A brief summary as to what this case means for you:

Franchisees should pay careful attention to the terms of their franchise agreement prior to transferring their franchise location to a purchaser. Specifically, franchisees must ensure that all of the requirements set out in the franchise agreement regarding transfer be complied with, and should note any rights of first refusal that their franchisor has over their franchised business. Purchasers of a franchised business would also be wise to ensure that if they are joining the franchise system that the transfer provisions of the franchise agreement were met, or, if they are buying the assets of a franchised business but not joining the franchised system should ensure that their business is not confusingly similar to the previously operated franchised business (i.e. make sufficient changes to the signage, décor, products and services offered for sale, etc. such that a member of the public would not be lead to think that the new operation is somehow connected with the previous franchised business).

2 FOR 1 SUBS LTD. V. VENTRESCA.

[2006] O.J. No. 1528, Ontario Superior Court of Justice.
E.P. Belobaba J.
April 19, 2006.

The defendant husband and wife were franchisees that operated one of the plaintiff franchisor's "2 for 1 Subs" franchises. The defendants operated the franchise for 7 years until they decided for heath reasons to get out of the business and sell their franchise. The defendants found a prospective purchaser ("Romita") for the location and contacted the franchisor to obtain its approval. The franchisor was willing to approve the sale on the condition that the transfer fees provided for in the franchise agreement would be paid upon transfer. The defendants advised the franchisor that they were not prepared to pay the transfer fees and the proposed deal fell through. Subsequently, the defendants became unable to carry on the business any longer and simultaneously offered to sell the assets of the location to Romita and notified the franchisor of its right of first refusal pursuant to the terms of the franchise agreement. 16 days prior to the expiry of the franchisor's right of first refusal period, Romita and the defendants closed the asset purchase transaction. Romita removed the 2 for 1 Subs signage and repainted the interior of the location, modified the menu slightly to include soups and salads and opened the location as "Rose's 241 Subs and Such". Romita continued to sell two for one subs and other main menu features of 2 for 1 Subs and continued to use the same telephone number. The plaintiff franchisor commenced this action seeking damages against the defendants for loss of the franchise and royalties owing, and against Romita for passing off. The defendants counterclaimed for damages based on the franchisor's misrepresentation of the food costs.

The franchisor argued that the defendants breached the provisions of their franchise agreement by underreporting income, disclosing confidential information, loaning mortgage money to a competitor, refusing to provide financial information, and selling the franchise assets without franchisor consent. The franchisor further submitted that the defendants' failure to provide financial information resulted in the franchisor being unable to comply with the requirements of the Arthur Wishart Act (the "Act") and was therefore unable to sell further franchises, and, the franchisor argued, these were breaches of the duty of good faith contained in the Act. The defendant franchisees argued that they had done nothing wrong and would have paid the franchise transfer fees had they thought them reasonable, and that they had full rights to sell the assets of their business. The court begun its analysis by examining the reasonableness of the transfer/training fee. It noted that although Romita was an experienced caterer, she had never operated a franchise before and required a detailed understanding of the rules, procedures, and formulae relating to the franchised system. The franchisor was contractually entitled to expect every new franchisee to complete a training program. Therefore, the court found that the franchisor's refusal to grant consent to the sale was neither unreasonable nor contrary to the franchise agreement. The court went on to examine the claim for payment of royalties, and found there was no dispute that the franchisees owed the royalties claimed by the franchisor. The court found that the defendants' actions of refusing to provide financial information and selling the assets to Romita within the period provided to the franchisor to exercise its right of first refusal constituted not only breaches of the franchise agreement but also breaches of the duty of good faith imposed by the Act. As a result of the breaches the franchisor lost an operating franchise in a prime location to a third party who continued to operate functionally the same business.

The franchisor was awarded damages for the denial of the right of first refusal, the sale of the assets without franchisor approval, and lost royalties. In quantifying the amount of damages, the court questioned why the franchisor did not seek to open another franchise in the area to mitigate its damages, and noted that the lack of information provided by the defendants could have been duly noted in the franchisor's disclosure document and the franchisor could have continued to sell franchises with that form of disclosure. The question before the court then was how many months or years of lost royalties should be recoverable before the franchisor's duty to mitigate takes effect? The court concluded based on evidence presented to it that a mitigation boundary of no more than 2 years was appropriate.

Considering the issue of damages for the tort of passing off, the court determined that each of the three requirements for passing off was present (existence of goodwill or reputation in the goods or services, a misrepresentation likely to lead the public to believe that the goods or services are associated with the plaintiff, and actual or potential damage to the plaintiff). The basis of the passing off action was not the general "two for one" concept that Romita continued to use, but the combination of factors that would lead the unwary purchaser to believe that Romita's 2 for 1 subs were associated with 2 for 1 Subs franchise, given that the signage colouring remained the same, the menu stayed substantially the same, the telephone number stayed the same, and Romita's business continued to sell the same products from the same location. The proper assessment of damages for a passing off action is an accounting of profits. The court found that although Romita's business made little to no profits, that was not to say that damages could not be awarded. The court turned to a decision whereby an accounting of profits was unable to made and therefore a royalty measure was appropriate. The court therefore concluded that the appropriate calculation of damages was 5% representing what would have been paid on Romita's gross sales had the franchise been purchased as originally intended.

Turning to the defendants' counterclaim, the court could not find any evidence that any misrepresentation was ever made concerning food costs.
In summary, the court awarded the plaintiff damages for breach of franchise agreement and breach of the duty of good faith. The counterclaim against the plaintiff for misrepresentation dismissed.

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