Franchising in the Courts




Court Again Finds a Deficient Disclosure Document is no Disclosure Document 

By:   Dominic Mochrie

Springdale Pizza Depot is the latest instalment in the growing line of cases warning franchisors that a deficient disclosure document will be considered to be no disclosure document at all. However, there are two additional points of interest that arose from the case. The first is that the court rejected the theory maintained by some franchise practitioners that the vendor franchisee could be responsible for providing a disclosure document to the purchasing franchisee. The second is that franchisees may, under the relatively new court proceeding rules in Ontario, have more ready access to rescission claims for absent disclosure due to judges’ ability make conclusive findings relating to credibility and evidence on summary judgment motions.

The corporate plaintiff and its principals in 2189205 Ontario Inc. v. Springdale Pizza Depot Ltd. sought, on a summary judgment motion, to rescind the franchise agreement for their Pizza Depot franchise. The facts are relatively straightforward; the plaintiffs purchased an existing Pizza Depot franchise from the previous franchisees in October of 2008. The plaintiffs began operating the franchise, later signing various agreements with the franchisor in December 2008. The plaintiffs served a notice of rescission on July 16, 2009 and began litigation in August. While the parties disputed whether the disclosure document was provided to the franchisee prior to the execution of the franchise agreement, the court determined that it did not need to decide the timing issue. Instead, it examined the contents of the document that was purportedly delivered, and cited sufficient deficiencies in the disclosure document to determine it was not a disclosure document at all, even had it been delivered in time. Among the deficiencies cited were no franchisor’s certificate, no audited financial statements, no head lease for the premises and no earnings projections (there is no discussion of why the court believed that an earnings projections was a mandatory disclosure item, however, there were enough remaining deficiencies that the document would have otherwise been determined to be deficient absent the earnings projection issue). This serves as yet another warning that franchisors must comply with all of the technical requirements of the legislation, and also be mindful of what else might be considered to be a “material fact” that is not expressly prescribed in the regulation (e.g., a copy of the head lease).

Interestingly, in determining whether there was a genuine issue for trial, the court considered the relatively new rules for weighing evidence and assessing credibility in a motion for summary judgment. The motion judge decided that she was in as good a position as a trial judge to determine whether the franchisor had complied with its disclosure obligations. She found that there was no genuine issue for trial and the franchisees had a right of rescission and properly exercised it. If this case is indicative of the willingness of courts to make conclusive findings on core issues, rather than deferring the matters for trial, not only will franchisees have more ready access to a court’s confirmation of a rescission claim, but franchisors must be aware that they may not get a second opportunity to convince a court that the disclosure document was not so deficient as to be considered to be no disclosure document at all. Accordingly, franchisors must be ready to present their best defense to such a case at the summary judgment motion.

The vendor franchisees were also named as defendants and, in a cross-claim by the franchisor, the franchisor claimed that the vendor franchisees carried the onus of providing a disclosure document to the prospective franchisee. The court dismisses this summarily, confirming that the legislation imposes this onus only on the franchisor. That puts to rest the theory maintained by some franchise practitioners that the vendor franchisee could be responsible to provide a disclosure document to the purchasing franchisee.

This case is another good illustration of the court’s willingness to find a disclosure document so deficient that it is no disclosure document at all. Further, given the apparent increased likelihood of a determinative finding on a motion for summary judgement, franchisors faced with claims of material deficiencies (e.g., missing head lease, financial statements or the franchisor’s certificate) would be well advised to evaluate the strengths of their case and consider settlement rather than pursue fruitless litigation.





Injunction Enjoining Interference with Franchisees’ Right to Associate 

By:   Jennifer Dolman and Colin Feasby 

The Ontario Superior Court of Justice in 1318214 Ontario Limited et al v. Sobeys Capital Incorporated granted an interlocutory injunction, restraining Sobeys from terminating franchise agreements and  taking possession of the franchisees’ stores; and requiring the franchisees to comply with the franchise agreements while the injunction is in effect and to not withdraw any further amounts from their “Price Chopper” businesses or bank accounts for legal and/or accounting fees without the prior order of the Court.

The Facts

The dispute arose in May 2009 when Sobeys delivered its 2010 pro formas and the franchisees formed the “Chopper Grocery Owners’ Alliance” to voice their concerns.  There were some meetings but the issues remained unresolved. Sobeys meanwhile discovered that contrary to the terms of the operating agreements (the Operating Agreements), the franchisees were withdrawing in excess of $2,000 per year for legal fees.  Prior to March 29, 2010, each of the franchisees had withdrawn approximately $27,000 for legal and accounting fees. On March 29, 2010, each of the franchisees transferred $55,000 for a total of $385,000 out of their accounts to their lawyers. Sobeys issued notices of default (the Notices) almost at the same time that the franchisees filed a Statement of Claim regarding the Price Chopper franchise system.  Sobeys said that failure to pay all monies in excess of $2,000 by April 12, 2010 would result in termination of the Franchise Agreements and Sobeys’ repossessing the stores. 

Interlocutory Injunction Test

The RJR-MacDonald Inc. v. Canada (Attorney General), [1994] 1 S.C.R. 311 test for an interlocutory injunction has three parts.  A party seeking an injunction must satisfy the court that:

         (a) there is a serious issue to be tried;

         (b) they will suffer irreparable harm if the injunction is not granted; and

         (c) the balance of convenience lies in their favour.

Serious Issue to be Tried

This first stage of the test requires only a preliminary examination of the merits and is satisfied so long as the moving party shows that its claim is not frivolous or vexatious.

Madam Justice Conway found the following three serious issues relating to the validity of the Notices and Sobeys’ right to terminate the Franchise Agreements: (i) whether the franchisees were in default under the Operating Agreements by using funds, without Sobeys’ consent, to fund the litigation against Sobeys; (ii) whether Sobeys had breached its duty of good faith at common law and under the Arthur Wishart Act (Franchise Disclosure), S.O. 2000, Chap. 3 (the Act) in issuing notices of termination of the franchisees’ franchise agreements; and (iii) whether Sobeys was interfering with the right to associate under section 4 of the Act.

Regarding the Operating Agreements, the franchisees asserted that if the clause prohibiting the withdrawal of more than $2,000 a year for legal fees was interpreted as restricting them from retaining counsel to sue Sobeys, it would effectively preclude the franchisees from asserting or enforcing their rights against the franchisor and would grant Sobeys immunity from franchisee suits. Justice Conway concluded that there was a serious issue as to the proper interpretation of the clause, its scope and enforceability.

Further, Justice Conway found that the fact that the Notices were issued around the same time as the Statement of Claim and that there were previous instances of Sobeys permitting franchisees to incur legal fees in excess of $2,000 where the claims were not against Sobeys, raised a serious issue to be tried as to whether Sobeys was acting in good faith when it issued the Notices. The franchisees, relying on the  recent Ontario Court of Appeal decision 40531 Ontario Limited v. Midas Canada Inc, 2010 ONCA 478 (Midas), submitted that by restricting their access to funds for legal fees and purporting to terminate the Franchise Agreements for the withdrawal of funds in excess of $2,000, Sobeys was interfering with their statutory right of association.  Justice Conway noted that this case was a collective effort of the franchisees to enforce their rights against Sobeys and found that there was a serious issue to be tried as to whether, in breach of section 4 of the Act, the issuance of the Notices and proposed terminations amounted to an interference with the franchisees’ ability to pursue collective action.

Irreparable Harm

Irreparable harm means harm that cannot be quantified in monetary terms and where a termination of a franchise is concerned, can include loss of business, profits, reputation and goodwill. 

Sobeys tried to argue that any damages suffered by the franchisees could be quantified in monetary terms on account of actual operating results being available when it took over the stores. Justice Conway, however, found that if an injunction was not granted, the franchisees would lose their family businesses they had purchased, operated and expected to develop over the franchise term.  Even though Sobeys had offered to waive the non-competition clause in the Franchise Agreements and to forego enforcing its security on the franchisees’ homes, Justice  Conway found that the franchisees would likely become employees of another store, rather than operating their own businesses, and that this change was not compensable in damages.  

Balance of Convenience

This part of the injunction test requires a determination as to whether the moving party will suffer more if the injunction is not granted than the responding party will suffer if the injunction is granted.  Justice Conway found that the balance of convenience clearly favoured the franchisees.  Whereas the franchisees would lose their family businesses, their employment and future prospects for their stores, the main inconvenience to Sobeys was that funds had been withdrawn for legal fees when perhaps they should not have been.  Such harm to Sobeys could be addressed by restricting the franchisees from withdrawing any more funds until the termination issue had been decided.

Costs

In a separate endorsement at 2010 ONSC 4984, Justice Conway awarded costs of $55,000 to each of the franchisees, payable by Sobeys within 30 days.  Her Honour referred to the earlier decision of Erinwood Ford v. Ford Motor Company of Canada Limited, 2005 CanLII 23333 (ON. S.C.) in which costs were awarded to a car dealership who obtained an injunction to restrain termination of the dealership pending trial, and found that the same factors of inequality in strength of position, the lack of urgency in terminating the Franchise Agreements prior to a court ruling, and the inevitability of an injunction motion given what was at stake for the franchisees, were present. 

Conclusion

Sobeys is a good example of how a court will react to what appears to be a tactical termination of a franchisee.  Franchisors should be careful when exercising termination rights and ensure that termination is not capricious, arbitrary, or self-interested.  Terminations that rely on the strict wording of an agreement but appear to have a collateral purpose will be strictly scrutinized by the courts.  Even though Sobeys may limit tactical terminations, itshould not prevent franchisors from terminating franchisees for material breaches of franchise agreements.

Sobeys is also significant because it is a group franchise action.  The franchisees’ collective action against Sobeys enabled them to effectively rely not just on the frequently pleaded common law and statutory duty of good faith and fair dealing but also on the statutory right of association.  As a result of the recent appellate decision in Midas, as applied in Sobeys, franchisors should expect that section 4 of the Act will receive further traction in future franchise disputes.  Section 4, like section 3, provides the franchisee with a right of action in damages against the franchisor or franchisor’s associate.





Interlocutory Injunction Granted Forcing Franchisees to Continue Paying Royalties 

By:   Aislinn Reid

Franchisors who pursue interlocutory injunctions to protect their franchise systems should get some comfort from the Ontario Divisional Court’s dismissal of the franchisees’ motion for leave to appeal in Bark & Fitz Inc. v. 2139138 Ontario Inc et. al.

In Bark & Fitz, the franchisor sought to enjoin 17 franchisees from breaching their franchise agreements by refusing to accept core products, failing to pay advertising and marketing fund contributions and royalties, and from terminating their franchise agreements and continuing independent operations. The franchisees, on the other hand, claimed that the franchisor’s changes to products and inventory, alleged misuse of the advertising and marketing fund and alleged failure to remit rebates and imposition of delivery charges deprived them of the benefit of the franchise system and therefore amounted to a fundamental breach of their franchise agreements.

The motions judge granted the injunction in part, and in doing so made some important statements with respect to the franchise relationship between the parties. The motions judge held that the even if the franchisees’ could prove their claims related to the franchisor’s changes to core products, rebates and discounts, those claims did not amount to fundamental breach of the franchise agreement by the franchisor, and did not deprive the franchisees of substantially the whole benefit of the franchise relationship, because the franchisees continued to operate with the brand, logo, marketing recognition and exclusive territory. The motions judge also held that the franchisees’ failure to pay royalties required under the franchise agreement caused irreparable harm to the franchisor which depended heavily on revenue from royalties to sustain its operations. Additionally, the motions judge stated that the franchisor’s “inability to maintain the advertising, marketing and quality control through core products creates a risk to the good will and reputation” of the franchise. 

The franchisees sought leave to appeal the order of the motions judge on the basis that the order was made against individuals – the principals of the franchise – who did not sign franchise agreements and that the order was made against certain franchisees who had rescinded their franchise agreement before the injunction motion was heard, who therefore should not be subject to the non-competition clause in the franchise agreement. Denying leave to appeal, the Divisional Court held that there was a fully executed franchise agreement between the franchisor and the corporate entities, and as principals of those corporate entities, the individuals were indeed bound by the non-competition clause of the franchise agreement.

Franchisors who pursue injunctions to enforce their franchise agreements should also take note of the costs endorsement in Bark & Fitz. The form of franchise agreement applicable to five of the franchisees provided for an award of substantial indemnity costs in the event of an injunction. The franchisor asked for its costs on a substantial indemnity basis, payable within 30 days. The court determined that although the franchisees’ conduct with respect to refusal to pay royalties was “egregious,” the amount claimed by the franchisor was not fair and reasonable. Among the factors cited by the court for its decision to award a significantly reduced amount of costs included the fact that the franchisor was not entirely successful in obtaining an injunction, and that the franchisor’s conduct in relation to alleged withholding of rebates and changes to core products raised serious issues to be tried and appeared to have been a significant cause of the breakdown in the franchise relationship. Additionally, the court expressed sympathy for the franchisees in exercising its discretion to order costs to ultimately be paid by the successful party at trial, rather than within 30 days as requested by the franchisor. The court stated that although the franchisor was required to seek an injunction, “serious issues outstanding affecting the financial viability of the franchisees and relating to the alleged breaches by the franchisor that contributed to the breakdown in the relationship,” made it unfair to require the franchisees to pay costs pending trial.



People Operating Closely-Held Franchisors Take Greater Personal Risk 

By:   Mary Paterson

In May 2010, the Ontario Superior Court refused to strike a franchisee’s allegations of breaches of the duty of good faith against Glenn Miller, a man alleged to control the franchisor even though he was not an officer, director or shareholder of the franchisor. As this case starkly demonstrates, people operating a closely-held franchisor take greater personal risk because they are less likely to be protected by the corporate veil.

The Plaintiffs in WP (33 Sheppard) Gourmet Express Restaurant Corp. v. WP Canada Bistro & Express Co. Inc. wanted a Wolfgang Puck franchise and entered into agreements with the Canadian Wolfgang Puck licensor (WPC), which was owned and operated by Glenn’s son, Neil Miller, and Marty Soltys. The Plaintiffs alleged that Glenn was one of WPC’s “directing minds,” although it appears he had no position with WPC.

Glenn had been active in the Wolfgang Puck system. He originally purchased the Canadian Wolfgang Puck licence from Wolfgang Puck Express Licensing LLC (WPEL) and transferred the licence to WPC. He continued to be the primary contact with WPEL. He allegedly was a “key financier” behind WPC. Along with Neil, he also agreed to fund the construction of a turnkey Wolfgang Puck operation for the Plaintiffs, although it was Neil and Soltys who made these representations to the Plaintiffs.

After a year of construction delays, the Plaintiffs allegedly learned that WPC had misrepresented the amount of funding the Millers would provide. Glenn and Neil decided to get out of the restaurant business and withdrew their funding. Glenn’s decision started a chain of events that led to WPC losing the Canadian Wolfgang Puck licence making it impossible for WPC to give the Plaintiffs a Wolfgang Puck franchise.

The Plaintiffs sued eight defendants, including Glenn, alleging a number of causes of action. The Plaintiffs alleged that Glenn was a franchisor or franchisor’s associate as defined by the Arthur Wishart Act and had breached the common law, contractual or statutory duty of good faith. Glenn argued that he was merely the financier of the Plaintiffs’ operation and not a franchisor or franchisor’s associate. After all, he had not signed any contract with the Plaintiffs and apparently was not a director, officer or shareholder of WPC. He brought a motion asking the Court to strike the claims against him.

The Court refused to do so, holding that Glenn could be a franchisor’s associate as defined by the Arthur Wishart Act. The Court noted that a franchise agreement includes any agreement “in relation to” a franchise and held that the franchise agreement in this case “must” include the Millers’ agreement to fund the franchise. The Court also held that “[e]ither directly or in [his] capacity as the directing mind of WPC” Glenn was a party to a franchise agreement.

The Court focussed on the fact that only three people, including Glenn, were actively involved in the franchisor and commented, “When a franchising corporation is run by a few people, as opposed to many, the court may look behind the corporation to those additional parties who are ‘franchisors’ or ‘franchisor’s associates.’” Given Glenn’s involvement in funding the construction, his history with the Wolfgang Puck franchise system, and the Plaintiffs’ allegation that Glenn was a directing mind of WPC, the Court could not find that it was obvious that Glenn was not a franchisor’s associate without a trial of the issue.

The Court also stated that the duties of controlling individuals are “heightened where...the actions of the franchisor can only reflect the directions of a small finite number of persons involved in the corporation, and particularly where those individuals step into the role of a franchisor’s associate,” again upping the ante for people working for a closely-held franchisor.

As this decision arose from a motion to strike pleadings, the evidence at trial may show that Glenn was not sufficiently involved in the franchise relationship to be a franchisor’s associate. The Court’s comments, however, are consistent with the increasing legislative and judicial protection of franchisees and the resulting increase in risk to franchisors.

As the Court seems to find it easier to pierce the corporate veil in closely-held franchise systems to find individuals personally liable for breaches of the duty of good faith, those working in such franchise systems should take steps to protect their assets. Other than the usual methods of doing so (i.e. structuring personal affairs so that one’s spouse owns the personal assets), one should also ensure that his or her role in the franchise system is clearly documented to avoid becoming tangled in a lawsuit that could lead to personal liability.





Clear Contractual Breaches by a Franchisee are Sufficient Grounds to Deny a Franchisee an Injunction to Stop a Termination 

By:   Derek Ronde

In the recent Ontario Superior Court of Justice decision in C.M. Takacs Holdings Corp. V. 122164 Canada Ltd. (c.o.b. New York Fries), the court sent a strong message that a franchisor is justified in terminating a franchisee that fails to abide by its contractual responsibilities concerning the payment of amounts due under the franchisee agreement.  In this case, the court refused to grant an injunction requiring a franchisor to return the possession of four franchise locations to a franchisee after the franchise agreements for those locations were terminated due to the failure to pay amounts owed to the franchisor and other breaches of the agreements.

The plaintiff franchisee (Takacs) operated four franchises under the “New York Fries” brand name. The plaintiff had failed to pay rent, franchise fees and other creditors on a timely basis. In May 2010, Takacs gave the franchisor (New York Fries) a cheque to pay outstanding franchise fees, but the cheque was dishonoured due to insufficient funds. Takacs requested a meeting with New York Fries to discuss the amounts owed, but New York Fries terminated the franchise agreements in June 2010. In bringing its motion for an injunction, Takacs argued that New York Fries prematurely terminated the franchise agreements given the proposed meeting and that prior conduct by New York Fries in which late payments were tolerated meant that New York Fries was precluded from terminating the agreements.

In defending its termination of the franchises, New York Fries pointed to the fact that although Takacs had a history of late payments, there had been a significant increase in the number of defaults in recent years, and furthermore, New York Fries had identified additional contractual breaches, including substantial arrears to other creditors, security interests that had been given by Takacs to other creditors and the failure of Takacs to pay rent on their restaurant locations. This latter fact was particularly egregious because New York Fries was the sub-landlord at these locations. New York Fries argued that Takacs’ financial situation was worse than had been initially anticipated, and when it learned of the true financial position of the franchises, the franchise agreements were terminated.

In rejecting Takacs’ motion for an injunction to reverse the terminations, the court found that Takacs could not establish that there was a serious issue to be tried in respect of contesting New York Fries’ right to terminate the franchise agreements. The court found that New York Fries did not act unfairly, in bad faith or in a commercially unreasonable fashion in enforcing the terms of the franchise agreements. Simply put, the court found that “[t]he explanations for the events of default do not cure the defaults,” and dismissed the idea that it should “impose notice requirements when the Franchise Agreement allows that termination without notice.” Given that New York Fries would continue to operate the franchise locations post-termination, no irreparable harm to the plaintiff was found, as any losses would be easily calculable given the continued operation. The court also found that the risks faced by New York Fries if the injunction was granted, namely liability for unpaid rent and potential breaches of the head leases by Takacs, meant that the balance of convenience regarding the injunction was in favour of New York Fries.

Franchisors can take some comfort in this decision, as it supports the principle that a franchisor is not acting unfairly or in bad faith if it simply enforces the terms of the franchise agreement between it and its franchisee. This decision, particularly with respect to the test for obtaining an injunction in Canada, will be of assistance to franchisors resisting injunctions by franchisees looking to set aside terminations resulting from contractual breaches.





Contractual Ambiguity may Result in a Franchise Agreement Interpretation that is Unfavourable to a Franchisor 

By:  Derek Ronde

Franchisors must be extremely careful when drafting franchise agreement provisions as any ambiguity in the franchise agreement could be interpreted in favour of franchisees. In the Ontario Superior Court of Justice’s decision in 1230995 Ontario Inc. v. Badger Daylighting, a franchisee brought a successful action against a franchisor for breach of contract based on the franchisor’s decision to take away territories that the franchisee believed it was entitled to under the terms of an apparently vague franchisee agreement.

In this case, the plaintiff franchisee (123 Inc.) owned a franchise involving specialized trucks used to dig holes and uncover underground utilities. 123 Inc. and the franchisor (Badger) entered into their initial franchise agreement in 1998. By the end of 2009, 123 Inc. had sales of over $4.3 million and was operating in nine counties within Southwestern Ontario. In 2002, the parties entered into an amending agreement to the franchise agreement which granted 123 Inc. the right to work in areas that were not part of its territory under the 1998 franchise agreement. In 2003, the parties entered into a new franchise agreement and both parties ultimately had a different understanding of what constituted 123 Inc.’s territorial rights under the new franchise agreement. 123 Inc. believed that it had the exclusive right to provide services in nine counties in Southwestern Ontario. Badger disagreed with this and took the position that it had the right to assign those counties to new franchisees. In fact, in 2005 Badger advised 123 Inc. that it was assigning four of the counties to other franchisees, which instigated 123 Inc.’s action against Badger.

The court found that the 2003 franchise agreement was a contract of adhesion that was drafted solely by Badger and presented to 123 Inc. on a take-it-or-leave-it basis. As such, any confusion or ambiguity in the terms of the agreement was to be resolved in favour of the franchisee. The court found that there was indeed confusion and ambiguity in the description of the territory in the 2003 franchise agreement. Accordingly, the court determined that the four counties that were reassigned by Badger were in fact part of 123 Inc.’s territory and that Badger did not have the right to effect such a reassignment.

Badger made the argument that 123 Inc. had breached the franchise agreement by failing to properly grow his business in London, Ontario, which gave Badger the right to reassign this territory to another franchisee. The court did not countenance this claim and determined that not only was there insufficient factual evidence to support this claim, but that the wording of the franchise agreement concerning the duty to develop market areas was drafted by Badger and vague, and as such “any franchisee would have difficulty knowing whether he had complied with that requirement.”

The court awarded damages to 123 Inc. for pre-trial and future loss in respect of these wrongly appropriated market areas, but refused to grant an injunction against Badger regarding the reassignment of the marketing rights in the remaining five counties, citing a view that there was no threat of reassignment and to enjoin such behaviour would be premature.

When drafting franchise agreements, franchisors should take steps to ensure that market areas and other key components of the franchise relationship are clearly and accurately defined. Courts may invoke the doctrine of contra proferentem, wherein an ambiguous term will be construed against the party that imposed its inclusion in the contract, in the franchise context where there has been little negotiation of the franchise agreement and the factual circumstances apply. However, this doctrine is only applicable where there is in fact ambiguity, so a well-drafted franchise agreement should remove any such potential problems.