Advice & TipsAsk an ExpertMay/June 2022

Q: What do I need to know if I lease my franchise property directly from a landlord?

A: When a franchise is operated from a retail space (for example, a restaurant or a store), franchisees are generally faced with two options related to the leasing arrangements: a franchisee might lease the space directly from the landlord, or the franchisor might hold the headlease—the direct contractual relationship with the landlord—and then sublease the premises to the franchisee. A sublease means that you as a franchisee would be leasing from the franchisor, and is popular with franchisors who want to have control over a location.

However, if you are leasing from a landlord, there are some legal elements that are important to know. Here are some key considerations that franchisees who are leasing directly from the landlord should keep in mind.

No rescission right against the landlord

New Brunswick, PEI, Ontario, Manitoba, Alberta, and British Columbia have instituted franchise laws that regulate the franchise relationship, including the obligation on franchisors to provide prospective franchisees with a disclosure document. If a franchisor fails to provide a disclosure document in accordance with the relevant law, the franchisee will have the right to rescind (essentially, revoke), effectively cancelling the franchise agreement.  

The “franchise agreement,” in this instance, would include any agreement entered into between the franchisor and franchisee that relates to the franchise.  If the franchisee has entered into a sublease for the premises with the franchisor or its affiliate, and the franchisee decides to rescind, then the sublease will be rescinded along with all other “franchise agreements.”  If that happens, the franchisee will have no further obligations regarding the property. However, since the rescission remedy does not extend to any contract between the franchisee and any true third party, such as a landlord, if the franchisee is leasing the space directly from the landlord and rescinds the franchise agreement, the lease will continue in full force and effect.

A recission of the franchise agreement does not permit the franchisee to terminate a lease agreement that it has signed directly with a landlord. Any damages the franchisee might suffer from holding that lease may be passed to the franchisor.

Non-compete provisions affecting a terminated lease

Most franchise agreements include post-term non-compete provisions. These typically state that if the franchise agreement expires or is terminated, the franchisee may not operate or participate in any business that’s competitive or similar to the franchise that he or she operated within a certain distance from the franchise premises, for a certain amount of time (for example, two years from the termination or expiration of the franchise agreement). These types of provisions continue to be enforceable after the termination or expiration of the franchise agreement.

A potential issue can arise if the franchisee is leasing the premises directly from the landlord, as opposed to subleasing from the franchisor. If the franchisor leases the space directly from the landlord, the franchisor may take over the premises if the franchise agreement expires or is terminated. If, however, the franchisee is leasing the premises directlyfrom the landlord, subject to any options the franchisor may have to take over the lease, the franchisor will have no rights or obligations with regards to the premises. The franchisee may be stuck with the lease and have limited options as to what to do with the location.  

This is because most leases contain clauses that will restrict the tenant’s use of the property and only permit the tenant to operate a certain type business at the premises–for example, the lease might state that the tenant can only operate a hair salon or a fast food restaurant. In some cases, these restrictions may even be brand-specific. Therefore, if the franchise agreement is terminated or expires and the franchisee holds the lease directly with the landlord, the franchisee may be left in a situation where the lease states it can only operate a certain type of business, but the non-compete provision in the franchise agreement stipulates that it may not operate a business the same as, substantially similar to, or competitive with that type of business.

In other words, the post-term non-compete provisions under the franchise agreement are likely to be directly at odds with the obligations under the lease. Franchisees should note that a franchisor is likely to vigorously enforce whatever rights it believes that it has under these types of non-compete provisions. However, if the franchise agreement is rescinded, as mentioned above, no part of the agreement will apply, including any post-term non-competition provisions–but the franchisees will still be prohibited from using the franchisor’s intellectual property.

Those thinking about investing in a franchise where they’re required to lease the premises directly should seek legal advice in the negotiation of their lease and fully understand its relationship to the franchise agreement.

John Yiokaris
Co-managing Partner
Sotos LLP

Anna Thompson-Amadei
Sotos LLP