Archive for August, 2012

Three’s
Company
Lease Negotiations
Involving Franchisors
By Gary A. Kravitz
 

Lease negotiations are normally a two-party activity; the
landlord and the tenant go head-to-head to work out
the best deal. When dealing with a franchisee as a ten-
ant, however, a third party often lurks in the background: the
franchisor. With more than 900,000 national franchised busi-
ness establishments, growing at a 4.3% annual rate according
to the International Franchise Association, landlords and their
counsel need to be aware of potential pitfalls-and benefits-
of having that third party at the negotiating table. This article
will explore the various ways franchisor involvement can
affect the course of lease negotiations.
Many franchisors have a standard addendum they require
franchisees to add to a lease. The addendum is designed to
protect the franchisor’s interests in the transaction. These
interests run the gamut from making sure the franchisee is
operating according to certain specified standards to protect-
ing the location for the franchise and for potential future
franchisees. Contrary to first impressions, landlord interests
do not necessarily run counter to franchisor’s. The parties can
reach a mutually beneficial arrangement-one that offers the
landlord greater long-term security and protects the interests
of the franchisor. For the purposes of this article” franchisee”
should be considered generally the same as tenant. The term
“tenant” will be used when discussing an issue that would
relate to nonfranchisee tenants as well.
Regardless of whether counsel represents landlord or
tenant, it is to everyone’s advantage to disclose the existence
of any franchisor addendum at the outset of the negotia-
tion. The landlord and its counsel do not appreciate being
surprised with additional terms at the end of a negotiation,
and the parties are likely to work out a more comprehensive
and mutually beneficial solution if all the facts are laid out in
advance. Nevertheless, landlord’s counsel must be aware of
the possibility that a franchisee will be subject to a franchisor
addendum and should inquire if one exists before starting
negotiations.
Although the goals of each party in a lease negotiation are
different, there are areas where the goals of the franchisor and
landlord coincide.
 

A landlord’s goals are simple: (1) limit the number of land-
lord’s obligations and liabilities, (2) eliminate opportunities for
franchisee or franchisor to terminate the lease, and (3) maintain
security interests such as guaranties, liens, and security deposits.
The landlord also wants to maintain consistency between the
lease and the addendum and avoid having conflicting obliga-
tions to the franchisee and the franchisor.
The franchisor’s goals relate to both the lease and the fran-
chise itself: (1) protect the location, (2) protect the franchise’s
reputation (that is, have control over a troublesome franchisee),
and (3) maintain consistency across franchise operations. The
tenant has little interest in franchisor addenda apart from making
sure that the deal gets done. The next sections address several
common clauses in franchisor addenda. Fortunately, sufficient
middle ground exists to satisfy the needs of each party.
Franchisor addenda frequently include a clause allowing the
franchisor to take an assignment of the lease. These provisions
take different shapes, but the common thread is that the fran-
chisor is given the right to take an assignment in the event of a
franchisee default-either under the lease or under the franchise
agreement. From a landlord’s perspective, this provision can be a
great advantage because it provides additional security. It affords
the landlord another ready and available party to take over the
lease if the original franchisee defaults. More importantly, the
franchisor will likely have deeper pockets than its franchisee.
Landlord’s counsel should make sure that the assignment provi-
sion contains adequate notice requirements, however, so that the
landlord will know which entity is responsible under the lease.
The keys to making this provision work for all parties are
knowing who is responsible for the liabilities of the defaulting
franchisee and clearly identifying those responsibilities in the
addendum. Generally, the franchisor will take the position that
the liabilities of the franchisee stay with the franchisee, and the
franchisor will not have to assume its existing debts. This ap-
proach would result in the landlord pursuing the franchisee for
outstanding debts. Landlords, of course, will take the position
that the franchisee was chosen by the franchisor, and the franchi-
sor should share in the burden of the franchisee’s failure to meet
its obligations. The resulting language in this provision often will £
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be determined by the relative leverage of the parties.
Assignt:nent to New Franchisee
Closely connected with the above provi-
sion is a second assignment clause allowing
the franchisor to assign the lease to a new
franchisee. As with the assignment to fran-
chisor provision, the landlord can benefit
from this clause. Having another franchisee
take over the lease, particularly when faced
with a defaulting franchisee, is a welcome
event—especially when another new tenant
may not be readily available. Franchisors
desire this provision because many franchi-
sors either do not have a business plan that
includes company-owned stores or may not
have the administrative capacity to manage
a company store in a location far from corpo-
rate headquarters. Allowing a franchisor to
assign the lease to a new franchisee gives the
franchisor the ability to continue business in
a desirable location or target market.
One way to address this provision is to
determine under what conditions a franchi-
sor will be able to make an assignment. The
addendum may not contain any limita-
tions on the free assignment of the lease by
the franchisor. Under these circumstances,
however, a landlord could argue that having
a new franchisee is akin to having the lease
start anew. With that understanding, land-
lord’s counsel should require that any new
franchisee be subject to the same review and
approval requirements as an original fran-
chisee. The landlord could retain the right to
request a review of financial statements, tax:
returns, and other financial indicators before
approving a new franchisee as a tenant. In
addition, the landlord may want to require
a guaranty and security deposit from a new
franchisee. With these protections in place,
the parties can balance the business needs of
both the landlord and the franchisor.

Franchisor addenda also can have a tertiary
effect on the default clause of the lease.
Franchisors have an obvious interest in
knowing when or why a default leading
to a termination might arise. They want to
protect the location and protect against er-
rant franchisees. In addition, as noted below,
a franchisor may even want to add to the
list of possible defaults to protect its interest
under the franchise agreement.
Notice of Defaults
Most franchisor lease addenda contain
a requirement that the landlord give the
franchisor notice of defaults that occur
under the terms of the lease. A franchisor
may not have day-to-day knowledge of
the operations of each of its franchisees
and may not have the capacity to per-
form regular reviews. In such cases, the
franchisor relies on landlord notices to
advise of trouble because the franchisor
will not always know if the franchisee
is working within the terms of the lease
agreement. Notice from the landlord of
the franchisee’s default affords a franchi-
sor the ability to address a breach in the
lease while options are still available. The
landlord also benefits from this require-
ment by having a second party ready to
cure a breach of the lease (or as discussed
above, accept an assignment of the lease).
From the landlord’s perspective, the
more parties available to cure a potential
default and pay rent, the better. Even if
the default is not one that could lead to
immediate termination, a franchisor that
receives multiple notices of default from
the landlord should recognize that the
franchisee is in need of assistance.
The notice requirement might appear
harmless at first, but it contains many
potential problems for the landlord that
need to be addressed. Initially, land-
lord’s counsel must make sure that the
landlord has the capacity to provide an
additional notice. Some landlords may
be too small to have the administrative
wherewithal to provide an additional
notice; quite simply, they may forget
to even look at lease addenda when
considering notice requirements. Further,
landlords who work from computerized
lease abstracts instead of the full leases
themselves may not have a system that
allows for a second party to receive no-
tice. If the computer program allows for
it, possibly the simplest way to address
the notice issue is to add the franchisor as
a specified party to receive notice in the
lease itself rather than just in the adden-
dum. This way, the obligation to provide
notice to the franchisor is in plain sight.
If the landlord agrees to provide
notice, and the provision is left in the
addendum rather than moved to the
lease, landlord’s counsel must consider
another critical issue. The notice lan-
guage should be consistent between
the lease and the addendum. In many
landlord form leases, a landlord does
not have to provide notice in the event
of a failure to pay rent. Landlords argue
that the tenant should know rent is due
at specified times and should not need
a written reminder of that ongoing and
unchanging obligation. There may even
be other automatic defaults in the lease
that also do not require notice from the
landlord. If the landlord’s form lease
does not require notice to its tenants, but
the franchisor addendum requires notice
of all defaults to franchisor, the landlord
may have unwittingly agreed to provide
notice when none is regularly given.
As this discussion suggests, it is criti-
cal for landlord’s counsel to ensure that
the landlord’s notice requirements, what-
ever they may be, are consistent between
the lease and the addendum. A simple
solution is for the landlord to agree to
give the franchisor only those notices
given to the franchisee, thus eliminating
what may become a separate obligation
with different terms. At a minimum, if
the parties are negotiating the lease and
addendum at the same time, the notice
requirements, whatever they may be,
can be drafted in a consistent manner
and agreed to in both the lease and the
addendum.

Along with notice, cure requirements
often appear in franchisor lease ad-
denda regarding defaults. These clauses
afford the franchisor the right to cure the
franchisee’s defaults and an additional
time period to cure such defaults. As
noted previously, granting the franchi-
sor the right to cure a franchisee’s breach
benefits both parties and should be freely
granted by landlords. The additional
time period to cure, however, can be
more problematic. This provision can
take several forms, such as a simple 30-
day time period to cure a lease default or
a requirement that a second written no-
tice be sent to the franchisor in the event
that the default was not cured within the
standard time provided. There are other
variations, but the bottom line is that the
franchisor is demanding additional time
to provide a cure.
From the franchisor’s standpoint, this
provision makes sense: the franchisor
may not be aware of the daily operations
of the franchisee, or the franchisor may
require additional time to review the
problem and assess the appropriate
remedy. Or the default may be a critical
one, and the franchisor may need time
to assess whether to take control of the
location or seek out a new franchisee.
Whatever the reason, the result for the
landlord is the same-increased delay
before a default under the terms of the
lease can be properly addressed.
A landlord’s receptiveness to provid-
ing additional time to cure rides mainly
on two factors: the economy and the
financial security of the franchisor. 1£ the
economy is strong, a landlord may have
a long list of tenants ready to occupy
the space in question. In this case, a
landlord may have no patience to deal
with a problem tenant. Conversely, if
the economy is poor and there are no
prospective tenants, the landlord may
want to make considerable efforts to
keep the franchisee in the space, so long
as the cost of doing so does not exceed
the rent paid.
In addition, the landlord’s response
to this issue may ride on the size and
draw of the franchisor. Is this a business
that draws a good deal of traffic into the
property (particularly important with
shopping centers)? Does the franchisor
have a large, financially sound operation
with the capacity and desire to take over
the space and operate the unit in default?
Either way, a landlord that agrees to pro-
vide additional notice should make sure
that the time period is reasonable and
that the trigger for a franchisor response
is clear. During this extended cure pe-
riod, the franchisor will likely determine
whether it will take over the location as
a corporate-owned store or with a new
franchisee.
On the one hand, a landlord should
avoid being stuck in the position of
suffering a defaulting franchisee that is
continuing operations on the premises
or, if the franchisee simply vacates the
premises, having a vacant space for an
unnecessarily long period of time. A
landlord should have the opportunity to
secure a new tenant quickly, if necessary,
because a vacant space or a problematic
tenant can injure the reputation of the
landlord’s property and have an adverse
effect on the landlord’s relationship with
its other tenants. On the other hand,
having a franchisor willing to step into
its franchisee’s shoes may be worth the
wait in a slow economy.
One additional factor that should be
considered when dealing with notice
and cure provisions is the type of default
under the lease. Not all defaults are cre-
ated equal or viewed in the same light
by all parties. A landlord may be willing
to allow for a delayed cure for a minor
technical breach of the lease, but not so
willing if a franchisee is two months
behind on rent. A landlord should be
wary of agreeing to wait an additional
30 or 45 days before possibly receiving a
rent payment or being able to exercise its
remedies under the lease. When con-
fronted with the specific issue of defaults
on the payment of rent, the parties can
consider a provision requiring the fran-
chisor to pay the past due rent while the
franchisor weighs its long-term options.
Frequently a franchisor addendum
will state that a franchisor’s cure of a
default does not constitute an assump-
tion of the lease. Such a provision should
be acceptable to landlords, because it
means the franchisor makes the land-
lord whole again, and the landlord can
proceed against the franchisee for any
ongoing defaults. There are certain
circumstances, however, when a land-
lord may have a tenant that repeatedly
defaults under the lease and cures at the
last possible second. In such cases, the
tenant is using the cure period as an ex-
tension of time on rent payments, which
causes the landlord to incur significant
administrative costs. Although this issue
goes beyond the scope of this article,
landlord’s counsel should ensure that
language is included in the lease, under
all circumstances, that penalizes a tenant
for repeated defaults under the lease.

Some franchisors take the additional step
of requiring landlords to provide notice
of any correspondence that pertains to
the lease, even if such correspondence
does not relate to a default. In addi-
tion, franchisors may insert clauses that
require landlords to provide notice to the
franchisor in the event of an assignment,
sublease, or modification to the lease.
Typically, these situations will require
franchisor approval before any action
takes place.
 

It is easy to see why a franchisor would
want to know about these events-they
may have a considerable effect on the fran-
chisor’s rights. The landlord, however, will
have to consider whether the addendum
is the best place for this provision. First, as
with notices of default, the landlord must
determine whether it has the administrative
capacity to send out these additional notic-
es-particularly when there is no default or
other trigger to send such a notice. Second,
a landlord may reasonably ask why such a
burden should be its responsibility.
Because the landlord does not have the
direct relationship with the franchisor, the
landlord may determine that it does not
want to be in the middle of the franchisor’s
relationship with its franchisee. In those
instances, the landlord can suggest that such
notices should come from the franchisee
to the franchisor. The landlord may also
decide that it does not want the burden
of determining whether the franchisor’s
approval has been obtained before one of
these actions takes place. More importantly,
a landlord will want to avoid making its
failure to provide notice to the franchisor a
default under the lease. That being said, the
franchisee’s success will rely heavily on sup-
port from its franchisor. A careful landlord
will want confirmation that the franchisor
concurs with its franchisee’s actions. There-
fore, in the event that the landlord does not
agree to provide notice to the franchisor,
the landlord can still consider requiring the
franchisee to confirm in writing that it has
obtained its franchisor’s approval when
such events (for example, an amendment to
the lease) occur.

Some of the remedies that a franchisor
may request, as discussed previously, are
reasonably free of conflict. For example,
assignment of the lease to the franchisor on
franchisee’s default is generally acceptable
and may be a preferred alternative for the
landlord given that the franchisor is likely in
better financial condition than the franchi-
see. Other franchisor remedies may be more
problematic. One such remedy would allow
the franchisor to “take over” the lease for
a set time period, six months, for example,
but not have any liability under the lease
(that is, the franchisee is still the responsible
party). This provision places a landlord in
an impossible position: the landlord can
neither evict the franchisee nor make any
long-range plans without knowing whether
the franchisor will ultimately take over the
location. In this case, the landlord should
be allowed to terminate, or at least limit,
the franchisor’s occupancy period if the
landlord secures a new tenant.
The limitation of liability provision in
the franchisor’s “take over” remedy is also
a source of dispute. This type of provision
states that the franchisor is responsible for
paying rent and for day-to-day operations
only during the applicable time period and
that the franchisor has no ongoing liabilities
under the lease. If the existing franchisee is
already in default, presumably for failure
to pay rent, the landlord should be wary of
allowing the franchisor to continue operat-
ing the business. In such a situation, the
landlord is left with no one, other than a
defunct franchisee, to take responsibility for
the liabilities that existed before the franchi-
sor took over the lease or for subsequent
liabilities beyond the mere obligation to pay
rent. Here a landlord may well require the
franchisor to either accept an assignment of
the lease with an assumption of its duties
and liabilities or allow the landlord to evict
the tenant. Presumably, if the landlord has
agreed to give the franchisor the right to
cure defaults on behalf of the franchisee
(and possibly has given the franchisor
the right to additional time to implement
a cure), the franchisor should have ad-
equate time to make a determination about
whether the location is worth keeping.
Franchise Agreement Defaults
One common clause in franchisor lease
addenda does place landlords squarely in
between the franchisor and franchisee. It
also threatens to undermine the integrity
of the lease agreement by providing the
franchisee and the franchisor a way out
of the lease. This clause provides that any
default under the franchise agreement
triggers a default under the lease. Although
the franchisor has an interest in limiting
its liabilities and terminating obligations
if a franchise relationship does not work
according to plan, a landlord should not
have to grant a third party the ability to
terminate the lease. Such a remedy puts the
landlord in between the franchisor / franchi-
see relationship. landlords will not want
to be in the position of having to terminate
a lease because of a technical default under
the franchise agreement. A landlord may
reasonably propose that if the franchisor
does not approve of the operations of
its franchisee, the franchisor can termi-
nate its agreement, remove branding
and equipment, and employ whatever
other remedies it has under its franchise
agreement. The franchisee’s lease agree-
ment with the landlord, however, should
remain, and the landlord and franchisee
will have to determine separately how
or whether that contractual relationship
will continue.

In addition to notice from landlords,
franchisor addenda often include the
right of the franchisor to inspect and
repair or modify the premises. Allow-
ing the franchisor onto the property will
presumably permit the franchisor to spot
problems and assist the franchisee before
a crisis occurs. Nevertheless, the landlord
should consider certain protections and
restrictions before providing a franchisor
unlimited access to the premises and the
unlimited right to make repairs on the
franchisee’s behalf.
First, the landlord could require that
the franchisor indemnify the landlord
in case the franchisor causes damage
on the property. Second, the landlord
could require that the franchisor provide
additional insurance-particularly if the
franchisor is making improvements on
the property-with the landlord listed as
an additional insured. Landlords should
also consider limitations on what type of
improvements the franchisor is allowed
to construct.
Landlord form leases often have
extensive language restricting when and
what improvements a tenant/franchisee
can make. Similar restrictions should be
employed when the franchisor is making
the improvements, for example, requir-
ing the landlord’s reasonable input and
review of the improvements. Also of
critical concern is what happens to such
improvements once the term of the lease
expires. Do the improvements become
the property of the landlord? Does the
franchisor have to remove the improve-
ments? Can the landlord specify specific
improvements that must be removed
at the expiration of the lease, and when
should the landlord make such a speci-
fication? landlords should be prepared
to discuss all of these issues during lease
negotiations.
 

The final addenda item to address is a
landlord security instrument that often
directly conflicts with the standard se-
curity interests of franchisors. Quite fre-
quently, landlords want to take a security
interest in the equipment and inventory
of a franchisee. Some states currently af-
ford landlords a statutory lien right over
tenant’s equipment and inventory. See,
e.g”f Ariz. Rev. Stat. § 33-362; Fla. Stat.
Ann. § 83.08; Or. Rev. Stat. § 87.162; Va.
Code Ann. §§ 55-230, 55-231. Where the
statutory framework is missing, land-
lord’s counsel can seek to provide for a
landlord’s lien in the lease.
In those leases involving a franchisee,
the franchisor will be, in many instances,
the party that provides the equipment
and inventory for the franchisee’s opera-
tions either on a rental or financed basis.
A franchisor will likely have a security
interest on such equipment and inven-
tory to protect the franchisor in the event
the franchisee is unable to meet its obli-
gations. Given that the franchisor has an
ongoing or equity interest in the equip-
ment and inventory, it makes sense that
the franchisor should have the priority
interest. In these instances, the landlord
can either eliminate or subordinate its
lien interests. The landlord can instead
rely on its other security measures, such
as security deposits and guaranties, to
protect itself. Further, in those states
(Arizona, Florida, Oregon, and Virginia)
where the landlord has a statutory lien
on tenant’s equipment, a franchisor
might request that the landlord provide a
lien waiver.

As with many lease negotiations, the
outcome of these various issues depends
on which party has the greatest amount
of leverage. Nevertheless, there is often
enough middle ground to arrive at a
solution that works well for all of the
parties. By knowing about the issues
that can arise in franchisor addenda and
bringing them to the negotiation table
both the landlord and the franchisor can
realize greater protection than if they
were operating without a franchisor addendum.


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