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

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…

Most franchisors whose franchisees operate from a fixed location choose B.

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 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?

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.

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.

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.

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? 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:

Mall Vacancy Rate: 30%, Rents Falling India: Mall Vacancy Rate:  30%, Rents Falling - Zmarter.com finances May, 2010

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

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 Assignment

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

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

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

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.

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

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)

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 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

Allows Landlord to have advance notice of potential problems. 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 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.

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 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.

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.

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