The Case For Mediation and Arbitration of Franchise Disputes

by Frank Zaid

Franchising has become big business in Canada. According to the Canadian Franchise Association website, franchise businesses account for 40% of all retail sales in Canada and there are over 78,000 franchise units across Canada. Franchising directly employs over 1,000,000 people, amounts to 10% of Canada’s gross domestic product, and accounts for 1 out of every 5 consumer dollars spent in Canada on goods and services.

Commensurate with the growth of franchising in the marketplace, franchise legislation has now been enacted in five provinces in Canada (in order of enactment, Alberta, Ontario, Prince Edward Island, New Brunswick and Manitoba). In addition, franchising is generally regulated in Quebec under that province’s Civil Code, in which franchise agreements are considered to be contracts of adhesion. The Manitoba Law Reform Commission, in its Franchise Law Consultation Paper of May 2007, stated that, “every year, thousands of Canadians are improving their lives by becoming franchisees”.

The franchise relationship is governed principally by a franchise agreement between a franchisor, the entity that owns the franchise system rights, and the franchisee, the person who obtains the right to operate a business in accordance with the franchisor’s business standards and the franchisor’s trade-marks. Franchise agreements are complex documents, reflecting the rights granted to the franchisee, the obligations of the franchisee to operate a business in accordance with the franchise system, and the rights and obligations of the parties to each other in respect of the franchisor’s administration of the franchise system and the franchisee’s standards of operation of the franchised business. Over the years a considerable number of franchise disputes have been heard by the courts, usually on an individual franchisee/franchisor basis. As the number of franchisees within a given franchise system grows, so do the number of disputes revolving around a common issue to all or virtually all of the franchisees within that system, both past and present. In more recent times some large group actions have been brought for damages allegedly caused to the franchisees by the franchisor in respect of contractual breaches or misrepresentations. With the introduction into Ontario of class action legislation in 1992 under the Class Proceedings Act, franchise disputes common to a distinguishable group of all or substantially all the franchisees within a specific franchise system have become the subject matter of very large and significant class actions. Companies with such prominent names as Petro Canada, Bulk Barn, A&P, Midas, Quiznos, Tim Hortons, Sears, Suncor, Pet Valu and Shoppers Drug Mart, and even the Ontario Government, have been or are currently involved in franchise class actions.

Given all this activity, one might question why more franchise disputes are not resolved or attempted to be resolved by alternate dispute resolution methods such as mediation or arbitration (“ADR”). In this writer’s opinion, franchise disputes are a natural fit for ADR, and more and more franchise disputes are likely to head to ADR in the future. There are a number of external reasons why this is likely to happen.

All Canadian franchise legislation is founded on two major principles. The first is that a franchisor must provide a prospective franchisee with a disclosure document which outlines in considerable detail the franchise being offered, unless an exemption is available. A disclosure document must be provided to a prospective franchisee at least 14 days prior to the prospective franchisee signing any agreement relating to the franchise, or paying any consideration to the franchisor or the franchisor’s associate relating to the franchise. If a disclosure document is not provided, or a disclosure document is provided but contains deficiencies, the franchisee has a statutory right to rescind the agreement within two years, in the case of no disclosure, or 60 days, in the case of deficient disclosure, after the date the franchisee entered into the franchise agreement. The statutory right of rescission creates a highly punitive and costly remedy in favour of the franchisee. If the agreement is rescinded pursuant to this right, the franchisor is required to: refund to the franchisee any money received from or on behalf of the franchisee other than money for inventory, supplies or equipment; purchase from the franchisee any inventory, supplies and equipment that the franchisee had purchased pursuant to the franchise agreement at a price equal to the purchase price paid by the franchisee; and compensate the franchisee (without duplication) for any losses incurred in acquiring, setting up and operating the franchise. When one considers the cost of establishing a franchise in some of the larger franchise sectors like hotels, car rentals, automotive dealerships, full scale restaurants and grocery stores, multiplied by the number of franchisees operating within a particular system, the exposure of a franchisor to rescission claims can easily run to hundreds of millions of dollars.

The second principle is that franchise legislation imposes on each party to any franchise agreement a statutory duty of fair dealing in the performance and enforcement of the agreement, a duty that includes the obligation to act in good faith and in accordance with reasonable commercial standards. Breach of the duty of fair dealing, when coupled with an alleged breach of an obligation or the assertion of a right under the franchise agreement, also exposes a franchisor to a significant claim for breach of contract. Again, if the alleged breach is in respect of a matter common to all or substantially all franchisees within a given system, the aggregate potential damages claim against a franchisor can run into the hundreds of millions of dollars.

While the franchise agreement has been characterized by the courts as a contract of adhesion, prepared by the franchisor with little or no ability of the franchisee to negotiate terms, and often between a corporation with significant assets and resources and an individual entrepreneur with very limited assets and resources, litigation between these parties has the potential to cause substantial damage to the reputation of the franchisor, significant exposure to huge damage awards and possible ruination and bankruptcy of the franchisee.

As a result, we are seeing in the franchise legal and business community many initiatives to direct franchise disputes into ADR at an early stage.

In 2005, the Uniform Law Commission of Canada released a report after nearly 5 years of consultative activity conducted by a specialized committee (of which the writer was Co-Chair) of lawyers, government officials and industry participants heavily involved in the franchise community. The report included a model Uniform Franchises Act, a model Disclosure Regulation, and a model Mediation Regulation. The model Mediation Regulation included detailed provisions allowing either party to a franchise to require the dispute to be submitted to mediation. Of the three provinces which have adopted franchise legislation since release of the ULCC Report (Prince Edward Island, New Brunswick and Manitoba), New Brunswick has substantially adopted the mediation process included in the ULCC model legislation.

While Ontario franchise legislation (the Arthur Wishart Act (Franchise Disclosure), 2000) does not include a mediation process, the Ontario Rules of Civil Procedure now include a program of mandatory mediation in case-managed cases in various areas of Ontario, including Ottawa-Carleton, the City of Toronto and the County of Essex. Certain actions are exempted from this procedure, including actions placed on the Commercial List in the Toronto region, and actions certified as class proceedings under the Class Proceedings Act, 2002. For all other actions in Ontario, the Rules of Procedure stipulate that a mediation session shall take place within 180 days after the first defence has been filed unless the court orders otherwise.

Matters which may be listed on the Commercial List include applications, motions and actions which in essence involve, among other matters, “suitable complex cases under the Arthur Wishart Act (Franchise Disclosure), 2000”. While mandatory mediation does not apply to cases on the Commercial List, the Practice Direction establishing the Commercial List states that “resort to the techniques of alternative dispute resolution (ADR), where appropriate, is recognized and encouraged as an effective aid in the disposition of issues and matters on the Commercial List.” Further, “it is the duty of the case management judge and the obligation of counsel to explore methods to resolve the contested issues between the parties, including the resort to ADR, at the case conferences and on whatever other occasions it may be fitting to do so”. In addition, “at any time, particularly on consent of the parties, the case management judge may refer any issue for ADR, as appears appropriate”. Once a matter, or any issue with the matter, has been referred to ADR, counsel are required to “report to the case management judge at regular intervals as to the progress of the ADR proceedings. The timing of such report shall be agreed upon by counsel and the case management judge.” As a result of the Commercial List rules, and the recognition that complex cases under the Arthur Wishart Act are appropriate subject matter for Commercial List applications, motions and actions, there is a recognized and encouraged initiative to attempt to resolve such disputes through mediation or arbitration prior to court proceedings.

Another fact which highlights government initiatives to promote mediation of franchise disputes is present in all provincial franchise legislation. Taking Ontario’s legislation as an example, regulations under the Arthur Wishart Act dealing with the content of disclosure documents provide that “if an internal or external mediation or other alternative dispute resolution process is used by a franchisor in disputes with a franchisee, the disclosure document must include a description of the mediation or other alternative dispute resolution process, and the circumstances when the process may be invoked. In addition, every disclosure document is required include the following statement:

Mediation is a voluntary process to resolve disputes with the assistance of an independent third party. Any party may propose mediation or other dispute resolution process in regard to a dispute under the franchise agreement, and the process may be used to resolve the dispute if agreed to by all parties.”

One of the required items of disclosure under all provincial franchise legislation is a statement, including a description of details, regarding whether the franchisor or a director, general partner or office of the franchisor has been convicted of fraud, unfair or deceptive business practices or a violation of a law that regulates franchises or business, or if there is a charge pending against the person involving such a matter. Further, a disclosure document must contain a statement, including a description of details, regarding whether the franchisor, the franchisor’s associate or a director, general partner or officer of the franchisor has been subject to an administrative order or penalty imposed under a law of any jurisdiction regulating franchises or business or if the person is the subject of any pending administration actions to be heard under such a law. Finally, a statement, including a description of details, indicating whether the franchisor or a director, general partner or officer of the franchisor has been found liable in a civil action of misrepresentation, unfair or deceptive business practices of violating a law that regulates franchises or businesses including a failure to provide proper disclosure to a franchisee or if a civil action involving such allegations is pending against the franchisee must be disclosed. However, disclosure regulations do not include any requirement to disclose whether a dispute has been submitted to ADR, or the results or settlement of any such dispute by ADR.

Franchisors would prefer not to have descriptions of these matters (especially civil suits), included in their franchise disclosure documents because of the negative effect on prospective franchisees and, in certain cases, because such actions may disentitle the franchisor from relying on an exemption from the requirement to disclose financial statements. If a franchise dispute is submitted to ADR and resolved without further court process, the resolution or decision will be confidential and private to the parties, and likely not subject to inclusion in a franchise disclosure document (unless considered to constitute a “material fact” as defined in the legislation).

Returning to the Canadian Franchise Association, whose members represent more than 40,000 business outlets across Canada, and include almost 500 franchise systems, franchise system members are required to abide by the CFA’s Code of Ethics in the general course of conduct and in carrying out their general policies, standards and practices. Among the ethical franchising practices adopted by the CFA are the requirements that franchise system members must fully comply with all federal and provincial laws, and must provide prospective franchisees full and accurate written disclosure of all material facts and information pertaining to the matters required to be disclosed at least 14 days prior to the execution of any binding agreement relating to the award of the franchise. The CFA’s Code of Ethics also states that “fairness should characterize all dealings between a franchisor and its franchisees”, and “both parties should make reasonable efforts to resolve complaints, grievances and disputes with each other through fair and reasonable direct communication, and where reasonably appropriate under the circumstances, mediation or other alternative dispute resolution mechanisms”.

In furtherance of the requirement for the parties to resort to mediation or other alternative dispute resolution mechanisms, the CFA has established a franchise ombudsman program under which the services of a confidential and neutral third party ombudsman are provided to help resolve problems as early as possible “in an amicable and expeditious fashion”. The ombudsman is a “neutral, independent resource who helps facilitate a resolution through discussing the issue and facilitating possible resolutions”. Of major importance to this program and ADR is that “where possible, the ombudsman will suggest and refer unresolved complaints and problems to alternative methods of dispute resolution”. There is no charge for the use of the CFA’s ombudsman program, and all proceedings before the ombudsman are private and confidential. The senior CFA ombudsman is a certified ombudsman through the International Ombudsmans’ Association and all ombudsmen are recognized members. The CFA program, along with the CFA’s Code of Ethics encouraging mediation and other forms of ADR, and the directive for the ombudsman to suggest and refer unresolved complaints and problems to alternative methods of dispute resolution, reinforces the industry initiative to utilize ADR as a dispute resolution technique for franchise disputes.

In addition to government and industry association initiatives, independent mediators and arbitrators and ADR organizations have recognized the utility and application of ADR as a means of resolving franchise disputes. As of January 1, 2012 ADR Chambers Canada, a highly recognized ADR organization that provides conflict resolution services across Canada and internationally, has established an expert panel of ADR neutrals (of which the writer is head) to specialize in franchise disputes: http://adrchambers.com/ca/expert-panels/franchising/.

Finally, the franchise media continues to recognize the desirability of having franchise disputes submitted to ADR. In an article entitled “Finding Bright Spots in Franchising – Observations from Industry Leaders”, LJN’s Franchising Business and Law Alert, Vol. 18, No. 4, January 2012, one of the authors said:

“I sense that the trend to enter into mediation, whether voluntarily, by contract, or by judicial order, will continue to increase. If you compare the cost of mediation with the possible cost of litigation, the resulting ratio clearly favours mediation.”

In conclusion, all aspects of franchising point to the need and desirability of having disputes submitted to ADR and, in particular, to mediation whenever possible. Legislators, judicial administrators, industry associations and the franchise media alike are encouraging this direction at the same time as franchising continues to grow and occupy a major position in the retail economy of the country. With all of these factors present, and with the continuing interest of the general print and electronic media to report on franchise disputes, particularly those involving well known names, it is almost a foregoing conclusion that more and more franchise disputes will proceed to ADR in the future. What the ADR community can and should do in preparation for the increased utilization of ADR for franchise disputes is to ensure that a sufficient number of mediators and arbitrators are well versed in the dynamics, business issues and legal regulation of the franchise relationship so as to develop understanding, promote efficiency and encourage practical resolutions to reflect fair and realistic results for the parties concerned.