February 27, 2023
Historically, it had been the standard practice of franchisors to enter into commercial leases with landlords directly and then sublet the premises to their franchisees. Under this model, the franchisor maintained ultimate control over the premises as well as the direct relationship with the landlord and the landlord obtained the covenant of the franchisor and likely the franchisee, by way of tri-party or assumption agreement. However, with that ultimate control came ultimate liability, as franchisors were liable as tenants under the lease for the premises operated by their franchisees.
In efforts to limit a franchisor’s lease liability, franchisors have moved to a “franchisee-first” model. In today’s market it is much more common among Canadian-based, as well as foreign franchisors, to insist that franchisees enter into leases directly with landlords as the tenant. Under this model, franchisors maintain control over operations of the premises through the franchise agreement, but the ultimate burden of risk of the lease remains with the franchisee-tenant. As a result, landlords have lost the financial covenant of the franchisor, which is almost always the party with deeper pockets. In order to manage the landlord’s risk under the “franchisee-first” model, landlords often seek an indemnity from the franchisor as a condition to entering into a lease with a franchisee.
Where a landlord conditions signing a lease directly with the franchisee on being granted an indemnity from the franchisor, the franchisor should exercise great care before agreeing to such a term, as the indemnity re-establishes the initial risk allocation as if the franchisor had entered into a lease directly with the landlord. In particular the franchisor should consider the following key terms and drafting tips.
Rather than acting as the first line of defence, include in the indemnity agreement certain conditions to be met by the landlord before the landlord is able to exercise the indemnity against the franchisor. For example, if the principal of the franchisee has also entered into an indemnity agreement, require the landlord to first pursue recourse against the franchisee’s principal prior to pursing the franchisor. In addition, a franchisor may insist that the landlord exercise and exhaust all remedies available against the franchisee-tenant prior to exercising its rights under the indemnity agreement.
Ensure that the indemnity is specific as to the scope of liability. It is paramount to understand specifically what the franchisor is indemnifying the landlord against. For example, is the indemnity as broad as to indemnify the landlord against the breach of all terms and conditions in the lease or only rent arrears? By narrowing the scope in this manner, the franchisor can limit its exposure and create more certainty as to potential future liability.
A standard indemnity agreement will provide that the indemnity is in place during the term, and potentially post-termination of the lease. Expressly limit the time period for which the indemnity will be in force, for example, for a period of 24 months. Upon expiration of the indemnity, the indemnity agreement should automatically terminate, and the franchisor will no longer have any liability under the lease.
In addition to limiting the scope of items for which a franchisor can be found liable and the time period the indemnity is in place, an extremely effective method of mitigating the franchisor’s risk is to set a monetary cap of the potential damages for which the landlord may claim against the franchisor. This monetary cap may be expressed as a lump sum amount (i.e. $100,000), or as an expression of the rent (i.e. up to twelve months net rent).
A standard indemnity agreement will often provide that the indemnity continues to apply following any transfers or amendments to the lease, regardless of whether the indemnifier is aware of such a transfer. The franchisor should ensure that the indemnity agreement is automatically terminated in the event of a transfer to a non-franchisee party. Furthermore, the franchisor should insist that any lease amendment must be approved by the franchisor in order for the franchisor to continue to be bound by the indemnity agreement The franchisor should not waive its right to notice under the indemnity agreement and must require notice of any default of the tenant under the lease.
In addition to negotiating the indemnity agreement itself, franchisors can mitigate their exposure by ensuring that the appropriate enforcement rights and remedies are in place under their franchise agreements. If the landlord enforces its rights against the franchisor under the lease indemnity agreement, the franchisor must have a clear avenue for enforcement and indemnification vis a vis the franchisee.
Insist as a condition of the franchisor entering into the indemnity agreement that the franchisee and the landlord enter into an agreement with the franchisor, which provides (a) upon the default of the franchisee of its obligations under the lease or the franchise agreement, the franchisor may step into the shoes of the franchisee and assume the lease and (b) the franchisor may assign the lease to a new franchisee. In both cases such transfers should not require the prior consent or approval of the landlord. This type of agreement may be referred to as a “Collateral Assignment Agreement,” “Lease Option Agreement” or “Tri-Party Agreement.” Such an agreement allows the franchisor to operate from the premises and avoid the location “going dark” and subsequently transfer the premises to a new franchisee in an efficient and expedient manner.
Review the franchise agreement through the lens of the franchisor’s potential liability under a lease indemnity agreement. Specifically consider what recourse and remedies may be available to the franchisor against the franchisee in the event the franchisee defaults under the lease. For example, will the franchisor’s damages be covered under a general security agreement with the franchisee or existing indemnity provisions in the franchise agreement?
Determine whether it is beneficial and practical to take an additional form of security from the franchisee in exchange for entering into a lease indemnity agreement, such as a deposit, a letter of credit, and/or a personal guarantee from the franchisee’s principal.
While a landlord will continue to seek opportunities to place the risk of default upon the franchisor wherever possible, a franchisor is not without opportunities to mitigate that risk. Through measured consideration of the drafting, strategies and tools outlined within this article, franchisors have opportunities to offset and reduce the risk imposed by landlords and franchisees alike. The risk may be inevitable, but it doesn’t always have to be the franchisor’s risk to bear.