The Lease Rider: An Essential Tool for Franchisors
By Mark D. Shapiro and David G. Gunther
Location.Location.Location. The old adage certainly applies to franchises—from gyms to muffler shops to fast food restaurants. The quality of a location can make or break a business. And, in the aggregate, the quality of locations can make or break a franchise system. The success of a franchise system is closely tied to the strength of its sites. Key considerations in approving new locations include geography, visibility, demographics, accessibility, competition and price. When a franchised business opens at a high quality site, the franchisor wants to ensure that the unit will remain in the franchise system, even after the initial operator is no longer a franchisee. Franchisors not only seek to build general goodwill for their brand, but also seek to build "locational goodwill" at specific sites in specific areas. In order to do so, however, franchisors need to control the real estate where their franchises are located.
It is essential for franchisors to ensure their sites remain in the system when the franchisee's term expires or terminates. Maintaining control over a large number of real estate sites, though, is a difficult task. Franchisors generally do not have the capital or the opportunity to own their franchised sites. Franchisors are also generally unwilling to directly lease franchise sites, due to high costs, liability risks and other logistical issues. How then can a franchisor control a site when it lacks an ownership or leasehold interest in the real estate?
A franchisor typically solves these problems by requiring its franchisees to present prospective landlords with a lease rider, which contains terms intended to protect the franchisor. By obtaining the landlord's consent to a rider and claiming status as an express third-party beneficiary to the lease, a franchisor can effectively control a site without relying on its franchisee and without additional expenditure.
In order to effectively negotiate a lease involving a franchised site, it is absolutely crucial to understand the issues involved in a franchise lease rider. This is true regardless of whether you represent franchisors, franchisees/tenants or landlords.
I. Negotiating a Rider
There is no single standard way to negotiate a rider. In some cases, a franchisor will participate directly in the lease negotiations between the franchisee and landlord. In other cases, the franchisor will convey its expectations to the franchisee and have it negotiate the rider with the landlord. Regardless of who negotiates the rider, it is crucial that the rider be presented to the landlord at the outset of the lease negotiations. If a franchisor or franchisee waits until the lease is fully or almost fully negotiated before presenting the rider, the landlord may become frustrated and inflexible due to the significant last minute points being raised. A landlord is more likely to accept a rider if it is presented early and negotiated along with the other lease provisions.
II. Standard Provisions in a Rider
The provisions contained in riders are generally standardized. Below are several typical key provisions:
•Use Clause
A "use clause" limits the tenant's right to use the leased premises to the specified type of business to be operated under the terms of the franchise agreement, and prohibits the tenant from makinganyother use of the premises. Occasionally, the use clause will even specify the trade name of the permitted business. Limiting use of the leased premises to the franchised business provides franchisors with additional assurance that the franchisee will not operate or allow another party to operate in violation of the franchise agreement or a related non-compete provision.
• Notice and Opportunity to Cure
A "notice clause" provides that the franchisor must simultaneously receive all notices sent by the landlord to the tenant in connection with the lease or premises. This allows the franchisor to monitor the status of the lease and the tenant's compliance with it. This provision also typically grants a franchisor the right to cure its franchisee's default under the lease. This cure right is an option rather than an obligation. The right to receive notice and the right to cure allows a franchisor to prevent the landlord from terminating the lease upon the franchisee's default. By curing a default that would give rise to termination, a franchisor avoids the possibility that a replacement tenant would capitalize on the franchisor's locational goodwill.
• No Amendment
A "no amendment" provision prevents the landlord and tenant from subsequently renegotiating the lease—specifically the franchisor-mandated provisions—without the franchisor's consent. In some cases, this restriction is limited to amendments that will adversely affect the franchisor. Without such a clause, the rights secured in the rider could be undone. Some provisions also prevent the tenant from renewing, terminating or changing the term of the lease without the franchisors' consent. This restriction ensures that the franchisee has a location at which to operate for the entire term of the franchise agreement, and precludes the franchisee from operating at the premises following expiration of the franchise agreement.
• Lease Assignment
Perhaps the most important provision in a rider is the "lease assignment" provision. A lease assignment provision requires that the tenant offer to assign its rights under the lease to the franchisor in the event that tenant has defaulted under the lease or franchise agreement. The assignment right can also be triggered if the tenant fails to exercise a renewal option under the lease or franchise agreement. The franchisor should negotiate the timing and length of the option so that it has sufficient time to exercise its option before the landlord can terminate the lease. Some franchisors will also attempt to limit the rent arrearages it will be required to pay the landlord (or other monetary defaults required to cure) in order to assume the lease. Landlords, however, are understandably reluctant to agree to such limitations and generally require the franchisor to fully cure any default before assuming the lease.
Another contentious issue involves the franchisor's ability to the use the lease assignment provision to designate a replacement franchisee and refranchise the site to a new franchisee, without directly assuming the lease. Franchisors often prefer this option because it allows them to avoid successor liability issues. Landlords, however, justifiably seek to retain the right to approve who their tenant will be and to perform creditworthiness diligence. A reasonable compromise is for the landlord to pre-approve a new franchisee that meets described net-worth requirements or is an existing operator within the system with several years of operational experience.
III.The Enforceability of Riders and Lease Assignment Provisions
The provisions in a rider are only useful if they can be enforced by the franchisor against both the franchisee and the landlord. One way to ensure that the franchisor can enforce the rider is for it to be a party to the rider. Although franchisors are sometimes reluctant to actually sign a rider, a carefully drafted rider can make clear that the franchisor will not have any liability unless and until it expressly assumes the lease obligations. Alternatively, the rider can clearly state that the franchisor is an express intended third-party beneficiary, with the ability to enforce the beneficial rights granted to the franchisor in the lease documentation. Lease assignment provisions are so crucial that sometimes a franchisor will seek to enter into a separate triparty collateral assignment agreement with the franchisee and landlord.
Courts will generally enforce lease assignment provisions in favor of franchisors, especially when the franchisor's enforcement rights are acknowledged by the landlord. The seminal case in this area isSnelling & Snelling v. Martin, Bus. Franchise Guide (CCH) ¶11,384 (N.D. Cal. Jan. 28, 1998). In upholding a lease assignment provision, the court noted that "the lease assignment provision in this case is apparently intended to allow Snelling to retain clients who are familiar with the precise location of the business; if defendants remain in the premises and Snelling is forced to operate elsewhere, it loses the intangible benefit of that location." See also, Dunkin' Donuts v. Taseski, 47 F.Supp. 2d 867 (E.D.Mich. 1999). The New Jersey Supreme Court has likewise upheld the enforceability of a similar provision and compelled a terminated franchisee to turn over the leased premises.Dunkin' Donuts of America v. Middletown Donut Corp., 495 A.2d 66 (N.J. 1985).
There are, however, exceptions to this general rule. Courts are more reluctant to enforce a lease assignment provision if the landlord has not expressly consented to it. InTrientPartners I v. Blockbuster Entertainment Corp., 959 F.Supp. 748 (S.D. Tex. 1996), the court refused to allow a franchisor to assume its franchisee's lease upon expiration of the franchise agreement. The court noted that the lease assignment provision would only be triggered by the franchisee's default and not by the mere expiration of the franchise agreement. Moreover, the court questioned whether the lease assignment provision was at all enforceable insofar as there was no privity between franchisor and franchisee. While this portion of the opinion was dicta, it highlights the importance of ensuring that the lease expressly identifies the franchisor as a third-party beneficiary under the lease, with express right to take an assignment of the lease. Likewise, inDanbury Mall Assocs. Ltd. P'ship v. Mazel Enterprises, CV030347873S, 2004 Conn. Super. LEXIS 1919 (Conn. Super. Ct. 2004), a landlord was permitted to ignore a franchisor's rights under a collateral assignment agreement with its franchisee where there was no evidence that the landlord had ever consented to such an assignment. These cases highlight the importance of a franchisor obtaining a landlord's explicit consent to a lease assignment provision or a collateral assignment provision.
IV.Conclusion
Franchisors use riders as a crucial tool in controlling the sites where there franchises are located. Lawyers who represent franchisors should be well versed in rider provisions and prepare a standard form rider that it can present to landlords early in the process. Lawyers who represent franchisees and commercial landlords should also be familiar with riders so that they can efficiently and effectively address franchisor concerns during lease negotiations and when problems may arise under the lease. •
Shapiro is a partner and Gunther is an associate at Hyland Levin in Marlton, NJ. Both are members of the firm's Franchise and Distribution Law Group.
Reprinted with permission from the October 5, 2015 issue of the New Jersey Law Journal.
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