Leasing to Franchised Businesses – Special Considerations

Commercial landlords routinely lease premises in shopping malls, plazas and standalone buildings to franchised businesses. Those businesses represent some of North America’s best known brands. A commercial lease for a franchised business has at least 3 and often 4, 5 or 6 interested parties – the landlord, the franchisor, the franchisor’s leasing affiliate, the franchisee, the franchisee’s guarantors/indemnifiers and the franchisee’s lender. Each has a distinct interest in the leasing arrangement and must consider its contracting strategy accordingly. What follows are some of the principal considerations:

1. Direct Lease to Franchisor or its Leasing Affiliate / Sublease

Many franchisors want ultimate and direct control over leased premises. Some do because they want the opportunity to charge their franchisees more rent under their subleases than they pay to the landlords. Some landlords do not want tenants upcharging rent under a sublease (or extracting other benefits) and will preclude this option.
Apart from a rent upcharge, some franchisors want the premises to be theirs exclusively and automatically if their franchisees default under their franchise agreements and subleases. It is easier to repossess premises in a default and termination situation when the franchisor holds the head lease. Franchisors (or their leasing affiliates) can more easily exclude terminated franchisees from leased premises when they hold the head lease.
Holding the head lease makes franchisors (or their leasing affiliates) directly liable to their landlords. If their franchisees default, they must pay rent even if they are not in a position to operate. Their leases may also oblige them to operate in which case they must have arrangements in place to be able to take over and operate.
To mitigate against these risks, some franchisors seek to interpose an affiliated company or companies (with no operating assets) to hold head leases if their landlords will permit. They often also seek to have a grace period to allow them to find replacement franchisees to operate so as not to be required to operate immediately.
Some landlords seek to have the franchisees and their guarantors have direct liability under the leases in addition to the franchisors (or their affiliates).

2. Direct Lease to Franchisee/Limited Guarantees from Franchisor/Right to Convey

For those franchisors that do not want the risk of lease liability for locations which may prove to be unsuccessful or may become damaged beyond rehabilitation by their franchisees’ operations, they often require franchisees to lease premises directly. In that case, landlords may want the franchisors to guarantee leases for at least some limited time period (e.g. 1 -3 years).
Franchisors often negotiate the form of lease and require their franchisees to accept the negotiated form. In some cases, franchisees are given free reign to negotiate their own leases.
In situations where franchisors require franchisees to lease premises directly, franchisors often request of the landlords and franchisees to incorporate into the franchisees’ leases the right of the franchisors to elect to have the leases assigned to them on a termination of the franchise agreement and the right to assume the leases if the landlords are going to terminate the leases, provided the franchisors cure any breach.

3. Tenant Inducements/Allowances/Scope of Tenant’s Work

An issue often arises as to whether the franchisors which negotiate tenant inducements or allowances will be passing the funds received from the landlords to the benefit of the franchisees. Although not necessarily of concern to the landlords either way, the intent of the inducement is typically to assist in the operator’s costs to build out the location or its overall occupancy cost (in exchange for higher rents over the term of the lease). If the benefits of these funds are not being passed along to the franchisees, the operators will not be the ones benefiting. Franchisees should consider this issue and try to negotiate the benefits of these funds.
Similarly, franchisees must often use the services of their franchisors including companies related to the franchisors to perform build outs. This work can be a profit silo for franchisors, including in the form of rebates from any designated suppliers. Franchisees should consider the scope of the required tenant’s work and independently assess the cost of this work to ensure the work is being performed to their maximum benefit or at least understand that in exchange for the creation of system standards and a method of efficient build out, their franchisors are receiving a financial benefit from the construction.

4. The Impact of Statutory Rescission

Franchisees in Ontario, Alberta, Manitoba, New Brunswick and PEI (and shortly British Columbia) have rights by statute to rescind or cancel their franchise agreements (and subleases) in circumstances where they receive inadequate disclosure. In the case of subleases, landlords care not if there is a rescission and their lease is with the franchisor and they have the franchisor’s covenant and obligation to operate. However, when the lease is direct with the franchisee, the franchisee’s rescission of its franchise agreement does not terminate its obligations under its lease (or with its third party lenders or suppliers). Practically speaking, rescinding franchisees will likely be looking to shut down operations immediately or in the near term following rescission or attempt to have the landlord negotiate a right to change their business names. Landlords may face the reality of abandoned units where the franchisees are looking to lay their potential exposure to the landlords off onto their franchisors in the course of their dispute with their landlords. The landlords must decide how they will address this event.

In order to minimize the potential impact of a rescission, landlords can take steps to protect themselves. Firstly, they can ask to get a copy of the disclosure document before leasing the premises to assess for themselves the likelihood of a rescission. They should ask for the disclosure document regardless of whether they are leasing directly to the franchisor or to the franchisee as it will contain valuable information about the franchisors including providing another source of financial information. Secondly, they can require as a term of any lease with a franchisee that if it rescinds the franchise agreement, the franchisor will take over the lease and be responsible for curing any defaults.

Conclusion

Leasing to and by franchise systems requires the adoption of distinct philosophies and strategies by all interested parties recognizing that the relationships involved present unique leasing considerations. There are special and unique lease provisions that should be considered for inclusion in any lease involving a franchised business, regardless of who is the tenant.
Although this article raises certain issues and ideas, there are many considerations to be given when franchises are leasing premises requiring particular knowledge and experience. At Sotos LLP we advise on all aspects of franchising for those who are engaged in the industry including commercial landlords, franchisors, franchisees, lenders and suppliers.