How to Avoid Common Pitfalls of Franchise Leasing

By Scott Frank, Esq.

Leases with nationally branded retail franchise tenants can be a real boon to a shopping center. That coffee, donut, or hamburger shop, or the family hair salon, can become a great traffic generator that helps increase the revenues of all your center's tenants.

However, a typical lease with one of these entities can require you to give up quite a bit of control over how the space is operated or who is operating in the space. This is because many national franchisors require having a say in the lease between their franchisee and the owner. Just as the owner has a financial interest in the reputation of its center, so too does the franchisor have a financial interest in the reputation of its brand.

As the owner of a franchise-attractive location, one of your biggest concerns when drafting the lease agreement should be the potential termination of the franchise agreement. It is one thing to have your premium endcap space bearing the name of one of the nation's top hamburger chains, and quite another to have that name replaced by something in the realm of “Bob's Burger Palace” (with apologies to any purveyor of a Bob's Burger Palace). There are two ways to avoid this occurrence—one preferred by the owner, and one preferred by the franchisor.

As the owner, your preference would be to incorporate the franchise agreement into the lease to the extent that a termination of the franchise agreement would be an automatic default under the lease. This would allow you to exercise your remedy rights, including eviction, without giving the franchisee-tenant the ability to cure the default.

The franchisor's preference would be to allow for an automatic conveyance of the tenant's lease rights to the franchisor, which could then freely assign those rights to any other tenant/franchisee that it sees fit.

Negotiate a Compromise

The creative franchisor and owner see a third option, which protects both parties' interests. This option incorporates the best of both ideas: It provides in the lease that a termination of the franchise agreement is a default under the lease, while allowing the franchisor to cure that default by assuming the lease directly. While this solution allows both parties to maintain what is most important to them, you still need to address one glaring problem: what to do about a (now-former) franchisee-tenant who may not willingly surrender its lease rights.

A well-thought-out lease will make provision for this possibility. You can include a clause that spells out what happens in the event the lease is terminated due to the termination of the franchise agreement. Like our Model Lease Clause: “Make Termination of Franchise Agreement a Lease Default,” in this issue, your clause should say that, provided that the franchisor executes a lease assumption agreement whereby the franchisor agrees to be responsible for the full compliance with the lease provisions from and after the time that the termination and eviction proceedings are commenced, the owner agrees:

• To pursue an eviction proceeding against the franchisee; and

• Upon final judgment, to grant possession to the franchisor.

Get Right to Approve Subsequent Tenant /Franchisee

Once the original franchisee is removed, who gets to decide who the next tenant/franchisee will be? While granting franchises is clearly a right within the purview of the franchisor, you have a very real interest in knowing who your tenant will be, and whether the next tenant will work out better than the last one. These competing interests can also be adequately addressed through careful lease drafting.

One approach is to get the right to reasonably approve any replacement franchisee. This would include the right to review the financial information and operating background of the proposed replacement tenant, so that you can feel assured that the lease obligations will be met by the replacement tenant.

Note, however, that some of the larger franchise operators may balk at this requirement, viewing it as an intrusion into their business operations. One compromise position is to incorporate the franchisor's then-current franchisee standards (minimum net worth, business history, and so on,) into the lease and to require any future replacement tenant to meet such standards. In addition, if the original tenant provided a guaranty from one or more of its principals, any replacement franchisee should be required to provide the same.

Leasing to franchisees of well-known operations can significantly boost traffic at a shopping center. And with proper planning and lease drafting, owners can be ensured of maintaining this beneficial relationship, even after the original tenant is no longer there.

Scott Frank is a partner in Arnstein & Lehr's Real Estate practice group, in the firm's West Palm Beach office.