In March, the Ontario Superior Court of Justice released its decision on a motion for summary judgment in Dodd v. Prime Restaurants of Canada (Prime).

The decision offers further insight into how the courts will apply the new summary judgment rules in the franchise context and raises some interesting issues regarding the interaction between Section 11 of the Arthur Wishart Act (Franchise Disclosure) (AWA) and a mutual release agreement executed by a franchisor and a franchisee in the context of a failed franchise.

The dispute in this case arose between the owner of East Side Mario's and two of its franchisees. In 2003, the parties entered into an agreement to open a new East Side Mario's franchise in Toronto. Almost immediately after opening its doors, the venture began losing money and the franchisees fell behind on rent, royalty and financing payments.

After one year, the franchisees made a voluntary assignment in bankruptcy and the franchisor took over operation of the restaurant. Concurrently, the parties entered into a mutual release under which they released each other from any debts, claims or actions. The franchisor also agreed to pay the interest on the financing debt owed to GE Canada Equipment Financing G.P. (GE) and to use reasonable efforts to find a buyer for the restaurant that would assume the debt to GE.

Shortly after executing the release, however, the franchisees issued a Notice of Rescission (Notice) on the basis that they had received inadequate pre-sale disclosure contrary to Ontario franchise legislation. The franchisor responded to the Notice, advising the franchisees that the Notice was unenforceable due to the mutual release and stated its intention to meet its obligations under the mutual release.

For nearly two years thereafter, the franchisor did precisely that: it operated the restaurant, paid interest on the financing debt and found a buyer for the restaurant. The restaurant was sold and the debt to GE settled with the proceeds and some further contribution from the franchisor. But, two years after serving its Notice, the franchisees commenced an action against the franchisor claiming, inter alia, damages for breach of contract, negligence, misrepresentation and rescission of the franchise agreement. The franchisor brought a motion for summary judgement on the basis that the action was barred by the mutual release. In response to the summary judgment motion, the franchisees claimed that a trial was necessary to determine the validity of the mutual release which the franchisees' argued was not enforceable since it was both unconscionable and void pursuant to Section 11 of the AWA.

The Court refused to grant the franchisor's motion for summary judgment.

Enforceability of the Release: Unconscionability and Section 11 of the AWA

The franchisees argued that the release was not enforceable because it was barred by Section 11 of the AWA, which voids any "purported waiver or release by a franchisee of any right given under [the] Act." They also argued that it was an unconscionable agreement and therefore unenforceable at law.

With respect to the latter, the franchisees argued that the mutual release contained all four of the essential elements of unconscionability: a grossly unfair and improvident transaction, the absence of independent legal advice, overwhelming imbalance in bargaining power and intentional exploitation of this vulnerability. In response, the franchisor maintained that there was insufficient evidence before the court to establish all of these requirements and the onus was on the franchisees to do so.

The Court concluded that the conflicting evidence in relation to the value of the benefits realized and rights forgone by entering into the mutual release, whether the franchisees had legal advice at the time they executed the mutual release and whether there was in fact an imbalance of power were all matters that should be resolved at trial, with the benefit of oral evidence.

The franchisor also argued that Section 11 of the AWA cannot be used as a bar to render ineffective an agreement between the parties to a franchise agreement that was intended to settle claims arising out of an alleged breach of that statute. In support of its argument they cited the Court's decision in 1518628 Ontario Inc. v. Tutor Time Learning Centres LLC (Tutor Time). In the Tutor Time case, the franchisor had provided a prospective franchisee with a disclosure document that failed to meet Ontario disclosure regulations.

Subsequently, in order to settle the ongoing dispute and with the advice of independent legal counsel the parties entered into a settlement agreement that included a mutual release of all rights and claims. Some time later, the franchisee delivered to the franchisor a notice of rescission of the franchise agreement. On a motion for partial summary judgment, the Court held that the mutual release was effective notwithstanding Section 11 stating:

s. 11 does not have application to a release given (with the advice of counsel) by a franchisee in the settlement of a dispute for existing, known breaches of the Act by the franchiser in respect of its disclosure obligations, which would otherwise entitle the franchisee to a statutory rescission.

The Court, however, declined to follow the decision in Tutor Time in this case. It distinguished the dispute before it from the Tutor Time decision on two bases. First, unlike the franchisee in Tutor Time, it was not clear to what extent the franchisees were aware of potential rescission claims at the time the release was executed. Second, there was conflicting evidence regarding the extent to which the franchisees had independent legal advice before executing the mutual release.

On this basis, the Court concluded that the extent to which Section 11 of the AWA may render ineffective the mutual release as a bar to the franchisees' action was a matter for determination at trial.

Lessons From the Decision

The decision provides some useful guidance on the way in which a court will consider a mutual release in the franchise context.

First, it should be noted that the Court appeared to accept the franchisor's argument that even if Section 11 of the AWA rendered ineffective any waiver of rights under the AWA, the release would still be effective to prevent parties to the waiver from claiming common law or equitable relief such as breach of contract, misrepresentation and negligence. In the case at bar, the franchisees made numerous common law and equitable claims that will be barred unless the mutual release is found at trial to be unconscionable. Thus, there is a clear benefit from continuing with the practice of obtaining releases from franchisees despite Section 11 of the AWA.

Second, the case provides an additional reminder to franchisors that mutual releases should only be finalized with franchisees who have received independent legal advice. The Court's refusal to summarily enforce the release in Prime flowed from the factual uncertainty as to the franchisees' access to legal advice at the time the release was executed. Had the franchisee obtained legal advice prior to signing the release, it would have been very difficult for it to assert that it was unaware of the potential rescission claim.

Any reasonable lawyer advising a franchisee in the context of a mutual release would need to review the previous disclosure document that had been provided by the franchisor to ensure that the franchisee is not inadvertently waiving a meritorious rescission claim without fair compensation.

In most cases, careful review of a disclosure document would allow counsel advising the franchisee to identify arguable deficiencies which could ground a claim for rescission under the two-year limitations period. If the franchisee insists that it only "discovered" a rescission claim after signing the release, it would need to prove this late "discovery" with clear and convincing evidence. Franchisors should therefore encourage their franchisees to obtain legal advice and request written confirmation that such advice was received prior to entering into any agreement to resolve a dispute.

Third, franchisors must be wary of entering into agreements with franchisees at a time when the franchisees are in desperate circumstances because it leaves them vulnerable to a claim of unconscionability. Moreover, simply because a franchisor has seemingly extended itself to "bail" its franchisee out by, for example, taking over rent or debt interest payments or relieving the franchisee of royalty back payments, does not mean that the release was mutually favourable.

The argument made by the franchisees in this case was innovative but not unreasonable: the franchisor stepped in to protect its brand and would have done these things whether or not the franchisees released them. Moreover, it also made the point that the franchisor would not likely have pursued the franchisees personally. As such, while the franchisees gave up the right to seek rescission and make other claims, it "received little of real value in return." While there are certainly strong arguments to counter this effort to claim that a mutual release is overwhelmingly favourable to the franchisor and not the franchisee, these arguments should be considered when approaching a franchisee to negotiate an agreement to resolve a dispute.

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This post was originally published on McCarthy T├ętrault's website and written by Jane A. Langford, Tyler McAuley and Adam Ship

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