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Franchisors Should Consider Signing a Conditional Lease Assignment Rather Than a Franchisee’s Lease

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By:  Richard H. Herold

In Franchise & High Properties, LLC v. Happy’s Franchise, LLC, a 2015 decision issued by the Court of Appeals in Michigan, the franchisor, Happy’s Pizza Franchise, LLC, signed a five-year lease for the commercial space to be occupied by its franchisee, Happy’s Pizza #19, Inc.  The franchisor did so to secure a right of first refusal to purchase the property and to enforce the franchise agreement to have the lease assigned to the franchisor if the franchisee defaulted.

The issue in the case was whether the term “tenant” referred solely to Happy’s Pizza #19 or whether it also included Happy’s Franchise as a co-tenant.  “Tenant” was defined as follows:  “Happy’s Pizza #19, Inc., 29102 Telegraph Road, Suite 607, Southfield, MI 48034, the lessee, and Happy’s Pizza Franchise, LLC, a Michigan limited liability company (hereinafter referred to as `Franchisor’), hereinafter designated as the Tenant.”

Because this provision of the lease signed by both Happy’s Pizza #19 and Happy’s Pizza Franchise appeared to include both entities as co-tenants, the district court ruled for the landlord and against the franchisor (after the franchisee failed to appear).  On appeal, the Court of Appeals ruled that, because both the signature lines and the right of first refusal provision distinguished the “Tenant” from the “Franchisor,” the lease was ambiguous.  The Court of Appeals remanded the case to the district court with instructions to consider extrinsic evidence to interpret the lease and determine whether the franchisor was a co-tenant.

Two practical pointers emerge: (1) as some franchisors are willing to sign leases, franchisors should carefully review any franchisee-tenant’s lease with counsel to understand the obligations they, as franchisors, are undertaking in the event of a franchisee default under the terms of the lease; and (2) franchisors should consider entering into a conditional lease assignment in lieu of signing the lease itself.  Under a typical conditional lease assignment, the franchisor may (but need not) elect to assume the tenant-franchisee’s obligations under the lease if the franchisee-tenant defaults – to remove the defaulting franchisee and bring in a new franchisee.