Landlord as Unintended Franchisee


Franchisors Beware: Landlord as Unintended Franchisee

By Filemon “Phil” Carrillo on January 09, 2020

California Lawyers Association, Business Law Section

Franchise Law Committee Case Report, January 2020

Franchisees rely on the goodwill that has been built under the franchised brand, and develop additional goodwill within their local market. This presents a risk to the franchisor of losing that goodwill if the franchisee decides to close its doors or to terminate the franchise and operate a competing brand. In California, this risk is accentuated due to the unenforceability of post-term non-competes under Business and Professions Code § 16600. Accordingly, franchisors often choose to include provisions in the franchise agreement requiring that the landlord and tenant-franchisee agree that the franchisor can elect to pursue an assignment of the lease at termination, to protect the franchisor’s interest in the goodwill from misappropriation by the franchisee or other competitor.

A landlord in this tripartite arrangement also has interests to protect, most notably its interest in securing the continuity of its tenant’s business. A landlord entering into a lease agreement with a tenant that happens to be a franchised business has an additional target for collateral—the franchise agreement. The landlord may attempt to require that the tenant-franchisee and the franchisor agree to assign the tenant-franchisee’s rights to operate the franchise to the landlord upon any default of the lease agreement.

In most cases, lease-assignment provisions and franchise-assignment provisions both require that approval of the assignment not be unreasonably withheld—in effect, the denial of the assignment must be based on good cause. As such, both of these provisions come with an inherent risk: if they are ever invoked, the landlord ends up with a new tenant—the franchisor—and the franchisor ends up with the landlord as its new franchisee, unless good cause for denial of the assignment exists.

The case of CHA La Mirada, LLC v. Red Robin Int’l, Inc., 2017 WL 2691576 (Cal. Ct. App. June 22, 2017), illustrates how these provisions, which are meant to protect the landlords and franchisors, can end in an undesirable result: the landlord can force itself into a franchise relationship.

Sunstone was the owner of a Holiday Inn hotel in La Mirada and leased restaurant space to LMRG (a Red Robin franchisee). Sunstone (as the landlord), LMRG (the tenant-franchisee), and Red Robin (the franchisor) signed an agreement under which (i) LMRG assigned to Sunstone its rights in the franchise agreement as partial security for the lease and (ii) LMRG assigned to Red Robin its rights in the lease as partial security for the franchise agreement (the Assignment Agreement). Sunstone later sold the hotel and property, which was then transferred to CHA La Mirada, LLC.

Thirteen years into the relationship, LMRG stopped paying rent. CHA filed suit for past‑due rent of over $628,000. It obtained a judgment against LMRG finding that the lease was terminated as a result of LMRG’s breach.

Following this, CHA gave notice to Red Robin that CHA should be recognized as the franchisee as soon as LMRG was evicted, invoking its right to step into the shoes of the franchisee. Four days later, Red Robin responded to CHA that it was terminating the franchise based on LMRG’s alleged abandonment of the franchise and pointed to a clause in the Assignment Agreement stating that assignment of the franchise agreement can only occur if LMRG was not in default of the franchise.

CHA filed cross-claims against Red Robin for wrongful termination of the franchise agreement in a suit that LMRG filed against CHA.[1] Red Robin successfully moved for summary judgment arguing (i) that CHA was not a party to the Assignment Agreement and (ii) that Red Robin did not wrongfully terminate the franchise agreement.[2] The trial court held that although Sunstone was entitled to step into the franchisee’s shoes, its successor (CHA) was not. It also held that CHA failed to cure the franchisee’s default under the franchise agreement. The trial court entered judgment in favor of Red Robin, and CHA appealed.

The court of appeal focused its analysis on Red Robin’s burden (on summary judgment) to show that CHA was not assigned the tenant-franchisee’s rights under the Assignment Agreement and that it did not wrongfully terminate the franchise agreement.

Was CHA a successor or assignee under the Assignment Agreement?

Red Robin relied on language in the Assignment Agreement that stated that the landlord (then Sunstone) had no right to assign either the entire lease or the right to step into the franchisee’s shoes. CHA argued that because the definition of “Landlord” included Sunstone’s “successors and assigns,” it automatically succeeded to Sunstone’s rights to the franchise agreement.

The appellate court ultimately agreed with CHA, finding that there was a reasonable interpretation of these seemingly conflicting clauses that harmonized and gave effect to both of them: “the landlord, whether it was Sunstone or a new property owner, was not permitted to assign its rights under the [Assignment] Agreement to a third party who did not own the property.” In arriving at this interpretation, the court noted that it “was reasonable . . . for both the franchisor and landlord to include provisions preventing the other party from reassigning their rights under the [Assignment] Agreement to a third party unrelated to the property or the franchise.” Based on this interpretation, the Court of Appeal held that Red Robin failed to carry its burden to show that CHA was not the successor or assignee of the Assignment Agreement.

Was CHA’s right to the franchise agreement terminated for LMRG’s default of the franchise agreement?

Red Robin also argued that CHA’s rights to the franchise under the Assignment Agreement were terminated when the tenant-franchisee defaulted on the franchise agreement, relying on language stating that Red Robin only consented to the assignment as long as the tenant-franchisee “is not in default of the Franchise.” Red Robin alleged that LMRG breached the franchise agreement when it abandoned the franchise on November 13, 2013. The franchise agreement stated that it was uncurable default for LMRG to not operate the restaurant for a period of five days. But CHA sent notice to Red Robin only one day later, on November 14, 2013 about its election to assume the franchise. The appellate court held that the facts would support a finding that CHA’s notice of its assumption of the franchise prevailed over Red Robin’s later notice of termination to LMRG.

The appellate court also found that CHA was not required to provide evidence that it was a qualified replacement franchisee. Ultimately, the court of appeal held that Red Robin did not meet its burden on summary judgment. It reversed judgment on the claims predicated on wrongful termination of the franchise agreement.

The CHA La Mirada case illustrates the dangers of entering into these agreements for franchisors. When deciding whether to agree to such provisions, franchisors must consider whether they are willing to accept the landlord—or even an (unknown) successor or assign—as a franchisee.

This case report was prepared by Filemon Carrillo (fcarrillo@mulcahyllp.com) of the Irvine law firm of Mulcahy LLP. Mulcahy LLP is a boutique litigation firm that provides legal services to franchisors, manufacturers and other companies in the areas of franchise, trademark trade secret, unfair competition, and distribution laws.

Disclaimer: While every effort has been made to ensure the accuracy of this article, it is not intended to provide legal advice as individual situations will differ and should be discussed with an attorney experienced alcohol and distribution law. For specific technical or legal advice on the information provided and related topics, please contact the author.

[1] The suit between LMRG and CHA is not discussed in this report and was not at issue in the appeal.
[2] CHA also sued Red Robin for its alleged failure to transfer the liquor license. This claim was based on a provision in the lease agreement, but the appellate court found that Red Robin had no contractual obligation to transfer a liquor license.

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