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ENFORCEABILITY OF LIQUIDATED DAMAGES CLAUSES IN FRANCHISE AGREEMENTS

Liquidated damages clauses are commonly found in franchise agreements as a measure of damages for recovery of lost profits or future royalties. These clauses are for the benefit of the franchisor, and generally consist of a formula by which money damages are calculated in the event of a breach by the franchisee. A complete understanding of the potential monetary impact of a liquidated damages clause is critical, particularly with long term franchise agreements. Franchisors need to be reasonably compensated for the time and money lost when a franchisee's default ends the franchise relationship before the contracted expiration date, while franchisees need to understand the financial impact of being on the hook for years of unrealized profits and royalties.

Postal Instant Press, Inc. v. Sealy (1996)("Postal") is the leading California case addressing a franchisor's termination of a franchise agreement and subsequent claim for recovery of lost future royalties. In Postal, after the franchisee failed to make several royalty payments, the franchisor declared the overdue payments constituted a material breach and sent the franchisee a termination letter. The franchisor sought damages in excess of $495,000, representing the estimated sum of all future royalty payments for the remaining 8 years under the contract term. The franchisor argued that the contract stated that any material breach would entitle the franchisor to terminate the contract and collect the "benefit of the bargain", which the franchisor interpreted as allowing for lost future royalties. The court rejected this argument and relied on the contract principle that a non-breaching party is entitled to recover only those damages which are proximately caused by the specific breach. The court found that the franchisee's failure to pay past due royalties did not prevent the franchisor from receiving future royalties; instead, the franchisor deprived itself of the right to receive future royalty payments by initiating the termination of the franchise agreement. Further, the court held that under the circumstances an award of lost future profits as damages would be unreasonable, unconscionable and oppressive. Since the Postal decision, courts have attempted to distinguish cases with similar facts to allow for the recovery of all or a portion of lost profits or future royalties.

In the 2007 California federal court case, Radisson Hotels International Inc. v. Majestic Towers, Inc. ("Radisson") the court awarded summary judgment to a franchisor with respect to its liquidated damages claim. Like the Postal case, the franchisee failed to pay royalty payments when due, and following repeated delinquencies the franchisor terminated the franchise agreement. The relevant clause of the franchise agreement provided that if the franchisor terminated the franchise agreement on the basis of the franchisee's fault the franchisor could recover twice the amount of royalties paid during the prior year, which was an estimate of the revenue/future royalties that would be lost by the franchisor while searching for a replacement franchisee. This basic formula resulted in a claim by the franchisor of over $668,000. The court distinguished the Postal case by explaining that the franchise agreement therein had no specific risk shifting provision indemnifying the franchisor for lost future profits. The court stated that the Postal proximate cause rule does not apply when the parties have mutually agreed to assignment of risk by way of an indemnification/liquidated damages clause. The court upheld the liquidated damages provision on the key finding that the method of calculating liquidated damages was reasonably related to the actual lost profits the franchisor would incur in the event of a default by the franchisee.

Since the Postal and Radisson cases, there have been no landmark decisions that further clarify the enforceability of liquidated damages clauses. While franchisors are advised to include such clauses in franchise agreements, careful drafting is necessary to ensure they are enforceable. Courts are more likely to uphold liquidated damages provisions if the formula for calculating damages is specific, cannot be altered post-breach, and bears some reasonable relationship to the harm that the franchisor could expect to suffer from the breach. The clauses should also (i) unambiguously state that the provision applies to lost profits or future royalties if termination results from a franchisee's breach, and (ii) avoid any language which would lead a court to construe the provision as a penalty for early termination.

Franchisees should be wary of liquidated damages clauses, as courts often validate these clauses. The potential liability imposed on a franchisee following a default can be extensive. When negotiating a franchise agreement, it is important to include a detailed review of any provisions that require the payment of lost profits or future royalties. Franchisors may accept a more favorable formula for calculating damages or a cap on liability for fees incurred as a result of early termination of the agreement.

Although the enforceability of liquidated damages clauses remains uncertain, paying close attention to these provisions when drafting or negotiating a franchise agreement can help protect franchisors and franchisees from unexpected outcomes if the franchise relationship dissolves.

The information on this website is for general information purposes only. Nothing on this site should be taken as legal advice for any individual case or situation. This information is not intended to create, and receipt or viewing does not constitute, an attorney-client relationship.

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