Financial statements and the disclosure document

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; or b) 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 noncompliance 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.