Canada: Give Your Franchise Agreement A Facelift

Changes in technology, customer needs, and the laws governing franchising require franchise agreements to evolve reactively, to accommodate such shifts as they happen, and proactively, in anticipation of what the future might bring. Regular review of your franchise agreement can help you stay on top of the waves of change, address current and potential business issues, and help protect your legal interests in the event of a dispute or termination of the agreement. To help get you started, we have created a three part article outlining common provisions in franchise agreements that you might want to consider revamping.

1. General Releases

Franchise agreements often stipulate that franchisees must release all claims against the franchisor as a condition for granting a transfer or renewal of the franchise. For example:

Recently the Ontario Court of Appeal confirmed that a franchise agreement provision requiring a franchisee to release its claims against the franchisor under the Arthur Wishart Act (Franchise Disclosure), 2000¹ (the "Act"), violates Section 11 of the Act and is therefore unenforceable, and that any release obtained pursuant to such a provision will be void.² Although the provision set out above does not specifically reference the Act, it states that any and all claims are to be released, which would, on a plain reading of the provision, include claims under the Act. One way to revise such a general release provision in light of Cora could be to add a carve-out for claims under the Act (e.g., "all claims are released except to the extent limited or prohibited by the Arthur Wishart Act (Franchise Disclosure), 2000").

2. Interest Rates

U.S.-based franchisors ought to be wary of carrying over their form of franchise agreement when expanding into Canada as certain legal concepts may not translate to the Canadian context. One example is the American practice of stating interest rates as "the lesser of [X]% and the highest lawful rate of interest permitted by applicable law". In the US, many state laws provide for certain statutory maximum interest rates that may be charged (called the "usury limit"). The usury limits differ from state to state and range from approximately 5% to 24%. State law also provides state-specific exemptions from usury limits. Given these differences, the interest provision set out above ensures that the franchisor is on-side of such usury laws without the need to adapt its form of franchise agreement for each state.

Unlike the U.S., however, Canada does not have usury limits under provincial laws which franchisors would be at risk of contravening in the normal course. Instead, franchisors must take note of other legislation governing interest rates when drafting such provisions. First, it is an offense under the Criminal Code to charge and collect interest over 60% per annum.³ In that regard, a common pitfall for franchisors is the failure to realize that lump sum penalties levied against franchisees for late payments may also be considered interest, especially since these penalties are often assessed monthly for every month the arrears remain outstanding. Accordingly, when such lump sum penalties are levied against franchisees in addition to the interest charged for late payments, the aggregate amount can result in the effective rate of interest under the agreement being greater than the criminal rate. Franchisors should also be wary, more generally, of applying late payment penalties of any sort, particularly when the penalties are very large in comparison to the actual amounts of the late payments to which they are applied. Second, the Interest Act requires that for interest rates exceeding 5%, the interest rate must be expressly stated on a yearly basis regardless of whether the interest is payable at a rate for a period that is less than a year (e.g., monthly interest rate).⁴ Failure to state the effective annual interest rate will result in interest rate being limited to 5% and any sum paid for interest over that amount would need to be returned.

3. Ability to Rebrand

As markets change, franchisors must consider the impact on their brand offering and their strategy to stay relevant. If there is a business case for rebranding the system or refreshing its image and marks, the next inquiry will be whether, and to what extent, the franchisor's existing franchise agreements give it the rights to change the current marks being used.

In Halligan v. Liberty Tax Services Inc.⁵ a franchisor sought to terminate its franchisee when the franchisee refused to change its name from "U & R Tax Services" to "Liberty Tax Services" in accordance with the franchisor's decision to rebrand the system. The governing franchise agreement contained the following language:

In Liberty Tax, the court found that the franchisee was entitled to continue using the old business name and that the franchisor did not have the right to terminate the franchisee for failing to rebrand its store. In coming to this conclusion, the court focused on the phrase "certain Licensed Marks" in the clause cited above, noting that while it allowed the franchisor to change or modify the trademarks, no reference was made to changing the name of the franchise or business. The lesson to be learned from Liberty Tax is thus that, in order to mandate an overall rebranding of a franchise system, the franchise agreements must expressly provide the franchisor with the right to change the primary mark and rebrand the system under a different trade name and trademark, as opposed to merely allowing the franchisor to substitute or change the trademarks (a right that is typically associated with the (limited) need to replace marks that are held to infringe upon the rights of third parties). Finally, to complete the exercise, the franchise agreement should require the franchisee to discontinue use of any modified or substituted trademarks as directed by the franchisor.

Another issue to consider when rebranding is the risk that franchisees might bring a claim against the franchisor for any business losses they experience as a result of the rebranding. To help reduce such risk, it may be helpful to include a provision in the franchise agreement requiring franchisees to provide a release against all claims arising from a change to the brand; bearing in mind, however, that such release could not cover the release of claims under applicable franchise laws. More practically speaking, many franchisors try to reduce their risk of franchisee claims by making any rebranding of their system voluntary for their existing franchisees (i.e., even if their franchise agreements permit the franchisor to force the issue) and usually pay at least part of the franchisee's cost to implement the change (i.e., by providing new signage, uniforms and other forms of trade dress free-of-charge).

Finally, franchisors looking to rebrand might also be assisted by having the flexibility to use the advertising fund monies for general marketing undertakings, which could include rebranding efforts. In this regard, provisions surrounding use of the advertising fund by the franchisor should be reviewed carefully, particularly in light of the risks described immediately above.

4. Social Media and Online Marketing Policy

Franchise agreements typically prohibit the franchisee from establishing websites using the system's trademarks and trade names. Such prohibitions should include appropriate restrictions and guidelines on the use of social media platforms by franchisees. For example, without a social media policy, franchisees in a system might post inconsistent marketing and messaging, or worse, publish comments that are damaging to the brand. In particular, responses to negative online reviews by customers need to be carefully managed and either dealt with centrally by the franchisor or by the franchisee at issue in accordance with guidelines. The acts of franchisees online could also easily offend advertising laws and anti-spam legislation if left unmonitored.

Franchise agreements should contain provisions requiring the franchisee to obtain the franchisor's prior written consent to use any of its trademarks, including online, and to follow all directives regarding marketing through social media.

5. Dispute Resolution Clauses and Waiver of Class Actions

Increasingly, franchise agreements include clauses whereby the franchisee waives its right to pursue a class action. Based on current case law, such clauses are not invalid. However, they will not necessarily be enforced by a court.

In 1146845 Ontario Inc. v. Pillar to Post Inc.⁶, a franchisor sought to stay a class action brought by some of its franchisees. The franchise agreement contained a class action waiver clause and mandatory arbitration provisions. The franchisees argued that Section 4 of the Act (which provides franchisees the right to associate with other franchisees and prohibits franchisors from interfering with that right) included the right to bring a class action. The court rejected that argument. However, in granting the franchisor's motion to stay the class action, the court relied on the mandatory arbitration clause in the franchise agreement, not the class action waiver. Thus, while the class action waiver clause was not specifically invalidated by the court, the clause was not specifically upheld, either.

In addition, in 2038724 Ontario Ltd. v. Quizno's Canada Restaurant Corporation⁷, the court found that the mere fact that a class action waiver clause was in a franchise agreement was insufficient justification for staying a class action proceeding. However, the court noted that a class action waiver clause would be a strong factor in determining whether a class proceeding is the preferable procedure.

In light of the Pillar to Post and Quizno's decisions, therefore, we can conclude that inclusion of a mandatory arbitration provision in a franchise agreement might be more effective for those franchisors wishing to avoid class action proceedings than inclusion of a class action waiver clause, alone.

On a related note, if arbitration is provided for in the franchise agreement, franchisors should consider specifying the related processes and procedures. For example, the franchise agreement should set out how an arbitration proceeding is initiated, how an arbitrator is chosen, timelines, etc.. With respect to choosing the arbitrator, the franchise agreement may allow the franchisor to choose the arbitrator⁸ provided that such discretion is exercised in good faith as required by Section 3 of the Act (e.g., appointment of a non-arms length party would likely not be upheld by a court).

6. Non-Competes

Developing a successful franchise system requires significant time, effort and resources. Naturally, a franchisor's proprietary information, including its operating methods, standards and specifications, is incredibly valuable. Post-term restrictive covenants, such as non-competition provisions, can help ensure that franchisees do not use that know-how to run a competing business and damage the goodwill of the franchise system once the relationship ends. Under Canadian law, non-compete provisions are generally considered to be contrary to public policy, in that they constitute restraints on trade. They will, however, be enforced if the restrictions they contain are reasonable, having regard to both the interest the covenantee is seeking to protect and the extent to which they prevent the covenantor from being able to make a living. The key parameters to consider in such an analysis are the duration of the covenant (i.e., for how long the covenantor is prohibited from competing) and its geographic scope (i.e., the area in which the covenantor is prohibited from competing). For this reason, franchisors are advised to consider very carefully how much protection they actually need and to draft the temporal and geographic scope of their non-compete provisions to reflect that minimum amount of protection.

Two additional practices also deserve consideration. First, franchisors will sometimes insert into their franchise agreements a non-compete clause that contains a cascade of restricted times and/or areas in which the prohibition will apply, with the intention that the court will strike out (i.e., "blue pencil") the overly-broad parameters, thus leaving the parties with a clause that is properly enforceable. An example of such a clause is as follows:

Unfortunately, while this practice is quite common and effective in other jurisdictions, such as the United States, Canadian courts have historically been quite reluctant to give effect to it, primarily on the argument that the court is not there to "re-make" the contract between the parties (i.e., to amend an otherwise unenforceable contract to render it enforceable).

Notably, in Shafron v. KRG Insurance Brokers (Western) Inc.⁹, the Supreme Court of Canada confirmed that "blue-pencil" severance, may only be applied if the parties would have agreed to the remaining obligation without varying other terms of the contract (in other words, the part that is severed is not the main purpose of the clause). Accordingly, non-compete provisions that include multiple geographic scopes, such the above example, would likely not be enforceable under Canadian law. Again, the better practice would be to draft such provisions to stipulate only the minimum distance and time period necessary to protect the franchisor's legitimate business interests.

The second practice franchisors typically employ to get around this issue is to insert non-solicitation clauses into their franchise agreements, either in addition to or in place of the non-compete. Canadian courts are generally much more willing to enforce clauses that restrict the covenantor from soliciting the employees or customers of the covenantee, primarily because the nexus between the restriction and the interest that the covenantee is seeking to protect is much clearer, and the damage the covenantor would cause by violating the restriction much more readily foreseeable.

Conclusion

When reviewing and revising your franchise agreement, the importance of clear and comprehensive drafting cannot be overemphasized. Since franchise agreements have been found to be "contracts of adhesion" (i.e., they are typically in a standard form and presented on a "take it or leave it basis"), courts will interpret the provisions of franchise agreements with a view to protect the more vulnerable contracting party (i.e., the franchisee).¹⁰ This means that any ambiguities in drafting will be resolved in favour of the franchisee, and even where the drafting is clear, the court will construe the provisions to give the franchisee the most preferable position possible as opposed to construing the provisions in accordance with commercial reasonableness.

As a final tip, franchisors must ensure that the franchise disclosure document and ancillary agreements are updated to accord with any changes made to their form of franchise agreement and consider whether and how such amendments might be implemented for franchise agreements currently in force.

Footnotes

1. S.O. 2000, c. 3.

2. 2176693 Ontario Ltd. v. The Cora Franchise Group Inc 2015 ONCA 152 [Cora].

3. Section 347, R.S.C. 1985, c. C-46.

4. Section 4, R.S.C. 1985, c. I-15.

5. 2003 MBQB 174 [Liberty Tax].

6. 2014 ONSC 7400.

7. [2008] O.J. No. 833.

8. 2162683 Ontario Inc. v. Flexsmart Inc., 2010 ONSC 6493.

9. 2009 SCC 6.

10. Cora, para 38.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.