March 22, 2010

Heading North? How to Expand Your Franchise System to Canada

To any Canadian consumer, it is apparent that many American franchise systems have chosen Canada as a place for expansion. Some of the obvious reasons for the many U.S. brands in Canada include geographic proximity, a common language, history, tastes, and culture, along with the fact that Canada has a standard of living that is on par with that of the United States. More recently an added reason is the relative good health of the Canadian economy, which, by many accounts, escaped the worst of the 2008 global recession.

However, any U.S. franchisor that wants to expand to Canada must understand that while there are more similarities than differences between the two countries, those differences must be respected and addressed in a Canadian expansion. This article will provide an overview of those areas.

Canada, like the United States, is rooted in a system of federalism. All aspects of governmental power are divided between one federal (national) and 10 provincial levels of government. For franchisors, the key jurisdictions over trademarks, patents, copyrights, and competition (antitrust) belong to the federal government, while provincial governments have exclusive jurisdiction over such areas as private contracts and relationships, including franchising.

To date only three of Canada's 10 provinces—namely Alberta, Ontario, and Prince Edward Island—have enacted franchise-specific legislation. A fourth province, New Brunswick, has passed a franchise law that is not yet in force, and as of the date of this article, no other province is seriously considering the passage of a franchise law.

Special consideration also must be given to franchising in QuŽbec, in part because it is a civil law jurisdiction (the only one in Canada), but also because of both the reality and the legality of QuŽbec's unique culture, with French as its official language.

Structuring an Expansion
Once a franchisor outside of Canada has developed a business plan for a Canadian expansion and decided to proceed with the expansion, it will need to determine two basic things: who will run the Canadian operation and how will it be structured?

Who Will Run the Canadian Operation?
The first issue is determining the vehicle to run the new operation in Canada. There are several possibilities, including the simplest approach, which is for the foreign franchisor to grant franchise rights directly to new Canadian franchisees using its existing sales and administrative staff. An alternative is for the foreign franchisor to open a Canadian branch office, which will be a permanent establishment of the franchisor in Canada for tax purposes. A third alternative is for the foreign franchisor to incorporate a Canadian subsidiary to operate the franchise system in Canada. If this route is chosen, then there are even different types of corporate structures to use. To add to the decision making, sometimes a joint venture or partnership structure is chosen, whereby the foreign franchisor grants a master franchise to a Canadian corporation, which the foreign franchisor will partly own.

The first option listed is simply to grant individual (or "unit") franchises. These days, it is just as common for a franchisor to enter Canada with a multi-unit strategy in mind, and in this way, their franchise operations may differ greatly from their domestic U.S. strategy of single unit franchises. If a multi-unit strategy is the preferred option, then the type of multi-unit strategy is the next decision to make, but the options include the grant of some, all, or some combination of area representative, area development, or master franchise rights.

Each method has its advantages and disadvantages, and presents different legal, business, and tax issues. In every case, however, the foreign franchisor needs to be well advised on its unique situation, and work with both its legal and accounting advisors to determine the preferred route. Many franchisors entering Canada for the first time wish to avoid complicated tax issues, and so usually grant their franchises directly from the United States.

"Canadianizing" Your Agreement
The franchisor will have a franchise agreement and ancillary documentation it uses in its home country. These agreements will invariably require some revisions to "Canadianize" them. In some instances this is necessary to deal with a particular legal requirement (i.e., compliance with Canada's franchise law statutes in those provinces that have enacted them), while in other situations it is recommended so that the agreement is in accord with Canadian business and general legal practices. Some of the notable areas within a typical franchise agreement that require such revisions include the following: the licensing of the intellectual property, including Canadian trademarks and domain names; governing law and venue; dispute resolution; enforceability of noncompetition and confidentiality covenants; statutory warranties; use and administration of advertising funds; currency; interest on overdue amounts; withholding, sales, and other taxes; the Canadian statutory and common law duty of fair dealing; price maintenance; waivers of class action and jury trials; and privacy law compliance.

Franchise Statutes
American practitioners may take comfort that, in all of Canada, as in the United States, the franchise relationship is dictated primarily by the contract (franchise agreement) between the franchisor and the franchisee.

As referenced at the outset, three (and soon to be four) Canadian provinces have franchise disclosure and relationship legislation. Unfortunately, the statutes, while similar, are not exactly the same. So, while Alberta's franchise law came first, it is the most different, as both Prince Edward Island and New Brunswick used the Ontario statute as their drafting model. Even the definition of what constitutes a franchise varies, with Alberta defining it sufficiently different that some relationships may be a franchise in Ontario, but not Alberta. In each of the provinces with franchise statutes, the very broad nature of a franchise means that there are likely many existing relationships that fall into the category of "accidental franchises," where franchises come into being without the intention of the parties.

Good Faith
All provincial franchise statutes provide for a statutory duty of fair dealing and good faith by both franchisor and franchisee in the performance and enforcement of their agreements. These obligations appear to be part of the common law, and therefore apply even in the nonregulated provinces. Consistent with the good faith duty, the franchisor must act promptly, honestly, fairly, and reasonably.

This duty is also enshrined in the Civil Code of QuŽbec, which imposes duties of good faith on parties to all contracts at the time the obligation is created and at the time it is performed or extinguished (including franchise agreements).

Provincial Disclosure Obligations
All of the provincial franchise statutes are disclosure based, meaning that franchisors are required to provide each prospective franchisee with a franchise disclosure document (FDD) before granting the franchise. A Canadian FDD is the functional equivalent of an American FDD, but the requirements are not similar enough to permit use of the U.S. FDD in those provinces with a franchise law. In no Canadian province is there a franchisor registration requirement, unlike the requirements under some U.S. state franchise legislation.

With regard to the content of a Canadian FDD, it differs from the U.S. model by providing an overall obligation to disclose all material facts. The statutes provide a mandatory list of issues or questions that must be addressed. Because of this list, many American franchisors might view the obligation as similar to the set list of disclosure items that make up the U.S. FDD. However, because of the overriding obligation in regard to material facts, a franchise lawyer in Canada needs to consider if there are any material facts, beyond merely the set list of questions.

The disclosure document, under all of the provincial franchise statutes, must be delivered at least 14 days prior to the earlier of the parties' entry into any agreement relating to the franchise or payment of any consideration (or a limited amount of consideration in the case of Alberta) by the prospective franchisee. The Ontario, Prince Edward Island, and New Brunswick statutes apply to any franchise to be operated in whole or in part in the province, regardless of where the prospective franchisee or franchisor is located. In contrast, for the Alberta law to apply, the prospective franchisee must have some preexisting connection to Alberta, such as residency.

The disclosure obligations are sufficiently similar among the regulated provinces that it is becoming common to prepare a single form of FDD that complies with, and for use in, all of the regulated provinces, as opposed to a different version for each of them. It is also becoming common for prospective franchisees from the "nondisclosure" provinces of Canada to ask for the type of presale disclosure required in the three regulated provinces.

Intellectual Property
Trademarks. At the core of a franchise system are one or more trademarks. Registration of trademarks should always be sought by a franchisor entering a new country. In Canada, there is a single, federal registration authority. Americans intending to franchise in Canada should file their Canadian trademark applications as soon as possible to avoid potential piracy. Canada is a relatively inexpensive country when it comes to registration fees for trademarks.

A U.S.-based franchisor has another reason to investigate in advance the use of its trademarks in Canada. There have been instances where a trademark in use and registered in the United States is, for very legitimate reasons, simply not available for use or registration in Canada because it is in prior use by others.

Similar to the United States, a trademark application may be filed in Canada on the basis of intent to use, acting as a reservation system of sorts. In some cases, it can be years before actual use need be shown.

Other Intellectual Property Rights. Copyright is also governed in Canada by federal statute, which provides that the owner of an original literary, dramatic, musical, or artistic work is given exclusive rights of production, reproduction, performance, and transmission, among others, of that work. In the franchise context, copyright can subsist in such works as advertising materials, operating manuals, computer software, graphics, and design marks. Works are automatically protected upon their creation, so registration in Canada is not required, although it does serve as an evidentiary benefit for the copyright holder. Works created in the United States that are not registered there are still fully protected in Canada without being registered, and in fact, it is uncommon in Canada for franchisors to register the copyright in their manuals and the like, in the absence of litigation.

Patents are not commonly an issue in franchise agreements and, unlike copyright, Canadian federal patent law requires registration by the inventor in order to grant a statutory monopoly over any new and useful inventions. Patent registration is country-specific, and an invention that is patented or capable of being patented in one country may simply not be capable of protection in another.

Trade Secrets-Confidential Information. Confidential information and trade secrets are pertinent to any franchisor because it will want to ensure that confidential techniques, formulae, recipes, technical information, and the like are not revealed to competitors. This area of intellectual property is not protected by any statute, but courts in Canada will enforce the confidentiality of information if protected by contract. Therefore, nondisclosure or confidentiality provisions in franchise agreements are essential.

Domain Names. American franchisors are familiar with the well-known ".com" and similar top-level domain names. Canada also has the ".ca" top-level domain name. While registration of a ".ca" domain is limited to Canadian residents, a subsidiary incorporated in Canada by an American franchisor is a Canadian resident.

Some Related Issues
Guarantees. The franchisor must pay special attention to the nature and form of the guarantees the franchisor will use in the provinces of Alberta and QuŽbec because there are special laws in those provinces that specifically affect the form and enforceability of guarantees.

For instance, Alberta has a Depression-era statute, still in force, that provides a guarantee is not enforceable against the person signing the guarantee unless that person obtained independent legal advice in advance of signing. In addition, a statutory form of certificate must be executed by the guarantor and their lawyer.

Lease Documents. In Canada, it is relatively common for franchisors to lease business premises and then sublet them to their franchisees. Sometimes this is done for the location control it affords, or simply because a landlord insists on it. There will be potential liability to the franchisor tenant if a franchisee subtenant defaults. Special care must be taken with leases and subleases in Canada because real property laws vary from province to province. Remedies that are available in one province may not be available in another. The franchisor's lease documents should account for these differences in the applicable provincial law.

Security Agreements. Security agreements over personal property fall under the jurisdiction of provincial law. Each province has a slightly different regime for dealing with the security of personal property. A franchisor taking security (for example, because it supplied inventory) will only be able to enforce those rights in priority to other creditors of the franchisee if it registers its security interest with the applicable provincial registry.

Operations Manual. The franchisor's operations manual should be revised to reflect differences in Canadian laws, for example, in income tax and employment. Other differences include federal laws requiring use of the metric system of measurement and bilingual (English/French) labeling of products. Point-of-sale systems need to account for Canadian sales taxes.

Privacy Laws. Privacy is becoming an increasingly important issue in Canada. The federal government and three Canadian provinces (British Columbia, Alberta, and QuŽbec) have enacted privacy legislation to protect the privacy of individuals. These laws protect all personal information collected by companies and other organizations (including franchisors and franchisees) during the course of commercial activities. Personal information includes information regarding race, age, marital status, religion, employment history, address, telephone number, biology, and personal opinions. It includes information that a franchisor and franchisee collect about any individual, including its personnel, customers, and members of the public.

This legislation imposes specific duties on franchisors and franchisees regarding the manner in which they collect, use, disclose, and maintain personal information that they collect. Such legislation is specifically intended to impose accountability on businesses in connection with their privacy practices. For example, this legislation generally requires franchisors and franchisees to create reasonable privacy practices and policies; to identify and appoint a responsible privacy officer; and to ensure that individuals are advised of the purposes for which their information is being collected, used, and disclosed by businesses. Unless the legislation otherwise permits, these privacy statutes require businesses to use and disclose information only with the individual's express or implied consent.

Privacy laws in Canada also impose an overarching duty on businesses to ensure that they have taken reasonable precautions to prevent the unauthorized collection, use, and disclosure of personal information, which might involve securing physical files and electronic systems and maintaining inventories and tracking systems to monitor the access and use of data.

In connection with the obligation to undertake reasonable security precautions, there has been some recent debate in Canada as to whether transborder data flows of personal information outside of Canada are consistent with this obligation. That debate has primarily been focused on the heightened investigatory powers vested in U.S. law enforcement authorities under the USA PATRIOT Act following the terrorist attacks of September 11, 2001. Canadian private sector privacy laws do not specifically prohibit the transfer of personal information by private business enterprises outside of Canada (although such prohibitions do exist in public sector privacy laws in British Columbia), but there remains a possibility of such issues being raised where information is sufficiently sensitive or may otherwise be vulnerable to seizure and inspection by foreign authorities.

Packaging and Labeling. There are various federal packaging and labeling laws that apply to the sale of goods in Canada. For example, the Consumer Packaging and Labeling Act requires that prepackaged consumer products bear labels that are accurate and meaningful. The Textile Labeling Act has similar requirements, but also requires that labels include a Canadian identification number. Except for certain local or specialty products, all labels must be in both French and English, and weights and measures must be expressed in metric units.

Inventory and Supplies. U.S. franchisors should not assume that inventory, supplies, equipment, and the like can be simply exported into Canada for sale to or use by franchisees. Various food products such as dairy and meat products must be locally sourced, due to Canadian restrictions on importation. Similarly, any electrical equipment must meet Canadian electrical safety standards and bear the proper approvals.

Conclusion
Canada is often a U.S. franchisor's first stop on the road to international expansion. While there are many similarities between the two countries, no one should take for granted that the differences are not meaningful. Nevertheless, they are almost always manageable, which speaks to the level of U.S. franchise activity in Canada.

Additional Resources

Avoiding the Accidental Franchise Malpractice Traps

Audio CD Package

Your client wants to expand their business by issuing licenses or distributorships to independent contractors who will invest their own money and hire their own employees to sell your client's goods or services. After discussing business objectives with your client, you draft the license or distribution agreement. A year later, the client receives a demand letter from an unhappy licensee or distributor alleging that the licensing or distribution program is really a franchise relationship which they now wish to unwind. The licensee or distributor has also complained to its local consumer protection agency, which has sent your client a demand letter inquiring into the specifics of the relationship. Your client wants you to explain why the licensing or distribution program is not a franchise and seeks advice on how to respond to the unhappy licensee or distributor as well as to the state regulator.

This audio package examines the meaning of the "accidental franchise" and the implications to you and your client for creating one.