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Outdated Financial Statements Fatal to N.B. Franchise Disclosure Document

Published:

January 20, 2022

Author(s):

• Michael Melvin

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On January 17, 2022, the New Brunswick Court of Queen’s Bench issued the first decision interpreting the New Brunswick Franchises Act. In AlphaTaho Inc. and Syed Abid Hussain v. Jose Costa, Maaco Canada Partnership LP, Maaco Canada GP and Noah Pollac, the Court held that a former MAACO^® franchisee in Fredericton, New Brunswick had validly rescinded its franchise agreement pursuant to Section 6(2) of the Act. The franchisee had the right to rescind its franchise agreement because before the franchisee signed it, the franchisor delivered to the franchisee a purported franchise disclosure document containing non-compliant, outdated financial statements of the franchisor. The franchisor argued that it qualified for an exemption from the requirement to disclose its financial statements – but it failed to claim the benefit of this exemption by including the prescribed statement on the franchisor’s certificate when it delivered the disclosure document. This failure, the Court decided, was fatal to its ability to claim the exemption.

Franchisors can take these three key points away from the Court’s decision:

1. Outdated financial statements, on their own, are fatal to a New Brunswick franchise disclosure document.

2. Franchisors cannot claim the “mature franchisor” exemption in New Brunswick unless they include a prescribed statement to that effect on their disclosure document certificate.

3. New Brunswick Courts will apply an objective standard in determining whether a franchise disclosure document is so deficient that a franchisee is entitled to rescind its franchise agreement pursuant to Section 6(2) of the N.B. Franchises Act.

Here’s a look at the case and how the Court reached its decision in AlphaTaho Inc. and Syed Abid Hussain v. Jose Costa, Maaco Canada Partnership LP, Maaco Canada GP and Noah Pollac. McInnes Cooper Franchise Lawyer Michael Melvin and Litigation Lawyer Benoit Arsenault represented the successful franchisee.

The Case

Syed Abid Hussain, the sole shareholder of the franchisee, AlphaTaho Inc., entered into discussions with the franchisor, Maaco Canada Partnership, LP, regarding the purchase of a MAACO^® branded automotive painting and collision repair franchise in February 2017. At the time, Mr. Hussain was living in Saudi Arabia and working to immigrate to New Brunswick.

The Disclosure. As required by Section 5 of the Act, Maaco provided Mr. Hussain with a purported franchise disclosure document on February 12, 2017. Maaco subsequently provided additional information, including material from a Maaco sales webinar, a copy of a US MAACO^® franchise disclosure document and, at Mr. Hussain’s request, a partly completed business plan, which included a pro forma income statement, for use in his immigration application under the New Brunswick Provincial Nominee Program. Mr. Hussain signed the MAACO^® franchise agreement and a bundle of related contracts on April 18, 2017. He later assigned these agreements to the franchisee, AlphaTaho Inc. The franchisee opened the MAACO^® franchise for business on June 2, 2018 – but it quickly failed.

The Rescission. On October 19, 2018, the franchisee sent Maaco a Notice of Rescission under Section 6 of the Act, cancelling the franchise agreement and demanding that, as required by the Act, Maaco repay monies the franchisee had invested and compensate it for its losses in setting up and operating the franchise. Maaco refused to pay these amounts. The franchisee initiated a legal action against Maaco based on rescission of the franchise agreement and other grounds, and moved for summary judgment against Maaco.

The Decision

The N.B. Court of Queen’s Bench held the franchisee had validly rescinded the MAACO^® franchise agreement because no document lawfully constituting a disclosure document within the meaning of the Act had been delivered to the franchisee prior to execution of its franchise agreement. The Court applied case law developed under the Ontario Arthur Wishart Act (Franchise Disclosure), noting the Act and the Wishart Act are “almost identical”. The Wishart Act cases hold that if a purported franchise disclosure document is so materially deficient that it doesn’t permit the franchisee to make a properly informed investment decision, then no disclosure document within the meaning of that statute has been delivered. In such a case, the franchisee is entitled, pursuant to Section 6(2) (which is the same as Section 6(2) of the Act), to rescind the franchise for up two years after signing the franchise agreement. Applying the Wishart Act decisions, the Court granted partial summary judgment in favour of the franchisee on the issue of rescission, but ordered a trial to determine the amount of the damages Maaco owed to the franchisee.

Rescission Grounds. In support of its claim for rescission, the franchisee alleged several material deficiencies in the MAACO^® franchise disclosure document:

• The financial statements contained in the disclosure document did not comply with the requirements of the Act.

• The franchisor’s certificate attached to the disclosure document was not compliant because it was signed one and a half years before the disclosure document was delivered and was not in the prescribed Form 1.

• Earnings projections included in the franchise disclosure document failed to identify the locations, areas, territories or market from which certain earnings projections were derived.

• Maaco didn’t disclose certain material facts in the franchise disclosure document, namely the cost of setting up the franchise so it could do insurance work and the fact that competitors in the market had existing relationships with insurance companies and car rental companies.

• Maaco gave disclosure in piecemeal fashion, rather than in one document at one time, as required by the Act.

Outdated Financial Statements Fatal. The Court relied exclusively on the fact that the financial statements included in the franchise disclosure document did not comply with the requirements of the Act and the associated Disclosure Document Regulation. Under Section 5(4)(a) of the Act, every franchisor must, unless it is exempt, include in its franchise disclosure document financial statements as prescribed. Under Section 7 of the Disclosure Document Regulation, the franchisor is required to provide its financial statements, prepared to either a review engagement or audit standard, for the franchisor’s last completed fiscal year. If 180 days have not yet passed since the end of the franchisor’s last-completed fiscal year, and the financials for that year have not yet been completed, the franchisor may use the financial statements from its second-last completed fiscal year. Accordingly, the franchise disclosure document Maaco delivered on February 12, 2017 should, at a minimum, have included Maaco’s financial statements for its 2015 fiscal year. However, only the 2014 financial statements were attached. The Court cited a long line of Wishart Act authorities standing for the principle that the financial information in a franchise disclosure document is of the utmost importance and failure to provide compliant financial statements is, in itself, a fatal flaw that invalidates a disclosure document. In particular, the Court cited the Ontario cases of Mendoza v. Active Tire & Auto Inc. and 2619506 Ontario Inc. v. 2082100 Ontario Inc. et al., in which the Ontario Courts held that outdated financial statements were a material deficiency in disclosure. The Court held it did not consider the other grounds alleged by the franchisee, either individually or in combination, to rise to the level that would entitle the franchisee to rescission under Section 6(2) of the Act.

No Mature Franchisor Exemption. Maaco argued the Court should not consider its use of outdated financial statements a material deficiency because, at the time the franchise disclosure document was delivered, it qualified for the so-called “mature franchisor” exemption. Under Section 8 of the Disclosure Document Regulation, a franchisor is exempt from the requirement to disclose its financial statements if it meets certain criteria related to its size, net worth and history. Section 8(2) of the Regulation states that if a franchisor is claiming the benefit of this exemption and not including its financial statements in its disclosure document, it must include this prescribed statement on the certificate attached to the disclosure document, which the franchisor is always required to sign:

“The franchisor meets the requirements of subsection 8(1) of the Disclosure Document Regulation – Franchises Act and is therefore not including financial statements in this Disclosure Document.”

Maaco’s certificate did not include this statement. Maaco argued the requirement to include this statement was merely a technical requirement and failure to include it should not disentitle it to claim the benefit of the exemption. The Court disagreed, stating that the requirement to include the prescribed statement, thereby notifying the franchisee it was not being provided with important financial information, was a substantive requirement and not a mere technicality, noting (at para. 52):

Given the central role and importance that financial statement disclosure plays in the scheme of the Act (discussed below) the failure of Maaco to claim the exemption is not a mere technical defect. In my view, the requirement to claim the exemption and give the required notice in the certificate is substantive. It is to ensure that the franchisee is alive to the fact that he is not receiving the full financial picture and he can decide to proceed or not as the case may be. Clearly, the exemption notice would have a material impact on the franchisor’s [sic] investment decision. Furthermore, I agree with the Plaintiffs’ submission that to permit retroactive exercise of the exemption would undermine the protections the Act is intended to provide to franchisees and encourage poor behaviour by franchisors.

Impairment Not Required. Maaco also argued, per the 2018 Ontario case of Raibex Canada Ltd. v. ASWR Franchising Corp., that the franchisee was required to lead evidence to demonstrate how the disclosure deficiency relied upon had actually deprived it of the ability to make a properly informed investment decision. However, the Court rejected this argument. Citing the 2021 Ontario case of 2611707 Ontario Inc. v. Freshly Squeezed Franchise Juice Corporation, et al., the Court held that the test for rescission under Section 6(2) of the Act is an objective one and does not require the franchisee to lead evidence demonstrating actual impairment of its ability to make an informed investment decision.

Please contact your McInnes Cooper lawyer or any member of our Franchise Law Team @ McInnes Cooper to help you ensure your franchise disclosure documents comply with franchise laws.

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