Franchise legislation may snare entrepreneurs

“The danger is in the penalty provisions of the [Ontario] franchise act for failing to disclose full information to franchisees,”…“your distributor not only rescinds your agreement without penalty, but also demands compensation for everything he has paid you over and above the wholesale cost of supplies, plus any money he’s lost.”

The Globe and Mail
July 5, 2000

Franchise legislation may snare entrepreneurs
Many business operators who don’t consider themselves franchisors may find Ontario’s law applies to them
John Southerst

The community of franchisors may be welcoming a slew of new members into its folds. But for many of these recruits, it’s not a club they want to join.

The reluctant franchisors are those caught by the definition of franchising included in Ontario’s new franchise law, passed in May.

Its wording was drawn from the regulations set by the U.S. Federal Trade Commission. And if U.S. court interpretations are any indication of what will happen in Ontario, many business operators who do not presently consider themselves to be franchisors may still find the law applies to them.

Those most at risk are companies whose agents, dealers, distributors or subcontractors use the organization’s trademarks, or even its advertising. This includes manufacturers’ sales agents and distributors, authorized software and computer dealers, and professional service networks.

“The danger is in the penalty provisions of the [Ontario] franchise act for failing to disclose full information to franchisees,” says Toronto franchise lawyer Paul Jones.

If a dispute with a distributor turns nasty, he says, a lawyer may claim the relationship falls under the franchise law and the franchisor hasn’t met disclosure requirements laid out in the act.

“Suddenly,” Mr. Jones says, “your distributor not only rescinds your agreement without penalty, but also demands compensation for everything he has paid you over and above the wholesale cost of supplies, plus any money he’s lost.”

This prospect has many business owners asking for legal opinions on whether they fall under the new legislation – and how they can change their agreements to avoid it.

As with the FTC, Ontario’s definition of a franchise contains three elements: “direct or indirect” payment of a fee in order to engage in a business; the right to sell or distribute goods or services that are “substantially associated” with the franchisor’s trademark, logo or advertising; and the franchisor’s exercise of “significant” control over or assistance to franchisee operations.

U.S. courts interpret these criteria liberally. Franchise fees can be anything beyond the wholesale cost of supplies, including markups, royalties, advertising payments, training fees or payments for manuals. “Substantial association” with a trademark could be as innocuous as advertising materials or an exclusive distributorship.

There’s also the issue of how U.S. courts have decided what constitutes “significant” control over agents or dealers. It’s possible that supplying agents with promotional giveaways for customers, or offering demographic breakdowns of sales into their territories may cross the line into franchising.

“You’ve got to distinguish between controlling your product and controlling the operation of other businesses,” Mr. Jones says. “If you’re teaching your dealers how your products work and how to repair them, that’s one thing. But if you’re training them how to sell and how to do point-of-purchase displays, you may have a problem.”

Mr. Jones cautions that most businesses are utterly unaware they are inadvertent franchisors. Or they are in denial.

Typically, owners and managers say that neither they nor their distributors intended to have a franchise relationship, that there is no franchise fee, that their dealers sell other products besides theirs, that their agents keep their own trade name or that they sell goods to their agents at cost. None of these arguments on its own, he says, would make a difference.

In one case, a professional services firm negotiates agreements with independent contractors to open what it calls a “branch office.” The contractor is responsible for finding customers and the agreement doesn’t mention a trademark licence. But the name on the branch office is that of the professional services firm, and the contractor pays for this association. According to Mr. Jones, it probably falls under the franchise law.

“In the U.S., the accepted practice is to advise clients who are near the line to comply with franchise legislation,” says Mr. Jones, who also chairs the American Bar Association subcommittee on Canadian franchising developments.

While Canadian judges are not bound by U.S. precedents, the uncertainty and potential penalties suggest these “maybe” franchisors should err on the side of caution. “Otherwise, every dealer you recruit has a right of rescission,” Mr. Jones says. “Everything you build can be torn down pretty easily.”

Many business owners’ first instinct is to avoid being a franchisor. “The reputation of franchising is sometimes seen as spotty, and they don’t like the association with fast food and retailing,” Mr. Jones says.

But to get around the law, a firm would have to rewrite its dealer or distributor agreements - and the implications may be more unpalatable than being a franchisor.

“A bare-bones licensing agreement will solve your problem,” Mr. Jones says, “but you may not compete so well.” Agents could make no payments for training, brochures or other services, for instance, and the manufacturer could offer supplies only on an optional basis at a true wholesale price. Also, it cold set only minimal quality standards to avoid allegations of control.

Another route is for manufacturers to accept that if they look like ducks and quack like ducks, perhaps they’re ducks. By complying with franchise law’s requirements, they protect their ability to hang onto sources of distribution and revenue, maintain quality and control use of their trademark.

“Being a franchisor isn’t the end of the world,” Mr. Jones says. “It’s actually a particularly good way to a maintain product and service reliability and market your product better at the local level, if you do it right.”

John Southerst is a Toronto area writer who can be reached at ac.ratsi|htuosj#ac.ratsi|htuosj

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