What happens next? Dealing with statements of material change and additional disclosure

For franchisors selling franchises in those provinces with franchise disclosure legislation, the law requires that they must provide all prospective franchisees in those provinces with a disclosure document. But what does a franchisor do after it has delivered its disclosure document to a prospective franchisee? When does the disclosure obligation end? Unfortunately for franchisors, the franchise disclosure legislation is not always clear.

The following provides a few “best practices” for how and when to disclose negotiated changes to a franchisor’s franchise documents and how to properly disclose additional agreements to be signed by the prospective franchisee that were not included in the disclosure document.

Negotiated Changes

It is not news to a franchisor that the franchise disclosure legislation requires a disclosure document to disclose information about the franchisor, the franchisor’s franchise documents that are to be signed by the franchisee, the franchisor’s financial statements, certain mandatory statements, and all material facts. But what happens where you have delivered proper disclosure and the prospective franchisee then negotiates changes to the franchise documents? If you have a prospective franchisee requesting amendments to the franchisor’s standard form of agreements, there is no obligation on a franchisor to disclose or even re-disclose amendments that have been requested by a prospective franchisee. Put simply, there is no purpose for you to disclose to a prospective franchisee the very changes which the prospective franchisee may have negotiated. The purpose of disclosure is to require you to provide a prospective franchisee with material information which it might not otherwise know, and not to waste your time and efforts on pointless exercises. For that reason, it is not necessary for you to disclose negotiated changes requested by the prospective franchisee. That being said, if franchisees regularly succeed in negotiating changes to your standard form agreements, that fact is definitely material and should be disclosed.

A franchisor should also be mindful that if it asks for concessions in exchange for granting the amendments requested by the franchisee, those concessions will need to be disclosed to ensure that the prospective franchisee has received full disclosure on the form of the agreements that he or she will sign. If additional disclosure is required, it will need to be done by way of a statement of material change. How does a franchisor prepare and deliver a statement of material change? Although the law does not impose an actual format for the form of the statement of material change, like the disclosure document, the statement should be “clear and concise” and should be drafted in such a way to allow the prospective franchisee to easily understand the affect of the material change on the disclosure document it received. In delivering the statement of material change, a franchisor should keep in mind that although the law mandates a 14-day “cooling-off” period following the delivery 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” following the delivery of a statement of material change. So, what does a franchisor and prospective 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 their intended purchase.

Additional Agreements

As mentioned above, a franchisor’s disclosure document must contain, among other things, copies of all agreements relating to the franchise that are to be signed by the prospective franchisee. Accordingly, despite providing a proper disclosure document and allowing the 14 day “cooling-off” period to pass, a franchisor should ensure that it does not subsequently have the franchisee sign any additional agreements relating to the franchise that were not part of the disclosure document or sign any agreement that was disclosed but which has been subsequently amended by the franchisor and the nature of those amendments are material. A disclosure document that does not contain all agreements signed by the prospective franchisee is deficient disclosure notwithstanding that an agreement was unavailable or inapplicable at the time disclosure was delivered.

A recurring example of this disclosure issue is the disclosure of subleases where a location is not identified until after the franchise agreement has been signed. For example, it is not uncommon for a franchisor to provide a prospective franchisee with a generic disclosure document, wait 14 days, get all of the franchise-related documents signed, and then go out and secure a location for the new franchise. In most cases where a location has not been identified in advance, the sublease that is signed by the franchisee contains several blanks and any references to the head lease or the actual location are left blank. But what happens once a location is secured? Many franchisors take the position that the disclosure obligation ended when the money was paid or the incomplete sublease and other documents were signed. These franchisors will simply fill in the incomplete blanks on the already signed sublease agreement and may also append the head lease to the signed sublease. The danger with this position is that it does not serve the purpose of the disclosure document. That is, it does not give prospective franchisees information about the franchisor and the franchise system allowing them to make an informed decision on whether to invest in the opportunity.

So what should a prudent franchisor do? The better approach is that once a location is secured the franchisor should return all money paid by the franchisee and the parties should rip up all signed agreements. The franchisor should then re-disclose the franchisee, this time the disclosure document should contain all material facts related to the head lease and the premises. The disclosure document should also include a copy of the head lease for the premises. Now, the purpose of pre-sale disclosure document is fulfilled and the franchisor does not have to worry about the franchisee making a claim that it was not fully apprised of key business information. But why not just use a statement of material change? It is important to make clear that, under this approach the franchisor is re-disclosing the prospective franchisee and not providing it with a statement of material change. While many franchisors take the position that a statement of material change is the only mechanism expressly contemplated under franchise legislation for supplementary disclosure, this position is simply wrong. The franchise legislation contemplates the use of a statement of material change under very specific circumstances, namely, during the “cooling off” period. Where the “cooling off” period has run and the franchisor has taken money from the franchisee or had them sign an agreement, your only option is to re-disclose.

Conclusion

Understanding and complying with franchise disclosure obligations in unique circumstances is a difficult endeavor for most franchisors. Failing to comply with your disclosure obligations can result in serious consequences, including, personal liability of officers and directors, a franchisee’s right to walk away, and a requirement that the franchisor pay back every dollar invested by the franchisee in acquiring and operating the business. To avoid potential liability for failing to properly disclose, franchisors should always keep in mind the purpose of disclosure and are well served by consulting the proper resources and professionals to ensure disclosure is both prepared and delivered properly.