Franchisor – Franchisee Risk in Canada

May 27, 2011

I have heard many people complain about Tim Hortons donuts being smaller than the competition, and that “always fresh” donuts (actually it is doughnuts) actually means “recently frozen”, but most of us wish we owned THI shares (trading at a 53 wk HI with a 36% increase over this time last year and a 55% increase over two years.)

However, there is a group who is not very happy about it. A (small) group of franchisees filed a $1.95 billion class-action lawsuit against Tim Hortons claiming breach of contract, breach of duty of fair dealing, negligent misrepresentation, and unjust enrichment stemming from Hortons’ conversion to frozen donuts. As with many franchisee claims, they seem to have a problem with inflated prices within the mandatory supply agreements. MACLEANS.ca released an article, here, in September last year, on the suit and the connections within the class action claim. They followed-up with a second article, here, a few weeks ago because the corporation provided a breakdown of average store profits. Please note this action has not been certified and the court has not ruled on the defendants’ motion for summary judgment.

It will be interesting to see if the court takes one look at the growth in per store profit since the introduction of the frozen product strategy and class action claim. But, the most important thing about this action is the risks it identifies for other franchisor entities. Outside of the almost $2 billion demand, the legal costs, distraction of management, franchisee infighting and the extraordinary reputational damage, actual loss will be difficult to measure. In the Tim Hortons case, a separate group of franchisees incurred considerable legal costs in an attempt to seek intervenor status, here, in the class action so they could argue against the certification of the action and protect private information and their corporate brand. Their motion was denied.

Franchisee – Franchisor risks are different from non-franchise operations, because franchise companies have the same exposures to property loss, general liability lawsuits, management liability, shareholder lawsuits, and employment practices and crime risk as any other operation, but they have a unique supportive / hostile relationship with their key business partner. The business model can be extraordinarily successful, and Tim Hortons is a textbook example, growing from one Canadian coffee shop in 1964 to 3,000 Canadian and 600 US stores today. But success can bread contempt and recent or ongoing franchise cases include the likes of Tim Hortons, Midas Inc., Quiznos, General Motors and Shoppers Drug Mart (see Financial Post, here.)

Managing franchise risks may come down to communication.

Risk management by contract language can be a mine field. Simple contract language may not provide the protection that many franchisors expect because language prohibiting class actions is common but the courts are still certifying national class actions. I do not suggest removing the language, just do not rely on it as your only form of risk management.

Another form of risk management could come from pre-screening potential franchisees. Myers Briggs and other personality tests are very common for large organizations, but there are now test specifically designed to measure future success of potential franchisees (here.) Individual franchisees may be more interested in starting a claim or participating in a class action if their individual franchise is not as successfully as other operations. It is easier to accuse the franchisor of collusion or negligence than it is to recognize that they are not cut-out to be a franchise owner.

Franchisor liability insurance is available in the insurance marketplace in Canada. It can respond to claims made by franchisees alleging breach of contract, breach of duty of fair dealing, negligent misrepresentation, and unjust enrichment. Limits of liability can be available from $1 million to $25 million or more, but large limits may become prohibitively expensive. The value of this insurance is not only in its response to defence costs, settlements or court awards, but also the support in the claim. One major issue for franchisors, is that they may not have the time and experience needed to find the best, non-conflicted, and most experience counsel available for their case. The lawyers who helped draft contract language may not have litigation defence experience, or may be conflicted out of handling your defence if their contract language has any connection to the underlying allegations. The insurance can also have a calming effect on public reaction to news of a lawsuit, because stakeholders are comforted to know that there will be at least some insurance in place to cover losses.  Finally, the value of any franchise is the ongoing relationship between franchisee and franchisor. A third party insurer being inserted into a dispute between franchisee and franchisor can help maintain the long-term relationships between the parties.

A few words of caution regarding insurance coverage: 1) a D&O policy is not designed to coverage the vast majority of total loss from a franchisee vs franchisor lawsuit, 2) you should determine the appropriate insurance broker based on experience, independence and effort, but only let one broker approach and negotiate with potential insurers, 3) don’t make assumptions about what the policies cover, ask questions and discuss claim scenarios and policy exclusions with your broker.

If you would like more information on franchise liability insurance please don’t hesitate to contact me directly, Greg Shields, Partner, Mitchell Sandham Insurance Services, gshields@mitchellsandham.com, or at 416 862-5626.

CAUTION: This is not an exhaustive list of definitions, duties, liabilities, limitations, defences, or suggested actions. The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decisions. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must receive the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com


Bill 65 – Ontario Not-For-Profit Corporations Act

April 26, 2011

NFPCA – the new Not-for-Profit Corporations Act, 2010, (NFPCA), here, passed by the Ontario Government October 19, 2010, is the new framework for Ontario’s 46,000 not-for-profit corporations (NFP).

NFPs may also incorporate federally and therefore subject to the federal Not-for-profit Corporations Act.

The NFPCA will replace the Ontario Corporations Act for the legislation of NFPs (over a transition period of three years.)

Actions: As Directors and Officers of NFPs you will need to:

Amend letters patent, supplementary letter patent, by-laws, or special resolutions,

Confirm NFP “purposes” – now the NFP can conduct commercial activities so long as they advance the NFPs purposes, even if the transaction is contrary to the corporation’s articles or by-laws,

Understand the definitions of:

“public benefit corporations” – defined as (a) a charitable corporation (a corporation incorporated for relief of poverty, advancement of education, advancement of religion or other charitable purpose) or (b) a non-charitable corporation that receives more than $10,000 in a financial year, (i) in the form of donations or gifts from persons who are not members, directors, officers, or employees of the corporation, or (ii) in the form of grants or similar forms of financial assistance from the federal government or a provincial or municipal government or an agency of any such government.

“non-public benefit corporations” – a corporation that is not a public benefit corporation.

Understand the Audit Requirements for these different structures,

Know your Duties:

Duty of Care to, (i) act honestly and in good faith with a view to the best interests of the corporation; and (ii)  exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances

Duty to Comply with the Act and the regulations, and the corporation’s articles and by-laws, and not to contract out of statutory duty

Disclosure of any conflict of interest (par. 41 of the Act), even if the material contract or transaction or proposed material contract or transaction that, in the ordinary course of the corporation’s business, would not require approval by the directors or members.

The conflicted director or officer must also remove themselves from the meeting and not vote on any resolution unless for indemnity or insurance.

Continuing Disclosure of any interest in any person (other corporation or entity) involved in any contract or transaction with the entity

Understand your Liability:

Jointly and severally liable for money or property distributed or paid, (i) to a member, a director or an officer contrary to this Act, (ii) as an indemnity contrary to this Act.

Limitation of Liability: Any action commenced after two years form the date of the resolution authorizing the action complained of.

Jointly and severally liability to the employees of the corporation for all debts (wages, etc.) not exceeding, (i) six months’ wages… and (ii) 12 months’ vacation pay, payable or accrued while they are directors.

Limitation of Liability: Only liable if, (i) the corporation cannot satisfy the debt, or (ii) before or after the action is commenced, the corporation goes into liquidation, is ordered to be wound up or makes an authorized assignment under the Bankruptcy and Insolvency Act (Canada), or a receiving order under that Act is made against it, and, in any such case, the claim for the debt has been proved

Know your potential Defences:

Where the director or officer acted honestly and in good faith, and where the contract or transaction was reasonable and fair to the corporation at the time it was approved, and if the contract or transaction is confirmed or approved by special resolution at a meeting of the members duly called for that purpose; and the nature and extent of the director’s or officer’s interest in the contract or transaction are disclosed in reasonable detail in the notice calling the meeting.

Where the director exercised the care, diligence and skill that a reasonably prudent person would have exercised in comparable circumstances

Where the director relied in good faith on, (i) financial statements presented by an officer or auditor (note, see previous blog post, here, regarding the Hercules case, here,  and auditors protection from director suits), (ii) report or advice   of an officer or employee of the corporation, if it is reasonable in the circumstances to rely on the report or advice; or (iii) a report of a lawyer, accountant, engineer, appraiser or other person whose profession lends credibility to a statement made by them.

Where the director recorded their dissent to a decision in the minutes of the meeting; however, a director who was not present at a meeting at which a resolution was passed or action taken is deemed to have consented to the resolution or action unless within seven days after becoming aware of the resolution, the director, (i) causes his or her dissent to be placed with the minutes of the meeting; or (ii) submits his or her dissent to the corporation.

Get comfortable with your Protection:

Indemnity agreements and indemnification from your corporation is a legitimate contract for the corporation, so long as it covers only directors and officers or former directors and officers of the corporation against  all costs, charges and expenses, including an amount paid to settle an action or satisfy a judgment, reasonably incurred by the individual in respect of any civil, criminal, administrative, investigative or other action or proceeding in which the individual is involved because of that association with the corporation or other entity, but only when they acted at the corporations request. However, this indemnification is only allowed if the individual acted honestly and in good faith with a view to the best interests of the corporation or other entity, and, if the matter is a criminal or administrative proceeding that is enforced by a monetary penalty, the individual had reasonable grounds for believing that his or her conduct was lawful.

The concerns with this indemnity:

                Financial impairment of the entity,

Granting indemnification is a very subjective test which will be based on the interests and attitudes of the remainder of the board of directors and/or members of the corporation at the time the costs need to be paid (which may be a completely different group from when the original transaction/decision occurred),

The indemnity provision is based on a “may indemnity” language, making that indemnification even more subjective,

The limitation of the indemnity is based on “shall not indemnify” language, suggesting the intent of the legislation was to make withholding indemnity easier than providing indemnity.

Insurance Coverage:

Directors have a responsibility to question management on all operations and risk of the business, including the current and proposed insurance coverage for General Liability and Property risk, as well as other operation-specific risk (Products Liability, Media Liability, Automobile, Environmental Impairment, Employee Benefits, Workers Compensation, Professional Liability, Crime, Employment Practices, Fiduciary Liability, Contracting, Construction, etc.) This is not the forum for full explanation of these insurance products, but appropriate risk management in these areas is a priority over Directors’ and Officers’ liability insurance, but, unfortunately, even extraordinary effort and due diligence in managing operational risk will not protect directors from 100% of their risk.

Directors’ and Officers’ liability insurance (D&O) has become critical for attracting and retaining a solid and experienced board of directors. However, most directors do not know how this insurance coverage actually works and many insurance buyers (not always a director) don’t know that there is no regulation of insurance policy contracts or premiums in Canada.  Therefore, with dozens of insurance companies (and Managing General Agents, who are not insurance companies), hundreds of policy wordings, thousands of endorsements and even more insurance brokers, selection of your insurance broker is your most important decision.

Unless you have D&O insurance experience, are willing to read every line of every policy being presented, and able to research the quality of the insurer(s) backing your coverage, then you need to rely on your insurance broker (and you should only use one.) Therefore, it is appropriate to question potential brokerage service providers on their, 1) strategy and recommendations for coverage and placement, 2) insurance market reach (how many market they deal with on this coverage line and who those companies are), 3) experience with this coverage line, including types of related products and claims, 4) independence (of the brokerage and the proposed insurance markets, including ownership, debt and remuneration agreements), 5) possible conflicts of interest, and 6) their dedication to you as a client over many years

D&O coverage questioning should include, but not be limited to, the following issues, 1. Continuity of Coverage, 2. Sharing of Limits, 3. Limit Exhaustion, 4. Severability (parties and matters), 5. Exclusions and their Preamble, 6. Hidden Exclusions and where to find them, 7. Exposures, and 8. Limit Adequacy.

Finally, don’t let any broker approach any insurance market on your behalf until you have selected your brokerage service provider. Board members might think they are helping the process by calling their insurance friend to investigate D&O coverage. But some brokers will use that opportunity to approach many markets with little or no information in an attempt to “block markets” from the legitimate broker. Being approached by multiple brokers for the same risk will create concern for the individual insurance company underwriters and may limit negotiating ability, increase premium and/or reduce coverage.

If you would like help navigating the risk of being a director officer, or you would like more information on insurance and D&O claim examples, please don’t hesitate to contact me directly, Greg Shields, Partner, Mitchell Sandham Insurance Services, gshields@mitchellsandham.com, or at 416 862-5626.

CAUTION: This is not an exhaustive list of definitions, duties, liabilities, limitations, defences, or suggested actions. The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decisions. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must receive the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.


Funding Plaintiff Securities Class Actions in Canada

April 20, 2011

The race to US style litigation just went from go-cart speeds to F1.

Prompted by contingency fees, promoted by the plaintiff bar, a little nitrous oxide boost by Bill 198 and recent class action certification decisions, and now we are rounding the corner to see the checkered flag.

In Dugal v. Manulife Financial Corp, here, a funding agreement has been (conditionally) approved by Justice Strathy of the Ontario Superior Court. The interesting thing is the entity funding a portion of plaintiff costs is an unrelated third party Irish corporation that is advancing up to $50,000 for plaintiff disbursements and “will indemnify the plaintiffs against their exposure to the defendants’ costs, in return for a seven percent (7%) share of the proceeds of any recovery in the litigation”

Perhaps the people behind this are investors and players recently forced out of the online poker business, here, and are looking for their next big gamble.

But this is an underwriteable gamble, so I guess we can be expecting ‘prospectus’ type documents on prospective plaintiff securities class actions. Actually, this not too far fetched. I remember receiving an insurance submission, back in the 90’s, for D&O coverage for a new entity that was proposing a public offering of common shares where the proceeds would be used to fund plaintiff class action suits. This entity did not end up pursing the offering (or even the business plan) that I know of, and I have no knowledge of any similar public or private entities in Canada. It is well known that US plaintiff counsel with shop their potential claims to other plaintiff law firms and ‘syndicate’ the deal, but I don’t know if that deal sharing exists among Canadian law firms. Justice Strathy’s decision (par. 29) says “indemnities given by class counsel are commonplace” and provides two Supreme Court decisions. But, lawyers tend to be fairly conservative so they are likely much more selective than private litigation funding entities. Also, indemnities from plaintiff class counsel may jeopardize their independence.

Class action funding by private ventures could be profitable, because the main competitor is the Law Society Amendment Act’s Class Proceedings Fund. As per par 31 of the decision, “The Fund was established by the Law Society Amendment Act (Class Proceedings Funding), 1992, S.O. 1992, c. 7. The Fund was given initial seed money in the form of a $500,000 grant from the Law Foundation of Ontario. The CPC receives a levy in the amount of 10% on any awards or settlements in funded proceedings, together with repayment of any funded disbursements. Its annual report indicates that from its inception to June 2010 it had awarded funding to class proceedings in the amount of $6.8 million, it had paid costs awards in favour of defendants in the amount of $1.9 million and it had received $18.6 million in revenues from its entitlement to 10% of settlements or judgments. At June 30, 2010 its account stood at a balance of $11.3 million. From 1992 until June 30, 2010 the CPC received 96 applications for funding. Of those applications, 52 had been approved for funding, 28 had been denied or deferred and 16 had been withdrawn or are currently in abeyance.”

The corporate Defendant is obviously very well connected in Canada, but the court decision suggests that none of the 25 largest pension fund/investment fund investors in Canada, nor any of the individual investors notified of the proposed funding agreement, came to the defence of the Defendant or objected to the funding agreement. This is a big surprise to me because the concept of outside funding of class action claims is still relatively new to Canada, and this court decision sets a very significant precedent. Class action securities claims are a balancing act for investors because, on one hand, they (at least the small individual retail investor) need class support for any realistic opportunity to seek damages, but, on the other hand, the publicity of a class action securities litigation can cause a significant stock price drop to their underlying investment and create a major distraction for directors, officers (their D&O insurers), management, employees, customers and analysts of their portfolio companies. I also thought that institutional investors would oppose anything that supports class action securities claims, because they have the means to pursue individual securities claim and don’t need to rely on class proceedings. But, since a large local pension plan is a lead plaintiff in this action, and no other fund manager objected to proceedings, my assumptions must be wrong. 

The  underlying allegations (see the decision on the application to amend the statement of claim, here, under “The Nature of the Action” 6-10, and here) include : “misrepresentations concerning the defendant’s risk management practices in its public disclosure documents”, “artificially inflating the values of its stock.”  The alleged culprits were the seg funds and variable annuities, which the plaintiff alleges were not sufficiently hedged against financial meltdown of the fourth quarter of 2008 despite claims of rigorous enterprise-wide risk management systems, and therefore caused a $5 billion increase in reserves for future payments and a significant stock drop in the defendant’s shares.

There were a bunch of other allegations, and the plaintiff named individual directors and officers as defendants, but this blog post is about the funding, not the “tapping of D&O insurance limits”, (which I will be sure to blog about if the action is certified as a class proceeding in September.)

The proposed class – all purchasers of the defendant’s securities between January 26, 2004 and February 12, 2009.

The alleged damages – $2,500,000,000.

The best case scenario payday for the Irish plaintiff securities class action funder – $10,000,000. Yes the agreement is for 7% of the proceeds of any recovery (settlement or judgement less costs and expences), but the agreement capped it at $5 million if resolution is reached prior to pre-trial conference brief, and $10 million after that. Too bad for the Irish funder, because it could have been worth $187,500,000.

The risk to the funder, $50,000 towards the plaintiffs’ disbursements and the funder “will pay any adverse costs award made against the plaintiffs.” If this leaves you scratching your head, me to. If the Plaintiff loses and the Defendant is awarded costs (Loser Pays), the funder could be out millions, but their reward is only millions. Not a great return when there is little precedent in Canada regarding the outcome of actions brought under Bill 198 (Section 130 and 138 of the Securities Act – relatively new legislation regarding a cause of action for misrepresentation in the secondary market – as opposed to the former legislation requiring the misrepresentation be in the IPO prospectus document (not the secondary market documents) and only where the plaintiff can prove reliance.)  And, as I read the March 21, 2011 decision from Justice Strathy denying an important part of the Plaintiff’s Amended Pleading, it seems like a good chunk was taken out of their case. The decision suggests the original action only “sought leave to asset the cause of action for secondary market misrepresentation set out in s. 138.3 of the Securities Act”, but “there was no specific pleading of s. 130” and no mention the word “prospectus.” When the Plaintiff moved to amend the statement of claim and assert a cause of action for misrepresentation in ten prospectuses filed by the defendant, Justice Strathy agreed with the Defendant and denied that portion of the amendment based on missing the 180 limitation period under s. 130. They issues raised in determining the denial included, 1) the Plaintiff was sophisticated, 2) they had very experienced securities lawyers, 3) Feb 12, 2009 was the first major write-down announced by the Defendant, and that would be the date they should have known about all potential damages, 4) the original statement of claim was issued July 29, 2009 (167 days), 5) amended statement of claim was November 17, 2009 (278 days), but no mention of s. 130 or prospectuses, 6) motion for certification and for leave under 138.8(1) was on May 18, 2010 (460 days), and this included amendments “which contained, for the first time, specific allegation of prospectus misrepresentation under s 130 of the Securities Act”, 7)  s 130 and prospectus misrepresentation could not be inferred from the original statement of claim, and, 8) the extension of limitation allowed in McCann v. CP Ships “was decided more than a year before this action was commenced”  and involved the same counsel and therefore “it is inconceivable that counsel would have asserted a s. 130 claim without specifically pleading the section or referring to the prospectus containing the alleged misrepresentation.”

With the decision on the first amended statement of claim, released January 19, going in favour of the Plaintiff, and the limitation period and funding agreement decisions not released until March 21, 2011, it will be interesting to see what direction this case takes. If the limitation period decision is in fact bad for the case, the funding company would simply have to reject the court’s requirements, and walk away.

I wonder if third party litigation funding will actually reduce the contingency fees paid to plaintiff counsel, because they were not taking any risk of indemnifying their clients. This answer will come over time, as there are still many securities class action claims in the pipeline and certainly more to surface.

If you would like to “stress-test” your Directors’ and Officers’ liability policy (D&O) against this type of potential claim, or if you would like an independent third party review of your insurance policy, please don’t hesitate (I really mean, don’t hesitate, because policy negotiation can quickly become impossible if a potential claim surfaces against you or your entity) to contact me directly. Greg Shields, Partner, Mitchell Sandham Insurance Services, gshields@mitchellsandham.com, or at 416 862-5626.

CAUTION: The information contained in the Mitchell Sandham website or blog does not constitute a legal opinion or insurance advice and must not be construed as such. It is important to always consult a registered insurance broker and a lawyer who is a member of the Bar or Law Society of the relevant jurisdiction with regard to this material before making any insurance or legal decisions. All material is copyrighted by Mitchell Sandham Inc. and may not be reproduced in any form for commercial purposes without the express written consent of Mitchell Sandham Inc. Anyone seeking to link this site from any external website must receive the consent of Mitchell Sandham Inc. by sending an e-mail to gshields@mitchellsandham.com.