My franchisee rescinded its franchise agreement: What to look for in reviewing the franchisee’s calculation of damages

Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000 (the “AWA”) created various remedies for breaches of a franchisor’s disclosure obligations, including the right of a franchisee in Section 6(6) to “rescind’ its franchise agreement. The right of rescission carries with it corresponding obligations on the part of franchisors. Other provinces with franchise legislation, including British Columbia, Manitoba, New Brunswick, and Prince Edward Island, have provisions on franchisors’ obligations on rescission identical to those in the AWA.  The notable exception is Alberta whose relevant legislative provisions impose fewer obligations on franchisors. For purposes of this discussion, it is assumed that the franchisor and its counsel have reviewed the franchise disclosure document and have concluded that the franchisee has a right of rescission under the relevant franchise laws. So now, what obligations does the franchisor have?

Quantifying claims under Section 6(6) of the AWA

The purpose of the statutory right of rescission is to restore a rescinding franchisee to the position it would have been in had it not executed the franchise agreement.[1]  Once the statutory right of rescission is triggered by late or no disclosure, Section 6(6) requires the franchisor and any franchisor’s associate to make certain payments to the franchisee within 60 days of the effective date of the rescission.[2] Franchisors must keep in mind that the courts have held that the franchisor has no right to delay payment because there are other claims being made against it.[3]

Note that Section 6(6) of the AWA specifically provides a rescinding franchisee with rights against any “franchisor’s associate”, in addition to the franchisor, in order to increase the possibility of recovery.[4]  A franchisor’s associate may be an individual or corporation that is in a relationship of control with the franchisor and is either involved in the grant of, or exercises operational control over, the franchise. This right is also found in the franchise legislation of all other provinces. Moreover, the courts have held that any claims pursuant to Section 6(6) can be asserted against an assignee of the franchisor as it is not only “reasonable but also consistent with commercial practice”.[5] An assignee is a third party that takes an assignment of the benefits of a franchise agreement from an original franchisor, while also assuming its obligations.[6]

What damages are claimed in the notice of rescission?

Notice of rescission is written notice delivered to the franchisor by the franchisee. Following receipt of a notice of rescission, Section 6(6) of the AWA requires the franchisor or franchisor’s associate to take four key steps to restore a rescinding franchisee to the position it would have been in had it not executed the franchise agreement.[7] First, the franchisor is required to refund money received from or on behalf of the franchisee. This amount does not include money for inventory, supplies, or equipment. However, the court in Country Style held that rent for the franchise premises paid by the rescinding franchisee to the franchisor or franchisor’s associate must be repaid to the rescinding franchisee.^[8]

Second, the franchisor must buy back any existing inventory that the franchisee purchased pursuant to the franchise agreement. The buy-back price must be equal to the purchase price paid by the franchisee. A franchisor must repurchase all inventory of the rescinding franchisee, regardless of its condition and if, in fact, it could actually be repurchased.[9] The AWA does not require the rescinding franchisee to ensure that all inventory is in usable condition.

Third, the franchisor is also required to buy back any supplies and equipment that the franchisee purchased pursuant to the franchise agreement. Again, the buy-back price must be equal to the purchase price paid by the franchisee. Similar to the rules for inventory, a franchisor must repurchase all equipment of the rescinding franchisee, regardless of its condition.[10]  The AWA does not require the rescinding franchisee to make any representations or warranties about the quality or condition of the supplies and equipment.

The fourth step requires the franchisor to compensate the franchisee for any losses that the franchisee incurred in acquiring, setting up, and operating the franchise. In making this calculation, rescinding franchisees must not include any of the amounts owing to them pursuant to the above three steps. In general, reasonable expenses incurred to operate the business include rent (if not paid to the franchisor or the franchisor’s associate), operating expenses, advertising, insurance, utilities, and legal fees (related to the purchase of the franchise and the ongoing operation of the business). In calculating damages, the courts to date have provided considerable guidance on compensation for any losses under step four, as follows:

• In order to claim insurance premiums that have not been refunded by an insurer, a rescinding franchisee should provide copies of a written request for a refund and a response from the insurer denying the request.[11]
• In order to claim business expenses that continue post-rescission, the rescinding franchisee must provide an explanation as to why these expenses were incurred and paid.[12]
• With respect to claiming interest paid by the rescinding franchisee on advances from family members and other closely-related entities, written evidence should be provided to substantiate any interest charges claimed.[13]
• If a rescinding franchisee wishes to claim lost income, the rescinding franchisee should present records of his or her job search to support any such claim as the courts do not appear willing to grant compensation for lost income if the rescinding franchisee has not mitigated his or her damages.[14]
• The courts have not been prepared to allow any deduction for expenses relating to employee wages and supplier purchases allegedly paid in cash and not recorded on the books of the business. Where there is no corroborating evidence to support the rescinding franchisee’s calculations of these expenses, the court will not speculate or make speculative assumptions in order to calculate a rescinding franchisee’s damages.[15]
• If the rescinding franchisee has operated its franchise at a profit, the amount of the net profit is not to be set off against compensation owing by the franchisor under the other steps in Section 6(6).[16]

Avoiding Double-Counting and Windfalls

With the notable exception of Country Style, the courts have attempted to strike a balance between the notion of returning the rescinding franchisee back to its pre-franchise position and providing adequate compensation to the rescinding franchisee. As mentioned, the courts have confirmed that the calculation of the amount owing by the franchisor to the rescinding franchisee for any losses incurred (fourth step) does not include any of the amounts owing to the rescinding franchisee under the other steps. Additionally, the courts have confirmed that all four steps are to be read conjunctively so as to avoid any double-counting of amounts owed to the rescinding franchisee.[17] Further, in instances where rescinding franchisees have claimed unsubstantiated expenses as part of their claims for any losses incurred under the fourth step, the courts have been careful in awarding such expenses. It is also worthy to note that the courts have yet to award rescinding franchisees with legal fees incurred in seeking compensation under their rescission remedy. The end result of most cases decided so far is that very few, if any, rescinding franchisees are actually returned to their pre-franchise position.

Despite the apparent inability of rescinding franchisees to fully become “whole”, the court in Country Style allowed all rent payments made to the franchisor or its associate to be included in the compensation to be paid to the rescinding franchisee (under the first step).[18]  While this decision follows the letter of the law, in the instance where a rescinding franchisee has paid rent directly to the franchisor or its associate and has operated the franchise profitability or its operational losses are minimal (i.e., an operational loss, net of rent payments, results in an operational profit), the ability to remove rental amounts from the fourth step (compensating loss) and place them into the first step (refunding money received from or on behalf of the franchisee) leads to an outcome where the rescinding franchisee has actually bettered its pre-franchise position.

Joint and Several Liability

In circumstances where a franchisor fails to make the payments required of it under Section 6(6), the franchisor may end up fulfilling those obligations via Section 7(1) of the AWA.[19] Section 7(1) of the AWA clearly provides that if a franchisee suffers a loss as a result of a franchisor’s failure to comply in any way with the duty to provide a disclosure document, the franchisee has a right of action for damages. In addition to pursuing compensation against the franchisor and franchisor’s associate, a franchisee also has a right of action for damages against the franchisor’s broker, agent, and every person who signed the disclosure document or statement of material change. Moreover, Section 8(3) affirms that all or any one or more of the aforementioned parties who are found liable are jointly and severally liable. This means that the franchisee may pursue one or more parties for the full amount. In Alberta, the right of action for damages is narrower and may only be pursued against the franchisor or those individuals who signed the disclosure document.

Conclusion

If a franchisor receives a valid notice of rescission from a franchisee, care must be taken from the onset to ensure that the franchisee’s compensation claims are realistic and in accordance with both the statute and common law regimes. Where necessary, the franchisor and its counsel should seek the appropriate accounting and tax advice from qualified professionals in calculating any compensation claims to be paid by a franchisor. While the rescission process afforded by the statute provides a suitable framework for a franchisee to return to its pre-franchise position, franchisors should take prudent measures to ensure that the claims are appropriate.

[1] Sovereignty Investment Holdings, Inc. v. 9127-6907 Quebec Inc. [2008] O.J. No. 4450, Ontario Superior Court of Justice (“Sovereignty”).

[2] Section 14(2) of Alberta’s Franchises Act, RSA 2000, c F-23 provides for a 30 day time period.

[3] Payne Environmental Inc. v. Lord and Partners Ltd. [2006] O.J. No. 273, Ontario Superior Court of Justice (“Payne Environmental”).

[4] Sovereignty.

[5] Sovereignty.

[6] Sovereignty.

[7] The notable exception is Alberta whose relevant legislative provisions provide that a franchisor must only compensate the franchisee for any net losses that the franchisee has incurred in acquiring, setting up, and operating the franchised business.

[8] 1159607 Ontario Inc. v. Country Style Food Services Inc. [2012] O.J. No. 1241, Ontario Superior Court of Justice (“Country Style”).

[9] 2189205 Ontario Inc. v. Springdale Pizza Depot Ltd. [2012] O.J. No. 2641, Ontario Superior Court of Justice “Springdale Pizza    Depot”).

[10] Springdale Pizza Depot.

[11] 1706228 Ontario Ltd. v. Grill It Up Holdings Inc. [2011] O.J. No. 2206, Ontario Superior Court of Justice (“Grill It Up”).

[12] Grill It Up.

[13] Grill It Up.

[14] Grill It Up.

[15] Springdale Pizza Depot.

[16] Springdale Pizza Depot.

[17] Payne Environmental.

[18] Country Style.

[19] 1490664 Ontario Ltd. v. Dig This Garden Retailers Ltd. [2005] O.J. No. 3040, Ontario Court of Appeal.