Franchise and distribution arrangements are important to our global economy. Robust franchise and distribution networks enable businesses to expand beyond their home markets and sell their products, services and customer experiences on a national or international stage.
We understand the laws regulating the Canadian franchise sector present unique challenges for franchisors looking to expand into the Canadian marketplace. McMillan recently hosted the interactive Franchise Law Webcast: Trends Affecting Franchise Systems Operating in Canada in which members of our Franchise and Distribution Law Group provided an overview of the Canadian legal landscape and recent trends affecting franchise systems operating in Canada. A summary of some of the topics covered by me in the webcast are set out below.
For franchisors that have been using the same franchise agreement template for a number of years, what are some of the key provisions that you would recommend be reviewed and potentially updated?
Advancements in technology, the constant evolution in consumer demand, and increased sophistication in franchise systems, their structures and business activities, have left many franchise agreements in need of significant updating.
Increasingly, franchise systems are taking advantage of app technology for use by their franchisees for both operations and customer experience. One of our childcare clients is using app technology to assist franchisees with their operations. Many quick service franchise systems are using app technology to streamline the customer ordering process. One of the primary concerns for franchisors is to ensure that the intellectual property associated with the app technology is specifically protected under the terms of the franchise agreement. In addition, it is strongly recommended that franchise agreements appropriately set out robust reservation of rights with respect to app technology – so that the franchisor has exclusive right to prescribe the app technology – as well as clear obligations of the franchisee to utilize (and how it must use) such technology. The finer detail of app functionality can be included in the operations manual, but not to the exclusion of the above suggest provisions that should be included in the franchise agreement.
Software solutions to assist franchisor field consultants in coaching and monitoring franchisee performance have improved efficiency and effectiveness in maintaining brand consistency and quality control. However, in order for franchisors to implement some of these systems, their franchise agreement provisions dealing with audit and inspection rights, authorized supplies and suppliers obligations, should specifically contemplate these sorts of technological solutions, rather than relying on operations manual to implement them. In addition, if franchisors want to pass on some of the technology costs associated with this software, it will need to be stipulated in the franchise agreement.
Another area of explosive growth is online sales and marketing. Once again, it is critical that the franchisor reserve the desired rights in this regard within the terms of the franchise agreement. In many cases, the rights an obligations as it relates to online activities and presence is shared with the franchisor and its franchisees. Nevertheless, it is critical that the terms and conditions around online activities and internet presence are clear, unambiguous and leave sufficient discretion for the franchisor to make determinations as new approaches unfold. For example, when it comes to websites and social media, typically franchisors will have the express exclusive right to maintain a website with franchisees having the right to contribute content (or maintain specific website pages). Social media is a more complex area and the approach to franchisee’s use of social media accounts is franchise system/industry dependent, and is usually guided by a specific social media policy. Suffice to say that the franchise agreement should clearly set out the franchisor’s right to monitor and require modification to social media account content. It is also critical that the termination/expiration/transfer mechanics in the franchise agreement set out in detail the obligation of the franchisee to remove content, close accounts, or to provide the franchisor with all passwords and other requisite rights to take over such social media accounts.
Franchisors are under growing pressure to keep up with consumer demand and, moreover, to lead with innovation, whether it be by way of new and improved products and services, revamping branding, or adding additional business activities. In addition, successful franchisors are on the look out for opportunities to implement changes that will improve unit economics and franchisee profitability.
Successful implementation of system changes is sometimes more about the right business strategy and process than it is a about the terms of the franchise agreement. For example, testing system changes within a corporate location, providing opportunity for obtaining franchisee feedback and consultation, and empowering “franchisee champions” to lead the way in implementing changes.
Having said that, effective business strategy and process should be a substitute for robust system change provisions in the franchise agreement. The art to drafting effective system provisions is to categorically call out the kinds of system changes that: (i) are pertinent to the franchise system/industry (eg for a tuition franchise, it may include changes to curriculum), (ii) are reasonably contemplatable (eg for a fast casual concept, it may include participating in a takeout menu offering), and (iii) touch the know-how or branding generally (including trademarks), while at the same time avoiding the specific so as not to be seen as “covering the field” with anticipating changes to the system. It is also common practice to include in the system change mechanics various underlying rationale for the right to make changes to the system. Once again, it is necessary to caution franchisors not to inadvertently restrict their ability to implement system changes because of stated circumstances justifying such change.
A strong system change provision will also include a clear statement as to the timing obligations and costs/expenses to be incurred by franchisees in implementing system changes. Even if franchisors would provide incentives for major changes, it may be advantageous not to include such intention in the franchise agreement to allow for more flexibility and reduce the potential for animosity and disputes. Finally, it is worthwhile stating that ultimately changes are typically implemented through the operations manual, and so the robust system change provisions need to connect the dots in this regard.
Reservation of rights
As franchisors have become more sophisticated, in part due to the involvement of private equity, in their structures and business activities, it is crucial that franchise agreements include the appropriate reservation of rights to protect the flexibility of franchisors to develop their franchise systems.
Firstly, the traditional reservation of rights with respect to distribution of products and services outside of the franchised business format must be broadly drafted. Second, the carve outs for alternative franchising – both in structure (eg mobile offerings) and specific locations (eg airports, universities) – should be extensive and well thought out taking into account the specific franchise system/industry and contemplated plans of the franchisor. Third, there should be reservation of rights for the franchisor to develop other franchise systems and business that may be dissimilar but nonetheless competitive with the franchise system (eg a burger franchise system and a hot dog franchise system). Finally, it is recommended that franchisors have a strongly worded reservation of rights provision as it relates to major transactions like M&A transactions that it can enter into – and protecting it from the outcome of such activities – for example, a franchisor may end up with multiple franchised business in the same territory. Finally, many franchise agreements lack the catch up provision that reserves to the franchisor any other rights that are not otherwise expressly granted to the franchisee.
Is cybersecurity also a critical issue that franchisors should be looking at?
Firstly, the collection and protection of personal information has become a significant area of concern in the past several years.
Maintaining robust data protection and privacy protocols is critical to the development and reputation of international franchise systems. Data breaches disrupt business operations, devastate the goodwill and reputation of a franchise brand, and often result in an inordinate degree of legal liability. In a landscape of ever-increasing privacy law regulation and scrutiny, it is imperative that franchisors develop and implement adequate policies and programs to ensure that their franchise systems safeguard personal information in compliance with applicable legal and regulatory requirements.
In Canada, data protection and privacy are governed by a complex legal and regulatory framework, one of the main pieces of federal legislation is the Personal Information Protection and Electronic Documents Act (“PIPEDA”). It is also worth noting that currently, Alberta, British Columbia and Quebec have enacted substantially similar legislation (as have some other provinces for the health sector only) and, as such, the provincial legislation generally applies in place of PIPEDA within those provinces.
At a high level, PIPEDA and the substantially similar statutes require the following implicit and explicit accountability and security obligations.
- Businesses are responsible for personal information in their possession or under their control, and must designate an individual or individuals who are accountable for compliance with the principles set out in Schedule 1 of PIPEDA.
- Security safeguards must protect personal information against loss or theft, as well as unauthorized access, disclosure, copying, use or modification, regardless of the format in which it is held.
- The nature of the safeguards will vary depending on the sensitivity of the information that has been collected, the amount, distribution, format of the information, and the method of storage. More sensitive information must be safeguarded by a higher level of protection.
Organizations should also be aware that the requirements to safeguard personal information vary depending on the sensitivity of the information at issue. For example, cloud storage of personal information is not always problematic for Canada. However, in the context of cannabis transactions, the identity of cannabis users may be considered particularly sensitive since cannabis is illegal in most jurisdictions outside of Canada. Cannabis retailers should therefore be mindful of the risks associated with storing data in the cloud, since this may include the transfer or storage of personal information outside of Canada, and such information could then potentially be accessed by foreign law enforcement. Therefore, it may be necessary for cannabis retailers to consider storing personal information on a server located in Canada in order to ensure compliance with Canadian privacy laws, unless the information will be encrypted and the cloud provider will not have access to the encryption key.
- The methods of protection include (a) physical measures – eg, locked filing cabinets and restricted access to offices; (b) organizational measures – eg, security clearances and limiting access on a “need-to know” basis; and (c) technological measures – eg, the use of passwords and encryption.
- Recent amendments to PIPEDA require organizations to report data breaches to the privacy commissioner and notify affected individuals in certain circumstances. Knowingly contravening the reporting, notification and record-keeping provisions can attract a fine of up to $100,000.
Beyond these obligations, prudent franchisors will develop appropriate cybersecurity protocols, policies and processes to ensure that their franchisees adequately protect the personal information (described above) as well as other sensitive franchise system information.
Best Practice Recommendations
We recommend that franchisors operating in Canada, or contemplating Canadian expansion, undertake the following:
- Carefully consider the nature and extent of the personal information obligations imposed on the franchisor and its franchisees (based on the collection and flow of personal information within the franchise system), and keep abreast of the rapidly evolving Canadian regulatory framework.
- Develop and implement policies, protocols, and programs based on the respective obligations determined from the above analysis, and be intentional about ensuring that all parties strictly comply with same.
- Ensure that franchise agreements contain specific data protection provisions addressing matters such as the following.
- How personal information will be collected, stored, used and disclosed by franchisees and the franchisor.
- The franchisor’s access rights to such information (both while the franchisee remains within the franchise system and thereafter).
- Addressing potential restrictions on the transfer of such information across Canadian borders.
- Appropriate levels of safeguards to be maintained with respect to such information.
- The allocation of responsibilities between the franchisor and the franchisee for compliance with data protection, privacy laws, cybersecurity protocols and the consequences for failure to comply with those obligations.
One of the chief areas of concern for franchisors is ensuring that their franchise development personnel are fully compliant with legal obligations relating to the sale of franchised businesses. What are some key points and recommendations on this point?
Firstly, for international franchisors, it is worth noting that there are no filing or registration requirements in Canada.
However, as already discussed, six provinces have enacted franchise-specific legislation requiring that pre-sale disclosure be made to prospective franchisees at least 14 days prior to the execution of a franchise agreement or payment of any money with respect to the franchise arrangement.
We have also discussed some of the specific requirements with respect to preparing and issuing franchise disclosure documents in those six provinces.
Having said that, there are a number of practical best practice recommendations that we have counselled clients on with respect to pre-sale disclosure, and particularly franchise development teams.
- To the extent possible, franchisors should prepare a strategy and plan on how pre-sale disclosure will be undertaken. For example, one of our clients has recently determined that it will provide early disclosure followed by disclosure that is more specific. It is not for the Raibex issue alone, but also because of the fact that the actual franchisee/principals will not be finalized at the first stage.
- One of the reasons why our client has taken this approach is to ensure that whatever information is provided is documented and there is less risk that contrary information can be made by oral discussion, emails or other communication (creating the risk of a claim for misrepresentation).
- In Canada, it is not required that information regarding operating costs and earnings projections (financial performance representations) be provided, but if it is, then certain supporting information and documentation needs to be made available. So for those franchisors that elect not to provide that information, need to ensure that franchise development representatives do not provide any such information – leaving the door open to misrepresentation or the claim that the franchise disclosure document was not provided in one document at one time. If the franchisor has elected to provide such information, then it must ensure that franchise development personnel consistently convey that information, and ideally it be provided at the time that the franchise disclosure document is provided.
- Training and preparing a “script” of sorts to assist franchise development personnel in meeting with prospective franchisees provides additional risk management and protection to franchisors against misrepresentation and deficiency claims.
- It is critical that the franchise development personnel keep accurate records of all interactions, conversations, provision of documentation, and particularly the provision of franchise disclosure documentation (together with copies of all receipts) so that there is evidence of compliance.
Private equity has increasingly become interested in franchise systems. What are some of franchise specific issues that need to be considered in franchise M&A transactions?
Franchise businesses have increasingly become a focus of M&A activity. This is in part due to greater interest and investment from private equity. Franchise systems present a valuable investment proposition for both strategic and financial investors attracted by: (i) robust, long-term and diversified royalty revenue streams; (ii) proven, and frequently international, business concepts; (iii) the potential for organic and rapid growth (with low capital investment); (iv) the inherent leverage on operating costs once a certain size is achieved; (v) pre-existing networks of experienced operating partners; and (vi) goodwill and strength of established brands that franchise systems can provide. In addition, strong performing franchise systems tend to hold up fairly well in good and bad economic conditions (depending on the industry).
The franchise business model is by its nature unique. Understanding its framework – and its moving parts – is paramount when engaging in any franchise M&A transaction.
We have written extensively on franchise M&A transactions, but for the purposes of today’s podcast, suffice to say that categorically there are 3 key areas of inquiry when it comes to franchise-specific due diligence on franchise systems:
- The intangible assets such as intellectual property assets (trademarks, trade secrets, copyright etc). Have these assets been appropriately identified, protected and policed. This category also includes the franchise agreement and arrangements. Well documented, consistent and consistently enforced franchise arrangements are key elements of value to a franchise system.
- Franchise regulation is another important area of inquiry. Given the increasing regulation in the area of franchise, it is critical that franchise systems have a strong history of demonstrated compliance.
- The presence of a franchisee community differentiates franchise systems from other businesses. To their peril, investors sometimes overlook this facet of a franchise system. The franchisor’s relationship with franchisees is critical to the health of the system. If that relationship is characterized by tension, disagreements, or defaults, it creates an additional burden and risk for an incoming franchisor.
Download the Franchise Law Webcast slides.
To receive further information or resources on franchise expansion into Canada, please email me. Stay tuned for our next post in the Franchise Expansion into Canada Series.
This post is published to inform clients and contacts of important developments in the field of franchise and distribution law. The content is informational only and does not constitute legal or professional advice. We encourage you to consult a McMillan lawyer if you have specific questions or concerns relating to any of the topics covered here.