A Primer on U.S. Franchise Legislation: How it differs from Canadian Franchise Legislation

Transcription

1 A Primer on U.S. Franchise Legislation: How it differs from Canadian Franchise Legislation By Edward (Ned) Levitt Aird & Berlis LLP Toronto And George J. Eydt Hodgson Russ LLP Toronto Ontario Bar Association 11 th Annual Franchising Law Conference: Mastering a Recovering Economy November 2, 2011 Toronto, Ontario

2 TABLE OF CONTENTS Page A Primer on U.S. Franchise Legislation: How it differs from Canadian Franchise Legislation I. Introduction... 1 II. Overview of U.S. Franchise Law... 1 III. Overview of Canadian Franchise Law... 2 IV. Issue by Issue Differences between Canadian and U.S. Franchise Legislation... 3 A. Registration State Franchise Laws are not pre-empted by the FTC Rule Scope of State Review Registration Package... 5 B. Exemptions from Disclosure and Registration Large/Seasoned Franchisor Fractional Franchise Isolated Sale Sophisticated Franchisee Large Investment by Franchisee Insider Exemption... 8 C. Scope of Disclosure Material Fact versus Prescribed Disclosure Ancillary Materials (e.g., FTC Compliance Guide) D. Clear and Concise Rule E. Information in the Disclosure Document Parents, Affiliates and Predecessors Background of Officers and Directors Litigation and Bankruptcy Costs, Investment, Working Capital Advertising Funds Computers and Electronic Cash Registers, Location Selection, Timing for Opening Patents, Copyrights and Proprietary Information i-

3 TABLE OF CONTENTS (continued) Page 8. Dispute Resolution Public Figures Financial Performance Representations Existing Franchises / Franchise Closures / Projected Openings Financial Disclosure a. Standards b. Avoiding the Requirement for Parental Disclosure Prescribed Statements / Certificates / Receipts F. Disclosure for Sales Agents G. Use of Wrap-Around Disclosure H. Triggers for Disclosure I. Electronic Delivery J. Annual Updates versus Continual Updates K. Supplemental Disclosure L. Remedies Limitation Periods Private Right of Action M. Relationship Laws N. Business Opportunity Laws V. Conclusion ii-

4 A Primer on U.S. Franchise Legislation: How it differs from Canadian Franchise Legislation I. Introduction The franchise markets in both the United States and Canada have grown in breadth, depth and vibrancy since the early 70 s. Parallel to that growth has been the steady increase of franchise expansions between the two countries, which has accelerated in the last several years. As a result, franchisors and those who advise them increasingly find themselves being confronted by the legislative regimes of the other country and the challenges they bring. This paper intends to compare and contrast some of the most significant aspects of franchise regulations in the United States and Canada. The reader is cautioned that this paper does not presume to cover every aspect of such regulation and resort must be made to the legislation itself for complete and accurate information. II. Overview of U.S. Franchise Law Franchise legislation has been a reality in the United States since the enactment of the California Franchise Investment Law in 1970 (effective on January 1, 1971). Today, both federal and state laws govern the sale of franchises. The Federal Trade Commission s franchise rule (the FTC Rule ) became effective on July 21, 1979 and was significantly revised effective July 1, It requires franchisors to provide a franchise disclosure document ( FDD ) to prospective franchisees before any offer or sale is made, unless an exclusion or exemption applies. No registration of the FDD is required. Fifteen states have enacted their own pre-sale franchise laws. 1 These state franchise laws also require pre-sale disclosure and typically require some form of pre-sale registration with the state. In addition, a number of states have specific laws governing the relationship between the franchisor and the franchisee after the sale is completed. 2 While the definition of franchise varies under these laws, for convenience the required elements can be summarized as follows: (i) the grant of a right to operate a business in association with the grantor s trademark or trade name, (ii) with significant control or assistance by the grantor (under state laws this element is sometimes replaced with a community of interest between the parties or the use of a prescribed marketing plan ) and (iii) payment of a franchise fee to the grantor. All three of these elements must be present for a franchise to exist, except under New York law where payment of a franchise fee combined with either one of the other two elements constitutes a franchise. If a company falls within this definition, and is not subject to a statutory exclusion or exemption, then there is a wide range of pre-sale disclosure and registration requirements and relationship restrictions in the United States. 1 2 California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin. Arkansas, California, Connecticut, Delaware, Hawaii, Illinois, Indiana, Iowa, Michigan, Minnesota, Missouri, Nebraska, New Jersey, Virginia, Washington, Wisconsin, Puerto Rico and the U.S. Virgin Islands.

5 III. Overview of Canadian Franchise Law From 1971 until 2001, Alberta had the distinction of being the only province in Canada with franchise specific legislation. That legislation required the registration of a prospectus-like document, which had to be approved by the Alberta Securities Commission, at great cost and delay to franchisors. In 1995, following a study of the statute and its effectiveness conducted at Laurentian University, the statute was repealed and replaced with the current Franchises Act, which is primarily a disclosure statute. 3 On January 31, 2001 Ontario became the second province to enact franchise legislation, The Arthur Wishart Act, 4 which was fashioned similarly to the current Alberta statute. Soon thereafter, Prince Edward Island (July 2006) and New Brunswick (June 2007) followed suit with similar franchise statutes of their own. 5 Manitoba, at the time of this writing, is poised to become the fifth province with such legislation. 6 While there are some differences among the various provincial franchise statutes, at their core, they are remarkably similar. Even Manitoba, the newest province with such legislation, has chosen a similar approach in its statute and presumably will do likewise in the regulations to the statute, which are expected shortly. There is no federal franchise legislation and none is expected. The provinces have chosen the disclosure approach, with no registration and a smattering of relationship regulation, i.e. the right for franchisees to associate and the implied covenant of fair dealing in all franchise agreements. The similarity of the provincial statutes and regulations allows for the creation of one FDD for use in all of the regulated provinces. There are a lot of similarities in the definition of a franchise among the provinces. 7 All but the Alberta statute extend the reach of the statutes to what is commonly referred to as business opportunities. Like in the United States, the key elements of the definition include the grant to a franchisee of a right to sell or distribute products and services, in association with the franchisor s trademarks, with significant control by or significant assistance from the franchisor and with a payment or payments by the franchisee to the franchisor. The definitions of a franchise in the provincial statutes, except for Alberta, are broad enough to capture distribution arrangements that may not have been intended to create franchise relationships. 3 Franchises Act, RSA 2000, c F-23 [ Alberta Act ]. 4 Arthur Wishart Act (Franchise Disclosure), 2000, SO 2000, c 3 [ Ontario Act ]. 5 Franchises Act, RSPEI 1988, c F-14.1 [ PEI Act ]; Franchises Act, SNB 2007, c F-23.5 [ NB Act ]. 6 The Franchises Act, SM 2010, c. 13 [ Manitoba Act ] [Note: This Act is not yet in force]. 7 Ontario Act, s. 1(1); Alberta Act, s. 1(1)(d); PEI Act, s. 1(1)(b); NB Act, s. 1(1); Manitoba Act, s. 1(1). Page 2

6 IV. Issue by Issue Differences between Canadian and U.S. Franchise Legislation A. Registration Fourteen of the fifteen states that have a pre-sale franchise disclosure law require that either the Franchise Disclosure Document ( FDD ) or some form of notice be submitted to the state in advance of any offer to sell a franchise. 8 In a number of these registration states, the FDD is reviewed by a Franchise Examiner for compliance with the state s franchise disclosure and relationship laws. 9 While in other registration states, the FDD is not reviewed and is simply kept on file pending a franchisee complaint. 10 Until the state franchise filing or registration becomes effective, a franchisor is not permitted to have substantive contact with a prospect covered by the state franchise law. 11 Franchise counsel should carefully review the jurisdictional scope of state franchise laws because registration and disclosure obligations may arise even if the franchise is to be located outside the registration state, if the franchisee lives in, the franchise offer is made or accepted in, or negotiations take place in, the registration state. As stated earlier in this paper, none of the Canadian provincial franchise statutes require registration of the franchisor s FDD. 1. State Franchise Laws are not pre-empted by the FTC Rule The Interstate Commerce Clause of the United States Constitution gives the federal government the right to regulate commerce among the states. 12 Franchising falls within interstate commerce. The Supremacy Clause of the United States Constitution provides that the Constitution and federal laws enacted under the Constitution take precedence over or pre-empt state laws. 13 However, the federal government has the right to decide the extent to which federal law will pre-empt state law. The FTC Rule provides that: 8 Oregon does not have a pre-sale filing requirement. 9 California, Hawaii, Illinois, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia and Washington. 10 Except that Michigan requires only a notice filing. The FDD does not have to be submitted Except that Hawaii and Wisconsin allow pre-sale discussions before the required franchise filings have been made. US Const. Art. I, sec. 8, cl. 3. US Const Art. VI, sec. 2. Page 3

7 The FTC does not intend to preempt the franchise practices laws of any state or local government, except to the extent of any inconsistency with part 436. A law is not inconsistent with part 436 if it affords prospective franchisees equal or greater protection, such as registration of FDDs or more extensive disclosures. 14 As a result, state laws requiring registration and additional disclosures are valid. All state regulators accept use of a FDD that conforms to the FTC Rule. Therefore, one document, the FDD, can be used to satisfy both the federal and state disclosure requirements. Additional state disclosures are required and are typically addressed in the FDD by adding a state cover page and state specific addenda. Although there is no federal franchise law in Canada, it is worth considering the interaction of the various provincial laws when U.S. franchisors grant master franchises. It is very common for U.S. franchisors to grant the whole of Canada to a single master franchisee. Do any of the four provincial statutes take jurisdiction in such circumstances, thus requiring disclosure? All of these statutes apply if the franchise (in this case the master franchise) is to be operated partly or wholly in the particular province. 15 Only Alberta adds the requirement that the franchisee must also be resident in Alberta (or, if a corporation, have a permanent establishment in that province). 16 The belief in legal circles, untested in court, is that a master franchisee for Canada could successfully argue that disclosure is required under the various provincial statutes, except possibly Alberta. To be safe, U.S. franchisors should comply with the relevant provincial statutes when the master franchise grant is for the country of Canada. 2. Scope of State Review As a general rule, State Examiners only review the FDD for completeness and do not comment on the quality of the franchise offering. If the State Examiner determines that the FDD does not fully comply with the state s disclosure requirements, it will issue a comment letter detailing the deficiencies. All deficiencies must be resolved before the State Examiner will declare the FDD effective in the state. In some states this can be a time consuming process involving several rounds of comment and response. One exception to this general rule relates to the quality of the franchisor s financial statements. If the State Examiner is not satisfied with the financial health of a franchisor, in a number of states he or she may require the franchisor to post a bond, or escrow or otherwise defer receipt of any franchise fees until the franchisor has met all of its pre-opening obligations to the franchisee CFR (c). 15 Ontario Act, s. 2(1); Alberta Act, s. 3(1)(a); PEI Act, s. 2(1)(c); NB Act, s. 2(2). 16 Alberta Act, s. 3(1)(b). Page 4

8 3. Registration Package A franchisor who wants to offer and sell franchises in a franchise registration state must submit its FDD along with specified application documents to the state franchise agency. As set out in the NASAA Guidelines 17 these application documents include: 1. Uniform Franchise Registration Application; 2. Franchisor s Costs and Sources of Funds; 3. Uniform Franchisor Consent to Service of Process; 4. Franchise Seller Disclosure Form; 5. Franchise Disclosure Document (varies by Franchise Filing State); 6. Application Fee; 7. Guarantee of Performance (if required); 8. Consent of Accountant to the use of the latest audit report in the Franchise Disclosure Document; 9. Advertising or promotional materials (if required by the Franchise Filing State. Certain states require that additional documents be submitted with the application. For example, California requires submission of a Customer Authorization of Disclosure of Financial Records and a Notice of Exemption for Internet Advertisement. The former gives the state the right to access any franchise sale records held by financial institutions and by signing the latter the franchisor agrees to comply with the state s rules when posting any Internet advertisement of franchise opportunities to a website. As stated earlier in this paper, none of the Canadian provincial franchise statutes requires registration of the franchisor s FDD. B. Exemptions from Disclosure and Registration Both federal and state laws provide a wide range of exemptions. Unfortunately, they are not uniform so an exemption that is available federally may not be available at the state level and vice versa. Some of the more commonly invoked exemptions include: 17 North American Securities Administrators Association ( NASAA ) 2008 Franchise Registration and Disclosure Guidelines (Amended and Restated UFOC Guidelines) issued June 30, Page 5

9 1. Large/Seasoned Franchisor New York exempts franchisors with a high net worth from its full registration and disclosure requirements. A franchisor with a net worth of (i) $5 million per audited financial statement, or (ii) $1 million with a parent net worth of $5 million per audited financial statement, is not required to register and has a moderate disclosure requirement. A franchisor with a net worth of (i) $15 million per audited financial statement, or (ii) $3 million with a parent net worth of $15 million per audited financial statement, is not required to register and has a minimal disclosure requirement. Other states provide exemptions based on franchisor net worth. 18 To be eligible, the franchisor must also meet an experience threshold, e.g., has been in business for 5 years and has at least 25 franchisees. Unfortunately, there is no corresponding large/seasoned franchisor exemption under the FTC Rule. None of the provincial franchise statutes exempt large franchisors or any franchisors from the general disclosure requirements. However, all of these statutes currently in force provide franchisors with an exemption from the requirement of including financial statements in FDDs, provided that the following criteria are met: (i) (ii) (iii) (iv) the net worth of the franchisor on a consolidated basis is at least $5,000,000 ($2,000,00 in PEI and New Brunswick) or $1,000,000 if the franchisor s parent company has a net worth of $5,000,000 ($2,000,000 in PEI and New Brunswick); 19 with some modifications depending on the province, in the five years immediately preceding the date of the FDD, the franchisor has at least 25 franchisees engaging in business at all times in Canada or a single jurisdiction outside of Canada; 20 with some modifications depending on the province, the franchisor has carried on the business being franchised for at least 5 years prior to the date of the FDD; 21 and with some modifications depending on the province, the franchisor, its associates, directors, general partners and officers has not had any 18 California, Illinois, Indiana, Maryland, North Dakota, Rhode Island, South Dakota, Washington and Virginia. 19 Ontario Act, s. 13(2); General, O Reg 581/00 [ Ont Reg ] s. 11(1)1.; Franchises Act Exemption Regulation, Alta Reg 312/2000 [ Alta Reg 312 ] s. 1(a); Franchises Act Regulations, PEI Reg EC232/06 [ PEI Reg ] s. 6(a); Disclosure Document Regulation, NB Reg [ NB Reg ] s. 8(1)(a). 20 Ont Reg, s. 11(1)2.; Alta Reg 312, s. 1(b)(i); PEI Reg, s. 6(b); NB Reg, s. 8(1)(b). 21 Ont Reg, s. 11(1)3.; Alta Reg 312, s. 1(b)(ii); PEI Reg, s. 6(c); NB Reg, s. 8(1)(c). Page 6

10 judgment, order or award made against any of them relating to fraud, unfair or deceptive practices, or a law regulating franchises Fractional Franchise The FTC Rule and seven state laws 23 provide an exemption from their disclosure requirements for fractional franchises. Generally, the fractional franchise exemption is available where (a) estimated sales of the franchisor s product in the first year do not exceed 20% of the franchisee s total sales and (b) the franchisee has at least 2 years experience in a similar business. Some states have additional requirements. In opinions regarding this exemption, the FTC Staff has stated that the franchisee s prior experience in the franchised business and factors that are likely to make the franchisee less dependent on the franchisor are relevant. These factors include the financial stature of the franchisee, individual goodwill and reputation, business sophistication and practical ability to disengage from the franchise relationship, if necessary. If the franchise system compliments the franchisee s existing and successful business, then the fractional franchise exemption may apply. All of the provincial statutes provide for an exemption from disclosure if it is anticipated or should be anticipated by the parties that the sales from the franchised business would not be greater than 20% of the total sales of the franchisee s existing business and the franchised business. 24 There is no requirement regarding the experience or qualities of the franchisee. 3. Isolated Sale Minnesota, Indiana and New York have exemptions permitting isolated sales (typically the sale of one franchise in the state within a certain period of time). The details of these exemptions should be reviewed before relying on them. No similar exemption exists in any of the provincial statutes. 4. Sophisticated Franchisee Under the FTC Rule, a franchise sale is exempt if the franchisee (or its parent or any affiliates) is an entity that has been in business for at least five years and has a net worth of 22 Ont Reg, s. 11(1)4.; Alta Reg 312, s. 1(b)(iii); PEI Reg, s. 6(d); NB Reg, s. 8(1)(d). 23 California, Michigan, Minnesota, New York, Oregon, South Dakota and Wisconsin. 24 Ontario Act, s. 5(7)(e); Ont Reg, s. 8; Alberta Act, s. 1(1) fractional franchise ; Franchises Regulation, Alta Reg 240/1995 [ Alta Reg 240 ] s. 4; PEI Act, s. 5(7)(e); NB Act, s. 5(8)(e). Page 7

11 at least $5 million. 25 Rhode Island, South Dakota and Wisconsin also have exemptions for high net worth franchisees. There is no exemption based on the net worth or any other characteristic of the prospective franchisee. 5. Large Investment by Franchisee Under the FTC Rule, a franchise sale is exempt if the franchisee s initial investment totals at least $1 million. Any financing received from the franchisor or its affiliate and the cost of unimproved land must be excluded. The prospective franchisee must verify the grounds for the exemption in writing. This exemption applies only if at least one individual prospective franchisee in an investor-group qualifies for the exemption by investing at the $1 million threshold level. 26 Maryland, Minnesota and South Dakota also have an exemption based on the size of the investment. Only in Ontario, there is an exemption from the disclosure requirements where the prospective franchisee is required to make a total investment to acquire and operate the franchise of more than $5,000,000 in one year Insider Exemption The FTC Rule also provides an exemption for franchisor principals who satisfy certain timing and experience requirements. 28 California, Rhode Island, South Dakota and Washington also have this type of exemption. There is an exemption from the disclosure requirements of all of the provincial statutes for the grant of a franchise to a person, for their own account, who has been an officer or director of the franchisor or of the franchisor s associate for at least 6 months CFR 436.8(a)(5)(ii) CFR 436.8(a)(5)(i). 27 Ontario Act, s. 5(7)(h); Ont Reg, s CFR 436.8(a)(6). 29 Ontario Act, s. 5(7)(b); Alberta Act, s. 5(1)(b); PEI Act, s. 5(7)(b); NB Act, s. 5(8)(b). Page 8

12 C. Scope of Disclosure 1. Material Fact versus Prescribed Disclosure 30 The FTC Rule no longer includes a definition of material. Instead the FTC has stated in the Statement of Basis of Purpose to the FTC Rule that it will rely on the jurisprudence developed around Section 5 of the FTC Act to determine what is material. Under this jurisprudence, material in the franchise disclosure context means information that is likely to affect a reasonable prospective franchisee s investment decision. The FTC Rule prescribes certain information that must be included in the FDD, all of which it considers material. It explicitly prohibits the inclusion of additional information: Do not include any materials or information other than those required or permitted by part 436 or by state law not pre-empted by part The stated reason for this prohibition is to prevent franchisors from including information that is non-material, confusing, or distracting from the core disclosures. This concept of prescribed disclosure was reinforced in the Statement of Basis of Purpose in a discussion concerning the definition of disclose, state, describe and list. 32 The FTC Rule defines these terms to mean to present all material facts accurately, clearly, concisely and legibly in plain English. During the request for comments phase of rulemaking, it was pointed out that this definition was confusing and could be interpreted to mean that the FDD must include all material information and not just that prescribed by the FTC Rule. The FTC Staff rejected this notion stating that a similar definition in the old UFOC guidelines did not create confusion. The Statement of Basis and Purpose does point out that the prohibition on adding to the FDD should be read narrowly and that franchisors are permitted to add footnotes and other clarifications to the FDD to ensure that the prescribed disclosures are complete and not misleading. 33 Most state franchise registration and disclosure laws contain anti-fraud provisions that prohibit making an untrue statement of material fact or omitting to state a material fact necessary to make a statement not misleading. These anti-fraud provisions relate to the information that is required to be in the FDD. Recent case law makes it unclear whether franchisors have a general obligation to disclose information that is material to a prospective franchisee if it falls outside the scope of the For a detailed discussion of this topic see Joseph Y. Adler and Michael R. Laidhold, Assessing Materiality in Franchise Disclosure Documents: A Canada-U.S. Analysis, Franchise Law Journal, Vol. 30, No. 4, Spring 2011, American Bar Association. 16 C.F.R (d). 72 Fed. Reg. at 15,455. Id at 15,516. Page 9

13 prescribed disclosures. In Colorado Coffee Bean, LLC v. Peaberry Coffee, Inc. 34, the court held that franchisors must disclose such information outside the FDD. The plaintiff franchisee claimed that Colorado Coffee Bean had failed to provide pre-sale disclosure that the corporate stores owned and operated by Colorado Coffer Bean s parent were unprofitable. Colorado Coffee Bean argued that because its parent did not guaranty its performance under the franchise agreement, disclosure of its parent s financial statements in its FDD was not prescribed under the FTC Rule. It correspondingly argued that it was prohibited by Section 436.6(d) of the FTC Rule (quoted above) from including this additional information. The court rejected this argument. It relied on Section 436.1(a)(21) of the FTC Rule which provided that franchisors are not precluded from giving other non-deceptive information orally, visually or in separate literature so long as such information is not contradictory to the information in the FDD. The court used this language, which appears to be permissive in nature, to create a positive obligation. However, this provision which existed at the time of the relevant Colorado Coffee Bean franchise sale was deleted when the FTC Rule was amended in Apparently forgetting that it was deleted, the FTC, in the Statement of Basis and Purpose to the amended FTC Rule, still advocates its application and makes reference to Section 436.1(a)(21) as though it still appears in the amended FTC Rule. 35 It will be interesting to see what, if any, effect both the Colorado Coffee Bean case and the deletion of Section 436.1(a)(21) from the FTC Rule will have in practice. In addition to the specific disclosure items prescribed by the regulations to the various provincial statutes, each one requires that the FDD contain all material facts. 36 A Material Fact is defined in the Ontario statute 37, Manitoba statute 38 and the New Brunswick statute 39, (with the small, but significant difference, that means replaces includes in the first line in the New Brunswick Act, as is the case in the Alberta statute 40, the differences in the definition under the Alberta Act in brackets and italics and the differences in the definition under the PEI statute 41 in square brackets and underlined) as follows: Material Fact includes [(means)] any information about the business, operations, capital or control of the franchisor or franchisor s (its) associate or about the [franchise or] the franchise system[,] that would reasonably be expected to have a Colo. App. LEXIS 210 (Feb. 18, 2010). 72 Fed.Reg. at n.733; n Ontario Act, s. 5(4)(a); Alta Reg 240, s. 2(1); PEI Act, s. 5(4)(a); NB Act, s. 5(5). 37 Ontario Act, s. 1(1). 38 Manitoba Act, s. 1(1). 39 NB Act, s. 1(1). 40 Alberta Act, s. 1(1)(o) 41 PEI Act, s. 1(1)(l) Page 10

14 significant effect on the value or price of the franchise to be granted (sold) or the decision to acquire (purchase) the franchise. There are no Canadian cases which provide any real guidance or general rules as to what would constitute a Material Fact in any given situation. Accordingly, a conservative approach should be taken and any fact which could in any way be considered material to the prospective franchisee should be disclosed. 2. Ancillary Materials (e.g., FTC Compliance Guide) U.S. franchise regulators provide franchisors and their advisors with a wide range of commentary and guidance with respect to compliance with both the FTC Rule and state franchise law. In the FTC Rule Statement of Basis and Purpose, the FTC sets out its reasoning for revising or not revising each provision of the FTC Rule and responds to comments submitted by the U.S. franchise bar. The FTC Compliance Guide provides guidance regarding disclosure under the FTC Rule. Practitioners also have access to the FTC Rule Frequently Asked Questions (FAQs) and FTC Staff Opinions regarding the original Franchise Rule. All of these federal resources can be accessed on the FTC website. 42 The North American Securities Administrators Association (NASAA) has issued the 2008 Franchise Registration and Disclosure Guidelines (Amended & Restated UFOC Guidelines) which can be accessed on the NASAA website. 43 All of these materials are extremely helpful. Unfortunately, no government body in Canada provides any guidelines or commentary on compliance issues or practices regarding the various provincial franchise statutes. D. Clear and Concise Rule Section 436.1(d) of the FTC Rule provides that disclose, state, describe, and list each mean to present all material facts accurately, clearly, concisely, and legibly in plain English. Section 436.1(o) of the FTC Rule provides that Plain English means the organization of information and language usage understandable by a person unfamiliar with the franchise business. It incorporates short sentences; definite, concrete, everyday language; active voice; and tabular presentation of information, where possible. It avoids legal jargon, highly technical business terms, and multiple negatives. All but the Alberta statute provide that all information in a FDD and a statement of a material change be accurately, clearly and concisely set out Ontario Act, s. 5(6); PEI Act, s. 5(6); NB Act, s. 5(7). Page 11

15 E. Information in the Disclosure Document 1. Parents, Affiliates and Predecessors In Item 1 of the FDD, a franchisor must disclose (i) the name and principal business address of any parent or affiliate that offers franchises in any line of business or provides products or services to the franchisees of the franchisor, (ii) the name and principal business address of any predecessors during the past 10 years, and (iii) the prior business experience of any predecessor listed above and any affiliate that offers franchises in any line of business or provides products or services to the franchisees of the franchisor. There are striking differences between the U.S. approach and the Canadian approach for these disclosure items. Other than the requirement, contained in all of the provincial statutes other than the Alberta statute, that, if the franchisor is a subsidiary, the name and principal address of the parent must be included in the FDD, such information is not required to be disclosed. 45 In Item 3 of the FDD, a franchisor must also disclose the details of certain litigation pertaining to (i) a predecessor, parent or affiliate who induces franchise sales by promising to back the franchisor financially or otherwise guarantees the franchisor s performance, and (ii) an affiliate who offers franchises under the franchisor s principal trademark. No such disclosure is required in any of the provincial statutes. In Item 3 of the FDD, a franchisor must disclose whether (i) a predecessor, (ii) a parent or affiliate who guarantees the franchisor s performance, (iii) an affiliate who has offered or sold franchises in any line of business within the last 10 years, (iv) or any other person identified in Item 2 (Business Experience) is subject to a restrictive order pertaining to certain laws, including franchise and securities laws. Other than the requirement to disclose certain civil, criminal and administrative proceedings, judgments and orders involving a franchisor s associates, 46 there are no similar disclosure requirements in any of the provincial statutes. The definition of a franchisor s associate in the various statutes does not include predecessors. In Item 4 of the FDD, a franchisor must disclose whether a predecessor, parent or affiliate has been involved in a bankruptcy proceeding in the past 10 years. 45 Ont Reg, s. 2.1.v.; PEI Reg, Sch I, Part 2, s. 1(e); NB Reg, Sch A, Part 2, s. 1(e). 46 Ont Reg, ss ; Alta Reg 240, Sch 1, ss. 2-4; PEI Reg, Sch I, Part 2, ss. 3-5; NB Reg, Sch A, Part 2, ss Page 12

16 Similar disclosure is required under the various provincial statutes, except that the relevant time period is 5 years for New Brunswick and 6 years for all of the other provinces. 47 In Item 21 of the FDD, a franchisor may substitute for its own financial statements certain financial statements of its parent or affiliate, if the parent or affiliate absolutely and unconditionally guarantees the franchisor s performance under the franchise agreement. Conversely, if the parent s or the affiliate s financial statements are disclosed, then the parent or affiliate must provide a guaranty. The franchisor must also include certain financial statements for any parent that commits to perform post-sale obligations for the franchisor. Affiliate means an entity controlled by, controlling, or under common control with, another entity.parent means an entity that controls another entity directly, or indirectly through one or more subsidiaries.predecessor means a person from whom the franchisor acquired, directly or indirectly, the major portion of the franchisor s assets. There is no concept in any of the provincial statutes of guaranties by parent, affiliated or associated companies to the franchisor. Also, there is no requirement for disclosure of financial statements of any company other than the franchisor. In fact, it is likely that consolidated financial statements among several related companies, including the franchisor, would not satisfy the spirit and letter of the provincial statutes, which require the financial statements of the the franchisor to be attached to the FDD. The argument would be that a consolidated statement would not provide a prospective franchisee with a clear picture of the financial condition of the franchisor with whom the franchisee is contracting. 2. Background of Officers and Directors In Item 2 of the FDD, a franchisor must disclose the five year employment history for its directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of the franchise. There is no requirement in the provincial regulations to disclose information about anyone who is not a director, general partner or officer of the franchisor. In Alberta 48 and PEI 49, such disclosure is required only with respect to directors, general partners and officers who will have management responsibilities relating to the franchise. 47 Ont Reg, s. 2.6; Alta Reg 240, Sch 1, s. 5; PEI Reg, Sch I, Part 2, s. 6; NB Reg, Sch A, Part 2, s Alta Reg 240, Sch 1, s. 1(h). 49 PEI Reg, Sch I, Part 2, s. 2. Page 13

17 For Ontario 50 and New Brunswick 51, the disclosure must be made with respect to all directors, general partners and officers of the franchisor. 3. Litigation and Bankruptcy In addition to the litigation and bankruptcy information required for predecessors, parents and affiliates, the franchisor must provide its own litigation and bankruptcy history for the past 10 years. The FTC Rule sets out in detail the type of litigation that must be disclosed in Item 3 of the FDD. This litigation includes pending actions, convictions, liability in material civil actions and the terms of settlements. Disclosure is required for both franchisee and franchisor initiated actions. Disclosure includes foreign litigation (and arbitration proceedings) and foreign bankruptcy proceedings. There are some differences between the provincial statutes and the U.S. requirements relating to time periods, but the essence of this area of disclosure is similar for the provinces, requiring disclosure about certain criminal, civil and administrative proceedings, judgments and orders Costs, Investment, Working Capital Item 7 of the FDD must include an estimate of the initial expenditures and other payments required to begin franchise operations. These expenditures include the cost of acquiring or leasing real property, equipment, fixtures and other fixed assets, construction costs, inventory costs, monthly expenses, and working capital requirements. Working capital is referred to in the FTC Rule as additional funds and is an estimate of the funds needed to operate the franchise during a three month start-up period. The start-up period should be extended if warranted for the particular industry. The provincial regulations have similar requirements 53 except that there is no requirement, other than in Alberta, to provide information about working capital. The Alberta regulations provide that, if an estimate of working capital is given, it must have a reasonable basis and include the material assumptions underlying the preparation and presentation of the information. 54 If such an estimate is not provided, the FDD must 50 Ont Reg, s NB Reg, Sch A, Part 2, s Ont Reg, ss. 3-6; Alta Reg 240, Sch 1, ss. 2-5; PEI Reg, Sch I, Part 2, ss. 3-6; NB Reg, Sch A, Part 2, ss Ont Reg, s. 6.1.; Alta Reg 240, Sch 1, ss. 7 and 8; PEI Reg, Sch I, Part 3, s. 1; NB Reg, Sch A, Part 3, s Alta Reg 240, Sch 1, s. 10. Page 14

18 include a statement that additional funds will be required to finance operations until a positive cash flow is produced Advertising Funds The franchisor must disclose in Item 11 of the FDD whether the franchisee must participate in any advertising fund. If so, it must disclose: (i) who contributes to the fund; (ii) how much the franchisee must contribute to the fund and whether other franchisees must contribute a different amount or at a different rate; (iii) whether the franchisor-owned outlets must contribute to the fund and, if so, whether it is on the same basis as franchisees; (iv) who administers the fund; (v) whether the fund is audited and when it is audited; (vi) whether financial statements of the fund are available for review by the franchisee; (vii) how the funds were used in the most recently concluded fiscal year, including the percentages spent on production, media placement, administrative expenses, and a description of any other use; (viii) if not all advertising funds are spent in the fiscal year in which they accrue, how the franchisor uses the remaining amount, including whether franchisees receive a periodic accounting of how advertising fees are spent; and (ix) the percentage of advertising funds, if any, that the franchisor uses principally to solicit new franchise sales. Disclosure requirements regarding advertising funds receive differing treatment in the various provincial regulations. In Alberta there is no disclosure requirement. In PEI there is a requirement to simply describe the fund, and the amount or the basis of calculating the amount of the franchisee s required contributions. 56 Ontario and New Brunswick have similar regulations requiring a statement describing: 57 (i) the percentage of the fund that has been spent on national campaigns and local advertising in the 2 fiscal years immediately preceding the date of the disclosure document, and the percentage of the fund, other than the above percentage, that has been retained by the franchisor, the franchisor s parent or the franchisor s associate in the two fiscal years immediately preceding the date of the disclosure document, and another statement describing: (i) the projected amount of the franchisee s contribution or (in New Brunswick) the basis of calculating the franchisee s contribution, (ii) a projection of the percentage of the fund to be spent on national or local advertising campaigns for the current fiscal year, (iii) a projection of the percentage of the fund to be retained by the franchisor, the franchisor s parent or the franchisor s associate in the current fiscal year, and (iii) an indication of whether reports on advertising activities financed by the fund will be made available to the franchisee. 55 Alta Reg 240, Sch 1, s PEI Reg, Sch I, Part 2, s Ont Reg, s. 6.6.; NB Reg, Sch A, Part 3, s.9. Page 15

19 6. Computers and Electronic Cash Registers, Location Selection, Timing for Opening In Item 11 of the FDD, the franchisor must disclose whether the franchisor requires the franchisee to buy or use electronic cash registers or computer systems. If so, the franchisor must describe the systems generally in non-technical language, including the types of data to be generated or stored in these systems, and state the following: (i) the cost of purchasing or leasing the systems; (ii) any obligation of the franchisor, any affiliate, or third party to provide ongoing maintenance, repairs, upgrades, or updates; (iii) any obligations of the franchisee to upgrade or update any system during the term of the franchise, and, if so, any contractual limitations on the frequency and cost of the obligation; (iv) the annual cost of any optional or required maintenance, updating, upgrading, or support contracts; and (v) whether the franchisor will have independent access to the information that will be generated or stored in any electronic cash register or computer system. If the latter applies, the franchisor must describe the information that the franchisor may access and whether there are any contractual limitations on the franchisor s right to access the information. In Item 11 the franchisor must also disclose the franchisor s preopening obligations to the franchisee, including any assistance in locating a site and negotiating the purchase or lease of the site. If such assistance is provided, the franchisor must state: (i) whether the franchisor generally owns the premises and leases it to the franchisee; (ii) whether the franchisor selects the site or approves an area in which the franchisee selects a site. If so, state further whether and how the franchisor must approve a franchisee-selected site; (iii) the factors that the franchisor considers in selecting or approving sites (for example, general location and neighborhood, traffic patterns, parking, size, physical characteristics of existing buildings, and lease terms); and (iv) the time limit for the franchisor to locate or approve or disapprove the site and the consequences if the franchisor and franchisee cannot agree on a site. In Item 11 the franchisor must also disclose the typical length of time between the earlier of the signing of the franchise agreement or the first payment of consideration for the franchise and the opening of the franchisee s business. It must describe the factors that may affect the time period, such as ability to obtain a lease, financing or building permits, zoning and local ordinances, weather conditions, shortages, or delayed installation of equipment, fixtures, and signs. There are no comparable disclosure requirements in any of the provincial statutes. However, some of this information may be revealed under the provincial requirements to disclose the costs of establishing the franchise, the cost of operating the franchise (if being made) and, where appropriate, material facts. 7. Patents, Copyrights and Proprietary Information In Item 14 of the FDD, the franchisor must disclose whether the franchisor owns rights in, or licenses to, patents or copyrights that are material to the franchise. It must also, disclose (i) whether it has any pending patent applications that are material to the franchise; (ii) Page 16

20 describe any current material determination of the United States Patent and Trademark Office, the United States Copyright Office, or a court regarding the patent or copyright and how the determination affects the franchised business; (iii) describe claims asserted, issues involved, and effective determinations for any material proceeding pending in the United States Patent and Trademark Office or any court; (iv) whether an agreement limits the use of the patent, patent application, or copyright, state the parties to and duration of the agreement, the extent to which the agreement may affect the franchisee, and other material terms of the agreement; (v) disclose the franchisor s obligation to protect the patent, patent application, or copyright; and to defend the franchisee against claims arising from the franchisee s use of patented or copyrighted items; (vi) disclose any known patent or copyright infringement that could materially affect the franchisee, and (vii) if the franchisor claims proprietary rights in other confidential information or trade secrets, describe in general terms the proprietary information communicated to the franchisee and the terms for use by the franchisee. All but the Alberta regulations require a description of the rights the franchisor or the franchisor s associate has to the trademark, service mark, trade name, logo or advertising or other commercial symbol associated with the franchise. 58 Other than that, except for anything that might need to be disclosed as a material fact, there is no requirement to disclose information about intellectual property. 8. Dispute Resolution Item 17 of the FDD simply requires disclosure of the choice of forum and choice of law under the franchise agreement. However, many state regulators require that the State Cover Page contain a risk factor if out of state arbitration is required or out of state law governs the franchise agreement. The following is an example of these risk factors: THE FRANCHISE AGREEMENT REQUIRES THAT YOU SETTLE ALL DISPUTES WITH US BY ARBITRATION ONLY IN NEW YORK. OUT OF STATE ARBITRATION OR LITIGATION MAY FORCE YOU TO ACCEPT A LESS FAVORABLE SETTLEMENT FOR DISPUTES. IT MAY ALSO COST MORE TO ARBITRATE WITH US IN NEW YORK THAN IN YOUR HOME STATE. THE FRANCHISE AGREEMENT STATES THAT NEW YORK LAWS GOVERNS IT, AND ITS LAWS MAY NOT PROVIDE THE SAME PROTECTIONS AND BENEFITS AS LOCAL LAW. YOU MAY WANT TO COMPARE THESE LAWS. Section of the California Franchise Relationships Law provides that a provision in a franchise agreement restricting venue to a forum outside this state is void with respect to any claim arising under a franchise agreement involving a franchise business operating within this state. However, the Ninth Circuit Court of Appeals has held that this provision is pre-empted by the Federal Arbitration Act. 59 The fact that an arbitration clause trumps this 58 Ont Reg, s. 6.9.; PEI Reg, Sch I, Part 3, s. 13; NB Reg, Sch A, Part 3, s Bradley v. Harris Research, 275 F.3d 884 (9th Cir. 2001). Page 17

21 California venue provision is one reason that arbitration is often specified for dispute resolution in U.S. franchise agreements. The FTC Rule and state franchise laws each provide that a franchisee cannot contract out of its statutory protections. All of the provincial statutes provide that a franchisee cannot contract out of the provisions of the respective statute and that any provision in the franchise agreement restricting the application of the laws or the jurisdiction of the courts of the particular province are void with respect to any rights, obligations or claims (depending upon the wording of the particular statute) under the statute. 60 Each statute goes on to specifically preserve other rights or remedies any party to a franchise agreement may have at law. 61 Under the Ontario statute, disclosure is required of any internal or external mediation or other alternative dispute resolution process used by the franchisor in disputes with Franchisees and the circumstances when the process may be invoked. 62 Under the PEI Act 63 and the New Brunswick Act 64, one must include a description of any restrictions or requirements imposed by the franchise agreement, including any requirements relating to location or venue of such process. The regulations under the New Brunswick statute uniquely provide for a process of mediation. 65 However, the process is not mandatory, if a party chooses to decline a notice to mediate Public Figures In Item 18 of the FDD, a franchisor must disclose certain information concerning the compensation of, management involvement of, and investment by, public figures who are used in the franchise name or symbol or in advertising for the sale of franchises. A public figure is defined as a person whose name or physical appearance is generally known to the public in the geographic area where the franchise will be located. statutes. There is no comparable disclosure requirement in any of the provincial 60 Ontario Act, s. 11; Alberta Act, s. 18; PEI Act, s. 12; NB Act, s Ontario Act, s. 9; Alberta Act, s. 15; PEI Act, s. 10; NB Act, s Ont Reg, s PEI Reg, Sch I, Part 3, s NB Reg, Sch A, Part 3, s Mediation Regulation, NB Reg Mediation Regulation, NB Reg , s. 4. Page 18

22 10. Financial Performance Representations A financial performance representation is defined as any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables. 67 Absent from this definition is any cost or expense information. Therefore, cost or expense information may be freely given to a prospective franchisee. However, a franchisor may not disclose costs or expenses in a way that allows a prospective franchisee to calculate sales, such as a percentage of sales, without including a financial performance representation in the FDD. If a franchisor chooses to make a financial performance representation, it may only do so in Item 19 of the FDD. There must be a reasonable basis for the representation at the time it is made. The disclosure must include the factual basis and material assumptions used to determine the financial information being presented. The franchisor must specify whether the information is historic or prospective. The FTC Rule also contains certain prescribed statements and admonitions that must be included. A U.S. franchisor is not required to provide any financial performance representations. If no financial performance representation is made, then there is a prescribed statement for Item 19 of the FDD. In this case the only financial information that a franchisor may provide to a prospective franchisee are the actual records of an existing location under consideration by the prospect. Under the Ontario regulation, if an earnings projection (which is not defined) for the franchise is provided, a statement specifying the reasonable basis for the projection, the assumptions underlying the projection and a location where information is available for inspection that substantiates the projection must be included in the FDD. 68 Under the PEI regulation and the New Brunswick regulation, if an earnings projection is provided directly or indirectly, a statement must be included in the FDD specifying: 69 (i) the assumptions and bases underlying the projection, its preparation and presentation; (ii) that the assumptions and bases underlying the projection, its preparation and presentation are reasonable; (iii) the period covered by the projection; (iv) whether projection based on actual results of existing franchises or existing businesses of the franchisor, its associates or its affiliates of the same type as the franchise being offered and if so, the location/territories/markets of those franchises; (v) if the projection is based on a business operated by the franchisor, its associate or affiliate of the franchisor, that the CFR 436.1(e). 68 Ont Reg, s PEI Reg, Sch I, Part 3, s. 5; NB Reg, Sch A, Part 3, s. 5(1). Page 19