Best Practices: Franchise Agreements and Consistencies with the SOPs

Lenders extending financing to franchisees – either to re-finance existing debt or open new facilities – have historically been concerned with determining whether affiliation exists between the franchisor and franchisee. The Small Business Administration (“SBA”) streamlined this determination in Standard Operating Procedure 50 10 5(I) (“SOP”) by requiring lenders to obtain the SBA Addendum to Franchise Agreement. See SOP 50 10 5(I) at pg. 81.

When dealing with franchises, however, lenders should not overlook provisions in the Franchise Agreement that could conflict with what the SOPs require of lenders and imperil the SBA Guaranty. For example, Franchise Agreements often contain provisions (1) granting the franchisor a security interest in a borrower’s assets or (2) an Assignment of the Borrower’s Lease in favor of the Franchisor with the option to cure a default.

1. Franchise Agreements and Franchisor’s Interest in the Borrower’s Assets

Franchise Agreements often grant the franchisor a security interest in the borrower’s assets. The SOP requires Lenders to obtain a first security interest in assets that are purchased or improved with loan proceeds. See SOP 50 10 5(I) at pg. 156. Such a provision can create SBA compliance issues if the franchisor perfects its security interest in the borrower’s assets before the lender files its own UCC or otherwise prefects its security interest.

After evaluating the Franchise Agreement, Lenders should review pre-closing searches to determine whether the franchisor has filed a UCC-1 financing statement on the borrower’s assets. Lenders are encouraged to contact the franchisor about executing a Subordination Agreement if the franchisor’s UCC was filed before the Lender’s. The Subordination Agreement should state that the franchisor’s interest in assets required to be collateral per the SBA Authorization, is subordinate to the lender’s interest in the borrower’s collateral.

In instances when pre-close search results do not reveal a franchisor’s perfected security interest, lenders should consider the following next steps:

1. Promptly obtain borrower permission to file a UCC securing the lender’s interest in loan collateral;
2. Contact the franchisor to determine whether it will be filing a UCC and to what extent it may exercise its rights to an interest in the borrower’s assets; and
3. After receiving proof that lender’s UCC has been recorded, review UCC searches to confirm proper lien position.

Despite what may be permitted by a boiler-plate Franchise Agreements, experience suggests that franchisors may pursue different courses of action with each franchise location.

1. Franchise Agreements and Rights Under an Assignment of Lease

The SOPS state that “[w]hen a substantial portion of the loan proceeds are to be used for leasehold improvements or a substantial portion of the collateral consists of leasehold improvements, fixtures, machinery, or equipment…the lender should obtain…an Assignment of Lease…with option to cure the default.” SOP 50 10 5(I) at pg. 177. Accordingly, lenders are advised to confirm whether Franchise Agreements include Assignment of Lease provisions that grant the franchisor the right to assume the borrower’s lease, cure a lease default, or any other lease related provision that could conflict with the SOPs.

Ultimately, and after discussing the matter with the franchisor, lenders may need to make a credit decision deciding how important a first right to an Assignment of Lease and right to cure are. Obtaining an Assignment of Lease and option to cure subject only to the franchisor’s right may be a prudent business decision if the franchisor is best situated to find a new tenant. For example, a franchisor may be able to more quickly determine whether there are third parties interested in operating outing of the subject location. That said – and in order to understand the legal rights of the franchisor, lender, and borrower – best practice is for lenders to determine what Assignment of Leases and options to cure already exist prior to closing and document its loan file accordingly.

For more information regarding SBA’s franchise requirements, please contact us at ingo@starfieldsmith.com or at 215-542-7070.