Many franchisees trade from retail premises. Of the 960 business format franchises operating in Australia in 2006, 44.7 per cent had franchisees operating from a retail site.1 This numbered nearly 2,900 individual retail premises (2,887).2 Fit-out costs associated with those retail premises payable by franchisees are estimated to range from $40,000 to $550,000.3 With these statistics it is easy to recognize the importance of leasing agreements for retail sites and the potential impact of effects of a surrender of lease on a franchise.
This update looks at the decision in a recent case concerning a dispute being run in the Federal Court in South Australia where the franchisee had provided undertakings to the Court during the course of the dispute not to deal with any of its interests in property and successfully sought to have these undertakings altered to surrender a lease of its existing retail premises to relocate to another site with lower rent.
Pampered Paws Connection Pty Ltd v Pets Paradise Franchising (Qld) Pty Ltd (No 9)4
Pampered Paws Connection Pty Ltd (Paws), the franchisee, and Pets Paradise Franchising (Qld) Pty Ltd (Paradise), the franchisor, were in dispute and proceedings had commenced in the Federal Court in South Australia. As part of that process Paws had provided undertakings to the Court for to deal with its interests in property.
The undertaking by the directors of Paws was that they would not sell, transfer or otherwise dispose of any interest in real property in their names or either of their names or in the name of Paws without giving 21 days’ notice to Paradise by notice in writing. Paws during the course of the running of the dispute matter sought leave of the Court to vary the undertakings provided to allow execution of surrender of lease of its retail premises.
Paws explained to the Court that the change to the undertaking sought was due to the business being operated unprofitably from its present location, with Paws seeking to move its business operations from the existing premises to lease alternative premises at a considerably reduced rental amount compared to the current leased premises.
Paradise resisted the attempt to change the undertakings on the grounds that the costs incurred in relocation could impair Paw’s ability to meet cost liabilities in the dispute proceedings on in the Court.
The Court examined:
- the purpose of the undertaking and concluded it was put in place to protect Paw’s interest in property assets of the directors, not necessarily the lease interest in the specific business premises from which the franchise was then being run;
- a substitute undertaking provided from the entity entering into the new lease that it would not dispose of its interest in the new commercial premises and concluded that this maintained the continued availability of those premises to satisfy the intended effect of the undertaking of securing those premises for potential costs recovery; and
- whether there was any significant value in commercial leased premises available in an event to satisfy an undertaking but was unable to form a conclusion on that point due to a lack of material before the Court and was not inclined to undertake a more refined analysis on this point. The Court did note that the lease was secured in any event by guarantees of its directors and that the surrender of the lease meant that Paradise will have the opportunity to relet the premises.
Comment on outcome and things to think about before seeking to break or surrender a lease
In this case Paws, in addition to the lease contract it had signed including a term for occupying the premises and paying an agreed rent, had also provided undertakings which restricted its ability to deal with the property.
An undertaking is a written promise offered as security for the performance of a particular act required in a legal action. A breach of such an undertaking may amount to contempt of court and can potentially result in imprisonment. The franchisees’ sought to vary the undertaking so they could surrender their lease with the agreement of the landlord.
Paws argued that as the business was not making any profit from its current retail premises and surrendering the lease and seeking a new premises for the business was necessary for its financial survival.
Prior to surrendering a lease the franchise tenants should carefully consider the following points:
Break or Surrender: “breaking a lease” generally implies that a tenant is acting without the consent of the landlord and is doing something which is legally a breach of the terms of its existing lease. “Surrendering a lease” generally implies that a landlord’s consent has been sought and agreed to, often on some terms, for the release of the tenant from that lease and a reletting of the premises to another.
Talk to your landlord/ franchisor. Discuss the circumstances with the landlord and /or franchisor if these are different parties and demonstrate the difficulties being experiences and how the relocation is expected to assist the continued existence of the franchise. The landlord if agreeable can re-lease the space but may require some incentive to agree to an early release. If faced with the risk of an insolvent tenant unable to pay its rent and the costs of removing, repossessing and then re-letting the premises the prospect of a tenant paying some amount to the landlord to agree to an early end to the lease may be attractive.
Find a replacement tenant. Landlords are more likely to be cooperative terminating your lease if a replacement tenant can be found for your space. The existing tenant can then, subject to the approval of the landlord surrender his/her lease agreement and provide the location back to the landlord to lease to the new replacement tenant. Often it is the case that the replacement tenant needs to be acceptable to the landlord and a landlord must act reasonably in considering such a request.
Check your franchise agreement: Sometimes it is the case a franchisor has a first right of refusal over a particular site and must be offered the chance to acquire the retail premises prior to any other party. Sometimes it is also a case that a franchise may not operate, unless the franchisor’s consent is obtained, from any other site than that leased. It is prudent to ensure that it is understood what restrictions are on franchisees and continue to be in dialog with franchisors.
Assign your Franchise Agreement. Finding another prospective franchisee to agree to take over your commercial space, current lease terms and franchise agreement. If the person taking an assignment of your lease agreement has also purchased your franchise business this is more acceptable to the landlord than if the use is completely changing to a different industry and to the franchisor if they wish to retain the site but do not hold the lease, step in rights to the lease or a first right of refusal. In this case often, a secondary or replacement formal lease is not required but consent is often required and it is necessary to understand the exact requirements for such a transaction.5
It is also possible to utilize dispute resolution processes in franchise agreements or under state based retail tenancy dispute resolution mechanisms if deadlocks or impasses arise due to break down of communication.
Importantly if providing undertakings of any form always consider the scope, effect and constraint such undertakings will have on continued business operation or financial position, as altering such undertakings does not always result in a successful amendment.