obligations when dealing with a prospective franchisee in the event they become an actual franchisee, the court’s decision provides two important guiding principles. Firstly, statutory relief for inadequate disclosure is only available to prospective franchisees who sign an agreement relating to the franchise, consequently becoming a franchisee. Secondly, the additional franchise exemption in the Act can apply even where there is a difference in the size of the locations or type of market, to the extent that the operational and financial relationship is not materially changed. While the jurisprudence provides some guidelines, the breadth of meaning to be ascribed to the term “material change” remains vague.

This case is also notable because the court awarded significant partial indemnity costs in favour of the defendant franchisor in an amount exceeding $780,000.00.