Franchisors, Take Heart: There’s New Hope for Lost Profit RecoveryAugust 2008 Focus on Franchising Advisory
For more than a decade, courts have been reluctant – at best – to award franchisors and licensors lost profits damages, such as lost future royalties or advertising fees, after a franchisor has been forced to terminate a franchise agreement following a breach by the franchisee. While courts generally have agreed that lost profits damages are available to franchisors when a franchisee terminates or abandons a franchise, a franchisor who must terminate a franchisee for failure to pay royalties, maintain system standards, or other violation of a franchise agreement has faced long odds when seeking to recover lost profits. Recent case law, however, suggests that courts are becoming more amenable to the enforcement of carefully crafted liquidated damages clauses designed to compensate franchisors for lost profits.
A California Court Causes Bi-Coastal Mischief
The long-shot profit recovery odds stemmed from two cases, one on each coast. The first case was decided in California in 1996. In Postal Instant Press, Inc. v. Sealy, a California intermediate appellate court held that a franchisor could not recover lost future royalties or advertising fees after it terminated a franchisee despite the fact that the franchisee’s failure to pay royalties caused the termination. The California court’s tortured theory was that the franchisee’s failure to pay past royalties didn’t cause the franchisor’s loss of future royalties and advertising fees. Instead, the court said that, because the franchisor had terminated the agreement, the franchisor’s own actions ended its right to future royalties and fees.
Given that the California court seemingly ignored the fact that the franchisee precipitated the termination of the franchise agreement by failing to pay past royalties, most observers concluded that the Sealy decision was, and would remain, unique to California law. Unfortunately, that changed in 2002, when a federal district court located in Florida decided Burger King Corporation, Inc. v. Hinton. Facing similar facts as Sealy, the judge in Hinton agreed that, even when faced with a breaching franchisee, the franchisor “caused” its own future losses of royalties and fees when it chose to terminate the franchisee.
A Different California Court, A Different Result
Returning to the scene of the crime, last year a California federal district court in Radisson Hotels International, Inc. v. Majestic Towers, Inc. held that a carefully crafted liquidated damages clause, including a provision for lost future royalties, was enforceable against a franchisee. The franchisee, which operated the Radisson Plaza Wilshire Hotel, agreed to pay royalties to Radisson Hotel International in exchange for the rights to brand the hotel as a Radisson and access to Radisson’s proprietary reservation system. Within months of signing the agreement, the franchisee fell behind on royalty payments to Radisson.
After Radisson and the franchisee failed to reach an arrangement for payment of the unpaid royalties, Radisson suspended the franchisee’s access to the reservation system and ultimately terminated the franchisee. Radisson then sued the franchisee for both the unpaid royalties and the damages to which it was entitled pursuant to the contractual liquidated damages clause. The franchisee, relying upon Sealy, argued that the liquidated damages clause was unenforceable because the franchisor had terminated the agreement. The court disagreed with the franchisee, distinguished Sealy, and enforced the liquidated damages clause.
What Have We Learned?
So, why was the liquidated damages clause in the Radisson case enforced? The most significant reason was that the provision was specific. The clause provided that if Radisson terminated the agreement due to the fault of the franchisee, liquidated damages of lost future profits would be available to Radisson. This provision ensured that the franchisee was made aware and agreed that, if its breach precipitated a termination of the agreement by the franchisor, the franchisee would be responsible for the payment of reasonable damages. In this way, the court sidestepped Sealy, concluding that the agreement in that case did not provide for specific damages.
The Radisson decision also suggests that how the liquidated damages are to be calculated is almost as important as the specificity of the remedy. The clause in the Radisson agreement stated that the liquidated damages were to be calculated as two times the amount of royalties payable to Radisson in the 12 months preceding the agreement’s termination. The court found this clause to be reasonable because Radisson provided evidence that, on average, it took two to four years for Radisson to find replacement franchisees for its hotels. In other words, at the point in time when the agreement was signed, the chosen method of calculating liquidated damages was reasonably related to the actual lost profits Radisson could expect to suffer in the future should the franchisee breach the agreement.
It must be emphasized that the question of whether lost profits damages are available to franchisors that terminate franchise agreements after a franchisee breaches the agreement remains unsettled. Nevertheless, the Radisson decision and other recent cases suggest that courts are now more willing than ever to enforce specific liquidated damages clauses so long as those clauses do two things. First, the clauses should specifically provide that they apply in the event of a termination precipitated by a franchisee’s default. Second, they should contain a reasonable and specific method of calculation that is related to the actual lost profits the franchisor is likely to suffer in the event of franchisee default.
If you have a question regarding how to incorporate such liquidated damages provisions into your franchise agreements, or any other franchise question, please contact an attorney in our Franchising, Licensing & Distribution Practice.