Sotos LLP • Lawyers & Trade Mark Agents[ 180 Dundas Street West, Suite 1250 :: Toronto, Ontario M5G 1Z8 :: 416.977.0007 :: sotosllp.com ]

FALL 2008 NEWSLET TER

Continued on pg. 3

In our last issue, David Sterns wrote an article on the issues involved in the imple-mentation of franchise system changes. Within weeks of the mailing of our news-letter, an important case from Ontario was released amplifying the issues.

On March 26, 2009, the Ontario Supe-rior Court of Justice released its decision certifying an action brought on behalf of all Canada Midas franchisees against Midas Canada Inc. as a class action.

The action resulted from Midas’ decision in 2003 to cease the manufacturing and distribution of automotive parts to its franchisees and to require its franchisees to purchase their products from third-party suppliers. The franchisees asserted

Midas Class Action Certified Developments in the Law on System Change by Allan D. J. Dick

that this change, which was made with-out a formal amendment to the franchise agreement, breached Midas’ obligations to the franchisees. After the change, Midas’ financial performance improved greatly while the fortunes of the Midas franchi-sees suffered.

The court found that the franchise agree-ment in place at the time of the change permitted Midas to get out of manufactur-ing and distribution and that Midas did not breach any specific provision of the fran-chise agreement in doing so. However, the court found that this was not the end of the matter because Midas owed duties of good faith and fair dealing to franchisees in how it implemented the change.

Sotos LLP Newsletter Spring 2009

Midas Class Action Certified . . . . . 1 Allan Dick reports on the recent certification of this class action.

Important factors to consider in selecting your trade marks . . . . . 2 Joseph Mucci explains the importance of proper trade mark selection.

What every Franchisor should know about Franchisee Advisory Councils and Franchisee Associations - Part 2 . . . . . . . . . . . . . . 4 In the second part of his article, John Yiokaris discusses the franchisor’s involvement with these groups.

Income Splitting and Inter-Family Loans . . . . . . . . . . . . . . . . 6 Rachel Loizos summarizes a valuable tax savings tool.

Is your disclosure document “fatally flawed”? -The Certificate . . 7 Sam Hall begins his review of potentially fatal disclosure errors.

Legislative Update . . . . . . . . . . . . . . . . . 8 A note on recent legislative changes.

by order of the articles

Allan D. J. Dick: adjdick@sotosllp.com Joseph Mucci: jmucci@sotosllp.com John Yiokaris: jyiokaris@sotosllp.com Rachel Loizos: rloizos@sotosllp.com Sam Oliver Hall: shall@sotosllp.com

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A brief stroll through the aisles of any major retailer will confirm the truism that, in most developed economies, the decision to purchase even the most common of consumer staples can often involve choosing from a dizzying array of competing products, many of which share similar characteristics. In a world where consumers can choose among 20 or 30 or more different types of breakfast cereals or toothpastes or shampoos etc., brand differentiation is often a key determinant in the success of a product (or a service). Trade marks are a critical component of the brand differentiation process. They are also enormously valuable assets of most successful businesses.

Because trade marks can be such valuable business assets, great care should be taken in selecting them. Another reason why great care should be taken in selecting a trade mark is that, while registration of a trade mark in Canada confers on the trade mark owner the exclusive right to use the registered trade mark throughout Canada, the trade mark owner is ultimately responsible – both legally and financially – for enforcing that monopoly right.

Ideal trade marks therefore tend to exhibit two qualities: first, they’re highly successful in serving their primary business purpose of effectively differentiating the goods or services of their owners from those of their competitors; and, second, there’s a high probability that their value as intellectual property can be legally protected. Both of the above qualities are possessed by trade marks that have a high degree of inherent distinctiveness.

Trade marks with a high degree of inherent distinctiveness are considered “strong” trade marks. In general, “strong” trade marks have either no inherent meaning of any kind, or no meaning in relation to the goods or services with which they’re associated. Invented (or “coined”) words are an example of “strong” trade marks that have no inherent meaning. Familiar examples include TYLENOL (for pain killers and cold preparations), KODAK (for photographic film), REEBOK (for shoes), EXXON (for gasoline) and CLOROX (for

Important factors to consider in selecting your trade marks by Joseph Mucci

laundry detergent). Common dictionary words, however, can also be “strong” trade marks if their use in relation to the goods or services with which they are associated is arbitrary and uncommon. Familiar examples include APPLE (for computers and software), CAMEL (for cigarettes), AMAZON (for online book-retailing services), and DUTCH BOY (for paints). The high degree of inherent distinctiveness of “strong” trade marks makes them relatively easy to protect since the intent of a competitor to encroach on the brand recognition that’s been widely established in the marketplace by a “strong” trade mark can usually be readily inferred.

Suggestive trade marks occupy a middle-ground in the “distinctiveness” spectrum (and similarly occupy a middle-ground between “strong” and “weak” trade marks). Suggestive trade marks “suggest” some character or quality of their associated goods or services, or the result of their use. Suggestive trade marks require consumers to guess at the connection between the trade mark and its associated goods or services. COPPERTONE, for example, suggests the tanning result that can be achieved through the use of its associated suntan lotion; GREYHOUND suggests the speed of its associated bus transportation services; while ROACH MOTEL suggests the deadly “accommodations” that will be provided to pests by its associated pest control products.

Trade marks with little to no inherent distinctiveness are considered “weak” trade marks. The most common characteristic of “weak” trade marks is that they consist of words in common usage that are descriptive, to some greater or lesser degree, of some quality or characteristic of the goods or services with which they are associated (e.g., SIMPLY PURE WATER). Laudatory prefixes (“premium”) or descriptive words (“builders”) often make up one or more (“premium builders”) of the components of a descriptive trade mark. If a prospective trade mark is so highly descriptive of its associated goods or services (or of their dominant quality

or characteristic) that registration of the trade mark may be in doubt, then the trade mark should not be selected since, even if registered, it would likely be very difficult to prevent competitors from using very similar trade marks. The case law clearly establishes that competitors will be permitted to use similar descriptive trade marks simply by re-arranging the order of the descriptive word components or by introducing additional components as part of their trade mark. (There are, for example, literally dozens of trade marks that have been registered in Canada that include the descriptive word “donuts” as a component of the trade mark.) A trade mark that consists entirely of descriptive words in common usage can only be registered if it can be proven that those words have acquired “secondary meaning” through extensive commercial use by the would-be owner of the registered trade mark.

As noted above, in general, the best trade marks are those that possess a high degree of inherent distinctiveness. Therefore, on a scale from best-to-worst, invented or arbitrary words are more ideal trade marks than suggestive words, while suggestive words are to be preferred over highly descriptive words. In the real world, the trade mark selection process is not always so clear cut. COCA-COLA, for example, which is perennially near the top of any list of the world’s most recognizable trade marks, is a descriptive trade mark that became one of the world’s “strongest” and most distinctive trade marks as a result of decades of extensive use. For the average owner/managed business, however, with a limited marketing budget, perhaps the simplest lesson to be drawn from the above legal principles is that highly descriptive trade marks should be “weeded out” early in the trade mark selection process, preferably long before they’re adopted for public use. Because of their low degree of inherent distinctiveness, highly descriptive trade marks are neither effective in distinguishing the goods or services that are associated with them nor is the value of any goodwill that’s created in them capable of any significant measure of legal protection.

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1 The legendary investor Warren Buffett once observed that he doubted that any competitor would be successful in unseating The Coca-Cola Company as the world’s number one supplier of carbonated soft drinks even if it devoted $10 billion to the effort – so dominant and recognizable has the COCA-COLA trade mark now become throughout the world. By some estimates, the COCA-COLA trade mark alone may be worth as much as half of the total market capitalization of The Coca-Cola Company.

Important to the decision was that the Midas franchise agreement stated that Midas had developed a system for the “successful” (i.e. profitable) operation of automotive repair shops and had granted the right to the franchisees to use this system. The system had evolved to include the entitlement of Midas’ fran-chisees to receive a 14.5% discount off Midas’ best prices in exchange for which the franchisees had agreed to increase their royalties from 5% to 10% when the current form of franchise agreement was negotiated in 1980 between Midas and the franchisee association. The question of whether Midas breached its duties to the franchisees as a matter of law will require the court to determine if Midas improp-erly defeated the franchisees’ legitimate expectations when it changed the system in 2003.

Although the court found that Midas franchisees which joined the system after Midas exited manufacturing could not be part of the class, it nevertheless held that since there was a provision in the franchise agreement which required each franchisee to receive the benefits of any changes to the Midas system, those franchisees also have the potential to benefit from any changes which the litigation may bring including any changes in Midas’ royalty structure which may result.

Sotos LLP was counsel to the franchisees in this case. Our firm is proud of its tradi-tion of promoting good franchising both in our representation of franchisors and large franchise groups against franchisors whose practices do not reflect these stan-dards. The success of franchising depends on franchisors and franchisees conducting themselves in a manner which maximizes the growth and success of the brands they represent.

Midas Class Action Certified Continued from page 1

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In the last issue, we looked at the key differences between advisory councils and franchisee associations, along with the reasons why those organizations are formed. In this issue, we will look at what proactive steps a franchisor can take when it comes to dealing with Advisory Councils and Franchisee Associations.

A. Franchisor reaction, recognition and involvementReaction and recognitionWhile four provinces have laws that protect franchisees’ right of association, there is no requirement that a franchisor negotiate or otherwise recognise an organized association. The obligations on a franchisor to “recognise” or deal with an association are not yet decided.

In deciding whether to acknowledge or negotiate with a Franchisee Association, the franchisor should consider whether the entity is truly representative of its franchisees. A franchisor may insist that a franchisee entity certify that a minimum number of franchisees, or units, are dues-paying members, or that the entity includes representatives from all geographical territories where franchised stores are located. A franchisor must also understand the reasons that an association has formed, whether this be due to an ineffective or non-representative advisory council, or because of a vocal minority promoting a specific agenda. The franchisor must use its best judgment to determine whether recognition of an independent franchisee association will help or hinder the chain wide franchise relationship.

Depending upon its size, a Franchisee Association, for better or worse, becomes part of a system’s dynamics and should be ignored at a franchisor’s peril. Franchisors who are not active in establishing lines of communications with a newly formed franchise association will likely have such communication thrust upon them. The best practice for a franchisor facing this situation is to be transparent in its business dealings with franchisees.

Both Franchisee Associations and Advisory Councils serve as important channels of communication and dispute resolution between franchisees and between a franchisor and its franchisees. Through these bodies, a franchisor can effectively communicate the need to implement changes and adjust to competitive circumstances in the market place.

A franchisor that recognizes the potential utility of a Franchisee Association may assist in the establishment of an association early in the development of the franchise. Franchisors who play a founding role potentially bypasses the formation of a more militant association down the road. A franchisor may be able to obtain the association’s endorsement of its plans for the system, legitimizing these decisions and encouraging easier system-wide implementation. Reluctant franchises may be more willing to embrace changes supported by their peers, over changes introduced by the heavy hand of a frustrated franchisor, whose first reaction may be to attempt to enforce contractual rights through a litigious recourse.

Increasingly, prospective franchisees are investigating franchise systems before investing in them. Fostering harmonious franchise relations enhances a franchisor’s ability to expand. Contented franchisees are, after all, a franchisor’s most effective franchise sales persons.

InvolvementA franchisor will initially determine the fundamentals of an Advisory Council: its purpose, its membership, the frequency of its meetings, and its funding. A preliminary consideration will be whether the franchisor’s representatives should be recognized as part of an advisory council. Depending on the dynamics of the system, this consideration can prevent an “us versus them” attitude from inhibiting the proper functioning of the council. Whatever course is taken, it is essential that franchisor executives with decision making authority meet with the council. Without this commitment, franchisees will perceive that they are unable to get the attention of those making critical decisions.

When significant decisions are made, the franchisor should consider the interests of its franchisees over and above short-term franchisor profitability. Factors affecting franchisor decision making should include, whether: (i) the decision is contrary to the interests of the franchisees? (ii) the decision is contrary to the interests of franchise customers? (iii) the decision will damage the franchisor’s relationships with its franchisees? (iv) the decision will damage the franchise brand?

What every Franchisor should know about Franchisee Advisory Councils and Franchisee Associations Part 2 by John Yiokaris Sotos LLP

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Franchisors that are transparent in their decision making, that listen and that respond to franchisees gain a competitive advantage through the more effective sharing of knowledge, resources, and innovation, and promotes more motivated and committed franchisees.

B. What roles do Advisory Councils and Franchisee Associations fulfill? Both Advisory Councils and Franchisee Association share a common goal: fostering constructive two-way communications between a franchisor and the franchisees of its system by having a select group of franchisees discuss on a regular basis matters of mutual interest with the franchisor. The benefits of these councils and associations are numerous and include:

1. Acting as a vehicle for collective bargaining and effective use of leverage.

2. Encouraging the protection of franchisee rights under franchise agreements.

3. Serving as a forum to advocate common issues and provide independent research and analysis. Independent scrutiny makes for better decision making, as franchisor’s proposals are proofed and/or endorsed by the council or association. This can be particularly helpful in considering changes to standard form franchise agreements.

4. Improving communication with franchisees on a variety of issues. For example, franchisees need to receive timely information about new developments relating to the brand, the franchise system, and the franchisor’s policies and procedures.

5. Developing institutional memory within a system. Associations can be repositories of knowledge which can promote the evolution of the brand, marketing and merchandising techniques, and best practices.

6. More often in the case of Franchisee Associations, providing financial support

for individual franchisees engaged in litigation with the franchisor or for franchisees acting in a representative capacity on behalf of the system’s franchisees.

7. Resolving franchisee dissatisfaction to avoid the inevitable costs of litigation.

8. Maintaining morale and promoting franchise group identity.

CONCLUSIONSFranchisors who wait until their franchisees initiate such steps to form representative franchisee entities risk an unpleasant wake-up call when confronted for the first time by dissatisfied franchisee representatives. In the right environment, franchise associations and advisory councils can be an effective means of advancing the shared interests of both franchisor and franchisee. Such organizations can enhance the leadership role of the franchisor and promote the overall vitality of a franchise system.

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Canada has a progressive income tax system - the more income you earn the higher the rate of tax you are required to pay. Income splitting is a tax planning technique designed to shift income from a high rate taxpayer to a lower rate taxpayer such as a spouse or minor child.

One way of achieving this is to lend money to a family member in a lower tax bracket with that individual earning and reporting investment income earned on the loaned funds.

Unless interest is charged on the loan, the entire investment income is attributed to the person making the loan and taxed in his or her hands. An exception to the attribution of income exists where the person lending the funds charges interest and collects interest from the borrower which is then declared on the lender’s tax return.

In order to prevent abuses of the Income Tax Act, the Canada Revenue Agency establishes the minimum rate of interest

Income Splitting and Inter-Family Loans by Rachel Loizos

that must be charged for loans of this type. This prescribed rate of interest for income tax purposes changes on a quarterly basis. For the second quarter of 2009, the rate will drop to 1%, the lowest it has ever been. This reduction provides an excellent opportunity for a high income tax rate individual to shift investment income to his or her spouse or minor child. By making loans to lower tax rate family members all income in excess of 1% will be taxed in the hands of such individuals. In this case not only is there no attribution of income earned back to you, but your spouse or child is entitled to an interest deduction on the interest paid to you.

Using these loans for investment purposes will allow for the income to be taxed at the lower income-earning family member’s tax rate indefinitely. Given that the rate of interest that must be paid is fixed at the time the loan is entered into, even if the prescribed rate increases in the future all loans made in the second quarter of 2009 will continue to bear interest at 1%.

If you have pre-existing inter-family loans where the prescribed rate was higher than 1%, consideration should now be given to renegotiating them at the current rate. This includes loans to family members, family trusts and certain loans from private companies. Furthermore, if you have excess cash for investment and are in a high tax bracket, consider making loans to family members in lower tax brackets to take advantage of this opportunity.

If you decide to proceed with this tax savings technique please ensure that you not neglect to make the interest payments. To avoid the attribution of income on loaned funds, the interest has to be payable, and actually be paid, by no later than January 30th of every year that the loan remains outstanding. Furthermore, it is highly advisable that loans be properly documented so that the obligation to repay the loan exists and that the lender is able to recover the amounts loaned.

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A recent decision of the Superior Court of Ontario serves as a strong reminder that franchisors must pay close attention to the content of the disclosure document that they provide to prospective franchisees and the manner in which that disclosure is provided.

In the decision of Sovereignty Investment Holding, Inc. v. 9127-6907, Justice Wilton-Siegel found that the disclosure document provided by the franchisor to the prospective franchisee contained four fatal defects. Each defect, considered by itself, was enough to allow the judge to find that no disclosure document had been provided to the prospective franchisee.

Subject to some limitations, when a franchisor fails to provide a disclosure document that meets the requirements of the Ontario franchise legislation, the Arthur Wishart Act (Franchise Disclosure), a franchisee may be entitled to rescind its franchise agreement. As some franchisors have found out the hard way, this rescission remedy provides a powerful recourse to franchisees against their franchisor. Once this remedy is triggered, a franchisor will, generally speaking, be required to pay to the franchisee all amounts invested by the franchisee in the franchised business as well as all amounts paid to the franchisor, including royalties, rent payments, and advertising fees.

The four deficiencies identified by the judge in the Sovereignty case were (i) lack of a dated and signed certificate from the franchisor attesting to the truthfulness of the disclosure document; (ii) failure of the franchisor to include up to date financial statements; (iii) failure to provide a disclosure document as one document at one time to the franchisee (i.e. in piecemeal fashion); and (iv) failing to include a statement which provided the basis for earnings projections provided by the franchisor to the franchisee.

Is your disclosure document “fatally flawed”? - The Certificate by Sam Oliver Hall

The fatal defects listed by the judge in Sovereignty do not comprise a closed list of the ways in which a disclosure document might be flawed so as to entitle a franchisee to the rescission remedy.

Failure by a franchisor to include a signed and dated Certificate in its disclosure document is a particularly interesting defect of disclosure, given the importance of the Certificate and the relative ease with which a franchisor might neglect this crucial aspect of the disclosure document.

The statutory requirement relating to Certificates is set out at section 7 of the regulation to the Arthur Wishart Act, which requires that every disclosure document include a Certificate certifying that the document contains no untrue information, representations or statements and includes every material fact, financial statement, statement and other information required by the Act and this Regulation. The Certificate must be signed and dated (i) in the case that a franchisor is not incorporated, by the franchisor, (ii) in the case of a franchisor that is incorporated and has only one director or officer, by that person, or (iii) in the case of a franchisor that is incorporated and has one officer or director, by at least two persons who are officers or directors. It is important to note that who is an officer and director may well not be limited to officers and directors of record filed with the government registries.

The purpose of the Certificate is to assure the franchisee that a senior person within the franchisor’s organization has taken the time to check the accuracy of the representations that are made in the disclosure document about the franchise system. It also provides a clear identification to the prospective franchisee of “who” the franchisor really is. Because those who sign the Certificate may be held personally liable for mis-statements contained in the disclosure document, the certificate is one means of encouraging the necessary fact checking with respect to the content of the disclosure document.

From the franchisor’s perspective, because the Certificate must contain a date, it enables the franchisor to assess the validity of its disclosure at different points in time and may assist the franchisor in availing itself of the limitation periods that exist under the Act.

A franchisor’s failure to include a properly signed and dated Certificate in its disclosure document creates serious legal exposure – the court’s award in the Sovereignty case, it might be pointed out, was in excess of $1 million. In future articles, this space will discuss the more common of the “fatal defects of disclosure” and highlight best practices in disclosure design.

Legislative UpdateSince our last newsletter, there have been the following legislative initiatives worth noting.

1. Changes to the Canada Small Business Financing (CSBF) ProgramCertain changes to the CSBF Program are in effect as of April 1, 2009. Notably, the new maximum loan amount is $500,000 of which the maximum amount of $350,000 can be used to finance the purchase or improvement of equipment and the purchase of leasehold improvements; this is an increase from the previous amount of $250,000. Additionally, the names of shareholders and guarantors of incorporated borrowers must be collected in a database to make it easier to track different incorporated borrowers with the same shareholders/guarantors and thereby detect and prevent potential abuse of the CSBF Program.

2. Competition Act Changes Come into ForceSweeping changes to the federal Competition Act came into effect on March 12, 2009.

The amendments repeal the criminal provisions of the Act that deal with a number of pricing offences such as price discrimination, predatory pricing and discriminatory promotional allowances. From now on, these practices will be subject to review only under the civil abuse of dominance provisions of the Act.

The amendments also replace the price maintenance provision with a new provision that will permit the Competition Tribunal to issue orders on application of the Commissioner of Competition, or a private party with leave, where the resale price maintenance is likely to have an adverse effect on competition.

These changes will affect franchisors and distributors in their dealings with franchisees, retailers and competitors.

3. Green Energy and Green Economy ActThe Ontario government recently introduced the Green Energy and Green Economy Act. The Act targets 3 main areas: 1) renewable power generation; 2) energy efficiency; and 3) the smart grid.

The Act not only maintains the previous government policies of establishing a framework for the provision of affordable and reliable energy but has added requirements for the maximization of environmental and economic objectives as well.

Three aspects of the legislation are worth noting for small businesses:

i) no real property will be able to be sold – or leased for extended periods of time without undergoing an energy audit;

ii) it has been suggested by the opposition party that the cost of electricity will rise as a direct result of the legislation; and

iii) investment and business opportunities have been identified resulting from the introduction of the legislation.

Sotos LLP • Lawyers & Trade Mark Agents[ 180 Dundas Street West, Suite 1250 :: Toronto, Ontario M5G 1Z8 :: 416.977.0007 :: sotosllp.com ]