Good Record Keeping Is Paramount: Lessons For Franchisors And Franchisees From The Ontario Superior Court Of Justice

The Ontario Superior Court of Justice's recent decision, Premium Host Inc. v. Paramount Franchise Group¹ ("Paramount"), confronts a number of legal issues that are of continuing importance to both franchisors and franchisees. But perhaps most importantly, it also serves as a stark reminder to franchisors and franchisees alike that any failure by them to document precisely what financial disclosure was provided, how it was delivered, by whom, to whom, and when, can prove to be a costly mistake for all parties.

Background

Paramount is a decision arising out of a factually complex dispute by which three related franchisees of the Paramount Fine Foods system of Middle Eastern restaurants sought to rescind their respective franchise agreements on the basis of the franchisor's alleged failure to have complied with its disclosure obligations under Ontario's franchise legislation, the Arthur Wishart Act (Franchise Disclosure), 2000, SO 2000, c 3 (the "Act").

The three franchisees seeking rescission were related in the sense that their principals were acquaintances or spouses of one another. Nonetheless, each franchise concerned a separate franchise agreement involving a different location. The three franchisees were (i) Versatile Holdings Inc. ("Versatile"), which first entered into a "generic franchise agreement" that did not grant a license to operate within any particular territory or location, and then entered into a complete franchise agreement after a location was identified; (ii) Everest Group Inc. ("Everest"), which entered into its own franchise agreement concerning a different location; and (iii) Premium Host Inc. ("Premium Host"), which also entered into its own franchise agreement with the franchisor concerning a third location, which (and unlike Versatile's and Everest's locations) was a location that had previously been operated by another (unrelated) franchisee.

Each of the franchisees delivered notices of rescission concerning their respective franchise agreements, after encountering operational difficulties and being the subject of default notices issued by the franchisor (and in the case of Premium Host, a termination notice). The franchisees claimed they were entitled to rescind on the basis of a number of disclosure deficiencies including (i) failure to provide the franchisor's financial statements and provision of disclosure in a piecemeal fashion, instead of as "one document at one time", as required by the Act.

The Paramount decision is the court's judgment of the three rescission claims, which were tried together. In lengthy reasons, the court ultimately denied Versatile and Everest their rescission claims but granted Premium Host its rescission claim. The decision is currently under appeal.

Key Takeaways

The court made a number of findings that will be of interest to franchisors and franchisees alike. But perhaps the most important lesson for franchisors and franchisees is that they need to maintain good records of the disclosure, both in terms of its content and manner of delivery.

1. The Burden of Proof is on the Franchisee to Establish It Did Not Receive Compliant Disclosure. The court agreed with the franchisor that the burden of proof was on the rescinding franchisee to establish that the franchisee did not receive compliant disclosure documents. The burden of proof is not often in issue in rescission litigation because there is typically no dispute about what disclosure was provided and when. But in the circumstances of this case, which involved conflicting accounts of how multiple versions of different disclosure documents came to be provided concerning different locations, and in the absence of clear record-keeping that could assist the court in establishing what disclosure was provided in each instance, the burden of proof became a focal point of the court's rescission analysis. The court did not explain the jurisprudential or doctrinal basis for its finding, so the legal finding is vulnerable in the pending appeal.

2. Entitlement to Rescission Will Be Hard to Prove in the Absence of Proof of the Impugned Disclosure Document. The court's underlying factual findings concerning disclosure also stand to be controversial, although they will be entitled to great deference in the pending appeal of this decision.

   In the face of starkly conflicting evidence and a general lack of credibility by witnesses presented by all of the parties, the court could not determine what specific form the disclosure took that was actually provided to the franchisees – neither their nor the franchisor's versions of the disclosure document were accepted by the court as having been the ones actually delivered.

   The court was therefore left to draw certain inferences as to the contents of the disclosure actually produced. In some cases, those inferences are controversial. For instance, while the court could not identify what disclosure had actually been provided to any of the three franchisees, the court was nonetheless prepared to infer that the franchisor would have properly included the required financial statements in whatever disclosure it did provide because there was evidence the franchisor was aware of the need to disclose those statements.

   Better record-keeping by the franchisor and the franchisees concerning disclosure would almost certainly have greatly reduced the scope of this dispute, or perhaps even have permitted the parties to avoid it altogether.
   

3. The Legal Test for Rescission Continues to Ignore the Conduct of the Franchisee. In recent years, there was some uncertainty in Ontario as to whether the conduct or knowledge of the particular franchisee claiming rescission should be a factor in the court's analysis of whether that franchisee was entitled to rescind its franchise agreement. Paramount is the latest in a fresh line of cases that affirms that the franchisee's conduct or knowledge have no role in the court's rescission analysis; rather, the court's analysis will focus on the adequacy of the disclosure itself, by reference to established judicial and statutory principles, and not on how that disclosure impacted the particular franchisee claiming rescission.
   
   
4. Franchisors Continue to be Exempt from Disclosure Only in Very Narrow Circumstances. The Act sets out a number of circumstances that, if present, exempt a franchisor from having to provide a prospective franchisee with the financial disclosure otherwise required under the legislation. One such exemption is available when a single franchisee is investing a significant amount of money at the outset to acquire the franchise. The franchisor in Paramount claimed entitlement to that exemption on the basis of the argument that Versatile, Everest, and Premium Host were effectively operated as a single entity by virtue of their shared principals and had invested in a single shared franchise more than the minimum investment amount required for the franchisor to qualify for the exemption. In rejecting that argument, the court characterized the grants here as being three separate grants of three different franchises, and not a single grant involving multiple locations. With respect to Premium Host, the court also rejected the franchisor's attempt to rely on a separate disclosure exemption that is available when the grant concerns a resale of an existing franchise without any active involvement by the franchisor. The court found (as have a number of other courts that have had occasion to consider this exemption) that the franchisor was not merely a passive participant in Premium Host's acquisition of the territory previously operated by another franchisee but was in fact actively engaged in the acquisition; that active engagement disentitled the franchisor from being able to rely on the resale exemption. The court also found that, in any event, there was no direct transfer of the franchise from the previous franchisee to Premium Host.

5. A "Generic" Franchise Agreement Is Not a Grant of a Franchise. The franchisor in Paramount attempted to rely on the earlier generic franchise agreement that Versatile had entered into in asserting that Versatile was out of time to rescind due to the operation of a limitation period. The court found that the generic franchise agreement was not a "franchise agreement" at all within the meaning of the Act, because it did not define the specific territory within which Versatile would be licensed to operate and therefore cannot be said to have granted a franchise.

6. A Prior Termination of a Franchise Agreement Does Not Foreclose a Subsequent Rescission. The court rejected the franchisor's argument that Premium Host could not legally have rescinded its franchise agreement because the franchisor had terminated that agreement prior to Premium Host's delivery of its rescission notice. The court followed well-established precedent that the purpose of the Act was to protect franchisees, including by voiding any purported waiver by a franchisee of the franchisee's rights under the Act; in light of that principle, the court found that the franchisor was not entitled to rely on the prior termination as an effective waiver of Premium Host's statutory right to rescission.

7. Piecemeal Disclosure Remains a "Fatal" Disclosure Flaw, Entitling Franchisees Automatically to Rescind. By and large a franchisor's provision of disclosure to a prospective franchisee in a piecemeal fashion has been found by Ontario courts to be a "fatal" disclosure flaw, that in and of itself would entitle that franchisee to rescind.

   The court was not prepared to find that the Versatile and Everest franchisees had received piecemeal disclosure in this case; however, the court did find that the Premium Host received important information in a piecemeal fashion, thereby entitling that franchisee to rescind. More specifically, the court found that the franchisor had provided Premium Host with important financial information concerning the operations of that franchisee's location by its previous franchisee owner in the form of emails, and that that information was not included in any disclosure document that was before the court.
   

8. The Characterization of Which Entity Related to a Franchisor is a "Franchisor's Associate" Remains Highly Fact-Specific. In Ontario, certain parties that are sufficiently related to the franchisor are deemed under the Act to be "franchisor's associates". Franchisor's associates are liable alongside franchisors to compensate franchisees for franchisees' losses under the Act, such as those losses arising from claims for rescission and misrepresentation. The court in Paramount found that the franchisor's related leasing company and an employee who was involved in the grant of the subject franchises were "franchisor's associates" within the meaning of the Act; the court declined, however, to find that the system's largest supplier of inventory or a construction management company related to the franchisor were "franchisor's associates", because there was not a sufficient operational or financial nexus between them and the franchisees.

Conclusion

The Paramount decision provides further authority for the now-familiar propositions that (i) the test for rescission is an objective one, (ii) franchisors should be wary of relying on statutory disclosure exemptions, and (iii) the spectre of being deemed a "franchisor's associate" looms large with respect to those people or companies that are closely tied to the franchisor and that are directly involved in the grant of the franchise or have close financial and operational ties to the franchisee.

It will be interesting to see what precedential weight attaches to this decision, particularly with respect to the court's placement of the onus on the franchisee to prove that it did not receive compliant disclosure. The case arises out of an idiosyncratic fact situation involving three related franchisees, all of whom were disclosed during roughly the same period and in the seeming absence of cogent evidence as to what disclosure was actually provided. That unusual set of facts stands to render this decision easily distinguishable from future ones. The outcome of the pending appeal also stands to affect the future authority of this decision.

What is clear already, though, is that it is incumbent on both franchisors and franchisees to maintain rigorous records of both the contents and manner of disclosure in order to ensure that any future disputes can at least be effectively adjudicated, if not avoided altogether.

Footnotes

1 2023 ONSC 1507, https://canlii.ca/t/jvzv7

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