October 16, 2012

Franchisors taking head leases in Ontario: did you consider rescission?

One of the fundamentals of good franchising for a franchisor is making the right decision over who will control the real estate occupied by the franchisee’s business. The choices are limited but the considerations are varied.

When the premises are to be leased from a third party landlord, the choice is whether the franchisor, or more often an affiliate of the franchisor, will take the head lease and sublet to the franchisee or whether the franchisee will lease directly from the landlord. Hybrids of these choices exist. Often, the choice is limited by the requirement of the landlord.

In some cases, a franchisee will only be permitted to lease the premises directly if the franchisor agrees to indemnify the lessor for a portion of the lease. In other cases, a landlord will require both the franchisor (or its affiliate) and the franchisee to be directly liable for all lease obligations although the franchisor (or its affiliate) is technically the tenant.

Franchisors often decide that they want the franchisee to be the direct tenant because they do not want the potential liability on the lease if the franchisee’s business fails and the franchisor is not in a position to operate the location or re-franchise promptly.

By contrast, some franchisors want to hold head leases as this gives them additional control over the site should they choose to terminate the franchise agreement (and the sublease). This reduces the opportunity for the franchisee to de-identify and stay in possession while a franchisor attempts to enforce its post-term covenants not to compete.

A franchisor is often able to negotiate arrangements with the landlord and its franchisee which permit the franchisee to take the head lease position but which write into the lease for the benefit of the franchisor an obligation on the landlord and franchisee to permit the franchisor to take over the lease if the franchise agreement is terminated or the franchisee is in default of the lease. In that way, the franchisee is principally obligated on the lease but the franchisor has the opportunity to take over the location upon a termination.

Large franchisors with strong brands and track records as tenants are desirable tenants for landlords. Those franchisors may well be able to negotiate lower rents for their leases given their market power as tenants. In those instances, franchisors may choose to sublease (with the landlord’s consent) and mark up the rents paid under the head lease in order to profit from their ability to supply real estate to a franchisee in the form of higher sublease rents.

These are the typical considerations and choices facing franchisors in the design and development of their systems.

Since January 31, 2001, franchisors in Ontario have had to add an additional consideration. Under Ontario’s Arthur Wishart Act (Franchise Disclosure), 2000, if the franchisee validly rescinds the franchise (and related) agreements due to faulty disclosure, it is entitled amongst its remedies under s.6 (6) of that Act to:

6 (6) The franchisor, or franchisor’s associate, as the case may be, shall, within 60 days of the effective date of the rescission,

(a) refund to the franchisee any money received from or on behalf of the franchisee, other than money for inventory, supplies or equipment;

(b) purchase from the franchisee any inventory that the franchisee had purchased pursuant to the franchise agreement and remaining at the effective date of rescission, at a price equal to the purchase price paid by the franchisee;

(c) purchase from the franchisee any supplies and equipment that the franchisee had purchased pursuant to the franchise agreement, at a price equal to the purchase price paid by the franchisee; and

(d) compensate the franchisee for any losses that the franchisee incurred in acquiring, setting up and operating the franchise, less the amounts set out in clauses (a) to (c). 2000, c. 3, s. 6 (6).

The question existed whether a franchisee who pays rent directly to a landlord but as a subtenant of the franchisor or its affiliate was entitled to recover as an element of its s.6(6) compensation all amounts it paid to the landlord upon the exercise of its rescission right.

A recent decision of the Ontario Superior Court of Justice on Sirianni v. Country Style, (“Country Style”) made it clear that the answer to the question is “yes”. Franchisors must compensate the franchisee for all rents paid under a sublease with it. This is so even though the franchisor did not necessarily benefit by one cent from the sublease arrangement (in other words, rent to be paid by the franchisor to the landlord under the head lease equals the rent to be paid by the franchisee to the franchisor under the sublease).

This decision only applies to circumstances when the rescinding franchisee was otherwise profitable in the operation of its business before it rescinded. If it suffered operational losses before it rescinded and the losses included the rents it paid over the course of its operation of the business, the franchisee was clearly able to recover these rents under section 6(6)(d) of the Act which required the franchisor to compensate the franchisee for all operational losses.

What Country Style clarified was that even in the case of the profitable franchisee which rescinds, the franchisor will have an obligation to repay all rents paid under a sublease. Although this results in a clear windfall to a rescinding franchisee, given the “draconian” nature of the rescission remedy as described by the Ontario Court of Appeal, the fact there may be a windfall is just another cost for a franchisor not disclosing properly in Ontario.

The prospects of a franchisor having to pay back to a profitable franchisee rents paid by the franchisee to a landlord where the franchisor derived no financial benefit from the sublease is an important factor to consider when making decisions about real estate control in the design of the franchise system.