Four-step plan to mitigate rescission risk

Background – Risks of Rescission

In Canadian provinces that have franchise disclosure legislation (Ontario, British Columbia, Alberta, Manitoba, New Brunswick and PEI), franchisees who do not receive a compliant FDD can be entitled to make a statutory rescission claim. If successful, a rescission claim will entitle a franchisee to get out of the franchise agreement and receive compensation for their entire franchise investment and losses in operating their franchised business. A successful rescission claim (or series of claims) can be devastating for franchisors, their principals and their franchise systems, resulting in court awards that can reach hundreds of thousands of dollars of liability per franchisee, and significant harm to the reputation and goodwill of the franchisor and the franchise system.

Step 1:  Identify Franchise Grants in the Past Two Years

The first step is to compile a “hot list” of all franchise grants in the past two years. Franchisees who signed a franchise agreement within two years are potentially sitting on rescission rights if the disclosure process used for them did not comply with all statutory disclosure requirements (for example, if the FDD was materially deficient). The limitation period for a franchisee to deliver a notice of rescission is two years from the date of the franchise agreement.

Step 2: Identify Disclosure Deficiencies

The next step should be to review the disclosure process used for the franchisees on this “hot list” and assess whether or not there were material disclosure deficiencies – either in the FDD itself or in additional materials that the franchisor gave to the franchisees outside of the FDD, such as through spreadsheets, sales brochures, etc.

Common disclosure pitfalls in growing franchise systems include the following:

• failing to prepare site-specific information and to compile and include site-specific documents in the FDD;
• delivering an FDD or franchise agreement containing outdated information or conditions;
• providing information in piecemeal, outside of the FDD;
• providing earnings projections, whether in the FDD or through spreadsheets, brochures, etc., and failing to comply with statutory requirements for making such projections.

These and other serious disclosure deficiencies can amount to rescission grounds.

Step 3: Strategically Assessing Which Franchisees to Approach

This step involves a strategic assessment of the risks and benefits of approaching franchisees on the “hot list” with potentially corrective disclosure steps. Any corrective steps require that the disclosure deficiencies be addressed and somehow resolved, typically through settlements. Sometimes, doing so may lead to more problems than doing nothing. Other times, taking these steps is the most prudent step to take before embarking on a rapid expansion.

Franchisees on the “hot list” can be often divided into two main groups: Group A will consist of locations that are doing well, and Group B will consist of locations that are performing poorly or whose franchisees are not content with their franchises.

Franchisees in Group B are at a greater rescission risk. Depending on various factors, a franchisor may sometimes prefer to wait until the two-year limitation period for a rescission expires for franchisees on the “hot list”. On the other hand, a franchisor may prefer to take proactive steps to correct disclosure errors before they become a problem. Neutralizing rescission risk lets a franchisor take preemptive action to prevent setting off a domino effect in the franchise system with successive rescission claims by different franchisees.

Dealing with franchisees in Group A may be easier, since their franchises are successful and thus they have a lower risk of making a rescission claim. Even if franchisees in Group A opt to leave the system, it may be relatively easy for the franchisor to retake those locations and resell them, assuming they are financially viable.

Step 4: Making the Fixes

Once the franchisor determines who to approach, an FDD settlement package needs to be drafted that is specific to each location and franchisee, taking into account its history, chronology of key events and all material facts. It is a legal settlement package because under franchise legislation, franchisees cannot by law simply waive their rights to rescission. Any waiver of rescission rights must be part of a legally enforceable settlement. Thus, franchisors cannot legally request franchisees to waive their franchise rights to rescission. A valid franchise settlement involves three legal components:

• a waiver (i.e., the franchisee’s agreement to give up any rescission or other rights),
• consideration (i.e., something of value offered to each individual franchisee as a benefit, financial or otherwise, in exchange for the waiver), and
• a certificate of independent legal advice from the franchisee’s lawyer documenting the fact that the franchisee obtained independent legal advice from a lawyer about his or her rights and the terms of the settlement.

Conclusion

Addressing and rectifying non-compliant FDDs is critical panning that franchisors should undertake to safeguard their financial stability, reputation, and the integrity of their franchise system. The potential legal and financial risks posed by rescission claims underscore the importance of proactively identifying and addressing disclosure errors and omissions. The four-step plan outlined in this article provides a structured approach to mitigate these risks and ensure compliance as a franchise system expands.

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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.

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