Proving Rescission Damages under the Provincial Franchise Acts

In October 2012, the Manitoba Franchise Act was proclaimed into law. The legislation, like its counterparts in several other provinces (including Ontario’s Arthur Wishart Act), provides franchisees with the right to rescind a franchise agreement within two years if a “disclosure document” is not provided. Upon rescission, the franchisee is entitled to receive an amount that will, generally, place it back in the same financial position it was in when it entered into the franchisee agreement. This provision, which also features in the provincial franchise legislation of Ontario, New Brunswick and Prince Edward Island, has given rise to much litigation (particularly in Ontario) over the past decade; yet reported decisions involving detailed outlines of rescission remedies awarded have been few and far between. The aim of this article is to provide counsel with two examples from amongst the various analytic tools that can be used at an early stage in the litigation process to assess the potential magnitude of such a financial remedy.

The various Franchise Acts use identical language in setting out the amounts that must be paid to the franchisee upon rescission under four subsections, (a) through (d). They require that, upon rescission, the franchisor must: a) Refund to the franchisee any money received from the franchisee, other than money for inventory, supplies or equipment; b) Purchase from the franchisee any inventory that the franchisee had purchased pursuant to the franchise agreement; c) Purchase from the franchisee any supplies and equipment that the franchisee had purchased pursuant to the franchise agreement; and d) Compensate the franchisee for any losses that the franchisee incurred in acquiring, setting up and operating the franchise.

Quantifying the amounts under subsections (a) through (c) can be relatively straightforward. The franchisor will have a record of amounts paid to it by the franchisee. The purchase of supplies and equipment is also typically well documented. The inventory component is often relatively insignificant.

But what of subsection (d), the start-up and operating losses? In order to quantify losses, one must be able to prove both the revenues and expenses of the business. Based on our experience in quantifying such claims, rescinding franchisees will often not have had proper financial statements prepared, in the absence of which it may be difficult at first glance to provide even a rough estimate of the potential quantum under this section. Revenues may be understated; expenses may be undocumented and therefore unrecoverable (see the recent decision in 2189205 Ontario Inc. v. Springdale Pizza Depot Ltd., 2012 ONSC 3344 (CanLII), in which both of these issues arose). Below, we provide a couple of techniques that will allow counsel to arrive at a preliminary sense of the magnitude, or even the very existence, of the potential claim under subsection (d).

Consider the example of a franchisee that operated a restaurant. It presents financial statements showing revenue of $800,000, cost of sales (i.e. food and drink) of $600,000, and other operating expenses (rent, wages, etc.) of $600,000, for total reported operating losses of $400,000. Assume that all of the expenses are fully documented.

Is there any evidence that the revenue figure is accurate and complete? Consider that, based on data from Statistics Canada, the average cost of sales for a full-service restaurant, as a percentage of sales, is generally in the range of 35%; yet this franchisee shows cost of sales of 75%. While some allowance may need to be made to account for poor management skills, this accounting ratio may be an indication that there have been significant levels of unreported sales, and that the reported operated losses are overstated. Recognition of this issue will likely have an impact on counsel’s strategy for the litigation.

Consider a second example. Suppose that the franchisee has provided accurate records with respect to its revenues. Unfortunately, this may be only half the battle, as the expenses incurred by the franchisee may not have been sufficiently documented.

In deciding whether or not to pursue a claim under subsection (d), it is often useful to attempt to estimate what portion of the franchisee’s expenses cannot be documented. In a recent case in which we were involved, the franchisee – who had operated a relatively large franchise restaurant – acknowledged that he had paid his employees in cash. While we did not have any documentation that would enable us to quantify the level of cash payments, based on data from Statistics Canada showing that labour costs for larger restaurants are typically equal to 25% to 35% of sales, we estimated that total labour costs for this restaurant were in the range of $300,000. Based on this level of undocumented expenses, we explained to counsel that in order to make any sort claim under section (d) the franchisee would have to have actually lost in excess of $300,000, a very large sum for this particular franchisee to have been able to have financed. Counsel decided to abandon the claim for operating losses and focus on subsections (a) through (c).

Franchise legislation contemplates swift settlement of franchise rescission claims; amounts are to be paid within 60 days of receipt of the notice of rescission. While the reality is that many such disputes become much more protracted, it is to be hoped that the sort of “high-level” analysis described above may prove useful to counsel in resolving claims more quickly and efficiently.

By Ephraim Stulberg. Published in The Law Times.

The statements or comments contained within this article are based on the author’s own knowledge and experience and do not necessarily represent those of the firm, other partners, our clients, or other business partners.