Franchise Head Lease and Sublease

In leasing language, the head lease is the lease granted by the owner of the property, and a sublease is a lease granted by a tenant out of its own leasehold interest. In franchising, the key question is who holds the head lease, because that party controls the site when the franchise relationship ends.

Three structures are common:

Franchisors with strong sites often prefer the sublease model because it is the simplest way to take a location back. Newer franchisors often avoid it because it puts them on the hook for rent. For the general difference between assigning and subletting commercial space, including landlord consent under the Commercial Tenancies Act, see lease assignment vs. sublease.

Where the franchisee holds the lease, the franchisor protects the location through an addendum or side agreement signed by the landlord, usually with the franchisee, often called a lease rider or collateral agreement, and sometimes through a conditional assignment of the lease to the franchisor. Typical terms:

• Notice of default. The landlord must copy the franchisor on any default notice.
• Right to cure. The franchisor may, but need not, cure the franchisee's default within an extra period.
• Step-in right. If the franchise agreement ends or the franchisee defaults, the franchisor or a replacement franchisee may take an assignment of the lease.
• Use and de-identification. The premises may be used only for the franchised business, and the franchisor may enter to remove signs and trade dress after termination.
• No amendment or surrender. The franchisee cannot amend, assign or surrender the lease without the franchisor's consent.

Franchise agreements commonly add a cross-default: a default under the lease or sublease is a default under the franchise agreement, and termination of the franchise agreement ends the franchisee's right to occupy. Landlords negotiate riders hard, especially any right to step in without curing past defaults, and a rider is only as strong as the landlord's signature on it. Our commercial lease negotiation guide covers the underlying lease terms, such as renewal options, operating costs and demolition clauses, that flow into either structure.

A sublease from the franchisor is usually back-to-back: the franchisee takes on all of the tenant's obligations under the head lease, often by reference to a document it did not negotiate. Before signing, a franchisee should ask for the head lease itself and check:

• Whether sublease rent equals head lease rent or adds a markup or administration fee.
• Who receives any tenant improvement allowance, rent-free period or deposit refund.
• Whether the sublease term, renewal options and franchise agreement term line up.
• What deposit or prepaid rent the head lease requires, and who pays it.
• Whether termination of the franchise agreement ends the sublease, and what happens to the franchisee's leasehold improvements.

Ontario's disclosure regulation requires the franchise disclosure document to list the franchisee's establishment costs, including estimated costs for leasehold improvements, leases and rentals, and any direct or indirect payment to the franchisor that the franchise agreement requires, with its nature, amount and timing. The Arthur Wishart Act also requires the document to attach copies of all proposed agreements the franchisee will sign, which includes a proposed sublease. The harder question is what happens when the head lease does not exist yet.

A leading Ontario appeal on undisclosed lease terms is Raibex Canada Ltd. v. ASWR Franchising Corp., 2018 ONCA 62. The franchisee received the disclosure document in October 2012 for a restaurant in Mississauga. No site had been chosen. The document included a draft sublease requiring the franchisee to accept all terms of the head lease the franchisor would negotiate, but no head lease. The franchise agreement required both parties to use reasonable best efforts to find a site, and let the franchisee terminate on 20 days' notice, with a refund less the franchisor's reasonable costs, if the franchisor did not negotiate a lease for a suitable location within 120 days of signing.

The franchisor's leasing affiliate later signed a head lease for a site the franchisee helped choose, requiring a deposit of about $120,000, and subleased it to the franchisee. About 20 months after signing, the franchisee served a notice of rescission under the two-year remedy for no disclosure, and the motion judge upheld it. The Court of Appeal reversed. Assuming, without deciding, that the disclosure breached section 5, it held the alleged deficiencies, which also included missing cost estimates for converting an existing restaurant, were not so serious that the document amounted to no disclosure at all. The site-selection and opt-out clauses meant the missing head lease had little impact on the franchisee's ability to make an informed investment decision. The franchisor was entitled to about $110,000 in unpaid construction invoices it had covered, plus the roughly $120,000 head lease deposit less any benefit it derived from operating the outlet.

The lessons are practical. When the site is unknown at disclosure, include the form of sublease, describe the lease structure and costs, and give the franchisee a real role in site selection and a way out if no acceptable lease is found. The decision limits the two-year remedy; it did not decide that leaving out lease terms complies with section 5, and a franchisee can still rescind within 60 days of receiving a deficient disclosure document under section 6(1).

Landlords want a strong covenant. When a franchisor's leasing affiliate is the head tenant, the landlord may ask the franchisor or its parent to guarantee or indemnify. The franchisor then passes the risk down: the franchisee's corporation signs the sublease, and its principals sign a personal guarantee covering the sublease and the franchise agreement. Where the franchisee leases directly, the landlord usually takes the principals' guarantee itself.

Points to negotiate include a cap tied to a number of months of rent, a burn-off after a period without default, and a release when the franchise is transferred to an approved buyer who signs a replacement guarantee. On a sale, the sublease or lease must be assigned with the franchisor's and usually the landlord's consent; without an express release, the outgoing tenant and its guarantors can stay liable for the rest of the term. Lamba Law's free personal guarantee tracker lets owners log the guarantees they have signed and see their total exposure.

Amara Okafor buys a fitness studio franchise for a 2,800-square-foot unit in a Mississauga plaza. The franchisor's leasing affiliate holds a 10-year head lease at $36 per square foot net, or $100,800 a year in base rent, and offers Amara's corporation a back-to-back sublease plus a 2% administration fee. The franchisor asks for an unlimited personal guarantee from Amara covering both the sublease and the franchise agreement.

Her lawyer asks for the signed head lease. It contains a demolition clause on six months' notice and a $30,000 tenant improvement allowance payable to the affiliate. Because the sublease is back-to-back, both terms would bind Amara, and the head lease cannot be reopened. The lawyer negotiates three changes instead: the allowance passes through to Amara, who is paying for the build-out; her guarantee is capped at 12 months of base rent, burns off after three years without default and ends if the landlord terminates under the demolition clause; and an approved transfer releases her and her guarantee.

In year five, Amara sells the studio to Priya Nair. The franchisor approves Priya, the sublease is assigned with the head landlord's consent, Priya signs a replacement guarantee, and Amara receives a written release on closing.