Accidental Franchise (Franchise vs. Licence)

An accidental franchise arises when a business grows by licensing its brand or appointing distributors or dealers, believes it has signed an ordinary commercial contract, and later learns the relationship is a franchise under provincial franchise law. The usual starting points are a brand licence agreement, a distribution agreement or dealer program, or a licence that lets a friend or former employee open a second location of a successful restaurant, salon or clinic.

The problem is rarely spotted at signing. It usually surfaces when the relationship sours and the operator's lawyer asks whether a disclosure document was ever delivered.

The label in the contract does not decide the question. Ontario's Act applies a functional test, set out in full under franchise, to any business operated partly or wholly in Ontario. A clause saying the arrangement is not a franchise, or that the operator waives the Act, offers no protection: section 11 makes any purported waiver or release by a franchisee of its statutory rights void.

The definition in section 1 of the Arthur Wishart Act has a payment element and two alternative routes. Commercial deals that were never meant to be franchises usually meet them in predictable ways.

Payment. The operator must be required, by contract or otherwise, to pay or commit to pay the brand owner or a franchisor's associate, directly or indirectly, to acquire the rights, to start operating or in the course of operating. Initial licence fees, monthly brand or management fees and required purchases from the brand owner are the usual candidates.

Route one: trademark plus control or assistance. The licensee sells goods or services substantially associated with the owner's trademark or other commercial symbol, and the owner or its associate has the right to exercise significant control over, or to provide significant assistance in, the licensee's method of operation. The Act's examples include building design and furnishings, locations, business organization, marketing techniques and training, so an operations manual, mandatory training and approval of the site or fit-out all point this way. A contractual right to control is enough, even if it is never used.

Route two: distribution plus location assistance. A supplier grants rights to sell goods or services that it or a designated supplier provides, whether or not a trademark is involved, and the supplier, its associate or a designated third party provides location assistance, such as securing retail outlets or accounts, or sites for vending machines and display racks. A dealer program in which the supplier finds the accounts is the classic case.

Some relationships fall outside the Act altogether. Section 2(3) excludes, among others, employment relationships, partnerships, prescribed co-operative memberships, and an arrangement arising from an oral agreement where no writing evidences any material term. An email confirming the fee can be enough writing to lose that exclusion.

The exclusion that matters most to licensors is the single-licensee rule: an agreement between a licensor and a single licensee to license a specific trademark or other commercial symbol, where that licence is the only one of its general nature and type the licensor grants in Canada for that mark. Granting a second licence of the same kind for the same mark anywhere in Canada removes the basis for the exclusion. Another exclusion covers an operator that leases space inside another retailer's premises and is not required or advised to buy the goods or services it sells from that retailer or its affiliate.

Other relationships are franchises but are exempt from disclosure under section 5(7). Examples include adding franchised goods or services to an existing business where those sales are not expected to exceed 20% of the business's total sales in the first year, a total initial investment of no more than $15,000, an agreement of one year or less with no non-refundable franchise fee, and a total initial investment above $3,000,000. These exemptions remove only the disclosure obligation; the duty of fair dealing and the right to associate still apply. Section 12 puts the burden of proving any exclusion or exemption on the party claiming it. The full list is under franchise disclosure exemptions.

Because an accidental franchisor never delivers a disclosure document, the franchisee can rescind the agreement, without penalty or obligation, up to two years after entering into it under section 6(2). Notice must be in writing. Once rescission takes effect, the franchisor or its associate has 60 days to:

1. Refund all money received from or on behalf of the franchisee, other than money for inventory, supplies or equipment.
2. Buy back the franchisee's remaining inventory at the price the franchisee paid.
3. Buy back supplies and equipment the franchisee bought under the agreement at the price paid.
4. Compensate the franchisee for losses incurred in acquiring, setting up and operating the franchise, less the amounts above.

That last item can include build-out costs and up to two years of operating losses. Separately, section 7 gives a franchisee a damages claim for losses caused by a failure to comply with the disclosure requirement, against the franchisor, its associate, its agent and its broker, and section 8 makes those found liable jointly and severally liable. A clause in the licence choosing another jurisdiction's law or courts does not help: section 10 makes it void for claims under the Act.

The fix is to decide the classification before signing, not after a dispute:

1. Map the deal against each element: what money flows to you or your associate, directly or through product pricing, and how much control or assistance you have the right to provide.
2. If you want to stay outside the Act, remove the element that triggers it, or document a specific exclusion or exemption and keep the evidence, since the burden of proof will be yours.
3. If the arrangement is a franchise, prepare a compliant franchise disclosure document and deliver it at least 14 days before the operator signs or pays.
4. Check the law of every province where operators will run the business, since several provinces have franchise statutes; see franchise legislation in Canada.

Owners who decide to franchise on purpose can follow our guide on how to franchise your business in Ontario and test a draft package with Lamba Law's free FDD Readiness Checker. Our franchise law practice reviews licensing, distribution and dealer agreements for franchise risk.

Olivia Chen owns two busy ramen shops in Markham. A regular customer, Samir Khoury, asks to open one in Pickering under her brand. Olivia's accountant drafts a brand licence: Samir pays a $30,000 licence fee and 5% of monthly sales, uses her recipes and supplier list, attends two weeks of training, and needs her approval of the location and fit-out. The contract states that it is not a franchise. A year earlier, Olivia had signed a similar licence with an operator in Richmond Hill.

Eighteen months later, Samir's shop is losing money, and his lawyer serves a written notice of rescission under section 6(2). Olivia's lawyer reviews the file. The fees satisfy the payment element, and the trademark, training, required suppliers and location approval point to significant control or assistance. The single-licensee exclusion fails because of the Richmond Hill licence, and Samir's $210,000 total initial investment rules out the $15,000 small-investment exemption. No disclosure document was ever delivered, and the notice came within two years.

Olivia faces a refund of the licence fee and royalties, a buy-back of inventory and equipment at Samir's cost, and compensation for his losses. She settles for $265,000 paid over 18 months, takes over the Pickering site, and has a disclosure document prepared before signing anyone else.