Franchisors must comply with these disclosure requirements

Who is Entitled to Disclosure

Who is the “franchisee” for purposes of the right to receive an FDD? Everyone who will have an obligation to the franchisor or the franchisor’s associate is considered a “franchisee” and must receive an FDD. This includes guarantors to the franchise agreement, head lease/sublease guarantors and signatories to any agreement that relates to the franchised business.

Timing of Disclosure

To be legally compliant with franchise disclosure obligations, a franchisor must provide a prospective franchisee with an FDD at least 14 days before the prospective franchisee signs a franchise agreement or any other agreement related to the franchise sale (e.g. a lease agreement).

An exemption to this timing requirement relates to certain confidentiality and site-designation agreements.

The 14-day timing restriction also applies to any payments of consideration to a franchisor or the franchisor’s associate (e.g. a franchise fee), so that an FDD is required before imposing such an obligation on a prospective franchisee.

An exemption to this requirement is a limited deposit of up to 20% of the franchise fee, to a maximum of $100,000. The deposit must be fully refundable, with no deductions and without binding the prospective franchisee to enter into any franchise or related agreement.

In other words, a franchisor is not allowed to require any firm legal or financial commitments of a prospective franchisee until at least 14 days after delivering an FDD.

FDD Must be One Document Delivered at One Time

A franchisor must not disclose pertinent information in a piecemeal fashion, i.e., through different documents at different times. All information must be delivered in one document at one time. This means that neither a franchisor nor any of its representatives (e.g. a real estate agent or broker) may deliver material such as financial projections or other material facts about the franchise, the franchise system or franchised businesses to a prospective franchisee outside of the FDD.

The only exemption to this rule relates to a material change that happens after delivering an FDD and before the franchise purchase is finalized (material change, described below, is information that was not known to the franchisor at the time of delivering the FDD).

Disclosure of all Material Facts

The FDD must contain all material facts that the franchisor knows or ought to know as of the date that they deliver it to a prospective franchisee. A material fact is defined under the Act as follows:

“any information about the business, operations, capital or control of the franchisor or the franchisor’s associate, or about the franchise system, that would reasonably be expected to have a significant effect on the value or price of the franchise to be granted or the decision to acquire the franchise.”

This means that the FDD cannot be a “boilerplate” document that is created once and then reproduced to be delivered to multiple prospective franchisees. It is considered an “ever-green” document that must be continuously updated with the latest information that is known by the franchisor and customized for each location or franchised business under consideration.

Some common areas where franchisors omit material fact include the following:

• Site-specific information: This is one of the biggest areas of omission in many FDDs. It includes known information about the location, premises, and area that is relevant to a prospective franchisee’s investment decision, and can include the history of the lease, and the current operation (if it is an existing location in the franchise system). It also includes a copy of the head lease if there is one, along with a summary of the key terms of the lease.
• Information about the franchisor’s associate: A franchisor’s associate may be a person or a company that directly or indirectly controls or is controlled by the franchisor or is controlled by another person who also controls the franchisor directly or indirectly. There are many possibilities for who is considered a franchisor’s associate. These can include a holding company, leasing company, sub-landlord, or supplier affiliated with the franchisor. Under recent Ontario court decisions, the officer or director of the franchisor who signs the franchisor’s certificate in the FDD is also considered a franchisor’s associate.
• Existing franchisee’s revenues or financials on a resale: On a resale, the sales revenues or possibly financials of the existing franchisee have been ruled to constitute material fact information. This is a type of site-specific information that applies when a location within the franchise system is being resold to a new franchisee. Resales can include scenarios where an existing franchisee is looking to sell its franchised business, or where the franchisor has taken over the operations in a termination and is looking to sell the location to a new franchisee, among various possibilities. On a resale, the FDD must contain at least sales revenues. More detailed financial information may be required as material fact information if the franchised business is losing money or is otherwise in financial distress.

Additional information may be considered material fact depending on the industry that the franchise system operates in. The following are links to articles and eBooks that we have written about industry-specific information.

• Child care and Education: Franchise Disclosure Obligations in the Highly Regulated Daycare Industry (article); Disclosure Obligations of Daycare Franchisors (eBook)
• QSR and Retail: Disclosure Obligations of QSR and Retail Franchisors (eBook)

Disclosure of Material Changes

Material changes occur after the delivery of an FDD, before signing the franchise and related agreements, and must be delivered through a Statement of Material Change. The Act defines a material change as follows:

“a change in the business, operations, capital or control of the franchisor or franchisor’s associate, a change in the franchise system or a prescribed change, that would reasonably be expected to have a significant adverse effect on the value or price of the franchise to be granted or on the decision to acquire the franchise and includes a decision to implement such a change made by the board of directors of the franchisor or franchisor’s associate or by senior management of the franchisor or franchisor’s associate who believe that confirmation of the decision by the board of directors is probable.”

Some examples of material changes include, but are not limited to, the following:

• updated or amended lease agreements received from the landlord after the delivery of the FDD,
• updated or renegotiated documents related to an asset purchase,
• updates about the franchised location, and
• updates about the franchisor or the franchise system.

Disclosure of Financial Statements as Prescribed

The financial statements for the franchisor’s most recent fiscal year must be included in the FDD. These financials must be prepared on higher accounting standards than normal – either on an audited basis or a review-engagement basis (together with the accountant’s certificate to that effect on a cover letter to the financial statements).

Financial statements that are prepared on a lower level of accounting review standard or for a different fiscal year end do not meet franchise disclosure requirements. The courts have ruled that including financial statements that do not meet these strict requirements has the same legal effect as not including any financial statements at all. In other words, the FDD either contains the required financial statements or it does not – there is no middle ground.

There are some exceptions to this requirement, including where less than 180 days have passed since the end of the franchisor’s most recently completed fiscal year, where the financial statements for the most recent fiscal year have not been prepared yet. If that scenario, the FDD must include the franchisor’s financial statements for the previous year, which must meet the same strict accounting standards.

Disclosure of Financial Projections of Earnings or Annual Operating Costs

Sharing financial projections or annual operating costs with prospective franchisees is another ripe area where franchisors and their associates and representatives can get into a lot of trouble if it is not done properly as required under the Act and the Regulation and as part of the FDD.

Under the Regulation to the Act, if a franchisor chooses to provide an earnings projection, it must also include the following important information in the FDD:

• a statement specifying the reasonable basis for the projection,
• all assumptions underlying the projection, and
• a location where information is available for inspection that substantiates the projection.

For annual operating costs, a franchisor must include the following in the FDD:

• a statement specifying the basis for the estimate,
• the assumptions underlying that estimate, and
• a location where information as available for inspection that substantiates the estimate.

Signed and Dated Franchisor’s Certificate

For an FDD to be valid, it must include a franchisor’s certificate that certifies that the FDD contains no untrue information, representations, or statements, and that it contains every material fact, financial statement, statement, and other information required by the Act and the Regulation.

The franchisor’s certificate must be signed and dated by the director or officer of the franchisor (if there is only one), or by two persons who are officers or directors (if there more than one officer/director). Failure to do so will invalidate the FDD. It is critical that the individuals who sign the certificate have fully reviewed the FDD and approved it each time before signing the certificate.

As franchisor’s associates, these individuals will have personal liability for the contents of the FDD and for potential rescission damages.

Delivery of the FDD

Finally, the Regulation outlines the required methods to deliver an FDD to a prospective franchisee – registered mail, prepaid courier, or electronically. The delivery of an FDD electronically must meet a set of technical requirements set out in the Regulation.

The Consequence of Non-Compliant Disclosure

The consequences of disclosure errors and omissions can be devastating to a franchisor and its associates. It can give the franchisee the right to claim rescission (i.e. legal cancellation of the franchise purchase) and a full refund of their entire franchise purchase and operating losses. There may also be grounds for a misrepresentation claim.

Compensation for rescission damages in a quick service restaurant franchise or a similar franchise can be well over $500,000 and, depending on the nature of the franchise investment, can reach $1.5 million or more.

There may also be personal liability for those who signed the franchisor’s certificate or others who meet the definition for franchisor’s associates. (Please see links below to additional resources).

Given the risk of non-compliant FDDs, franchisors should pay close attention to the disclosure requirements in the Act and the Regulation.

Additional resources from Law Works on Franchise Rescission:

• 5 Tips to Identify Disclosure Risk for Growing Franchisors
• What to Do if Your Franchisee Wants a Rescission
• Four-Step Plan to Mitigate Rescission Risk
• Reducing the Risk of Rescission Claims: Key Information to Give to your Franchise Lawyer when Preparing an FDD

—

The information contained in this article is provided for informational purposes only and does not constitute legal advice. Readers should not act on this information without seeking professional legal advice from a lawyer experienced in this area. The content in this article may not reflect the most current legal developments, and the application of law can vary in different provinces and territories. As such, the information in this article is not guaranteed to be complete, correct, or up to date. The author and the publisher of this article disclaim all liability for any actions taken or not taken based on any or all of the contents of this site.

The Law Works website offers a vast number of resources by way of blog articles, courses and webinars about franchise, commercial and real estate disputes. Subscribe to our newsletters to stay up to date on the latest information from us.

Law Works offers complimentary initial 15-20 min telephone consultations, which you can book online.