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FALL 2008 NEWSLET TER

In thisissue...Common pitfalls of start-up franchising and how to avoid them . . . . . . . . . . . . . . . . . . . . . . . .cover & pg. 2 John Sotos discusses the common pitfalls of startup franchising

Debtors become even more optimistic - New bankruptcy law changes . . . . . . . 3 Sam Hall discusses the new laws protecting common investments in a bankruptcy

Disclosure in the Sale of Franchises: A One-time Affair. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 David Sterns examines Ontario’s requirement of single document disclosure

The News on Class Action Waivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Allan Dick explains the court’s ruling on the enforcabiity of class action waivers in Canada

Disclosure Document Refresher –What is this document anyways?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 John Yiokaris reviews the issues pertaining to material changes in disclosure documents

An Estate Plan-Do you have yours? . . 7 Rachel Loizos advises on the benefits of having a proper estate plan

Financial statements and the disclosure document . . . . . . . . . . . . . . . 8 Lou Alexopoulos explains the Ontario require-ments for financial statements in disclosure documents

Continued on pg. 2

Start-up franchising ought not be a shot in the dark. After all, one of the biggest selling propositions of franchising over starting up an independent business is that with franchising, the franchisor has invested the time, money and sweat equity to work out all of the major impediments to operating a unit of the business so that the franchise concept may then be used by a prospective business operator or franchisee. As a result, the franchisee gets a head start in exchange for the initial and on-going fees that it undertakes to pay. Unfortunately, not every start-up franchisor follows good franchising practices often resulting in poor outcomes for everyone involved. What follows is a discussion of some of the common - and easily preventable – difficulties faced by the start-up franchisor.

1. Idea vs. Successful Business Concept.

A good idea for a business does not mean that it is ready for presentation on a franchise show trade floor. Although virtually anything and everything is franchisable, converting a good idea into a great concept is neither simple nor straight forward. Even a wildly successful business unit does not equate with success when multiplied. While many franchises originate from a single successful operation, the successful start-up franchisors go through a process of replication, refinement and evidence of

Common pitfalls of start-up franchising and how to avoid them

profitability in different locations and under different management. A franchise concept needs to exist and improve under a variety of conditions before franchising is undertaken. This trial period is necessary to validate that success is not location dependent (the proverbial seafood restaurant on the Vancouver waterfront) and that there is a viable market beyond the direct management of a charismatic founder.

The failure to understand and invest in the systematic process of franchising often

By John Sotos

At Sotos LLP, being “in the know” is the first order of our responsibility to our clients and finding the best ways to service our clients is our first priority. We hope you enjoy this in-augural issue of our newsletter and we invite you to visit our revamped website and learn more about our practice, experience and our approach in helping our clients achieve their objectives. - John Sotos

Sotos LLP Newsletter Fall 2008

consigns fledgling franchise concepts to the dustbin of history. Those that manage to survive generally do so after the founders have been forced to sell the concept to more experienced and better capitalized investors who understand franchising as a process. The start-up franchisor who invests in doing it right after going through the crucible of franchisee dissent and litigation can also experience great long-term success. As we always counsel our clients, you either make the investment upfront or you will make a much larger investment later. There is no escaping the cost of proofing the concept.

2. Unprotected trade name.

The first discussion between the prospective franchisor and his or her lawyer should end with instructions to secure trade mark protection for the distinctive trade name and identity of the prospective franchisor. Without a secure trademark and related intellectual property, it becomes extremely difficult to franchise. Yet, without fail, year after year, start-up franchise companies receive a nasty letter from a law firm advising them that the trade name they are doing business under and have licensed others to do the same is the protected property of their client and that the franchisor must cease and desist from further use and pay unspecified damages. While any problem can be resolved with enough time and money, the expense of re-identification or buying-out the interest of the rightful trademark owner is going to be far more expensive than the modest cost of investigating and securing or selecting an alternative trade name from the outset.

3. No Manuals.

We have yet to see a franchise agreement, however badly written, that does not contain a provision requiring franchisees to observe the franchisor’s proven methods of operation and management techniques as described in more detail in one or more manuals. Yet many a start-up franchisor will grant franchises without a manual, or worse, by producing one that is a copy of somebody else’s system, replete with references and processes or equipment unknown to this franchise system. While the franchise agreement defines the nature of the legal relationship between franchisor and franchisee, the manual is the heart of every system. The failure of the franchisor to prepare a manual or manuals that describe the details of how its particular business is run always demonstrates premature franchising. While

corporate consultants can be hired to assist with the preparation of manuals, this exercise requires extensive input and time commitment from the principals of the franchisor, which explains, in part, why manuals get neglected.

4. Training.

Prospective franchisees will often lack experience with the franchisor’s business, industry or concept. Even with manuals in place, the absence of adequate initial training sufficient to impart all of the basic components of operating and managing the proposed franchise business will hamstring the franchisee from day one. Failure to train franchisees from the get-go results in their perpetuating and training on their own mistakes, an outcome which the purchase of a franchise is intended to prevent in the first place. More importantly, failure to properly train franchisees impedes execution at store level thereby sapping the concept of its early growth potential. Every franchise has to budget and develop a training programme at the inception of the system complete with a training manual and a competent trainer to deliver it. A charismatic chef who communicates by throwing kitchen utensils around should not qualify as a competent trainer.

5. Site Selection or Real Estate.

Control over one’s real estate is a tremendous advantage to any franchisor whose business relies on customer visits. One of the best ways to exercise that control is for the franchisor to take a head lease of its locations and then to sublease them to its franchisees.

However, the indiscriminate or inconsistent selection of sites, particularly during economic downturns, has been a significant source of start-up franchisor failures. The burden of even a few uneconomic locations, when added to previously marginal locations failing more or less at the same time, can bring the average start-up crashing down. While there are numerous planning devices to protect against such outcomes, this planning has to anticipate the problem. Experienced franchise counsel can assist in structuring the appropriate real estate and leasing vehicles for a particular system.

6. The Accidental Franchisor / Ignorance of the Law.Since the enactment of franchise-specific laws in various provinces, a fair number

of legal relationships, commonly referred to as dealerships, are now considered to be franchises by the relevant franchise statutes. In many provinces, franchisors must provide a disclosure document prior to the grant or renewal of a franchise. Failing to do so allows a franchisee (in most cases) to claim, pursuant to franchise legislation, both the return of their initial investment paid to the franchisor as well as all losses accumulated in connection with the business for a two year period from the date of the franchise grant. If, for example, one’s business network consists of the sale or distribution of goods and services using the owner’s trademarks, and the owner makes a profit by selling goods, then experienced legal advice should be obtained, despite the fact that in other jurisdictions, such business structures might not be considered to be examples of franchising.

7. Running Afoul of Legal Requirements.

Since the enactment of franchise legislation, franchisors in the affected jurisdictions are required to produce a disclosure document in relation to the business opportunity being offered, which is similar to a securities-type prospectus. Franchisors doing business in provinces with franchise legislation often fail to appreciate the risk of inadequate disclosure. In the interests of false costs savings, these franchisors attempt to prepare a disclosure document internally, or based on price rather than professional expertise. As with the accidental franchisor, the consequences can be devastating if the system has a couple of hiccups in its early stages of growth. Specific issues in disclosure are covered in separate articles in this newsletter.

Risk Avoidance Tips.

While no business can avoid all risk, minimizing foreseeable risk is possible. Retaining experienced consultants to help develop a successful franchise system, together with the engagement of experienced legal counsel to advise on legal structures and prepare documentation catered to a particular franchise concept, are measures that will go a long way towards reducing the foreseeable risk and personal liability that otherwise attaches to those who ignore the law.

Common pitfalls of start-up franchising and how to avoid them Continued...

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One of the pervasive myths of start-up entrepreneurship is that the successful en-trepreneur typically uses unsecured third-party financing to get a new venture off the ground, so as to limit personal financial exposure should the business go belly up. The reality is, however, that the vast major-ity of new businesses are not financed by venture capitalists. For the most part, start-ups remain heavily financed from personal savings. This factor tends to aggravate the consequences of business failure, which in its most severe form results in the personal bankruptcy of the unsuccessful entrepre-neur. In an unexpected move this summer, the federal government made changes to the law of bankruptcy that considerably benefit the small business owner facing the chal-lenges of personal insolvency.

On July 7, 2008, amendments to the Bank-ruptcy and Insolvency Act came into effect which now provide that Registered Retire-ment Savings Plans (RRSPs), Registered Retirement Income Funds (RRIFs) and Deferred Profit Sharing Plans (DPSPs) are exempt from seizure by business (and oth-er) creditors in a bankruptcy. Prior to these amendments, such personal savings – of-ten built up over a lifetime of contribution

- could be seized by creditors in a personal bankruptcy. This often had disastrous con-sequences for the small business owner pre-siding over a failed enterprise, especially for those owners in the twilight years of their earning capacity.

These changes remedy a prior inconsisten-cy in the law of bankruptcy thought to be unfair to those who derived their primary income through self-employment. Previ-ously, contributions to private pension plans were exempt from seizure in a bankruptcy. Small business owners tend not to enjoy the benefit of a private pension plan and rely on RRSPs as their primary source of retire-ment savings. In order to protect his or her RRSP contributions prior to these legislative changes, the small business owner would have had to purchase so-called “segregated” investments, which tend to be more expen-sive than ordinary registered investments but have the benefit of being shielded from creditors in a bankruptcy. The new bank-ruptcy law changes mean that the re-tirement security of small business owners is safeguarded in the same way that private pension contributions are, with-out the expense of purchasing the additional protection of a segregated investment.

One caveat bears keeping in mind. Contribu-tions made to one’s RRSP within the twelve month period prior to bankruptcy are not shielded from seizure by creditors under the new legislative changes. This limit prevents a debtor from evading his or her creditors by using available RRSP contribution room just prior to declaring bankruptcy.

In addition to the increased debtor protec-tion brought about by these changes, the fed-eral government introduced unprecedented wage protection measures this summer with the Wage Earner Protection Program Act and regulations. This legislation cre-ates a super-priority for wage earners over other creditors, including secured creditors, in a bankruptcy or receivership. Employees who are owed wages in the six month pe-riod prior to the bankruptcy or receivership of their employer will be able to claim up to a maximum of $3,000 for unpaid wages, less income tax and other deductions.

While we’ve yet to see how this flurry of legis-lative activity will work itself out in practice, one thing is certain, there is nothing like the threat of an election to spur lawmakers into action, even during the summer months.

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By Sam Oliver Hall

Debtors become even more optimistic - New bankruptcy law changes

When it came to elections, Maurice Duplessis, the autocratic former premier of Quebec, was fond of telling his supporters to “vote early and vote often”. When it comes to selling franchises in Ontario, franchisors would be better advised to “disclose fully and disclose once”. This is because the Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”) imposes serious financial consequences on franchisors who disclose material facts, including earnings projections, to franchisees outside of a formal disclosure document.

Before the Act came into effect, franchises were often sold based on glossy brochures distributed by the franchisor with little consideration for their legal implications. Projections as to future sales and profitability of the location were routinely provided, but their reliability was a different matter. Some were based on actual results of the units within the chain, but often they were no more than the franchisor’s hopes about what level of sales and profitability were achievable under optimal conditions. The problem was that there was no way of knowing whether they were reliable or mere puffery. The franchisee either had to take the franchisor at his or her word, or lose out on the next big opportunity which the franchisor was offering. The franchise agreements contained provisions, called “entire agreement” or “integration” clauses, which meant that any representations outside the agreement itself were unenforceable.

The introduction of mandatory disclosure requirements under the Act was supposed to change all of that. Stringent disclosure requirements were backed up by powerful rights and remedies to ensure that they were followed. Out went the profit projections given to franchisees on the proverbial “back of the napkin” and in came the newly legislated disclosure document with its strictly regulated contents.

It is beyond the scope of this article to state what information the disclosure document

must contain. Suffice it to say that it requires a high level of disclosure about the franchise system, the agreements that the franchisee must sign and the business background of the principals of the franchisor. The disclosure document must be provided to prospective franchisees at least 14 days before any agreements are signed or any money is paid toward the franchise.

So, has the Act changed the way franchises are sold in Ontario? Yes and no. Most franchisors are careful to provide a disclosure document to prospective franchisees within the 14 day deadline. The problem, however, is that old habits die hard and many franchisors can’t resist the urge to provide additional disclosure outside of the formal disclosure document.

What these franchisors overlook is that the Act requires all material information about the franchise to be included in the disclosure document, which must be a single document delivered at one time. Any statements, whether oral or written, made by a franchisor or its representatives regarding the profitability of other franchisees, the system in general, or even about the particular location which is for sale must be included in the disclosure document. Otherwise, the franchisor, its officers and the individuals involved in the sale of franchise may be exposed to serious, personal financial liability.

It surprises many franchisors (and pleases many unhappy franchisees) to learn that information which the franchisor provides about the franchise system in its brochures, on its website or in other documents given to the franchisee could be considered improper disclosure which gives rise to liability. Similarly, statements made by the franchisor’s sales representatives at trade shows could also lead to a lawsuit by a dissatisfied franchisee.

Where franchisors often run afoul of the Act is in providing separate earnings projections (also known as pro formas, profit and loss statements or P&Ls) to franchisees outside of the disclosure document. This practice is not permitted under the Act. While the Act does not require a franchisor to provide earnings projections to the franchisee, if a franchisor chooses to provide earnings projections, it must do so within the four corners of the disclosure document and adhere to all of the attendant formalities. Information such as “average store sales”, “break-even analyses”, and “low-medium-high” revenue scenarios could all come within the definition of earnings projections and must be included in the disclosure document or not provided at all.

The temptation of franchisors to provide unofficial earnings projections to prospective franchisees is understandable since many franchisees request this information from the franchisor to assist them in deciding whether to purchase the franchise, or to prepare a business plan to obtain financing.

Franchisors should strongly resist the temptation to provide franchisees with any disclosure outside of the formal disclosure document, even if requested by the franchisee. Franchisees cannot waive their rights under the Act. The franchisor and its associates can be sued for improper disclosure if material information is provided outside of the disclosure document, especially if such information is inconsistent with the disclosure document.

The Act was intended to make a complete break from the past in terms of how franchises are sold. All members of a franchisor’s sales team should ensure that disclosure is a one-time occurrence not an ongoing affair. Franchisors should consider an internal compliance program and continuing training for all members of the sales team to reinforce the message.

Disclosure in the Sale of Franchises: A One-time Affair By David Sterns

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The News on Class Action Waivers By Allan D.J. Dick

Class Actions are often perceived by corpo-rations as one of the biggest threats to their operations. They are costly, time consuming and can draw substantial media and public attention to unproven claims for huge sums of money.

Not surprisingly, corporations often seek to limit their exposure to class actions. One conceptual way to achieve this is for a corporation to insert into its contracts with parties which could conceivably have claims against it in common with others, a clause which purports by agreement to prevent the other party from commencing class action litigation against it.

This is but one example of many clauses commonly found in contracts which are in-serted with the intention to potentially limit one party’s liability for contractual breach-es, negligence or other wrongful conduct on its part.

The validity of clauses ousting a party’s right to commence a class action was considered for the first time by a Canadian court in the case involving the Quizno’s franchise sys-tem known as 2038724 Ontario Ltd. et al v. Quizno’s Canada Restaurant Corporation et al.

Our firm successfully argued that clauses which purport to prevent one party from commencing a class action are not strictly enforceable under Cana-dian law.

The Judge who decided the issue made the following statement:

“…a contract that precludes class proceed-ings interferes with the administration of justice….such an agreement denies the administration of justice the opportunity of economies of judicial resources and it denies the public the access to justice and behavioral modification provided by class proceedings.”.

Neverthless, the Judge went on to state that “[a]n agreement to preclude class proceed-ings is not an obvious evil, and its enforce-ment should be determined by the balanc-ing of public interests”.

In the class action context, the plaintiffs must successfully bring a motion to have the action certified before it may continue as a class action. There are five criteria which the plaintiffs must satisfy in order for the court to certify the action as a class action. One of the criteria is that it is “preferable” for the action to continue as a class action rather than as an individual action.

There is a substantial body of case law that has developed over this “preferable proce-dure” criterion.

In Quizno’s, the Judge decided that whether a class action waiver clause should be up-held should be considered as part of the preferable procedure analysis. In that case, the Judge held that where the defendants offer no reason to uphold the class action waiver other than their contractual right, this would be insufficient to uphold the clause.

The Judge in Quizno’s, however, was very clear that he was not categori-cally striking down all agreements that contract out of class proceedings legis-lation. The Judge left open the possi-bility that “[t]here may be instances where contracting parties may be able by contract to shape the contours of a class proceeding in whole or in part”.

Given this decision and the limited guidance offered by this court, it is important for all businesses which may be susceptible to class action liti-gation to revisit any provisions they com-monly use or may con-

sider using for the purposes of preventing class actions being brought against them.

What can be taken from the Quizno’s deci-sion is that a clause which does not address with justification what the public’s interest may be in ousting the availability of a class action over the issue in dispute will likely be unenforceable.

At Sotos LLP, our substantial experience in litigating franchising class actions assists us to shape and meet the contractual goals of Canadian franchisors.

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“Material Changes” to a Disclosure Docu-ment – What do they mean to Franchisors and Prospective Franchisees?

For franchisors selling franchises in Ontario and Alberta, the law requires that they must provide all prospective franchi-sees in those provinces with their disclo-sure document. In preparing its disclosure document, a franchisor must disclose all “material facts” in its disclosure document. As a franchisor or prospective franchisee, you should already be familiar with the definition of “material fact” - but are you as familiar with the franchisor’s obligation to disclose a “material change” once it has given out its disclosure document?

What is a “Material Change”?

The legislation in both Ontario and Alberta define a “material change” as a change in the business, operations, capital or control of the franchisor or its associate, or a change in the franchise system, that would reasonably be expected to have a signifi-cant adverse effect on the value or price of the franchise to be granted [Alberta uses the term “sold” instead of “granted”] or the decision to purchase the franchise, and in-cludes a decision to implement the change made by the board of directors of the fran-chisor or its associate or by senior manage-ment of the franchisor or its associate who believe that confirmation of the decision by the board of directors is probable.

So what happens after a franchisor has prepared its disclosure document, en-sured that all “material facts” have been disclosed, has delivered it to the prospec-tive franchisee, and then discovers that a “material change” has occurred? What does this mean for a prospective franchisee and for the franchisor?

When does a franchisor disclose a “Mate-rial Change” to a prospective franchisee?

A franchisor is required to provide a prospective franchisee with a writ-ten statement disclosing any “material

Disclosure Document Refresher –What is this document anyways?

change” (known as a statement of material change) to the information in its disclosure document as soon as practicable after the change occurs and in any event before the 14-day “cooling off" period expires. A prospective franchisee should be aware that if a “material change” occurs, a franchi-sor must provide you with a statement of material change setting out the relevant information.

How does a franchisor disclose a “Mate-rial Change” to a prospective franchisee?

Although the law doesn’t impose an actual format for the form of the statement of material change, both franchisors and pro-spective franchisees should keep in mind the Ontario requirement that disclosure must be “clear and concise”. That’s why a statement of material change should either be formatted in the same manner as the disclosure document it modifies, or else it should contain a cross-reference table which points out where the information that is being amended may be found in the disclosure document. The idea is that a prospective franchisee should be able to easily understand the effect of the “mate-rial change” to the franchisor’s disclosure document.

Since every person who signs the state-ment of material change may be sued for any misrepresentation that may exist in the document, by necessary implication a statement of material change must have some sort of “Certificate of Disclosure” that is similar to that found at the back of a disclosure document. Since the law doesn’t specify a format for this certificate, a franchisor’s safest bet is to adapt the form of certificate prescribed for its disclosure document. From the perspective of the prospective franchisee, the statement of material change should include some form of “Certificate of Disclosure”.

How does a franchisor deliver its State-ment of Material Change to a prospective franchisee?

To add to all of the confusion, the law does not specify an actual delivery method for a statement of material change by the franchi-sor to a prospective franchisee. Despite the lack of any guidance from the legislators, a good way to proceed would be for a fran-chisor to use one of the delivery methods available for the delivery of a disclosure document.

Although the law mandates a 14-day “cooling-off” period following the deliv-ery of a disclosure document before the prospective franchisee makes any payment or signs any agreement relating to the franchise, there is no obligation to provide for any “cooling-off period” following the delivery of a statement of material change. So, what does a franchisor and prospec-tive franchisee do? Obviously some sort of “cooling-off” period would be appropriate, but of course there is nothing sacred about 14 days. If a franchisor can wait 14 days then that would be preferable, otherwise a franchisor should simply wait long enough for a reasonable person (the prospective franchisee) to absorb the new or modified information presented in the statement of material change and to consider its effect on the intended purchase.

What about negotiated changes?

There is no purpose for the franchisor to disclose to a prospective franchisee the very changes which the prospective franchisee may have negotiated. The purpose of dis-closure is to require a franchisor to provide a prospective franchisee with material in-formation which they might not otherwise know, and not to waste a franchisor’s time and money on pointless exercises. There-fore, we don’t believe it is necessary for a franchisor to disclose negotiated changes requested by the prospective franchisee. Of course, if franchisees regularly succeed in negotiating changes to a franchisor’s stan-dard form agreements, that fact is definitely material and should be disclosed…. but that’s a topic for another day.

By John Yiokaris

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An Estate Plan - Do you have yours?Crafting an estate plan is the best way to min-imize the amount of taxes payable on death and an effective estate plan begins with a well drafted will. Every adult should have a will; if you die without a valid will, you will have died “intestate.” This means that the Ontario courts will appoint someone to administer your assets and that your assets will be dis-tributed according to the provincial rules. A will simplifies the administration of your es-tate and ensures that your property is distrib-uted according to your wishes. Careful estate planning will also allow for the reduction in the amount of taxes payable on death.

In Ontario, tax payable on death is called estate administration tax and is levied at the rate of 1.5% of the value of the assets re-quiring administration. As some assets do not require administration (formerly called probate), one effective planning strategy in-volves the creation of multiple wills; one to deal with assets that do require probate, and a separate will to deal with assets that do not. If you own property in another jurisdiction, it is also advisable to have yet another will to deal with that asset.

The multiple will strategy is particu-larly useful for people who own shares in privately held corporations. Due to the fact that shares and debt of a private company may be transferred by the direc-tors without a probated will, no estate ad-ministration tax (probate fee) is payable. In the right circumstances, this can result in considerable savings. If you are consider-ing the use of multiple wills, you will want to consult a professional. Multiple wills must be properly drafted and executed, and care must be taken that one will does not inad-vertently revoke the other.

Reducing estate administration tax is only one aspect of an estate plan, and should be viewed in light of the plan in its entirety. For example, excluding assets from your estate will result in fewer assts available for other goals, like establishing a trust for a child or a disabled family member. Weighing the

needs of your estate against the desire to re-duce the amount of tax paid is a significant aspect of estate planning.

Another important aspect of estate plan-ning includes the creation of a power of at-torney document. A power of attorney for the management of property allows a per-son you designate to manage your property should you become incapacitated, unlike a will that only comes into effect upon death. From a practical perspective, it makes sense to ensure that a person of your choosing will have access to your bank accounts and the ability to make sure your bills get paid should you become unable to do so your-self. Like a will, the proper drafting and ex-ecution of a power of attorney will ensure that it accomplishes what you intend it to. In the event that you become incapacitated without a valid power of attorney in place, an application to the provincial court for

appointment of a guardian of your property may be necessary. That appointed guardian may not be the person you would have des-ignated.

An effective estate plan will provide for the smooth transition of your assets upon death and ensure that your assets are distributed as you intend. No matter how well crafted your estate plan is, it is wise to review your plan every few years. Your family circum-stances may change or these may be changes in the law that your estate may benefit from. In either case, your estate plan should be up to date and reflect your current needs and circumstances.

Estate planning is an important part of the services that we regularly provide to our entrepenurial client base in meeting the goals of their businesses and their personal investment in their businesses.

By Rachel Loizos

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Prospective franchisees base their decision to enter into a franchise relationship on many factors, one of the most important being their perception of the franchisor’s financial health. Consequently, the franchisor’s financial statements, which indirectly address the economic viability of the franchise system as a whole, is one of the most important pieces of information that the franchise disclosure legislation requires be included in the disclosure document provided to a franchisee.

Considering the importance of the financial statements to a prospective franchisee, it is not surprising that Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”) defines the methods for preparing financial statements which are acceptable for the purposes of the disclosure document.

Any non-compliance with the disclosure requirements under the Act may permit the franchisee to rescind the franchise agreement and recover damages against the franchisor and against the principals of the franchisor, personally. As a franchisor, you can expect that the courts will not overlook the importance of the financial statements to the disclosure document and will likely award the remedies available to the franchisee under the Act if the financial statements are not prepared in conformity the Act.

What Financial Statements are Acceptable for the Disclosure Document

Unless the franchisor qualifies for the financial statement exemption in the Act, the Act requires the franchisor to include in the disclosure document either:

a) audited financial statements for the most recently completed fiscal year of the franchisor’s operations; orb) financial statements for the most recently completed fiscal year of the franchisor’s operations that are at least equivalent to the review and reporting standards to review engagements set out in the CICA Handbook.

Failure to provide the prescribed financial statements means non-compliance with the disclosure requirements of the Act.

Consequences of Non-Compliance with the Act

Certain statutory remedies are available to a franchisee if the disclosure requirements of the Act are not met. The Act gives the franchisee the right to rescind the franchise agreement if the contents of the disclosure document do not meet the standby requirements, but this rescission remedy must be exercised by the franchisee within 60 days after receiving the disclosure document.

The Act gives the franchisee the further right to rescind the franchise agreement if the franchisor did not provide a disclosure document, but this rescission remedy must be exercised by the franchisee within two years after entering into the franchise agreement.

Upon a rescission right being exercised, the franchisor will have to return the franchisee’s investment in the franchise and compensate the franchisee for any losses incurred in setting up and operating the franchise, all within 60 days after the effective date of rescission. Further, if the franchisee suffers a loss because of the franchisor’s failure to comply in any way with the Act’s disclosure requirements, the franchisee has a statutory right of action for damages against the franchisor.

Strict Compliance with Act

Recent Ontario jurisprudence demonstrates that the courts will strictly interpret the franchisor’s disclosure obligations under the Act in favour of franchisees.

The Ontario Court of Appeal has held that the franchisee’s statutory right of action for damages is in addition to the rescission right and concluded that franchisors need to provide disclosure documents that include all of the information required by the Act. As a result, should a franchisor fail to include either audited or review engagement

financial statements in the disclosure document, it is open to the franchisee to argue that because the franchisor’s financial health is so fundamental to a prospective franchisee’s investment decision, what the franchisee received was not a “disclosure document” within the meaning of the Act, so that the franchisee may take advantage of the two-year rescission period.

Conclusion

A franchisor which does not provide or fails to complete the disclosure document in strict compliance with the Act, including financial statements prepared in accordance with the Act, runs the risk of having an unhappy or disappointed franchisee rescind the franchise agreement within two years after the grant of the franchise. The consequences are far more detrimental than the extra cost of including financial statements prepared in accordance with the Act.

The disclosure document is the cornerstone of the Act. We work closely with our clients and their financial advisors to ensure compliance with the Act.

Financial statements and the disclosure document By Lou Alexopoulos

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John Sotos: jsotos@sotosllp.com

Sam Hall: shall@sotosllp.com

David Sterns: dsterns@sotosllp.com

Allan Dick: adjdick@sotosllp.com

John Yiokaris: jyiokaris@sotosllp.com

Rachel Loizos: rloizos@sotosllp.com

Lou Alexopoulos: lalexo@sotosllp.com

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