January 2007 Issue

FDH Newsletter |

Article 1: Court Provides Direction on Franchisor’s Disclosure Obligation

Article 2: Protecting the Family Business from Spousal Equalization Claims

FDH News & Legal Tidbits

InProfile: Edson Packaging Machinery Limited

Court Provides Direction on Franchisor’s Disclosure Obligation

by Debi M. Sutin

A recent decision of the Ontario Superior Court of Justice has clarified a franchisor’s disclosure obligation under Ontario’s franchise legislation, The Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”). The Court has now provided some guidance as to when a transfer of a franchise by a franchisee is “effected by or through the franchisor” and thus, not exempt from the obligation to disclose. It also sheds light on the application of Section 11 of the Act which prohibits the “contracting out” of a right or obligation under the Act.

In 1518628 Ontario Inc. v. Tutor Time Learning Centres Inc., the plaintiffs sought a declaration that they were entitled to rescind the franchise agreement because the franchisor had failed to comply with the disclosure obligations set out in the Act. Although the Court found that the franchisor had breached its disclosure obligation, it nevertheless dismissed the plaintiffs’ claim, upholding the validity of a release given by the plaintiffs to Tutor Time.

Shortly after its purchase, the plaintiffs discovered financial irregularities in the former franchisee’s operation which resulted in financial difficulties being suffered by the plaintiffs. Following this discovery, and other damaging information regarding the former franchisee’s operation, the plaintiffs alleged that Tutor Time had knowingly withheld information which it had an obligation to disclose. In a settlement agreement which followed, the franchisor agreed to waive payment of arrears which arose under the former franchisee’s operation and granted certain other financial concessions to the franchisee in exchange for a full release against any claims arising out of the franchise relationship. The plaintiffs continued to be unsuccessful in the operation of the franchise and less than one year later sold the business as a non-franchised daycare centre. Shortly thereafter, the plaintiffs delivered to Tutor Time a Notice of Rescission under the Act.

The franchisor, a U.S.-based franchisor of daycare centres, argued that because the plaintiffs had purchased the shares of an existing franchisee, the grant of the franchise to the plaintiffs was not “effected by or through the franchisor” and that the franchisor was therefore exempt from the disclosure requirement. The Court disagreed, holding that Tutor Time’s requirement that the spouse of the principal shareholder of the franchisee sign a personal guarantee (an additional condition to those set out in the franchise agreement) resulted in the transaction being “effected by or through the franchisor”. As a result, the franchisor could not rely upon the exemption from disclosure and it was required to have delivered a compliant disclosure document to the prospective new franchisee.

The Court then had to consider whether the delivery by the franchisor of a Uniform Franchise Offering Circular (a U.S. form of disclosure document) met the test required for disclosure under the Act. In making this determination, the Court agreed with the opinion of Debi M. Sutin and Arthur Trebilcock in their article “The Case Against the Use of Wrap-Around Disclosure Documents in Canada” that an Ontario disclosure document must “be updated to reflect all material facts as they exist on the date that it is delivered to the prospective franchisee”. On the particular facts of this case, including the franchisor’s failure to disclose irregularities in the francisee’s operation and its acknowledgement that it provided the UFOC for “informational” purposes only, the Court concluded that the franchisor “never provided the disclosure document” and, as a result, the franchisee was entitled to the 2-year period for rescission of the franchise agreement granted under the Act (rather than the 60-day rescission period available in the case of incomplete disclosure). Tutor Time then argued that the release in the settlement agreement precluded the plaintiffs from recovering damages arising from Tutor Time’s failure to provide the disclosure document. The plaintiffs attempted to rely on Section 11 of the Act which makes void any purported waiver or release of a right given, or obligation imposed, under the Act. The Court dismissed the plaintiffs’ argument, holding that the settlement agreement was a valid contract and constituted a valid release in favour of Tutor Time against a claim for damages arising from Tutor Time’s breach of the disclosure requirements of the Act.

This decision adds significantly to the small but growing jurisprudence arising from Ontario’s franchise legislation. The guidance provided by this decision as well as future decisions under Ontario’s franchise legislation must be taken into account by both franchisors and franchisees in the establishment and development of their relationship and the continued growth of the franchisor’s franchise system.

On December 11, 2006, the plaintiffs were granted leave to appeal this decision to the Divisional Court. The appeal is expected to be heard early next year.

Protecting the Family Business from Spousal Equalization Claims

by Ron J. Weston

When asked if they have a written marriage contract, clients often acknowledge that they gave the matter some thought but found it difficult or discomforting to discuss the issue with their future spouse. Apparently legal documents are not overly romantic. The benefits of these contracts, if properly drafted, can be invaluable to assist in an orderly, predictable and amicable resolution of a division of property following marriage breakdown. Despite their virtues, however, the fact is that most people who own or will in the future own a family business do not have a marriage contract. Issues arising from the division of property following a marriage breakdown are then determined in accordance with the provisions of the Family Law Act (the "Act"). One need merely attend Superior Court and examine the lengthy case hearing list on the Court's docket to discover that the Act itself is capable of divergent interpretations by family law practitioners and their clients.

So what is available to a business owner to unilaterally avoid the need for a domestic contract or Court Order to protect his or her interest in the business? So long as all family members are co-operative, the answer is a simple reorganization of the corporation which operates the business. Through a "net family property freeze" the shareholdings of a shareholder in a privately-held corporation, or the future shareholdings of his or her children, can be sheltered from inclusion in the calculation of “net family property” and thus excluded from a spousal equalization claim.

This technique is available to be used in two common scenarios: 1) The parents who are the sole shareholders of a family business wish to transfer the business to one or more of their children; and 2) a shareholder of a family-owned business wishes to stop or “freeze” the value of his shareholdings which are, or may in the future be, subject to equalization.

In the first situation, a standard freeze technique is used in which the common shares owned by the parents are converted into preference shares which have a fixed redemption value equal to the fair market value of the common shares. Since preference shares have a "preference" to shareholder equity, any common shares issued following this conversion will generally have no value at the date of issue but may acquire value over time if the business grows. Following the conversion of the shares, the corporation issues to the parents a number of common shares and a greater number of special shares, with no substantive rights other than the right to vote. The common shares are then gifted to their children by “deed of gift”. Gifted property is excluded under the Act from a spouse’s net family property calculation. Accordingly, there is no obligation under the Act to equalize on the value of these gifted shares. This technique is also beneficial to the parents as there are no tax consequences on the conversion of the common shares and voting control is retained. Further, the parents have the ability to redeem their shares over time and to decide the appropriate time to relinquish management control to their children.

The second scenario differs from the first in that it does not involve succession of the business. Rather, any shareholder with voting control of a private business can freeze the value of his shareholdings without obtaining the consent of his or her spouse (the only asset that is subject to nontitled spousal consent is the matrimonial home). Once the freeze is completed, the shareholder invites the co-operation of family members to subscribe for common shares who then immediately gift the shares to the original shareholder. Thereafter, because the common shares are “gifted property”, any growth in their value is exempt from an equalization claim. The value of the preference shares, however, will be included in the calculation of the shareholder’s net family property and subject to an equalization claim.

If one is hesitant to raise the subject of a marriage contract at the time of marriage or acquires an ownership interest in a business following marriage, it is essential that the business owner obtain proper advice on protecting this asset into the future, both for succession planning purposes and in the event of marriage breakdown.

FDH News & Legal Tidbits

Debi Sutin will speak at the Canadian Franchise Association’s annual Legal Symposium, taking place January 11, 2007, on the topic “Best Practices in Renewals, Resales, Transfers and Buybacks”
Christopher Neufeld has been invited by the City of Hamilton’s Economic Development Division to participate in the City’s “Goods Movement Focus Group” which is charged with mapping out the future of transportation for the City of Hamilton.
James Tuck was elected Vice President of Burlington’s Sound of Music Festival. The Festival is held annually in June on the City’s Downtown Waterfront and has been voted one of the Top 50 Festivals in Ontario for the 6th year in a row.
Lori Brown spoke on Wills and Estate Planning at 3 separate events this past fall. The events were hosted by Duca Credit Union, Mississauga Wealth Management of your CFO Advisory Group Inc. and Investors Group of Burlington.
A number of the members of firm, together with their guests, attended a luncheon with Prime Minister Stephen Harper on October 27th. The luncheon was sponsored by the Oakville Chamber of Commerce.
Feltmate Delibato Heagle has partnered with WAVE 94.7 FM Smooth Jazz as the exclusive sponsor of The Performing Arts Burlington Update on 94.7 FM radio in 2007. Funded by Feltmate Delibato Heagle, the program communicates upcoming performances, festival and event information and supports tickets sales for Performing Arts Burlington events.
Debi Sutin, Lori Brown and Diane Rocheleau attended the 5th Annual Oakville Toy Tea hosted by Oakville accounting firm, Henderson Partners LLP. Attendees are asked to donate an unwrapped toy which are then distributed to underprivileged children in the Oakville community.
Christopher Neufeld’s article on the significance of legal audits, “Frozen Donuts: The Importance of a Legal Audit When Transforming Production and Manufacturing Processes”, was recently published in the “Business Beat”, a publication of the Ontario Bar Association.