Key Points in Advising Franchisors

Transcription

1 FRANCHISING 2010 PAPER 3.1 Key Points in Advising Franchisors These materials were prepared by Peter V. Snell of Gowling Lafleur Henderson LLP, Vancouver, BC, for the Continuing Legal Education Society of British Columbia, September Peter V. Snell

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3 3.1.1 KEY POINTS IN ADVISING FRANCHISORS I. Introduction... 1 II. What is a Franchise?... 2 III. Structures and Methods of Expansion Through Franchising... 3 A. Master Franchising... 3 B. Area Representative... 4 C. Area Development... 4 D. Direct Franchising... 4 E. Partnership or Joint Venture... 4 IV. Alternative Arrangements to Franchising... 5 A. Distributorship Agreement... 5 B. Trademark License... 5 C. Sales Agency... 5 V. Brand Protection...5 VI. Canadianizing US Franchise Agreements... 7 I. Introduction British Columbia and Quebec are conspicuous as representing the largest populations in Canada without franchise legislation. In Quebec, there are civil code provisions that apply to franchisors, leaving BC standing with Saskatchewan, Newfoundland and Labrador, and Nova Scotia as being the remaining jurisdictions without franchise legislation. Under the division of powers between the Federal government in Canada and the Provinces, franchising falls under the jurisdiction of the Provinces. Alberta was the first province to institute franchise legislation in 1971, followed by Ontario, PEI, New Brunswick (which comes into force on February 1, 2011) and Manitoba (regulations to the Act are currently being drafted. It is anticipated that the legislation may be in force as early as the end of 2011). In this paper, these Provinces will be referred to as the Franchise Provinces and the legislation in the Franchise Provinces as the Franchise Legislation. While BC does not currently have franchise legislation, often lawyers in BC are involved in working with and advising franchisors on other matters, and it is good to have a basic understanding of the Franchise Legislation in Canada. As well, many clients are of the view that they are not a franchise when in fact by definition their activities may have them fall under the definition of a franchise in the Franchise Legislation and under the franchise laws of the US and other territories that have franchise legislation. This is often referred to as an accidental franchise.

4 II What is a Franchise? When someone says franchise the instant image that comes to most peoples mind is of a quick service restaurant, like McDonalds, Burger King, Subway, KFC or Quiznos. However, franchises come in all sorts of different shapes and sizes and cover many industries. Many products or services can be franchised such as cleaning services, fitness centres and fitness bootcamps, tax services, dog walking and doggie daycares, preschools, business coaching and many other non-traditional franchise products and services. So what exactly is a franchise? The Franchise Legislation in each of the Franchise Provinces has a similar definition of franchise. Here is the definition from the Ontario Arthur Wishart Act (Franchise Disclosure), 2000 S.O. 2000, c.3: franchise means a right to engage in a business where the franchisee is required by contract or otherwise to make a payment or continuing payments, whether direct or indirect, or a commitment to make such payment or payments, to the franchisor, or the franchisor s associate, in the course of operating the business or as a condition of acquiring the franchise or commencing operations and, (a) (b) in which, (i) (ii) in which, (i) (ii) the franchisor grants the franchisee the right to sell, offer for sale or distribute goods or services that are substantially associated with the franchisor s, or the franchisor s associate s, trade-mark, service mark, trade name, logo or advertising or other commercial symbol, and the franchisor or the franchisor s associate exercises significant control over, or offers significant assistance in, the franchisee s method of operation, including building design and furnishings, locations, business organization, marketing techniques or training, or the franchisor, or the franchisor s associate, grants the franchisee the representational or distribution rights, whether or not a trade-mark, service mark, trade name, logo or advertising or other commercial symbol is involved, to sell, offer for sale or distribute goods or services supplied by the franchisor or a supplier designated by the franchisor, and the franchisor, or the franchisor s associate, or a third person designated by the franchisor, provides location assistance, including securing retail outlets or accounts for the goods or services to be sold, offered for sale or distributed or securing locations or sites for vending machines, display racks or other product sales displays used by the franchisee; ( franchise ). It is not uncommon to have businesses claim to not be franchising. They may view their activities as licensing, distributing or having a sales representative agreement, or other form of documentation of the relationship between themselves and their licensee/distributor or sales agent. As I have often quoted to clients, if it walks like a duck, talks like a duck, it is a duck. It does not matter what label one puts on the relationship. What is more important is to analyze the elements of the relationship to identify if it is indeed a franchise. The key elements of a payment being made as a condition of granting the right to operate, operating in associate with a trademark, and exercising significant control over the operations, has lead many businesses to be an accidental franchise. Why does this matter to lawyers in BC? Often clients will look to expand their business beyond the BC border and this can trip them up as an accidental franchise leading to potentially onerous compliance requirements in the Franchise Provinces and possible rights of rescission for the

5 3.1.3 franchisees. BC lawyers need to be able to identify the elements of a franchise and advise clients when they need to seek additional specialized advice on franchise laws in the Franchise Provinces, the US or other overseas territories. In each scenario, the elements of the definition of a franchise need to be checked to see if the license/distributorship/sales agency is in fact a franchise. III. Structures and Methods of Expansion Through Franchising Whether it is an existing franchise in Canada, a start-up franchise, or a franchise from the US, or another country looking to expand their business in Canada, there are some basic methods used for building franchise systems in Canada. The basic methods are: 1. Master Franchising; 2. Area Representative; 3. Area Development; 4. Direct Franchising; 5. Partnership or Joint Venture. A. Master Franchising Under a master franchise, the franchisor grants the rights to the master franchisee to develop a territory and sell sub-franchises to third parties. In effect, the master franchisee acts as a franchisor for the territory. An example would be Taco Time in Canada is operated by a Master Franchisee who selects franchisees, trains, supports and enforces all aspects of the Taco Time operations in Canada. The Master Franchisee is operating under license, and usually a portion of the royalties collected from franchisees are paid to the franchisor. The rights granted to the master franchisee are often exclusive within a territory, and include the right to grant sublicenses to use the franchisor s trade-marks and system in the territory. More then one master franchisee can be appointed in a country, for example, a system might select a master franchisee to develop western Canada while selecting a separate master franchisee to develop eastern Canada. Territories can be large, or small, depending upon the expansion plans of the franchisor. In Canada, it is common to see the country split up into several master franchise areas. The division of the country is usually to reflect the diverse population base and geography of Canada. In a master franchise structure, the franchisor has selected the master franchisee because of its ability to expand the franchisors system. Usually all aspects of the development of the system are the responsibility of the master franchisee and therefore the franchisor needs to select a master franchisee that has the required skills and expertise to make the system a success in the territory designated to the master franchisee. Often the master franchisee will be required to open and operate one or more test locations itself or through a subsidiary, in order to test and adapt the system in Canada. This location can also be used by the master franchisor for future training of subfranchisees. It is essential that the franchisor provide thorough training to the master franchisee and usually this will take place at the franchisors head office. Once trained, the master franchisee will be responsible for training subsequent third parties selected as franchisees in the system. A formula for sharing initial franchise fees and ongoing royalties between the franchisor and master franchisee will be established in the master franchise agreement and often a development schedule is included. Given the significant investment the master franchisee will be making, it is expected that the master franchise agreement is open to negotiation (unlike the common perception that franchise agreement are largely take it or leave it ).

6 B. Area Representative A variation on the master franchise relationship is the selection of area representative. If a franchisor pursues this approach, one or more area representatives will be selected by the franchisor to perform various functions such as: selection of franchisees, training, support, selection of locations, etc. Many of these functions are the same as a master franchise arrangement, but the main difference is that the franchisor will be the one signing the franchise agreement with the third party franchisees that are selected by the area representative. The area representative does not contract with the third party franchisees and therefore the ongoing disclosure obligations remain with the franchisor. Usually the franchisor will pay a share of the fees paid by the franchisees to the area representative as compensation for the work performed. If appropriately structured, the area representative arrangement is not a franchise relationship at all, but rather is an agency or marketing relationship. C. Area Development An area developer is granted the right by the franchisor to develop multiple locations within a defined territory. This is different then a master franchise in that the area developer does not have the right to subfranchise to third parties and it does not have any responsibilities for training, support, etc., of third parties. It is responsible for its own locations and the area development agreement will normally have a development schedule (number of locations to be open in a set period of time) as a material provision of the agreement. Often the area developer is permitted to use separate subsidiary companies to operate each franchise location and to have others invest capital in these subsidiary locations, as long as the area developer maintains control of the subsidiary locations through share ownership and voting rights. The franchisor will require the area developer to provide copies of bylaws and articles of incorporation and any shareholders agreements so that the franchisor can confirm adequate control and governance by the area developer. D. Direct Franchising The simplest way for a franchisor to expand its franchise system is through direct franchising. This is the most common form of franchising. If a franchisor is from outside of Canada, they will often consider creating a new subsidiary to operate the franchise system in Canada. The franchisor would need to put in place an intercompany license to allow the new subsidiary to franchise to system to third parties. In effect, this new subsidiary would be a master franchise for Canada, This structure is favoured by many foreign franchisor to act as a buffer for potential start-up losses and other liabilities that may arise in Canada. As well, it can simplify its disclosure obligations, and financial reporting obligations. Any planning for the use of a subsidiary will need to involve tax advice, both in Canada and in the home jurisdiction of the franchisor. E. Partnership or Joint Venture In some cases franchisors will look to expand their system through the use of partnerships or joint ventures. This is less common, but in some instances the franchisor wishes to maintain an ownership positions in the expansion franchise locations. The franchisor will normally enter into a traditional franchise arrangement (direct franchise agreements, master franchise or area development agreement) with a company that it is a part owner of (a joint venture entity) or a partnership that it is a partner of so as to properly define rights and remedies and to maintain better control over use of its trade-marks and franchise system. The partnership agreement and the joint venture agreement will then in more detail describe the relationship of the parties and their various rights and obligations.

7 3.1.5 IV. Alternative Arrangements to Franchising Clients that do not want to be a franchise system, need to develop a business model that avoids the elements of the franchise definition as discussed above. There are many ways to go about doing this, and the discussion below is just a few of the possible solutions. A. Distributorship Agreement If the arrangement is a true distributorship, and does not contain all of the required elements to be defined as a franchise, this can successfully avoid franchise disclosure obligation. Under a distribution agreement, a distributor will be licensed to sell product to clients, potentially in a defined territory (exclusively, or non-exclusively). The products will display the trademark of the supplier of the products, and the distributor will be responsible for the marketing and sale of the products. The supplier of the products may require the distributor to adhere to certain practices (minimum stock, employ appropriate people, perform in a professional manner, etc.) but generally speaking, the restrictions on how the distributor operates are much more limited then is the case in a franchise. The concern is that some agreements that are characterized as Distribution Agreements end up putting strong controls on the operations of the distributor, have a fee flowing back to the supplier of the products, and the products are substantially associated with the supplier of the products trademarks. This can, therefore, trigger the accidental franchise. It is import to note that franchise agreements are in themselves really an extension of a distribution agreement and therefore the line between what is a distribution agreement and what is a franchise can be blurred. B. Trademark License Some client will want to provide simply a trademark license to a third party and not want it to be a franchise. The elements of s. 50 of the Trade-marks Act, R.S.C. 1985, c. T-13 (see discussion under Brand Protection below) need to be satisfied, including the direct or indirect control of the character and quality of the wares and services being sold. As soon as a license starts to control the character and quality of the services, the drafter has to consider whether the control element has gone so far as to meet the definition of a franchise. C. Sales Agency Another potential method that franchisors have used when they want to stop being a franchise is to convert the system to a sales agency arrangement. For this to work, the commissioned sales representatives cannot be making any payments to the supplier of products/services. The sales representatives would be compensated for the products/services sold. It is important to note that if the sales agency arrangement includes a payment by the sales agent to the supplier of products/services (for example, for product samples) then this can trigger an accidental franchise. V. Brand Protection A franchise system is often described at its core as being a variety of intellectual property rights, bundled together to form a system. When one stops to think about what a franchise is, for example, a McDonald s, you quickly associate it with products (trade secrets), the appearance of the restaurant (trade dress), trade-marked names, a system of operations (copyrighted manuals), and patented processes or equipment. Quickly you realize that some of the most valuable aspects of a franchise system is its intellectual property.

8 3.1.6 As a result, when a franchisor is looking to expand, it needs to very concerned with protecting its intellectual property. This will involve trademark filings, registration of domain names, copyright protection, trade secret protection and in some cases, patent filings. When a franchisor first starts talking to potential franchisees, master or area developers, it needs to keep in mind these protections. Franchisors need to include non-disclosure and confidentiality provisions in the franchise agreement (whether a direct franchise, area development, area representative, or master franchise) relating to the franchisor s intellectual property. In addition though, any key or critical information which employees are privy to as a result of their work with the franchise must be also protected by a confidentiality agreement with the employees. As employees will generally not be parties to the franchise agreement, the franchisor should include a covenant in the franchise agreement that the franchisee will obtain signed confidentiality agreements from all employees (in the form provided by the franchisor) prior to the disclosure of any confidential information. Operation and system manuals should be labelled as being copyrighted materials, and they may also need to be protected as a trade secret. To assist in protecting the copyrighted materials and trade secrets, the franchisor should require in its agreements that all manuals are to be returned upon termination or expiry of the agreement. As well, the manuals are to be stored in a location that protects their confidentiality. Often the manuals are characterized as being loaned to the franchisee, further asserting the fact that the franchisor owns the manuals. One of the most significant elements in a franchise system is its brand. Trademark protection should be sought for all key brands, although many franchise systems will not look to register non-core marks, such as product names, and instead rely upon common law trademark protections for those items. A franchise agreement has as one of its key elements a trademark licensing agreement. The franchise agreement will look to restrict the use of trademarks in ways such as: (a) any use not authorized by the franchisor will be considered an infringement of the franchisor s ownership rights; (b) if the franchise agreement, is terminated, expires or is assigned, the franchisee will cease all use of the trademarks; (c) the right to use the trade-mark is subject to continued compliance with the terms of the provisions of the trade-mark sections of the franchise agreement; (d) the franchisee agrees that it will sign all applications or agreements requested by the franchisor to protect the interests of the franchisor in the trademarks; (e) the franchisee acquires no right, title or interest in and to the trademarks and all goodwill associated with the trademarks remains to the benefit of the franchisor; (f) the franchisee will not dispute the ownership or enforceability of the trademarks or do anything that would directly or indirectly affect the value of the goodwill relating to the trademarks; (g) the franchisee is restricted from using the trademarks in any port of its corporate name or domain name or any other purpose except as permitted by the franchise agreement. In order to protect the trademarks further, the franchisor must require the franchisee to post a notice in accordance with the provisions of s. 50(2) of the Trade-marks Act. The franchisee must give public notice of the fact that the use of the trade-mark is a licensed use. The notice must identify that the franchisor is the owner of the trade-mark. The scope and contents of a typical franchise agreement will provide the franchisor with the direct or indirect control of the character and quality of the wares or services offered by the franchisee in association with the trademarks. This element must also exist to satisfy the requirements of s. 50 of the Trade-marks Act.

9 3.1.7 So, for instance, with respect to the quality of products that are to be sold by a franchisee, a typical provision would be: The franchisee agrees to sell only such products and items that meet the franchisor s uniform standards of quality and quantity, and such products and items have been expressly approved for sale in writing by the franchisor, and as have been prepared in accordance with the franchisor s methods and techniques for product preparation in accordance with the operations manual. When drafting trademark licensing provisions in the franchise agreement, the drafter should be aware of the rule set out in s. 50(3) of the Trade-marks Act. In the absence of an agreement to the contrary between the franchisor and the franchisee, the franchisee may force the franchisor to take proceedings for infringement of the licensed trademarks and, if the franchisor refuses or neglects to do so within two months after being so requested, the franchisee may institute proceedings for infringement in the franchisee s own name as if the franchisee were the owner, making the franchisor a defendant. In view of that provision, it is common in the franchise agreements to include a waiver by the franchisee of these rights. Increasingly, franchise agreements are also address protection of the franchisors brand as used by the franchisee in websites and social media. Mention of controls will be made in the franchise agreement, but normally the actual wording of any policy or guideline will be contained in the franchisors operations manual as it is easier to update the operations manual from time to time as needed to reflect the rapidly changing world of social media. VI. Canadianizing US Franchise Agreements Most US based franchisors want to use their form of franchise agreement when pursuing an expansion to Canada. In most cases this can be accomplished by focusing on some key provisions in the US agreement. Below is a list of the some of the primary areas of review, although each agreement must be reviewed on its own merits and other Canadianization might be required. 1. One difference that is commonly seen between US franchise arrangements and those in Canada is the control of the leased premises. Canadian franchise systems are more likely to want to control the leased premises and then sublease the location to the franchisee. This is less common in the US and it is important to discuss this with the US client. 2. In Canada, especially where the franchisor is an ongoing supplier of products, it is quite common for the franchisor to take a security interest by way of a general security agreement over the assets of the franchisee. This is not as often the case in the US. 3. In Alberta, an independent legal advice certificate is required if there is a guarantor signing the agreement. This can be easily overlooked by a US franchisor. 4. Recent changes in case law in Ontario make it less attractive for franchisors to offer renewal rights. As well, the general release that franchisors would normally insist upon when renewing need to be rethought in light of recent decisions out of the Ontario courts. 5. Non-compete provisions contained in US franchise agreements need to be carefully reviewed as they may be too long, too far reaching, or cover too broad of a territory to be enforceable. Non-competition provisions during the term of the agreement can be generally broad in geographic scope, except in Quebec where the geographic scope needs to be reasonable. 6. It is more common in US agreements for them to seek third party beneficial rights to enforce non-competition covenants (for example, where there is a master franchisee in Canada who has signed a franchise agreement with a franchisee who is in breach of its non-competition obligations). The concept of third party beneficial rights has not found as much favour in Canada.

10 Withholdings tax is often an issue in franchise agreements. It is important to address all taxes, but especially withholdings tax as this has tripped up many unwary franchise systems in the past. The franchisor should seek tax advice in its home jurisdiction, as well as in Canada. 8. Interest rates must respect the provisions of the federal criminal code, and must also be expressed as a rate per annum. 9. Other considerations for US franchisors include being away of restrictions on certain food items through marketing boards (for example, dairy and poultry). The franchisor should determine whether a marketing board exists for a particular product they use in their system and determine what restrictions exist under the appropriate marketing board. 10. Canada has specific packaging and labelling issues with respect to consumer products. Information must be shown in both French and English, and if it is an edible product the number of servings and net quantity of each serving must be shown. Canadian units of measurement must be used. 11. If the franchisor is going to be operating in Quebec, other considerations also come into play concerning French language laws, guarantee provisions, disclosure obligations for contracts of adhesion and insurance provisions to name a few. Specific advice of Quebec counsel should be sought before entering the Quebec market. 12. Canadian spelling is different and the US franchise agreement can be updated to provide the Canadian spellings. This is often done for the reason that the US franchisor wants to appear to be willing to adapt to the Canadian market and not be too American in its approach. 13. Currency selection is often an issue with US franchisors. The sharp fluctuation in recent years of the Canadian and US dollars can make this problematic. In some cases the US franchisor wants the up front franchise fee to be paid in US Dollars, and all other payments to be made in Canadian dollars. 14. It is more common to find penalty clauses in US agreements. Financial penalties are less likely to be enforceable in Canada unless they are found to be a genuine pre-estimate of liquidated damages. 15. If the arrangement is to be a master franchise, the form of franchise agreement to be used with the subfranchisee needs to address indemnification provisions of the franchisor by the subfranchisee. 16. The governing law provision should be looked at carefully. It is normally advisable to have the laws of the Canadian province where the franchisee is to be located govern the franchise agreement. Of note, recent case law in Ontario has found that the franchise legislation of Ontario will apply to franchise locations outside of Ontario if the franchise agreement provides for the laws of Ontario being the governing laws. A whole article can be devoted to this topic and this paper cannot go into the details, but the heads up to lawyers advising franchisors is to avoid a governing law provision that selects Ontario as the governing law if the franchise is to be located outside of Ontario.