Can a Franchisee Rescind a Franchise Agreement Because a Head Lease was Not Included in the Disclosure Document?
February 16, 2018
The Short Answer:
A part of our practice includes reviewing franchise disclosure statements or documents. From our experience, a specific location normally has not been selected by the prospective franchisee at the time of disclosure. In most franchise agreements and disclosure statements that we’ve reviewed, the franchisor would set out a procedure for the selection of locations and stipulate that the franchisee will have an opportunity to review the location before executing a sublease or further agreements necessary to start the franchise location. A head lease is therefore not available at the time the disclosure document is provided to the prospective franchisee. In Raibex Canada Ltd. v. ASWR Franchising Corp. (“Raibex”), the Court found that this practice was in breach of the disclosure obligations of the franchisor and granted the franchisee a rescission of the franchise agreement (ie. the return of all funds paid to the franchisor).
On September 21, 2012, the franchisee was provided with the disclosure document. The disclosure document was mostly complete with the largest exception being the exclusion of a head lease. At the time, a location had not yet been chosen and no head lease existed. The disclosure document did however include a sublease which stated that the franchisee would become responsible for all obligations under the future head lease. On November 21, 2012, the franchisee entered into the franchise agreement. After a period of searching for a location, the franchisor entered into a head lease on September 19, 2013 (almost 1 year after disclosure!). The franchisee executed the sublease on October 23, 2013, but did not receive a copy of the head lease before executing the sublease. A term in the head lease required the franchisee to pay prepaid rent and security which totaled approximately $120,000. The franchisee refused to pay these amounts and other outstanding development costs. After the franchisor noted the franchisee in default, the franchisee served notice of rescission on the franchisor on July 25, 2015 (22 months after disclosure and 20 months after executing the franchise agreement).
The Court’s Analysis:
The head lease was a critical component of disclosure and would be crucial for a franchisee to determine the extent of its financial liability primarily because the franchisee would be required to perform all obligations of the head lease pursuant to the disclosed sublease. Prior to this case, courts had already decided that where a franchisor is in possession of a head lease then the act of non-disclosure of the head lease was a violation of the obligations of the franchisor. The Court in this case found that where the crucial terms of a head lease cannot be disclosed at the time of disclosure, then disclosure would not be possible. A franchisor is further not permitted to prematurely disclose as this creates an opportunity for a franchisor to circumvent its disclosure obligations to encourage the signing of a franchise agreement. The Court does opine that absent a head lease, it may still be possible to satisfy a franchisor’s disclosure obligation if all material terms have been disclosed and the resulting head lease does not materially differ from the disclosed terms. Ultimately, the franchisee served notice of rescission within two years of signing the franchise agreement, the Court decided that the effect of the missing head lease in the disclosure documents was equivalent to no disclosure ever being delivered and the remedy of rescission was granted to the franchisee.
Some writers in the legal profession have called this case the most important in franchise law in the past decade. Interestingly, in 2212886 Ontario Inc. v. Obsidian Group Inc., the Court held that the disclosure of an offer to lease was sufficient to satisfy the disclosure obligation even when the head lease was not yet in existence, but ultimately allowed rescission on other grounds. Raibex is currently under appeal and we are eagerly awaiting the Ontario Court of Appeal’s decision.