Cannabis Retail Franchising – Benefits and Limitations

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By: Ben Hanuka, Law Works

This article was originally published in The Lawyer’s Daily as a two-part series on May 25 and 27, 2021. 

The recreational cannabis retail market in Ontario is slowly growing with the expansion of the maximum number of permissible retail store authorizations.  Does the franchise business model have a useful role in the recreational cannabis retail market?  If so, what are some of the limits and unique features that parties to a franchise arrangement in this industry should consider?

Benefits of being part of a cannabis retail franchise

There are potential benefits to operating a cannabis retail store that is part of a cannabis franchise system (assuming that the franchisor is knowledgeable and experienced in this sector).  Areas of benefit include the following:

• site-selection and understanding municipal zoning restrictions on the operation of the cannabis store;
• obtaining cannabis licences and approvals from the Alcohol and Gaming Commission of Ontario (AGCO);
• good store layout;
• product selection in-store and online and merchandising strategy;
• brand recognition and goodwill;
• online marketing;
• financial management; and
• human resources – hiring and training staff.

Legislative limitations on the franchise model

The sale of recreational cannabis through a cannabis retail store is highly regulated, including through the imposition of a retail operator licence, retail store authorization, cannabis retail manager licence, and operating standards.  The Cannabis Licence Act, 2018 (the “CLA”), the regulation under the Act (Ontario Regulation 468/18), and the Registrar’s Standards for Cannabis Retail Stores, which are passed under the CLA and the Regulation, impose limits on many business and operational aspects that a traditional franchise model normally tends to control by contract.  These can impact in one way or another at least the following areas:

• store premises, equipment and facilities, including surveillance and security;
• safeguarding the business against unlawful activities;
• advertising and promotion;
• staff training standards;
• protection of store assets; and
• record keeping and confidentiality.

Unique issues to consider in the retail cannabis franchising model

Franchisors and franchisees should consider at least some of the following areas that may create unique franchise requirements under the CLA, the Regulation and the Registrar’s Standards.

• The role of the franchisee and other stakeholders

Parties should consider the role of the franchisee, franchisor and other stakeholders.  This includes all parties who will be involved in providing services, such as advice, expertise and management, or who will be involved in the operation, revenue-sharing, financing, control, marketing or lease.

This could include parties that hold equity interests, such as of course franchise and licensing agreements, as well as consulting agreements, agreements of purchase and sale of equity holdings in the applicants, shareholder agreements, options agreements, debt instruments, agreements governing operations or management, service contracts, revenue sharing agreements, partnership and leasing agreements.

What are the limits to the franchisee’s control of a retail operator licence and retail store authorization?  It is unclear whether a franchisor has a right to control these licences.  Similarly, will there be a separation from the retail operator and the retail manager.  If the latter is separate, he or she requires a cannabis retail manager licence.

• Site selection

The location that the parties select for the cannabis retail store must comply with the AGCO’s site-selection requirements, which are set out in the Act and the Regulation.  This may also impact proximity between various locations in the system, including corporate-owned.

• Control of the lease

Would there be restrictions on lease rights?  The Registrar’s Standards require the holder of the retail operator licence to control the store’s assets.  This raises the question if a franchisor has a right to hold the head lease and sublease the store premises to the franchisee without violating the control requirement.  This also potentially ties in to the holder of the retail store authorization and the structure that the parties choose to put in place.

• Responsibility for AGCO application process

Who will be responsible for the application process with the AGCO?  This includes disclosing to the AGCO all stakeholders and all related agreements (see earlier section about the role of the franchisee and other stakeholders).  The completion of a franchise deal could be subject to delays depending on the complexity of franchise structure and approval from AGCO.

Franchisors and franchisees must also keep in mind that under the licensing requirements, there is a continuous obligation to notify AGCO of any material changes to the information supplied as part of the licence application.  That may include notices, and where necessary, obtaining approval for, changes in ownership or name, transfers, and post-termination issues.

• Impact of Registrar’s decisions

The Registrar is authorized under the CLA and the Regulation to set standards and requirements for the operation of cannabis retail stores, such as in the Registrar’s Standards.  This brings into question the scope of the Registrar’s power and its interplay with the Licence Appeal Tribunal.

• Scope of disclosure in the franchise disclosure document

Parties should note the scope of franchise disclosure under the Arthur Wishart Act (Franchise Disclosure), 2000 and how it compares with the scope of disclosure to the AGCO under the CLA.  The cannabis legislation requires disclosure of “[a]ny parties with a financial and/or beneficial interest in the applicant, or the operations or proposed operations of the applicant…”.  Where disclosure of stakeholders to the AGCO under the CLA appears to be otherwise broader than franchise disclosure, it may be that the broader disclosure is deemed a material fact and should apply to disclosure in the franchise disclosure document.

• Franchisor’s right to access POS

 Are there limits on the franchisor’s right to access the information in the POS system of the cannabis retail store?  The Registrar’s Standards impose control requirements on the retail operator with respect to confidentiality and security of records.  Parties should consider where and how those requirements can be reconciled with access to the POS system that a franchisor may want to have.

• Changes to the business model

 To what extent can a franchisor change the business model of the franchise system that can affect the cannabis retail store?  A typical franchise agreement gives the franchisor the right to make such changes.  But the cannabis retail industry is new and retail systems probably need fine-tuning or more significant changes to their business models.  For example, a potential area of change is the use of the premises, as a cafe.  Parties should also turn their mind to whether it may be suitable in this area to allow more local store customization than what is normally allowed in a typical franchise system.

• Impact of termination on the cannabis license

Franchise agreements generally contain termination rights on the occurrence of various events of default.  Here, agreements should be conditional on the continued maintenance of the retail store authorization, retail operator licence, and, if applicable, cannabis retail manager licence, in good standing.

• Indemnity for violations of the franchisor’s obligations

There may be situations where the franchisee’s ability to maintain its licence can be at risk if the franchisor is found in violation of some obligation.  There can perhaps be violations of duties related to record keeping, marketing or promotion, and confidentiality.  Consideration should be given if the franchisee can be rendered in breach of its obligations under the CLA and the Regulation, and of course how to rectify this.

• Enforceability of restrictive covenants

Restrictive covenants are common in franchising.  It is uncertain how common law rules that apply to non-compete restrictions (during the term of the agreement and after termination) and other restrictive covenants may be affected in the cannabis legal framework.  For example, who would own such things as customer lists?  Under the Registrar’s Standards the holder of the retail operator licence must be in control of such records.

It remains to be seen to what extent franchising will play a role in the Ontario recreational retail cannabis sector, and what types of franchise arrangements take hold.  It also remains to be seen how the franchisor-franchisee relationship, and the relationship with potential other stakeholders, is impacted by the plethora of requirements and conditions outlined in this article.  This includes not only requirements under the CLA and the Regulation, but also parties’ rights and remedies under the Wishart Act.