The Franchisee’s Right of Rescission

The Franchise Disclosure Act (Ontario) has introduced a seemingly absolute right of rescission to a franchisee, for breach on the part of the franchisor of its disclosure obligations under the Act…Two recent cases in the Ontario Superior Court of Justice exemplify the power of the rescission remedy, both statutory and at common law, enabling the Court to make the franchisee “whole”, without any apparent obligation on it to account for benefits received by virtue of the franchise arrangement.

Siskind, Cromarty, Ivey & Dowler LLP
February 26, 2003

The Franchisee’s Right of Rescission – The Contrast Between the Statutory and Common
Law Remedies

www.franchiselaw.ca
David A. Broad

Synopsis:
The Franchise Disclosure Act (Ontario) has introduced a seemingly absolute right of rescission to a franchisee, for breach on the part of the franchisor of its disclosure obligations under the Act. However, the traditional concept by requiring the party claiming rescission to account for benefits received under the contract, has not been included in the provision. Moreover, it is unclear as to the extent to which traditional equitable defences will be available to franchisors, arising from the conduct of the franchisee. Two recent cases in the Ontario Superior Court of Justice exemplify the power of the rescission remedy, both statutory and at common law, enabling the Court to make the franchisee “whole”, without any apparent obligation on it to account for benefits received by virtue of the franchise arrangement.

The rescission rights provided in section 6 of the Arthur Wishart (Franchise Disclosure), 2000 Act, S.O. 2000, c.3 (the “Act”) represent among the most innovative, and at the same time, the most troublesome, provisions of this new legislation. By conferring “walk away” rights on franchisees in circumstances where a franchisor has failed to provide a “disclosure document” or statement of material change, or has done so, but not within the enumerated time limits or otherwise in accordance with the requirements of the Act, the Act has given teeth to the disclosure obligations of section 5. However, by conferring effectively absolute rescission rights on franchisees, without recognizing the possibility of variations in the reality of different franchisor-franchisee relationships, section 6 has the potential for unbalanced and unfair results.

SECTION 6 RESCISSION RIGHTS
In summary, section 6 provides that a franchisee may, by notice, rescind a franchise agreement:

(a) within 60 days of receiving a disclosure document, if the franchisor failed to provide the disclosure document or a statement of material change with the time required by section 5, or if the contents of the disclosure document did not meet the requirements of section 5; or

(b) within two years after entering into the franchise agreement if the franchisor never
provided the disclosure document.

Subsection (6) enumerates the franchisor’s obligations on rescission, including refunding money received from the franchisee, purchasing remaining inventory, supplies and equipment and compensating the franchisee for any losses that the franchisee incurred in acquiring setting up and operating the franchise.

3%20for%201%20Pizza%20%26%20Wings%20franchising.jpg

FIRST JUDICIAL APPLICATION OF SECTION 6
Section 6 of the Act received its first judicial treatment in the recent case MAA Diners Inc. et al v. 3 for 1 Pizza & Wings (Canada) Inc. et al (February 10, 2003, Ontario S.C.J., G. Speigal, J.) This case demonstrates the utility of this new statutory remedy to protect a franchisee from the potentially devastating impact of an imprudent franchise acquisition in circumstances of complete default on the part of a franchisor to adhere to the disclosure requirements of the Act. However, it has left many of the problem areas of section 6 to be dealt with in future cases.

THE FACTS
The facts of the MAA Diners case, as recited in Justice Speigal’s reasons, exemplify one of the archetypal situations that the disclosure provisions of the Act were arguably designed to address. On April 23, 2001 the plaintiff Gill and the defendant Triple Pizza Holdings Inc. entered into a purchase agreement whereby a company to be incorporated by Gill would acquire the assets of an existing pizza business. Under the agreement the purchaser was required to execute a standard form franchise agreement with the franchisor 3 for 1 Pizza & Wings (Canada) Inc., as well as a General Security Agreement in favour of the franchisor, It was also required to enter into a sublease of the business premises.

In his reasons Justice Speigal recited that although the premises “were to have been refurbished” it is not apparent as to whether that was a requirement of the contractual documents, or whether it was a verbal understanding of the parties. In any event, he found that the premises were in a deplorable state, complete with Fire Code violations. Within two months of the closing of the purchase transaction, MAA returned the keys to the franchisor and delivered a notice of rescission, claiming, not that there had been misrepresentation with respect to the condition of the premises, but that no disclosure document had been received by the franchisee as required by the Act.

The respondents argued that disclosure was given, and in the alternative, that even if it was not given, it was not required under the Act, on the basis that the franchisee acquired the franchise by virtue of a re-sale from Triple Pizza, and not from the franchisor 3 for 1.

THE DECISION
Justice Speigal dealt swiftly with the argument that the vendor of the assets was not the franchisor, concluding on the facts that the respondents treated the three separate corporations as “one entity”.
All three respondent corporations were found to be the franchisors, and therefore the notice of rescission to two of them, was notice of rescission to the remaining one.

The exemption from disclosure involving a sale by a franchisee conferred by subsection 5(7)(a) of the Act was found not to apply. The four conjunctive and necessary elements of the exemption include subclause 5(7)(a)(iv) which requires that the grant of the franchise not be “effected by or through the franchisor” (although subsection 5(8) does stipulate that this would not be the case merely because the franchisor has the right, on reasonable grounds, to approve the grant, or to be paid a transfer fee). The principal of all three of the respondent corporations admitted on cross-examination that he was asked to “facilitate or manage the transaction” and therefor the grant was found to have be effected “by or through the franchisor.” Moreover, since all three of the corporations were found to be franchisors, subclauses 5(7)(a)(i) and (ii) were found not to have been satisfied. These subclauses require that for the exemption to apply the transferring “franchisee” be at arm’s length from the franchisor and that the grant be for the franchisee’s own account. Hence Justice Spiegal found that there was no applicable exemption available from the obligation to provide disclosure under section 5 of the Act.

Although the franchisee in the MAA Diners case signed an acknowledgement that she had received an “Agreement Package”, which the respondents claimed contained the “disclosure documents,” the respondents were unable to produce copies any such documents. The Respondents blamed this failure on “sloppy paperwork”. An Acknowledgement contained in the signed franchise agreement that “The franchisee has been afforded the opportunity to receive and review a copy of this Agreement and the disclosure documents… and is satisfied with all disclosed information of the disclosure documents” also proved to be of no avail to the franchisor. Justice Speigal found that this acknowledgement did not suffice under the Act as the “opportunity to receive and review a copy” does not equate to mandatory receipt of a disclosure document. He held that the acknowledgement referred to disclosure documents, plural, whereas section 5(3) of the Act mandates one disclosure document delivered, as such, at one time. He also found that, pursuant to section 11, the parties could not contract out of the disclosure requirements of the Act. The evidence of the franchisee that she had received no disclosure document, as required by the Act, was accepted.

Having found that no disclosure document had ever been given, Justice Speigal granted rescission pursuant to section 6 and then went on award damages pursuant to section 7 against the three franchisor corporations, pursuant to clause 7(1)(a) and against their principal as an “associate”, pursuant to clause 7(1)(d). The respondents took no issue with the applicants’ calculation of damages which consisted of the aggregate of the amount paid to acquire the franchised business and the losses suffered in acquiring, settling up and operating it. Justice Speigal was evidently not called upon to consider whether under the Act, the value of any benefit conferred on the franchisee by the franchisor should be offset against the damages payable to the franchisee.

PROBLEM AREAS IN THE RESCISSION REMEDY
Section 6, in conferring statutory rescission rights, focuses exclusively on a failure to disclose, late disclosure, or non-compliance with the requirements respecting contents of the disclosure document, rather than on the existence of material misrepresentations in the disclosure itself or of detriment suffered by the franchisee as a result of the faulty or late disclosure. It confers the right of rescission in these circumstances in an apparent absolute sense, without a requirement for the franchisee to have suffered harm, nor to account for any benefits received, or even retained by the franchisee, by virtue of the grant of the franchise.

Section 9 of the Act does provide that the rights conferred by the Act are in addition to and do not derogate from rights the franchisee or the franchisor may have at law. Accordingly, misrepresentation in a compliant and timely disclosure document, may still, in appropriate circumstances, confer a right of rescission on a franchisee at common law.

However, a technical breach of the disclosure requirements of section 5, such as a disclosure document delivered one day late, or a disclosure document omitting a prescribed item, or disclosure being comprised of more that one “document”, will give a franchisee the right to rescind, even seemingly for a collateral purpose unconnected with the statutory breach, and without any requirement to have suffered any harm arising from the technical breach by the franchisor. Moreover, since a franchisee having a right to rescind, may do so “without penalty or obligation,” (emphasis added) he or she would presumably enjoy the return of all moneys paid to acquire the franchise, without any obligation to account for profits earned from it, nor for benefits obtained, such as training and the acquisition of know-how. It is arguable that rescission of the franchise agreement would also serve to release the franchisee from any confidentiality or non-competition covenants contained in it.

CONTRAST WITH TRADITIONAL PRINCIPLES OF RESCISSION
Traditionally, rescission was granted in order the restore the status quo ante and accordingly, rescission for misrepresentation would not be available if the parties were unable to make restitutio in integrum. For example in Clarke v Dickson, 1 Crompton, J. stated that when a party “exercises his option to rescind the contract, he must be in a state to rescind; that is he must be in such a situation as to be able to put the parties into their original state before the contract.”2

In contrast to the situation at common law, equity did not require that restitution be precise, and permitted accounts to be taken between the parties, to adjust for profits made and deterioration suffered. This flexibility facilitated the granting of the remedy, even in cases involving the provision of services by the representor, rather than restricting its application to situations involving benefits which are, by their nature, returnable, such as contracts for the sale of goods. This development has obvious application to the franchise situation, where many of the benefits conferred on the franchisee by the franchisor are intangible, such as service or product quality, training for the franchisee and employees, market goodwill and intellectual property. The courts developed the concept that although the contract was rescinded ab initio, the representee must make an allowance for the services received by virtue of the contract. 3

Although a full discussion of the jurisprudence under American franchise disclosure legislation is beyond the scope of this paper, it appears that, at least in some jurisdictions, American courts have sometimes required rescinding franchisees to offset against the return of franchise fees and royalties paid to the franchisor, income and other benefits derived from the franchise. 4

Country%20Style%20franchising.jpg

RECENT APPLICATION OF THE COMMON LAW RESCISSION REMEDY IN A FRANCHISE CONTEXT
In the case of Country Style Food Services Inc. v 1304271 Ontario Ltd. and Mesic et al [2003] Court File 01-CV-219404CM2, released on February 11, 2003 (one day after the release of the reasons in the MAA Diners case), the Court had occasion to invoke the remedy of rescission at common law, in a case involving pre-contractual misrepresentation. As is typical in the food-service context, the franchisee entered into a sublease of the franchise premises with a subsidiary of the franchisor, consisting of a free-standing coffee and doughnut restaurant, with a drive-thru, in an uncompleted shopping centre development. Both the head lease and the sublease contained schedules encompassing the proposed site plan for the development. Madam Justice Chapnik accepted the evidence of the principals of the franchisee that they carefully considered the proposed layout of the site plan prior to proceeding with the purchase of the franchise. Approximately one year after the opening of the business the landlord undertook construction of the remainder of the development pursuant to a revised site plan, the configuration of which negatively impacted the flow of traffic in and out of the franchisee’s business and its drive-thru facility. Although the landlord’s plans for the change in the site-plan were well underway at the time that the head lease was negotiated, the franchisor had no knowledge of the change at the time the sublease was entered into with the franchisee. Justice Chapnik nevertheless found that “the inaccurate and misleading nature of the site plan attached as a schedule to the sublease formed a critical element of the commercial lease, making the misrepresentation, though innocent [i.e. on the part of the franchisor], significant.”

Justice Chapnik found that the franchisee would never have entered into the franchise and sublease agreements had the its principals known about the revised site plan and that they were therefore entitled to “rescission-like remedies in order to make them ‘whole’”. They were therefore entitled to claim damages for all amounts expended or lost in connection with the franchised business. Although not abundantly clear from the reasons, this recovery appears to have been in addition to the franchisees recovery for lost profits resulting from the landlord’s actions. Acknowledging that assessing damages in this type of situation is “hardly an exact science” Justice Chapnik assessed the defendants’ damages in the counterclaim at a global sum of $400,000.00. However, there was no accounting taken of any benefits or services obtained by the franchisee by virtue of the franchise arrangements on the basis of the principles described above.

PRESERVATION OF COMMON LAW RIGHTS UNDER THE ACT
Section 9 of the Act specifically provides that the rights conferred by the Act, including the rescission rights under section 6, are in addition to and do not derogate from any other right or 6 remedy a franchisee or franchisor have at law. Thus, in addition to a right of rescission for failure to make required disclosure or for late disclosure in section 6 of the Act, a franchisee may continue to claim rescission on the traditional bases of fraud 5, error in substantialibus, or complete failure of consideration. 6

However, in seeming contrast to the statutory remedy provided by section 6 of the Act, a franchisee claiming rescission at common law should be required to account for benefits received from the franchisor. Although the Court in the Country Style v. Mesic case did not invoke this principle, it did not preclude it from being applied in an appropriate case in the future. In addition, a franchisor, faced with a non-statutory claim for rescission, should be able to defend, in appropriate circumstances, on the basis of such traditional bars as affirmation, lapse of time, undue delay, waiver, equitable estoppel and unclean hands. These defences are preserved by the application of section 9 of the Act.

Although section 6 provides that where the section applies, the franchisee may rescind, without penalty or obligation, it is unclear from the section whether all of the above-mentioned bars will be necessarily excluded, insofar as they do not impose a “penalty” or “obligation”, similar to a duty to account for benefits received.

The Court in MAA Diners was not called upon to consider whether any of these equitable defences remain available in a rescission claim under section 6. Presumably lapse of time, and delay, for instance, would have limited, if any, application in situations involving the two month period for rescission in subsection 6(1), however, many of the equitable defences could potentially have application in cases involving the two year rescission period in subsection 6(2). One could imagine, for instance, a situation involving a franchisee seeking rescission based upon a technical untimely disclosure, being guilty of a serious breach of the franchise agreement, such as engaging in prohibited competition with the franchisor, or making improper use of intellectual property. The court, when faced with such a situation, will be called upon to measure, on a policy basis, the general deterrent value of an absolute right to rescission for breach of the disclosure requirements in the Act on the part of franchisors, against the impetus to do justice, based upon the particular facts, between the parties to the dispute.

*The author would like to gratefully acknowledge Peter Macrae Dillon for his editorial assistance in the preparation of this paper.

1 (1858) E.B. & E. 148 at 154

2 see Chitty on Contracts (26th ed, 1989) p. 312.

3 Ibid at p. 315.

4 See Dollar Systems, Inc. v Avcar Leasing Systems, Inc. 890 F.2d 165, Bus. Fran Guide (CCH) para. 9,498.

5 See for example Machias v Mr. Submarine Ltd. [2002] O.J. No. 1261 (S.C.J.)

6 Waddams, The Law of Contracts (4th ed), at pp.303-04.


Brought to you by WikidFranchise.org

Risks: Arthur Wishart Act (Franchise Disclosure), 2000, Canada, Fraud, Gag order (confidentiality agreement), Misrepresentations, Non-compete restrictions, Rescission, Canada, 20030226 The franchisees

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License