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Whose Business Goodwill Is It?

Daily Journal
06/16/11

When property and business owners negotiate a lease, one of the provisions that is often overlooked and misunderstood is the "condemnation" provision.  Eminent domain is uncommon, and the standard form condemnation provision usually suffices to split the proceeds between the parties in a reasonable manner (most of the compensation for real estate typically goes to the landlord, and compensation for business goodwill losses and fixtures and equipment typically go to the tenant).  When negotiating franchisor/franchisee agreements, however, the appropriate allocation of the condemnation proceeds is not as clear-cut, as the franchisee frequently runs the business with the help and assistance of the franchisor.  This can result in a dispute between the franchisor and franchisee as to who is entitled to recovery for loss of goodwill.

Typically, franchisors have no direct ability to recover goodwill in condemnation actions, as California courts have uniformly held that the goodwill statute (Code of Civil Procedure Section 1263.510) requires that the party seeking goodwill actually operate a business on the site being condemned.  An interesting twist on this issue was recently addressed by the 4th District Court of Appeal in Galardi Group Franchise & Leasing LLC v. City of El Cajon, 2011 DJDAR 8273 (June 7, 2011), where the franchisor played a larger role in the business by leasing the entire store including fixtures and equipment, to a franchisee on a month-to-month basis. 

The 4th District held that despite its involvement, the franchisor still fails to qualify for recovery of goodwill because it is not operating a business on the property unless it has an ownership interest in that business, but a franchisee's waiver of its rights to compensation can effect an assignment of those rights to the franchisor, including rights to goodwill losses (which, as a result, allows the franchisor to recover for the franchisee's loss of goodwill).  The second prong of the holding may have broader implications in the landlord/tenant context, as it arguably modifies existing law that a blanket waiver does not eliminate a tenant's right to seek loss of business goodwill.

Galardi (the franchisor of the well-known fast food chain Weinerschnitzel) subleased, on a month-to-month basis, the store, its fixtures and equipment, to an individual who operated the city of El Cajon restaurant.  The parties' operating agreement provided that in the event of condemnation, the operator/franchisee "waives all right to or interest in any condemnation award or settlement." 

In 2005, Galardi was notified that the property might be acquired by eminent domain.  The restaurant eventually closed when the city acquired the property for a new police station.  Thereafter, in accordance with the waiver language in the parties' operating agreement, the operator assigned to Galardi any claim he had for loss of business goodwill.  Galardi then filed an inverse condemnation action, asserting it was entitled to lost goodwill compensation because it was the owner of the restaurant, or it had acquired by assignment the operator's goodwill claims.

At trial, the city argued that Galardi was not entitled to compensation pursuant to Redevelopment Agency v. International House of Pancakes Inc. (1992) 9 Cal.App.4th 1343, in which the court held that a franchisor was not entitled to loss of business goodwill because it was not the owner of a business conducted on the property taken.  The city also argued that given the operator's prior "waiver" of his rights to compensation under the operating agreement, the operator's assignment of his goodwill claim was ineffectual (i.e., the operator's waiver resulted in there being nothing to assign).

The trial court agreed with the city and held that the operator was the party operating the business on the property and that the assignment was ineffective since the operator had previously waived all claims.  Galardi appealed.

While the appellate court agreed with the city as to Galardi's lack of entitlement to goodwill compensation as an owner, it disagreed with the trial court's conclusion as to the validity of the assignment. 

The court walked through the IHOP decision and concluded that the agreement between Galardi and the operator evidenced that Galardi had no ownership in the actual business operating on the property.  Galardi tried to distinguish IHOP by arguing that the agreement with the operator did not satisfy the legal requirements of creating a franchisor-franchisee relationship because the operator did not pay a franchise fee.  The court rejected this , concluding that IHOP did not turn on the franchisor-franchisee relationship, but rather on whether the claimant actually owned the business conducted on the condemned property.  Because Galardi could not establish some sort of ownership interest, Galardi could not recover for loss of business goodwill.

In addressing whether the parties' conduct had effected an assignment to Galardi of the operator's goodwill claim, the court concluded "that the parties intended the waiver clause [in the operating agreement] to define their respective rights to goodwill damages vis-à-vis one another."  The court explained that it would be fundamentally unfair to construe the agreement between Galardi and the operator in a manner that would enable the city to pay [no] compensation for lost goodwill for its taking of the property - a potential windfall for the condemning agency. 

California law allows landlords and tenants, and franchisors and franchisees, to define their respective rights to compensation and apportion an award as they see fit.  The court held that the parties intended the waiver to transfer the operator's goodwill claim to Galardi, as further evidenced by the subsequent express assignment of that claim.  The Court reversed, remanding the case so that Galardi can pursue the goodwill claim.

What are the lessons to be learned?  The court's decision in affirming the rationale behind IHOP was not surprising and appears consistent with the legislative intent behind Code of Civil Procedure Section 1263.510.  If franchisors want to preserve goodwill claims as an "owner" of the business, they may need to go back to the drawing table and find a creative way to "operate" a business on the property.  Without engaging in some sort of joint venture or partnership with the franchisee (which obviously comes with a number of risks and liabilities), franchisors will not be able to recover goodwill as a business owner.

However, franchisors can back-door the right to recover goodwill by having an express provision in an operating agreement whereby the franchisee waives or assigns any and all rights to compensation in the off chance a condemnation occurs.  Such a provision is potentially catastrophic to a franchisee, and it highlights the importance for all parties to pay attention to the frequently overlooked condemnation provision to ensure everyone agrees how eminent domain proceeds are to be allocated between the parties. 

Moreover, the Galardi opinion has potential implications for landlords and tenants.  Until now, the law has been that a condemnation clause containing a blanket waiver of all rights to compensation nonetheless does not eliminate the tenant's ability to seek loss of business goodwill.  Such waivers act to transfer all compensation for the real estate to the landlord, but do not affect the tenant's separate goodwill claim. 

It is unclear whether Galardi changes this balance.  Though the court appears to have concluded that the operator's blanket waiver of compensation included a waiver (and, effectively, an assignment) of the goodwill claim, two unique facts cast uncertainty as to whether the decision will apply more generally to typical landlord-tenant relationships. 

First, Galardi involved a franchisor-franchisee relationship, which is different than a typical landlord-tenant relationship in that the franchisor does have a direct stake in the business being operated. 

Second, the franchisee executed an express assignment of the goodwill claim after the condemnation arose.  It is not clear whether the court would have concluded that the parties intended the blanket waiver to encompass goodwill in the absence of the subsequent express assignment. 

Still, until a reported decision provides more clarity on this issue, landlords and, particularly, tenants should take heed of the Galardi decision.  All parties should carefully analyze their leases to ensure their condemnation provisions do not someday get interpreted in an unexpected manner. 

Bradford B. Kuhn is a member of Nossaman's Eminent Domain and Valuation Practice Group and specializes in real estate and business litigation with an emphasis on eminent domain, inverse condemnation, and other real estate disputes.  He can be reached at bkuhn@nossaman.com or (949) 833-7800.

David Graeler is a partner in the Eminent Domain Practice Group whose condemnation experience encompasses a wide array of matters including right to take challenges, direct and inverse condemnation actions, real estate valuation, and business goodwill.  He can be reached at dgraeler@nossaman.com or (213) 612-7800.

Rick E. Rayl is the chair of Nossaman's Eminent Domain and Valuation Practice Group and a member of the Firm's Real Estate Practice Group.  He is an experienced trial attorney dealing with eminent domain, inverse condemnation, and other real estate and business disputes.  He can be reached at rrayl@nossaman.com or (949) 833-7800.

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