An increasing number of franchisors are including liquidated damages clauses in their franchise agreements. Prospective franchisees should be extremely wary of such clauses but should stifle any sigh of relief if their franchise agreement doesn’t have one. That’s because the absence of a liquidated damages clause does not mean an absence of damages.
In a liquidated damages clause, the parties to a contract pre-determine or stipulate an amount of money damages that is payable to the non-breaching party in the event of an early termination. In the context of a franchise agreement, the “non-breaching party” is always the franchisor. There is never a reciprocal provision that entitles the franchisee to liquidated damages.
The amount of liquidated, or stipulated, damages is generally a multiple of the royalties that were paid in the last 12 months of operation preceding the early termination. For example, in one of the most significant recent court cases on liquidated damages in a franchise context, a California Federal court upheld a liquidated damages clause that allowed the franchisor to recover twice the amount of royalties that the franchisee paid in the in the two years before the franchisor terminated the franchise agreement. In addition, the American Bar Association’s 2010 Annotated Franchise Agreement for franchisors has a model liquidated damages clause that provides:
Upon the Franchisor’s termination of this agreement in accordance with the terms of this agreement, the Franchisee shall pay to the Franchisor within 30 days of the date of the termination, as liquidated damages for the premature termination of this agreement and not as a penalty, an amount equal to 3 ½ times the continuing royalty fees payable to the Franchisor in respect to the last 12 month’s of the Franchised Business’ active operations or the entire period the Franchise Business has been open for business, whichever is the shorter period.
Sometimes, though, a liquidated damages provision may require the franchisee to pay all remaining royalty payments due through the remaining term of the franchise agreement. But such a Draconian provision may be difficult to enforce and the industry standard appears to be the royalties-multiple formula.
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Typically a liquidated damages provision comes into play when a franchisor terminates a franchise agreement before the end of its term because franchisee stops paying royalties or abandons the franchise. And, usually, the franchisee takes such actions because the franchise is operating at a loss or is not getting the agreed upon support from the franchisor. Sometimes a franchisee may simply be seeking a better deal with another franchise, but that’s probably the exception rather than the rule.
In any case, staring down the barrel of a liquidated damages clause is a little unnerving and its enforcement can be financially ruinous. As a result, many franchisees against whom a liquidated damages clause is being exercised will challenge its enforceability. In a recent case decided in favor of the franchisor, a North Carolina Federal Court, applying Maryland law, upheld the liquidated damages clause in Choice Hotel’s franchise agreement, which provided for damages based on a royalty multiple through the remaining term of the franchise agreement (subject to a 36 month cap and a floor of $40.00 times the number of “Rentable Rooms”), because:
- The clause provided “in clear and unambiguous terms for a sum certain, i.e.,” “[a]s of the date of termination the exact dollar amount of liquidated damages is immediately ascertainable.”
- It constituted a fair and reasonable attempt to fix just compensation for an anticipated breach of the franchise agreement, i.e., it was not “grossly excessive and out of proportion” to reasonably expected damages; in other words, it was not a penalty.
- The liquidated damages were not changed to correspond to the actual damages that were determined after the fact.
Franchise agreements are governed by State law so there is no uniform test for the enforceability of liquidated damages provisions. But a common formulation for enforceability provides that (1) the parties intended the stipulated amount not as a penalty but as an approximation of the damages to the non-breaching party, (2) the liquidated damages are reasonably proportionate to the anticipated loss and (3) the non-breaching party’s actual damages are difficult to determine.
Franchisors like liquidated damages clauses for a number of reasons but mainly because they can avoid costly, protracted litigation (including discovery, expert witnesses, etc.). Franchisees and their attorneys hate such clauses because they view them as one-sided, very harsh measures that really only benefit the franchisor. In fact, some States, like Minnesota, are not particular fans of liquidated damages provisions in franchise agreements and make them illegal.
Nevertheless, franchisees should not breathe too easily if their franchise agreement does not have a liquidated damages clause or their franchise attorney successfully gets it removed (don’t count on that: franchisors tend to view the sanctity of the such provisions in their franchise agreements with something bordering on piety or, in some cases, zealotry).
Many franchisees relax when they learn that their franchise agreement does not contain a liquidated damages clause. Maybe too much. A franchisor still can sue a franchisee to recover lost profits or future royalties in the event of an early termination for a franchisee’s breach – even in the absence of a liquidated damages provision. This typically lengthy process may even cost the franchisee more than he or she might have paid under a liquidated damages clause. And it almost certainly will take more time and energy. Accordingly, you need to fully understand the scope of your potential damages as a franchisee whether or not your franchise agreement has a liquidated damages clause.