Jul 10, 2014

Not All Complaints by Franchisees Are Legitimate

Caffé Demetre v. 2249027 Ontario Inc., 2014 ONSC 2133 (CanLII)

Identifying ‘material facts’ is important to franchisors and franchisees because all material facts are required under the Arthur Wishart Act (Franchise Disclosure), 2000 (and similar franchise legislation in other Canadian provinces) to be fully disclosed in the Franchise Disclosure Document.

Failure to disclose all material facts entitles a franchisee to a rescission (cancellation) of the franchise purchase, and to claim against the franchisor very significant damages.

In my last blog article of April 21, 2014, titled Material Facts Explained: A Disclosure Document Primer, I outlined the three key components of the definition of ‘material fact’ under the Act. In that article, I gave an example of what would qualify as a material fact.

What about facts that are not material? In a recent decision of the Ontario Superior Court, out of London, Ontario, released on April 3, 2014, in a case called Caffé Demetre v. 2249027 Ontario Inc., the court ruled that the disclosure deficiencies about which the franchisees complained were not material, and therefore, the franchisees were not entitled to a rescission of their franchise purchase.

The franchisor was the operator of the Caffé Demetre franchise system, which specializes in desserts and ice cream. The franchisee operated a Caffé Demetre restaurant on Dufferin Street in Toronto, which he purchased from a previous franchisee for $800,000. This restaurant was one of the highest-grossing restaurants in the system.

The franchisor terminated the franchise agreement after the franchisee failed to comply with renovation requirements and failed to produce required accounting records relating to significant cash register irregularities.

The franchisee continued operating the restaurant under another name. The franchisor brought an action for damages against the franchisee.

In response to the franchisor’s lawsuit, the franchisee counterclaim for rescission on the basis of the following alleged disclosure deficiencies:

1) Failure to disclose the fact that the franchisor was involved in litigation against the previous franchisee owner of the restaurant;

2) Failure to disclose that the franchisor was planning to implement a “Tip Out Policy”;

3) Failure to disclose that the franchisor was planning to change the ice cream manufacturing policy, requiring franchisees to be directly responsible for preparing ice cream, and
4) Failure to disclose that the restaurant would require extensive remodelling and renovations in excess of $50,000.

The court dismissed all four alleged disclosure deficiencies on the basis that they did not amount to ‘material facts’ as defined in the Act.

1) Litigation against former franchisee. The court concluded that the
franchisor’s lawsuit against the former franchisee did not represent a potential liability to any of the existing franchisees in the system. It relied on the following reasons:

a) The franchisor commenced that other lawsuit as plaintiff at the urging of other franchisees in the system, because the former franchisee set up and started operating a similar restaurant 7.5 km away from the Dufferin St. location. The lawsuit was for the benefit of the existing franchisees in the system.

b) When the franchisee learned about the existence of this litigation, he raised no concern about it. There was no basis to conclude that the operation of the other restaurant, 7.5 km away, had any impact on the sales revenues of the Dufferin St. location.

c) The franchisee was never asked to participate in the lawsuit.

d) The former franchisee’s restaurant eventually went out of business.

2) Tipping out policy. The court ruled that the tipping out policy, based on a new law that prohibited employers, including franchisees, from taking a share of their employees’ tips, had no impact on the franchisee’s sales performance. It cited the following reasons:

a) The policy change did not arise until more than a year after the disclosure document was delivered.

b) In any event, the franchisee refused to implement the new policy. Therefore, it had no impact on the profitability of his restaurant.

3) Ice cream manufacturing policy. The court decided that the requirement for franchisees across the system to make ice cream on site was immaterial for the following reasons:

a) The policy change was the result of inconsistent ice cream quality across the system. It was implemented based on a standard provision in the franchise agreement that permitted the franchisor to alter products, methods and standards on an ongoing basis as part of the evolution of the System.

b) This policy came about twenty month after the disclosure document was delivered.

c) In any event, as before, the franchisee declined to implement this policy.

4) Remodelling and renovations. Here, too, the court concluded that the remodelling and renovation requirement did not amount to a material fact. The reasons were as follows:

a) The requirement did not arise until over a year after the disclosure document was delivered.

b) The franchisee was well aware of this requirement in the franchise agreement at the time of his purchase of the restaurant.

For these reasons, the court dismissed the franchisee’s counterclaim and his request for a rescission of the franchise purchase.