The Real Deal - September 2012

Date: September 17, 2012

Shopping Center Leases and Franchises: A Landlord's Checklist
By: David L. Cahn, Esq.

Takeaway: Because of their brand recognition, consistency of operation and support network, franchised businesses can be wonderful tenants at shopping centers and other multi-use commercial properties. Franchisees are small business owners with substantial investments and drive to succeed, but who are able to use brands and business systems that provide competitive advantages. However, a lease with a franchisee raises concerns separate and distinct from those with independent small business owners or with regional or national chain store operators. What follows is a summary of some important issues and suggestions on how to navigate through them.

  1. Franchisor’s Options to Assume the Lease. Franchisors typically want the option to keep a franchised business operating at the leased location even if a particular franchisee develops financial or operational problems. This option applies if the franchisee defaults under the lease and does not cure by the applicable deadline, or if the franchisor terminates the franchise agreement due to a franchisee default. Some matters of concern with such options are:
    • Does the Franchisor Have Adequate Net Worth as a Tenant? Franchisors of well-established franchise systems typically (although not always) have strong balance sheets and cash on hand, making them at least as credit worthy as the franchisee tenant. However, many early and medium stage franchisor entities have limited assets and, for legal compliance and liability reasons, do not themselves operate any of the businesses being franchised -- instead stores are operated through affiliated entities that may be thinly capitalized. Since the original franchisee entity tenant is likely to be in financial distress if the franchisor is exercising this option, and the franchisee’s principals may no longer be credit worthy guarantors, the landlord should be careful to reserve its ability to require adequate security as a condition of allowing “smaller” franchisors to exercise lease assumption options.
    • How Long Will the Franchisor Have to Exercise The Option? In the case of a tenant’s failure to pay rent a landlord wants to retain the right to move quickly to evict. A franchisor typically wants thirty days from when the tenant fails to cure the default to determine whether it wants to assume the lease. Since evictions take time, a landlord may want to require a shorter option period.
    • What Happens if the Franchisee Resists Turning Over the Premises? If the franchisor’s option is triggered by a failure to pay rent, the franchisee will rarely stand in the way of the franchisor’s assumption, and if it does so the cost of eviction is properly the responsibility of the landlord (with the defaulting franchisee liable for the attorneys’ fees). However, if the franchisor’s option is triggered due to termination of the franchise agreement and the tenant is not in default under the lease, the franchisee may resist forced assignment on the basis that there is not good cause for termination. In that situation, the landlord can feel caught in the middle and should be able to require the franchisor to pay the legal costs to enforce its termination and obtain a court order requiring the franchisee to release the premises. In either scenario, if the franchisee has ceased paying rent, then the franchisor may be required to pay rent into an escrow account pending resolution of the legal proceeding.
    • What are Franchisor’s Rights to Re-Assign to a New Franchisee? The franchisor will want the absolute right to subsequently assign the Lease to a new franchisee and to be released from future lease obligations. The landlord will want recourse against the franchisor if the new franchisee defaults. A compromise is that the landlord will consent to such a subsequent full assignment if the new franchisee is credit-worthy under the landlord’s then-current standards for new tenants.
  2. Use Clauses. Franchise systems change product and service offering in response to market conditions, and franchisors want the right to require the franchisees to adopt new products and methods in accordance with overall system changes. Landlords want to restrict tenant uses to assure proper tenant mixes and also to be able to retain current tenants and recruit new ones. A franchise’s use clause should be sufficiently broad to adopt to change within its industry sector but not so broad as to harm other current or future tenants. For example, a tutoring center’s use could be for academic instruction services, which would be broad enough to cover methods of instructions other than traditional tutoring, but not so broad as to compete with a children’s fitness facility (like My Gym®) or a day care center.
  3. Protected Territory. If a portion of the rent will be a percentage of the franchisee’s gross sales, then the landlord should require that no other businesses operating under the same trademark operate within a specific distance of the premises. If the franchise agreement provides the franchisee with such a “territory” in which neither the franchisor nor any other franchisee may open a competing business, then the franchisor should not object to a similar clause in the lease, except for locations in special use facilities like sports facilities and military bases. If there is no such commitment by the franchisor to the franchisee, then the landlord should consider eliminating percentage rent in favor of a higher fixed rent unless the franchisor (as well as the tenant) will specifically make such a commitment to the landlord.
  4. Signage, Trade Dress and Renovations. Franchisors want to have the ability to require implementation of the franchise’s updated interior and exterior signage, trade dress and interior design in reasonable intervals during the course of the lease. Landlords want to have some control over the exterior signage and over substantial changes to the interior premises. The franchise should be able to update signs at the premises’ entrance and the premises’ trade dress and decor, provided that it does not fundamentally conflict with the design of the shopping center or any applicable laws. For structural changes that would require a governmentally-issued permits or licenses, the franchise should have a right to either obtain consent to the changes by providing specific information, insurance and fees, or the franchisee should be able to terminate the lease after a suitable notice period.
  5. De-Identification. If the Lease or the Franchise Agreement is terminated, the franchisor needs to have access to the leased premises to remove signs, décor and materials displaying any marks, designs or logos owned by the franchisor. The landlord needs to make sure that the franchisor is responsible for any damage or disturbance to the property caused by such a “de-identification” process. The landlord should include provisions in the lease addressing such an eventuality.
  6. Renewal. If the franchisee-tenant has a renewal option under the lease, but does not choose to exercise it, the franchisor may want to have the option of assuming the lease for the renewal period. If the franchisor requests such a right, it is reasonable for the landlord to attach strict conditions on the franchisor’s exercise of that right, including timing and notice requirements.

Time to Revise the Attorneys' Fee Provisions in Your Maryland Contracts
By: Christopher B. Lord, Esq. & Erin O. Millar, Esq.

Take-away: Look at your leases, loan documents, settlement agreements and promissory notes. Your standard language may no longer protect you.

Percentage Calculations

Ordinarily, the American system of justice does not permit a party who wins a lawsuit to recover the attorneys’ fees it incurred in pursuing the action. However, parties may agree otherwise in a contract, and courts will enforce those provisions. As a result, fee-shifting provisions have become commonplace in American contracts, particularly in leases, loans, settlement agreements, and promissory notes.

Typically, rather than get into a fight over how much the actual legal fees were, the terms provide for the prevailing party to recover a certain percentage, usually 15%, of the principal amount owed as reasonable attorneys’ fees and costs of collection. A recent decision from the Maryland Court of Special Appeals, however, significantly calls into question the prudence of providing a percentage as the basis for calculating the amount of attorneys’ fees owed and how and when the prevailing party’s fees are determined.

Despite the Court’s statement that contractual agreements calculating attorneys’ fees based on a percentage are not unenforceable per se, the Court’s recent decision in SunTrust Bank v. Goldman, 201 Md. App. 390 (2011) signals that percentage based fee calculations will not be enforced unless the amount of attorneys’ fees actually incurred by the prevailing party exceed the amount calculated in accordance with the percentage formula. The Court reasoned that fee-shifting provisions are indemnification obligations, and thus, a party should not be permitted to obtain a judgment for an amount greater than the amount the party owes its lawyers.

Attorneys’ fee provisions have always been subject to the requirement that the amount of fees be reasonable. Over the years, many courts have found a contract providing for 15% of the award was reasonable. After the decision in SunTrust, however, regardless of the percentage set forth in the contract, attorneys should submit their billing statements (redacted for privileged communications) to the court whenever seeking an award of attorneys’ fees and should not rely solely on the percentage set forth in the contract.

Given the Court’s statement that a prevailing party may only recover the attorneys’ fees and costs actually incurred, percentages will likely only be used to cap the amount of attorneys’ fees that are recoverable. Contract drafters should consider removing all references to percentages in their boilerplate fee-shifting provisions when the contract is to be governed by Maryland law.

Merger Doctrine and Post-Judgment Legal Expenses

In addition, the SunTrust case also addressed the effect of the doctrine of merger on attorneys’ fee awards. Under the doctrine of merger, when a judgment is entered on a contract, the contract and any rights afforded by the contract, including the right to recover attorneys’ fees and collection costs, are “merged” with the judgment. Thus, when a judgment is entered, the contract is extinguished, as are all rights and obligations arising from it except to the extent set forth in the judgment. Accordingly, under the doctrine of merger, a prevailing party cannot recover any costs and attorneys’ fees incurred in trying to collect the judgment (e.g. filing liens, garnishing wages and bank accounts, foreclosing on real and personal property, etc.) because the contract no longer exists and the judgment disposes of the rights and obligations of the parties In SunTrust, even though the Court agreed that the language in the contract at issue was sufficiently broad to cover post-judgment collection costs, the Court held that the plaintiff was only permitted to obtain a judgment for its attorneys’ fees and collection costs incurred through the date of judgment.

To avoid the doctrine of merger, the Court suggested that parties include non-merger clauses in their contracts. Non-merger clauses are often included in separation agreements in divorce cases and provide that even though the court grants a decree of divorce, the terms of the separation agreement remain in effect. In addition, some form promissory notes contained boilerplate non-merger clauses -- clauses that have been given new importance in light of the Court’s holding. While the Court stated that it was not aware of any case in which merger had been avoided by contract outside of the divorce context, the Court intimated that such clauses would be enforceable. To date, no Maryland court has applied a non-merger clause outside of the divorce context.

It is unlikely that a standard attorneys’ fee provision stating that a prevailing party can recover its attorneys’ fees and costs will be sufficient to avoid merger. Contract drafters should consider adding a non-merger clause to their attorneys’ fees provisions. The language must be clear that the parties mutually intend that the contract not be merged with the judgment with respect to post-judgment collection costs and attorneys’ fees. For example, consider adding the following: “Notwithstanding any judgment related to this contract, this fee-shifting provision shall not be merged into such judgment but shall survive the same and shall be binding and conclusive on the parties for all time. Post-judgment attorneys’ fees and costs incurred related to the enforcement of such judgment related to this contract shall be recoverable hereunder in the same or separate actions.”