In the franchising context, one fundamental decision that a would-be restaurant franchisor makes is who will hold the lease for the business. There are typically four options: the franchisor; the franchisee; an affiliate of the franchisor, which holds leases for the entire system and sublets premises to its franchisees; or a single-purpose affiliate of the franchisor that holds an individual lease, which it sublets to a particular franchisee.

There are traditional considerations, pro and con, impacting franchisors’ decisions for the land-control aspect of the design of their systems. These considerations are re-examined below in light of the approaching endemic.

Direct or indirect franchisor control
Franchisors looking to maximize control over their franchisees’ premises typically enter into leases directly or through either a leasing affiliate or single-purpose affiliate. In situations where the franchisee may be terminated or abandon the system, having land control is useful because it prevents the franchisee from remaining in possession of the premises and operating from a location previously affiliated with the system. In these circumstances, land control also helps to minimize the likelihood a franchisor will need to sue to enforce any applicable covenant not to compete.

Landlords may require franchisors to provide an indemnity, or limited indemnity in duration or amount, if they are prepared to accept a franchisor’s affiliate as the tenant because these affiliates, typically speaking, are mere holding companies with no meaningful covenant to offer themselves. In this scenario, it’s the franchisor or its affiliate who is directly responsible for fulfilling the tenant’s obligations under the lease. To that end, franchisors often face the situation of funding rental payments when they terminate a franchisee’s sub-lease, pending their ability to re-franchise the location.

In the age of an endemic, this strategy of holding leases, whether directly or indirectly, can create tremendous financial hardship on a franchisor where the sub-tenant franchisee may not itself be able to maintain its payments under its sub-lease and any franchisee indemnifier does not have the wherewithal to make good on any indemnity given under a sub-lease/franchise agreement.

Franchisee Control

The immediate reaction to the potential financial burden on a franchisor resulting from holding leases, whether directly or indirectly, is to instead require franchisees to lease their premises directly from their landlords. The decision to have franchisees lease directly as a matter of system design is not a standalone decision, but involves several other critical decisions:

• Is the franchisee or the franchisor primarily responsible for seeking out suitable premises and negotiating the lease?
• Is the franchisee or the franchisor responsible for the build-out of the premises?
• Who will receive any tenant allowance which may be available to the tenant?

Leaving these considerations aside, allowing franchisees to lease premises directly from a landlord creates the following dynamics:

• The franchisee will have the primary relationship with the landlord. The franchisee may not have the necessary gravitas or skill to negotiate with its landlord during an endemic;
• There is a greater likelihood of a default occurring if the franchisee cannot sustain its rents with no, or limited, business;
• If the franchisee is seeking to terminate its obligations with its franchisor, it will have control at first instance of its location and may have a positive relationship with its landlord who may support a de-identification;
• A franchisee may be behind in their obligations for some time before the franchisor becomes aware of the default; and
• It may be more difficult for the franchisor to negotiate for its receipt of tenant allowances or inducements.

The experience from this endemic has overwhelmingly suggested that franchisors need to design their systems with the least exposure to lease liabilities and cross-defaults under their leases as possible. Funds that must be paid to landlords are needed for other purposes — innovation, franchisee support, wage support for key employees and maintaining corporate locations. Paying rent on closed or partially open locations can create a significant risk to the health and future of a franchise system very quickly.

Assuming the endemic is here to stay, with the prospects of future variants and renewed partial or total closures, along with the unpredictability of government-support programs, the choices for franchisors on the matter of land control are narrowing. At this time, franchise systems should approach land control with the following design features:

• Franchisees should be responsible for finding locations within the territory agreed to, subject to the franchisor’s approval. If suitable locations are not found within a specified period, franchisees should be entitled to a return of the initial franchise fees, in whole or in part;
• Franchisors should provide guidance to franchisees on lease terms, and should either consider providing franchisees with an approved form of a letter of intent to be utilized by franchisees or take responsibility for the negotiation of the letter of intent and lease on behalf of the franchisees;
• Franchisors should be entitled to approve the form of an offer to lease and lease, which the franchisee intends to enter into if they have not undertaken the negotiations themselves;
• Franchisees will take the ultimate responsibility for the terms of any offer to lease or lease they enter into;
• Franchisors should require franchisees as a term for their approval that they be given the following rights:

1. To notice by the landlord if a breach of the lease occurs;
2. to have the lease conveyed to the franchisor upon a termination of the franchise agreement;
3. To have time to re-franchise upon a conveyance of the location and, during that intervening period, to be “dark” if necessary;
4. To occupy the location under the franchise agreement in the event of a large group of defaults by a franchisee and to operate the business for the account of the parties as set out in the franchise agreement;
5. To receive any tenant allowances to support construction;
6. To control the construction at the franchisee’s expense;
7. To take security over the tenant’s assets (to the extent permitted by any loan which a franchisee may need to procure to support the construction and store opening); and
8. To act as the franchisee’s agent for an additional fee to negotiate with the landlord where necessary.

These guidelines require a great deal of understanding on the part of franchisors and significantly impact the drafting of the default agreements utilized within the system.

Lease Terms

Franchisors will want to pay particular attention to the following matters if they allow their franchisees to lease their premises directly.

Force Majeure: As a result of the pandemic, most landlords and franchisors re-visited the wording of the force majeure/unavoidable-delay provisions of their leases and other agreements. For a franchisor, to the extent possible, it will not want the tenant to be paying rent if the tenant is not receiving revenues of any significance or governmental assistance. More specifically, the franchisor will want to ensure that these provisions, which would suspend the tenant’s obligations to perform, include government lockdowns, whether formal or informal, and specifically do not require the tenant to pay rent during this time.

Use Clause: Franchisors should confirm that the use clauses in their leases are limited to the activities of operating the system’s business but allow for sufficient flexibility to permit them to modify the business as they may need to.

Insurance: Franchisors will want to ensure that the franchisee/tenant is carrying sufficient and appropriate business-interruption insurance.

Formal Lease: If the franchisors’ entitlements are to be more specifically included in the formal lease rather than the offer to lease, they will not want their franchisees taking possession of the premises under the franchise agreements until the subject lease is fully executed.

Landlord’s Work/Tenant’s Work: Whether in an offer to lease or lease, franchisors should ensure that they have approved all work that is expected to be performed by the landlord and the tenant. A franchisor’s form of letter of intent that its franchisees either utilize or are guided by should include these provisions.

Land control is one of the most difficult pieces of franchise system design that a franchisor must understand, appreciate and gain expertise in. The decisions made around land control and the execution of these decisions can make the difference between system success and failure during a pandemic/endemic.

Allan Dick, Sotos LLP

Sotos LLP assists many franchisors in the design of their systems. Many of the aforementioned leasing considerations are also applicable to single unit or multiple unit non-franchised restaurant operations. If you have any questions about your leases or land control issues, please contact the author at adjdick@sotos.ca or 416-805-8989.

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The federal government has introduced the Canada Emergency Rent Subsidy (“CERS”) which has replaced the Canada Emergency Commercial Rent Assistance.  CERS will be available retroactively to September 27, 2020 until June 2021, and the current parameters will apply until June 5, 2021.

CERS takes landlords out the equation by delivering aid directly to applicants. The subsidy is available on a sliding scale – the amount of the subsidy that eligible organizations receive will be proportional to the amount of their revenue losses.  The maximum base rate subsidy is 65% for organizations with a revenue drop of 70% or more. The base rate then declines to a rate of 40% for organizations with a revenue drop 50%, and gradually reduces to 0% for organizations that have not experienced a decline in revenues. The federal government’s CERS website provides a calculator that applicants can use to calculate the amount they can apply for.[1]

Eligible expenses include commercial rent, property taxes, property insurance, and interest on commercial mortgages for a qualifying property, less any subleasing revenues.[2]  Further, only expenses paid under rental agreements in writing that were entered into before October 9, 2020 (and continuations of those agreements) and are related to real property located in Canada are eligible.  If the applicant has not paid the amounts due for the eligible expenses yet, they must attest that these amounts will be paid within 60 days of receiving the rent subsidy payment.

Non-eligible expenses include any expenses that were paid or payable to non-arm’s length entities[3] or for a timeframe that falls outside of the claim period.  Qualifying properties include any buildings or land in Canada that the applicant’s business or organization owns or rents and uses during the course of ordinary activities.  Properties that do not qualify include: residential properties, properties used to earn rental income from arm’s-length parties or any properties that are primarily used to earn rental income directly or indirectly from a non-arm’s length party, that are primarily used by that party to earn rental income.[4]

Expenses for each qualifying period will be capped at $75,000 per location and be subject to an overall cap of $300,000 that would be shared among affiliated entities.

Eligible entities include individuals, taxable corporations, trusts, and non-profit organizations and registered charities.  In order to be eligible, organizations must meet one of the following criteria:

1. Have a payroll account as of March 15, 2020 or have been using a payroll service provider;
2. Have a business number as of September 27, 2020 (and satisfy the Canada Revenue Agency that it is a bona fide rent subsidy claim); or
3. Meet other conditions that may be prescribed in the future.

For the purposes of calculating the CEWS, an entity’s revenue is its revenue from its ordinary activities (in Canada) earned from arm’s-length sources, determined using its normal accounting practices. Revenues from extraordinary items and amounts on account of capital are not counted.  Special rules will be provided in order to take into account certain non-arm’s-length transactions – for example, where an entity sells all of its output to a related company that in turn earns arm’s length revenue.

[5]

Applicants can apply for the rent subsidy retroactively for any period up to 180 days after that period has ended.

Lockdown Support

The new Lockdown Support will provide a 25% top-up as additional support to businesses with locations that are temporarily forced to close or have their business activities significantly restricted by a public health order issued by a federal, provincial, or municipal government, or a local health authority.  This includes situations where the organizations has had to shutdown as a result of an outbreak of COVID-19.

In order to qualify for the Lockdown Support, a business must:

1. have a base rent subsidy rate of more than 0% for the claim period;
2. qualify for the base CERS; and
3. be required to completely shut the location down; or cease some or all of the activities at the location and it must be reasonable to conclude that the ceased activities were responsible for at least 25% of the revenues of your business at that location.

In order to apply, a public health order must be limited based on one of these factors: geographical boundaries, type of business or other activity or risk associated with a particular location.  It must also result in sanctions or be an offence if the business not does comply.[6]

All applications must be made on or before 180 days after the end of the qualifying period. [7] Applicants can apply for CERS as of November 23, 2020.

At Sotos LLP, our team of experts has been advising businesses in the automotive, restaurant, grocery, personal, home and professional services, hotel, retail and cannabis sectors as they face challenging economic and financial issues relating to the current pandemic. Please contact us if you wish to discuss your eligibility for any of the government assistance programs, and to determine an effective approach to combatting business challenges caused by the outbreak of COVID-19.

Anna Thompson-Amadei, Sotos LLP

Anna is an associate with Sotos LLP in Toronto, Canada’s largest franchise law firm. She practices business law with a focus on franchising, licensing, and distribution. Please contact Anna at 416.572.7322 or athompson-amadei@sotosllp.com if you would like to discuss this or any other topic relating to the operation of your business.

[1] https://www.canada.ca/en/revenue-agency/services/subsidy/emergency-rent-subsidy/cers-calculate-subsidy-amount.html#h-3
[2] Note that any sales tax component of these costs would not be an eligible expense.
[3] Note that on February 24, 2021, the government announced a proposed change to amend the rules in the Income Tax Act so that Lockdown Support would be available in situations where the activities of a party not dealing at arm’s length are required to cease as a result of a “public health restriction”, that party rents the property from the entity, and all other conditions for the Lockdown Support are met.
[4] https://www.canada.ca/en/revenue-agency/services/subsidy/emergency-rent-subsidy/cers-expenses-claim.html
[5] https://www.canada.ca/en/department-finance/news/2020/11/canada-emergency-rent-subsidy.html
[6] https://www.canada.ca/en/revenue-agency/services/subsidy/emergency-rent-subsidy/cers-calculate-subsidy-amount.html
[7] https://www.canada.ca/en/revenue-agency/services/subsidy/emergency-rent-subsidy/cers-how-apply.html

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