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Mr. Claude J. Pellan,
L.L.B., B.Comm., Attorney

(450) 674-5551

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125 St-Charles West J4H 1C7

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Number 22 – October 14, 2010

FRANCHISING

THE MIDAS CASE GROWS TENTACLES

In the last article on Franchising, the Midas case was analyzed in light of a franchisor’s obligation to provide prospective franchisees with a Disclosure Document under the Arthur Wishart Act (the “Act”). The repercussions of the Midas case on franchising were felt across Canada.

It solicited a lot of attention and I received numerous questions and comments. All of which led me to further analyze the Midas case. As you will read, the effects are far reaching and the entire pipeline of certain industries will be hit by this case which is taking on a life of its own.

The first article and the Midas judgement are on www.claudepellan.com.

A. Summary of Facts

The Plaintiff was a Midas franchisee involved in a class action suit against Midas Canada, the franchisor. To determine the applicable law to resolve an issue dealing with a request for a release by Midas Canada, the Ontario Court of Appeal studied the governing law clause in the franchise agreement.  Midas’s standard form franchise agreement provides that the laws from the Province of Ontario are the governing laws for franchises located in Ontario, Alberta, British Columbia, Manitoba, New Brunswick and Nova Scotia.

At Court, while counsel for Midas Canada argued that the Act (the franchise law in Ontario) specifically provides that it applies only to franchises operated in the Province of Ontario and persons that live in that Province, the Ontario Court of Appeal concluded that parties to a contract are free to elect the governing laws of any jurisdiction to apply to their legal relationship.

B. Food for Thought

1. Just Franchising?

There is no codified definition of a franchise in Quebec or in any other province that does not have franchise legislation. However, there is a definition of a franchise in the Act:

“franchise” means a right to engage in a business where the franchisee is required by contract or otherwise to make a payment or continuing payments, whether direct or indirect, or a commitment to make such payment or payments, to the franchisor, or the franchisor’s associate, in the course of operating the business or as a condition of acquiring the franchise or commencing operations and,
(a) in which,


   (i) the franchisor grants the franchisee the right to sell, offer for sale or distribute goods or services that are substantially associated with the franchisor’s, or the franchisor’s associate’s, trade-mark, service mark, trade name, logo or advertising or other commercial symbol, and
  (ii) the franchisor or the franchisor’s associate exercises significant control over, or offers significant assistance in, the franchisee’s method of operation, including building design and furnishings, locations, business organization, marketing techniques or training, or

(b) in which,
  

(i) the franchisor, or the franchisor’s associate, grants the franchisee the representational or distribution rights, whether or not a trade-mark, service mark, trade name, logo or advertising or other commercial symbol is involved, to sell, offer for sale or distribute goods or services supplied by the franchisor or a supplier designated by the franchisor, and
  (ii) the franchisor, or the franchisor’s associate, or a third person designated by the franchisor, provides location assistance, including securing retail outlets or accounts for the goods or services to be sold, offered for sale or distributed or securing locations or sites for vending machines, display racks or other product sales displays used by the franchisee; (“franchise”)”
While part (a) of the definition of a franchise is similar to some drafted by franchise attorneys in Canada, the second part of the definition is a lot wider in scope then the “traditional” definition of a franchise.

Point and fact, it includes rights of representation and distribution and specifically refers to “vending machines, display racks or other product sales displays…”

It follows that the Midas case will not only have repercussions on businesses that operate under the franchise business model, but also on a number of other distribution business models. For example, it would apply to distribution arrangements like affiliations, concessions, multi-level marketing, direct sales, distributorships, buying groups, certain licenses and manufacturers’ agents.

Furthermore, a franchise includes a master franchise and a subfranchise.

If you fall within one of these categories of business models and if the law governing your legal relationship is Ontario, Alberta or Prince Edward Island, I suggest you have a franchise attorney study your agreement to determine whether or not it falls within the tentacles of the Midas case.

2. Other Obligations for Franchisors

In the first article, I addressed the obligation of a franchisor to provide a prospective franchisee with a Disclosure Document in the context of a franchise agreement governed by the laws of the province of Ontario.

However, the Act creates a number of additional obligations for franchisors and a number of rights for franchisees.

While there are too many to describe in detail here, examples include thefollowing:

i) every franchise agreement imposes on each party a duty of fair dealing in its performance and enforcement and a right of action against a party that breaches this duty;

ii) the right of franchisees to form an association and a prohibition that the franchisor shall not interfere with, prohibit or restrict, a franchisee from forming or joining an organization of franchisees and shall not, directly or indirectly, penalize, attempt to penalize or threaten to penalize a franchisee for exercising any such right;

iii) the obligation of a franchisor to disclose to a prospective franchisee any “material change” of the franchisor that would have a significant adverse effect on the value or price of the franchise to be granted or on the decision to acquire the franchise. This obligation, like the obligation to provide a prospective franchisee with a Disclosure Document, carries with it the same right of action for the franchisor to purchase the business of the franchisee (See first article).

3. Renewals and extensions

In the first article, the comments were limited to franchises granted over the last two (2) years. However, the Act goes further and also applies to renewals and extensions of a franchise agreement:

“2(1) Application

2. (1) This Act applies with respect to a franchise agreement entered into on or after the coming into force of this section, with respect to a renewal or extension of a franchise agreement entered into before or after the coming into force of this section and with respect to a business operated under such an agreement, renewal or extension if the business operated by the franchisee under the franchise agreement or its renewal or extension is to be operated partly or wholly in Ontario. ”
Does this mean that franchise agreements that have been renewed or extended over the last two (2) years fall within the obligation of a franchisor to provide those franchisees with a Disclosure Document?

At one end of the spectrum of opinion, one could argue that a simple renewal or extension without any changes to the franchise agreement and concept is just the prolongation of an existing business relationship and that the Act only applies to new franchisees. 

At the other end of the spectrum of opinion, a franchisor may require material changes to the franchise agreement and concept upon the extension or renewal of the franchise agreement, including new financial obligations and an important investment by franchisees. Under these circumstances, one could argue that due to the important changes imposed by the franchisor, the franchise is a new one and that the franchisee should be treated as a prospective franchisee under the circumstances. Therefore, franchisees should be provided with a Disclosure Document.

4. Franchisees and the Lease

A franchisor does not provide a prospective franchisee with a Disclosure Document. The franchisee sends the franchisor a notice of rescission of the franchise agreement. What happens with the Lease?

The answer to this question depends on a number of factors including whether the franchisor or the franchisee is on the Head Lease and whether or not they have provided other guarantees to the landlord (general security agreement, personal guarantee).

First, it should be noted that landlords are not subject to the Act.

The rescission of the franchise agreement involves putting the parties in the same situation they were in at the time of the signing of the agreement.

The Act provides that a franchisor has sixty (60) days from the date it receives the notice of rescission to refund a franchisee any money received from or on behalf of the franchisee (franchise fee, royalties, etc.) and purchase any inventory, supplies and equipment.

The franchisor must also compensate the franchisee for any losses that the franchisee may have incurred in acquiring, setting up and operating the franchise.

There is nothing specific in the Act that deals with a lease or sublease signed by a franchisee and the Act only addresses the rescission of the franchise agreement and not any other contract that a franchisee may have entered into with a franchisor or a third party.

So, what happens with the lease when the franchisee rescinds the franchise agreement? What about the shareholders and/or directors of the franchisee that have personally guaranteed the rent payable under the Lease?  Has the law omitted to take into consideration this situation and make it practically impossible for a franchisee to rescind a franchise agreement?

4.1 Franchisee as Subtenant

Many franchisors have as a policy to be the Tenant on the Head Lease of all or part of the locations where they grant a franchise. They then sublease the premises to a franchisee.

In this context, the franchisee signs a sublease agreement with the franchisor. As already mentioned, the sublease agreement does not fall within the agreements that may be rescinded by a franchisee under the Act.

However, when a franchise is granted, I consider all the other agreements entered into between the franchisor and the franchisee as accessory or ancillary agreements to the franchise agreement. The sublease agreement is just that.

Therefore, given that the franchise agreement is the principal agreement signed by the franchisee and franchisor, if it is rescinded, it follows that all the accessory and ancillary agreements to the franchise agreement are also rescinded at the same time. That would also include a general security agreement, a personal guarantee agreement, a consignment agreement, an equipment lease, etc.

All these agreements exist because of the franchise agreement and if the latter is rescinded, it stands that all the other agreements would be automatically rescinded at the same time as the franchise agreement…and the franchisor would remain liable for the rent under the lease because it is the Tenant under the Head Lease.

4.2 Franchisee on Head Lease

As already mentioned, the landlord is not subject to the Act. So, when a franchisee sends a notice of rescission to the franchisor, what happens to a franchisee that signed a Lease?

Sections 6 (d) and 7 of the Act provide that a franchisee has a right of action for damages in the event it suffers a loss:

“Franchisor’s obligations on rescission

 (6) The franchisor, or franchisor’s associate, as the case may be, shall, within 60 days of the effective date of the rescission,
(a)…
(d)   compensate the franchisee for any losses that the franchisee incurred in acquiring, setting up and operating the franchise, less the amounts set out in clauses (a) to (c).

 

Damages for misrepresentation, failure to disclose

 

7.(1) If a franchisee suffers a loss because of a misrepresentation contained in the disclosure document or in a statement of a material change or as a result of the franchisor’s failure to comply in any way with section 5, the franchisee has a right of action for damages against,
(a) the franchisor;
(b) the franchisor’s agent;
(c) the franchisor’s broker, being a person other than the franchisor, franchisor’s       associate, franchisor’s agent or franchisee, who grants, markets or otherwise offers to grant a franchise, or who arranges for the grant of a franchise;
(d) the franchisor’s associate; and
(e) every person who signed the disclosure document or statement of material change.”

It follows that if the payment of rent by the franchisee were to cause a “loss”, a franchisee would have a claim against the franchisor for same. Therefore, here again, the franchisor would become liable for the payment of the rent under the Lease signed by the franchisee.

5. Other Jurisdictions

I have addressed the context of franchisors situated in Canada that operate a franchise network in Canada.

What about franchisors from other countries that grant franchises, master franchises or subfranchises in Canada and have a clause in their franchise agreement that provides that the laws of their country and/or state are the governing laws?  And what about franchisors from Canada that export their franchise concepts to other countries with a franchise agreement that contains a clause that the governing laws are those of Canada and/or a province in Canada?

I am not and do not contend to be an International Franchise Attorney. However, I have had the opportunity to work in files that involved franchisors from the United States and Europe.

Therefore, I can confirm that the United States has Federal and State franchise legislation, as do certain European countries. Therefore, franchisors from these jurisdictions that have granted franchises in Canada that provide that the governing laws between the parties are those of the United States, a State in the United States or those of a European country should have their franchise attorney provide them with an opinion as to the applicable legislation to the franchisor-franchisee relationship. The same suggestion applies to franchisors from Canada that have exported their franchise concept to other countries.

Given that commercial laws are similar across North America, certain foreign and Canadian franchisors may find themselves in the same position as Midas Canada.

C. Conclusions

The repercussions of the Midas case are not limited to the franchise business model, but also apply to other distribution arrangements. Neither is the Midas case limited to franchises granted over the last two (2) years, but may also apply to renewals and extensions of franchise agreements. Franchisors have more obligations and franchisees have rights. Franchise legislation is present in the United States and Europe. The issues raised by the Midas case are not Canadian, there are international.

Given the wider than first anticipated effects of the Midas case, this Pandora’s Box will not only affect franchisors in Ontario, Alberta and Prince Edward Island, but also franchisees in all provinces and territories of Canada, franchisors from Canada that have exported their franchise concept to other countries and franchisors from outside of Canada that have exported their franchise concept to Canada.

What first started out as a storm is now a Category 5 Hurricane!
 

Claude J. Pellan
Franchise Attorney
www.claudepellan.com



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