The Franchise Agreement and Sublease: Siamese Twins or Independent Organisms?
One of franchising’s enduring assumptions is that a franchise agreement and sublease must be viewed together and that, with a proper cross-default provision, one cannot survive the termination of the other. While this may appeal on an intuitive level, it must be reconsidered in light of the recent Ontario decisions in Majdpour et al. v. M&B Acquisition Corp. et al. and 3P3W Holding Co. v. Nguyen. As David Sterns points out in this article, these two decisions recognize the independence of the lease in the franchise relationship and the importance of taking this into account on termination.
One of franchising’s more pervasive assumptions is that a franchise agreement and sublease are inextricably bound together and cannot be viewed in isolation. Over time, this view has become ingrained to the point where the distinction between these two very distinct agreements is often overlooked, particularly at the time of termination.
The source of this assumption is that, taken together, the franchise agreement and sublease appear to form a code governing all aspects of the parties’ contractual arrangements. Two Alberta cases reinforce the notion that the franchise agreement is the “dominant” agreement and the sublease merely an adjunct. Many franchisors and counsel assume when planning terminations that cross-default provisions commonly found in franchise agreements and subleases provide the unfettered right to terminate subleases without having to consider the effect of tenant protection legislation.
This truism may now be a little less true following the recent Ontario decisions of Majdpour et al. v. M&B Acquisition Corp. et al. and 3P3W Holding Co. v. Nguyen. These decisions recognize the independence – if not the primacy – of the lease in the franchise relationship. They are also a reminder of the risks of failing to take this fact into account when terminating the relationship.
Majdpour was an application by a group of former franchisees of the Moneysworth & Best franchise system. Following the franchisor’s voluntary bankruptcy in July, 2000, the franchisees served notice on their head landlords under section 39(2) of the Commercial Tenancies Act (CTA). That section entitles a subtenant to assume a direct tenancy with the head landlord by providing notice to that effect within 90 days of the head tenant’s bankruptcy. This statutory right of the subtenant is superior to the right of the trustee in bankruptcy to assign the lease to a third party.
Within two months of the bankruptcy, the trustee in bankruptcy purported to assign the bankrupt franchisor’s interest in the leases, subleases and franchise agreements to a newly formed company called M&B Acquisition Corp (M&BAC). Following the assignment, M&BAC disputed the franchisee’s rights to assume a direct tenancy, claiming that they did not meet the requirements of section 39(2) of the CTA.
At the hearing, the franchisees argued that, regardless of whether the franchise agreements had survived the franchisor’s bankruptcy, they were no longer bound by the subleases because they had exercised their rights under section 39(2). M&BAC countered that the sublease and the franchise agreement were integrally linked. According to this argument, if the franchise agreement was still valid, the sublease simply could not be allowed to terminate by operation of law. M&BAC also argued that the franchisees did not come within section 39(2) because the head landlords had not previously consented in writing to the subleases.
The court concluded that while the franchise agreement had survived the bankruptcy, the franchisees were nevertheless entitled to assume a direct lease with their head landlords and be released from the subleases. In coming to this conclusion, the court rejected the argument that the franchise agreement and the sublease must be read as a whole.
The court’s approach in this case is consistent with the decision of the Ontario Court of Appeal in 3P3W Holding Co. v. Nguyen. In that case, a franchisee was permitted to remain in possession of the premises after termination of the franchise agreement even though the franchise agreement expressly contemplated that the sublease came to an end with the franchise agreement.
The courts in Madjpour and 3P3W Holding Co. are more concerned with the franchisee’s rights as tenant than with any notion of the pre-dominance of the franchise agreement. These cases stand in contrast to the dicta in Phil’s Restaurants Ltd. v. Parkmount Inv. Ltd., a case frequently cited for the proposition that a sublease is merely collateral to the franchise agreement. In that decision, Dixon J. ventured to say that the franchise agreement “was intended to be the governing document with the sublease being a necessary complement thereto.” Or, as more bluntly stated by Master Funduk in C. Corp. (Ontario) Inc. v. E. & S. Kramps Holdings Ltd.:
“The sublease and the franchise agreement cannot be separated. The franchise agreement is the life support system for the sublease. Once that life support system is turned off (as both parties agree it has) the sublease cannot breathe on its own.”
While such broad statements may appeal on an intuitive level, they must now be regarded as questionable guideposts for the prudent franchisor. The franchise agreement is certainly the lifeblood of the franchisor, but the sublease is the body and soul of the franchisee. In terms of investment in a typical franchise, the franchisee will have sunk far more into leasehold improvements than it will have paid for a franchise fee. Tenant protection legislation such as the CTA was enacted to protect all tenants, including franchisees. In the absence of clear waivers of such protection, franchisee/subtenants will understandably be reluctant to view their tenant rights as subordinate to the franchisor’s wide powers of forfeiture.
A second issue which arose in Majdpour was whether the covenants in the sublease requiring the subtenant to perform all obligations under the franchise agreement could even be enforced by M&BAC as successor franchisor/sublandlord assuming that the sublease relationship survived. Although the court did not address the point (having found that the subleases had effectively been brought to an end), the issue may yet be considered when the case comes before the Court of Appeal in October, 2001. The answer may depend on whether the franchise-related covenants in the subleases are considered personal covenants or, alternatively, covenants that “run with the reversion.”
A covenant is said to run with the reversion when either the liability to perform it or the right to take advantage of it passes to the landlord’s assignee. Originally, at common law, if the reversion was assigned, the assignee did not get the benefit of any covenant made by the lessee, except for payment of rent. A landlord’s assignee could not enter upon the leased premises if the tenant breached any other covenant.
This was changed by the adoption of the Grantees of Reversion Act, 1540 (Eng.), c. 34 and, in Ontario, section 4 of the Commercial Tenancies Act. However, section 4 and the corresponding section of the English statute apply only to covenants which concern the land demised. Collateral or merely personal covenants remain unenforceable by the landlord’s (or sublandlord’s) assigns.
The rules for determining whether a covenant or condition runs with the reversion are the same as those governing covenants which run with the land. Various attempts have been made to define covenants which run with the land but the leading texts mostly provide case-by-case examples. On balance, it could be said that covenants which run with the land are those which directly benefit or concern the premises. The obligation to pay rent, insure the property and keep the premises in a good state of repair are all obvious examples of this type of covenant.
It is difficult to see how the requirement contained in subleases that the franchisee perform each obligation under the Franchise Agreement (which often includes the Operations Manual) could be viewed as touching or concerning the land. These covenants exist mostly for the benefit of the franchisor and the franchise system. They generally have little to do with the leased premises.
In fact, some covenants typically found in franchise agreements have already come under analysis by the courts and been found to be merely personal. For instance, in Mitchell v. McCauley, the Ontario Court of Appeal held that a condition in a lease that provided that the lease could be terminated if a writ of execution was levied against the goods of the tenant was found to be collateral and could not be enforced by the lessor’s assign.
Similarly, in Walsh v. Walper, the Ontario Divisional Court held that a tenant’s covenant to apply for a liquor licence and assign the licence to the lessor at the expiry of the term was personal and unenforceable by the landlord’s assign. Would a covenant that a franchisee pay royalties or deliver sales reports to the franchisor necessarily be any different?
If a court finds that most or all of the covenants in a franchise agreement are personal, the successor franchisor/sublandlord may be prevented from terminating the sublease for breach of those personal covenants. The subtenants, while still contractually bound by the franchise agreement, could not be dispossessed upon termination of the franchise agreement.
Arcane as it may seem, this factor could play a significant role in the sale of a franchise system. To avoid the problem, successor franchisor/sublandlords would either have to purchase the shares of the predecessor company or ask the franchisees to sign new subleases directly with the successor company. Franchisees would presumably require concessions before agreeing to do this. It would be prudent to take this into account when advising on a potential purchase of a retail franchise system.
It is not surprising that the courts are beginning to view the property law aspect as distinct from the strictly contractual rights of the franchise agreement. Franchisors who choose to maintain a headlease-sublease relationship enjoy tremendous powers compared to parties in a typical licencee-licensor or distributorship relationship. While franchisors are accustomed to terminations, courts generally do not look favourably upon the remedies of re‑entry and forfeiture. They have insisted on strict compliance with notice requirements and will treat improper lease terminations as trespasses. If the franchisor’s intent is for the franchisee to contract out of tenant protection legislation, specific wording to that effect is required in the sublease.
The lesson of Majdpour and 3P3W Holding Co. is that bad practice, however widespread, does not make good law. The preferred approach is to analyze the franchise agreement and lease separately and with regard to their distinct legislative underpinnings. Rather than viewing the sublease as a collateral or secondary agreement, a franchisor must strictly follow all statutory and contractual conditions concerning the leasehold relationship. Effective representation requires counsel to be ever mindful of these differences.
For a discussion of the application of subsection 39(2) of the CTA in franchising, see F. Zaid, Canadian Franchise Guide Vol. 1, Carswell Looseleaf ed., pp. 2-967 to 2-968 and M. O’Reilly, Q.C. “Bankruptcy and Insolvency – Its Effect on Franchising” 45 C.B.R. 182
See Re 780046 Ontario Inc. and Columbus Medical Arts Building Inc. (1994), 20 O.R.(3d) 457 (C.A.); Ellis v. Breslin (1974), 2 O.R. (2d) 532 (H.C.J.); Mount Citadel Ltd. v. Ibar Developments Ltd. (1976), 14 O.R. (2d) 318 (H.C.J.); Koumoudouros v. Marathon Realty Co. (1978), 21 O.R. (2d) 97 (Div. Ct.)