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Lease of the Premises by a Third Party with Option in Favor of Franchisor. Moderator: Carl Zwisler Gray Plant Mooty Washington, DC 2010 IDI Annual Conference Torino, Italy June 11-12, 2010 . Be Careful What You Wish For.

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lease of the premises by a third party with option in favor of franchisor

Lease of the Premises by a Third Party with Option in Favor of Franchisor

Moderator:

Carl Zwisler

Gray Plant Mooty

Washington, DC

2010 IDI Annual Conference

Torino, Italy

June 11-12, 2010

be careful what you wish for
Be Careful What You Wish For

There are two tragedies in life. One is to lose your heart’s desire. The other is to gain it.”

- George Bernard Shaw

slide3
In the US, one FDD item requires disclosures about the duties of the franchisor to a franchisee. The first requirement in this item is:
  • Describe the franchisor’s obligation to the franchisee in locating a site and negotiating the purchase or lease of the site. If such assistance is provided, state:
  • Whether the franchisor generally owns the premises and leases it to the franchisee
  • Whether the franchisor selects the site or approves an area in which the franchisee selects a site…
slide5
They also disclaim liability to the franchisee for their role in appraising a site or the terms of its lease, claiming that the final decision over these issues belongs to the franchisee.
franchising and subleasing are distinct businesses
Franchising and Subleasing Are Distinct Businesses

At its essence, franchising is shifting investment obligations and risks to franchisees.  If a franchisor will not invest in businesses operated by a franchisee, why would it invest in the real estate from which a franchised business operates?

slide7
In most franchise programs, the franchisor's marginal costs of granting a new franchise are recovered from initial fees. Thereafter, the franchisor's exposure to risk is principally from litigation from franchisees.
  • By subleasing, a franchisor exposes itself to months or years of liability if a franchisee does not pay rent.
  • Commercial real estate is a business. It is different from franchising. Being in the real estate business only makes sense if it is an independently profitable business, and the returns from subleasing include a risk premium.
slide8
When a franchisor takes over a franchisee’s store, the franchisee has usually fallen several months behind in royalties, rent and other amounts owed to the franchisor.
slide9
Most franchisors make little on rent they charge their franchisee subtenants. When franchisee/tenant defaults or is terminated, franchisor must find a new franchisee and/or hire a manager to operate the business. Often, reason for the default is related to the location.
slide10
Operating as a company owned store or re-franchising the store may be the only way to protect the lease investment.

What does it do for the brand?

what is the risk of subleasing
What is the risk of subleasing?

Owning a location which is unprofitable for the franchisee, and having to recruit a new tenant or franchisee to occupy the location to reduce losses. Consider some statistics relating to vacancy rates:

slide13
India:

Mall Vacancy Rate:  30%, Rents Falling

- Zmarter.com finances May, 2010

slide14
Exxon Mobil announced yesterday it's had it with the measly returns on selling gas to consumers.  Following the industry trend away from the retail gas station business, the oil giant plans to unload the 2,200 stations it still owns.

BP expects to be rid of its company-owned stations in the US by the end of next year and Conoco Phillips is nearly out of the business altogether.

  - www.minyanville.com June 13, 2008

slide15
If the objective is to control the location, keep it affiliated with the franchise brand, but avoid the risks of subleasing, conditional lease assignments or lease riders are the instrument of choice for most US franchisors.
elements of a conditional lease assignment17
Elements of a Conditional Lease Assignment

Amendment to Franchisee’s lease signed by Landlord and Franchisee

  • Landlord must be a party

Incorporates references to Franchise Agreement

  • No mistake about relationship between Franchise Agreement and Lease
slide18
Restricts use of premises to the franchised business
  • Establishes a basis for Franchisor to assume control if Franchisee attempts to change the use of the premises

Requires notices of default and termination to be delivered to Franchisor in time for Franchisor to act

  • With notice Franchisor can decide whether to help Franchisee comply, or whether to assume the lease and search for a new Franchisee for the location
slide19
Franchisor has the option, but not duty, to cure breaches
  • Avoids liability arising from a sublease

Franchisor has the right to enter the premises to cure breaches

  • Self-help cure rights always depend upon the Franchisor not breaching the peace.
  • In many jurisdictions self-help cure rights are not enforceable and may be treated as an unlawful trespass
slide20
Franchisee has unconditional right to assign lease rights to Franchisor or its affiliates or successors, without changes in lease terms, and without executing a guaranty of the Lease
  • Gives flexibility to Franchisor as to the entity which will hold the lease if the Franchisor exercises the option.
slide21
Lease assumption only occurs, and Franchisor only assumes liability, after notifying Landlord and Franchisee of its assumption
  • Avoids disputes about whether and when Franchisor incurs lease liability
slide22
Franchisor is not liable for pre-assumption obligations of Franchisee to Landlord
  • Allows Franchisor or its assignee to be treated as a new tenant. Landlord can pursue claims it has against the Franchisee and its guarantors (if any)
slide23
After assuming the lease, Franchisor may assign lease to a new Franchisee, with Landlord’s consent, but without changes in lease terms
  • Gives Franchisor flexibility to operate business as a “company owned store” until a new Franchisee can be recruited for the location
optional components
Optional Components

Franchisor has right to receive all reports of sales, income that Landlord receives from Franchisee

  • Aids Franchisor in corroborating Franchisee reporting, and may alert Franchisor to issues not regularly identified in its own reports
slide25
Landlord has right to receive notices of default or termination from Franchisor.

Allows Landlord to have advance notice of potential problems.

  • May accelerate Landlord’s exercise of remedies against Franchisee
benefits to landlords of conditional lease assignments
Benefits to Landlords of Conditional Lease Assignments
  • The franchisor may become the landlord's "partner" in quickly finding a new tenant to keep the premises occupied, using the same brand, maintaining the same tenant mix.
slide27
The landlord's willingness to sign a conditional lease assignment may induce a franchisor to approve other locations owned or managed by the landlord for future franchisees.
  • As use of conditional lease assignments has become a standard for many franchisors, landlords who wish to attract franchisee tenants have a competitive advantage over those who do not. In the US franchising accounts for approximately 40% of retail sales.
benefits of conditional lease assignment franchisor perspective
Benefits of Conditional Lease Assignment - Franchisor Perspective
  • The CLA substantially reduces the likelihood that a franchisee will break away or not renew at the end of its franchise term if it is a successful operator.
  • If a franchisee is unsuccessful and breaches lease, the franchisor has the opportunity to preserve the location and its reputation with the landlord.
slide29
Except for the benefit of  rental income, a franchisor acquires every advantage of a sublease, but none of the risks, and none of the financial statement liabilities.
  • In international franchising in countries which prohibit foreign property ownership or foreign business operation, a CLA allows a foreign franchisor to control real estate, without owning it.
slide30
Thank you.

Carl E. Zwisler

Gray Plant Mooty

2600 Virginia Avenue, NW

Suite 1111 – The Watergate

Washington, DC 20037

Phone: 202-295-2225

Facsimile: 202-295-2275

carl.zwisler@gpmlaw.com