Terminating A Franchise Agreement: A Primer

How to get out of a Franchise Agreement

How to get out of a franchise agreement or franchise contract is often asked by franchisees who are “disenfranchised” (pardon the pun) by the experience of owning a franchised business. Franchising should not usually have such a result.  Many franchise systems are legitimate and worthwhile businesses.  Unfortunately, there are also many franchise systems that are untested or unproven and lack adequate means to support franchisees and maintain the promise of business success.  In the latter situation, a franchisee who is losing a significant amount of money from the operation may be justified to want to get out of the franchise agreement.

The answer to whether a franchisee is entitled to get out of a franchise agreement broadly depends on one or both of the following conditions: whether either party broke the franchise agreement, or, where required under provincial law, whether the franchisor failed to deliver a franchise disclosure document.

For franchisors who wish to terminate a franchise agreement with a franchisee, or to terminate a franchisee so to speak, the analysis usually focuses on the default and termination provisions in the franchise agreement.  Often a franchisor will be able to exercise what is commonly referred to as “a self-help remedy” by terminating the franchise agreement and either shutting down or taking over the location without going to court.

Franchisor Breaking a Franchise Agreement

The franchisee is required to show that the franchisor broke key terms of the franchise agreement.  The breach of the franchise agreement has to be extensive.  So much so that it becomes practically impossible for the franchisee to continue operating the franchise.

To determine whether the franchisor broke the franchise agreement, a franchise lawyer needs to extensively analyze all the terms and conditions of the franchise agreement and all other franchise contracts, as well as obtain from the franchisee all relevant facts about the allegations.

The contractual implications of the franchise agreements depend on the applicable franchise and contract law.  The franchise lawyer needs to apply provincial franchise law (in Ontario, the Arthur Wishart Act (Franchise Disclosure), 2000), and general contract principles under Canadian common law.

The legal characteristics of a franchise agreement are typically somewhat different from normal commercial contracts in that they are “contracts of adhesion”, meaning they are drafted in a franchisor’s standard form contact and are generally signed by the franchisee with little or no modifications.

Analyzing the alleged actions or omissions of the franchisor and franchisee in the context of the contractual implications of the franchise agreements and provincial franchise law, the franchise lawyer has to determine whether the franchisor’s alleged actions amount to breaking the franchise agreement.

Another important part of the analysis in which the franchise lawyer will need to carefully engage is whether the franchisee – not only the franchisor – broke parts of the franchise agreement, or failed to comply with his or her obligations under the franchise contract.

This could complicate the analysis.  The franchise lawyer needs to determine whether the franchisor’s alleged breach of the franchise agreement, given all of the above, entitles the franchisee to get out of the franchise agreement on the basis that there was a termination of the franchise agreement.  The franchise lawyer will need to assess the conduct of all parties to the franchise dispute and give the franchisee full and frank advice about all the factors that will come into play when assessing who is right and who is wrong, whether the franchisee may be entitled to get out of the franchise agreement, and if so, under what conditions.

Franchisee Breaking a Franchise Agreement

A franchisor wishing to terminate the franchise agreement early (meaning before the end of the term in the franchise agreement) will typically rely on the default and termination provisions of a franchise agreement.

The default and termination provisions set out what acts or omissions of the franchisee are curable or non-curable, and the mechanism that a franchisor is required to follow to give notice to the franchisee.

Curable defaults refer to defaults of the franchisee which he or she can diffuse, repair, or “cure”.  The franchisee can get out of trouble by complying with curing requirements set out in the franchise agreement and, by doing that, avoid being terminated.

Non-curable defaults refer to defaults of the franchisee which he or she cannot cure.  Having committed non-curable defaults, the franchisee cannot cure those defaults.  The ball then shifts to the franchisor to decide whether to terminate the franchise agreement.  The franchise agreement typically provides a mechanism for doing so.  A franchisor is wise to strictly follow the notice and any other formal requirements set out in the franchise agreement to effect termination.  A termination of a franchise agreement by a franchisor in this way is called a “self-help remedy”, because the franchisor effects this process without court approval, essentially on a self-help basis.

What happens to the retail location of the franchised business after the franchise agreement is terminated depends on who controls the lease (whether the head lease of the location is in the name of the franchisor or franchisee), the terms and conditions in the franchise agreement about any continued operation of the location, and non-compete and other “restrictive covenants” in the franchise agreement.

A franchisee who disputes the franchisor’s termination of the franchise agreement or the franchisor’s right to take over the operation of the location will have to commence legal proceedings, whether in court or arbitration (depending on the language of the franchise agreement), to dispute the termination and either seek damages or injunctive relief, or both.

Similarly, a franchisor that wishes to terminate the franchise agreement or take over the franchised business but does not wish to do so on a self-help remedy basis, will need to launch a legal proceeding for damages or injunctive relief, or both, to terminate the franchise agreement and, where desired and justified, take over the operation of the franchised business.

Franchisor Fails to Deliver a Franchise Disclosure Document

For franchisees wishing to get out of the franchise there is another avenue, one that franchisees commonly pursue in Ontario.  It is the “rescission” (meaning cancellation) avenue.  A rescission cancels all franchise contracts on the basis that the franchisor failed to deliver a franchise disclosure document.

Under Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000, a franchisor that fails to deliver a disclosure document as required under the statute and its applicable franchise regulation entitles the franchisee to terminate all franchise contracts and receive compensation for all his or her losses.  The franchisee in this case is entitled to cancel (rescind) the entire purchase of the franchise from the very start of the franchise purchase.

There is a critical limitation period that applies to this rescission right: the entitlement to rescission where the franchisor has failed to deliver a proper disclosure document (I will discuss more on what is meant by “proper disclosure document” in future Law Works Franchise Blog posts) is subject to a limitation period of two years from the date that the franchise agreement was signed.

In order to exercise his or her right to claim rescission, a franchisee is required do deliver to the franchisor a “notice of rescission” within this two year period.  The notice of rescission should be drafted by a competent franchise lawyer.  It should refer to the key legal grounds on which the notice of rescission is based, and set out the rescission damages that the franchisee is seeking, broken down by legal categories as set out in the Arthur Wishart Act.

Rescission under the Arthur Wishart Act is quite a dramatic remedy.  It entitles the franchisee to compensation of all his or her investment in the franchised business, including the purchase price of the franchise, the cost of setting up the franchised business, the cost of inventory and supplies, all royalties and franchise payments paid to the franchisor, and all losses that the franchisee incurred in the operation of the franchise.

Often, a franchisee will have to launch a legal proceeding to prove that he or she is legally entitled to rescission, and to legally prove the damages that he or she is seeking.

The legal proceeding is typically pursued in court as a lawsuit.  However, often the dispute is required under the language of the franchise agreement to be resolved by private arbitration, outside of the court system (see existing and future blog posts in the Law Works Franchise Blog about franchise arbitrations).

The franchise lawyer representing the franchisee in pursuing such a claim, and the franchise lawyer representing the franchisor, need to be litigators experienced in the court litigation or arbitration processes.

Whether in court or arbitration, proving the last category of damages, being the losses that the franchisee incurred in the operation of the franchise, is not easily done and requires a fair bit of accounting evidence and analysis.

The franchise lawyer may be required to obtain a forensic accounting report about the franchisee’s losses from a qualified forensic accounting expert.  The franchisor’s franchise lawyer will be then entitled to dispute any of the alleged damages claimed by the franchisee, including the alleged losses.  The franchisor’s lawyer may obtain an opposing forensic accounting report disputing the franchisee’s alleged losses.  Hence may start the “war of the experts”.  A skilled franchise lawyer may be able to find ways to resolve these issues and continue advancing the dispute towards an amicable resolution.

Conclusion

The analysis and pursuit of a right to terminate a franchise agreement often involves an extensive process.  It starts with a comprehensive analysis of the issues, facts and evidence.

Once completed to the satisfaction of the franchise lawyer and franchise client (franchisor or franchisee), a legal process often commences, likely through a court action or private arbitration.

Skilled franchise lawyers for both sides to the dispute will represent the parties professionally and with vigour.  As the case progresses through its litigation phases and where the desire exists, the parties and their counsel are able to explore reasonable settlement options.

Failing a successful and amicable resolution to the dispute, the case will need to advance to final adjudication where a court or arbitrator will rule on the parties’ claims and damages.

***