How Far Is Too Far?
Franchisors traditionally include liquidated damages provisions in their franchise agreement. A liquidated damages provision in a franchise agreement can be an important tool for a franchisor to ensure that it will be contractually and adequately compensated in the event its franchisee breaches. That said, post-termination provisions can often be deal breakers for a sophisticated franchisee. A franchisor must weigh the value gained by post-termination leverage over the franchisee against the restrictions imposed on the development of the brand when mandating a liquidated damages provision.
A liquidated damages clause specifies a predetermined damage amount or a set formula for computing monetary damages in the event a franchisee breaches the contract. Instead of having a judge or jury calculate the amount of damages the franchisor has suffered, the franchise agreement will delineate the sum of money the franchisee must pay to the franchisor or non-breaching party. Some liquidated damages formulas are industry-specific. In the hotel industry, for example, the formula is routinely based on the number of rooms in the hotel, and it is the hotel industry that has produced some recent rulings that merit examination.
In the hotel industry, while liquidated damages provisions are commonly used in franchise agreements, the enforceability of such provisions may vary from state to state. A franchisor needs to carefully draft these provisions to increase the likelihood of their enforceability. A recent case involving a hotel franchise in Maryland provides guidance regarding the factors a court will consider when determining the enforceability of a liquidated damages provision in a franchise agreement.
In Choice Hotels International, Inc. v. Smith Hotel Properties, LLC (2011), Choice sued Smith for breach of its franchise agreement and sought summary judgment on the liquidated damages provision in the franchise agreement. The trial court denied summary judgment, but that ruling was reversed, and summary judgment on liquidated damages was granted upon a motion for reconsideration.
The court considered three factors when determining the enforceability of this type of liquidated damages provision under Maryland law: 1) the contract must identify a mechanism so that, at the time of the breach, a specific dollar amount can be determined; 2) the amount of damages must be reasonable in comparison to the amount of damages anticipated to be incurred as a result of the breach; and 3) the amount of damages may not be altered after the fact to cover the actual damages incurred as a result of the breach. The court decided that because there was a specific calculation that determined the exact amount of damages at the time of the breach, such damages were not "grossly excessive and out of all proportion."
In Radisson Hotels International, Inc. v. Majestic Towers, Inc., et al. (2007), the U.S. District Court for the Central District of California granted Radisson summary judgment in the amount of $1,006,714.55 for past due fees and liquidated damages. In doing so, the court held that Radisson's contractual liquidated damages clause was reasonable and enforceable. The court also determined that California's leading case on a franchisor's ability to collect future lost profits in the context of a termination for cause, Postal Instant Press, Inc. v. Sealy (1996), was inapplicable to the facts of the case and decided in error. The Radisson decision validated the franchisor's timeline for replacing a terminated franchisee. In addition, the holding supports that liquidated damages provisions are not a penalty and can be an accurate computation for calculation of lost future royalties. The court held that the plain language of the liquidated damages clause did not support the franchisee's defenses and was enforceable as a matter of law.
In Country Inns and Suites by Carlson, Inc. v. Bandera Pointe Hospitality, LP, the plaintiff franchisor sued the defendant franchisee in federal court in Minnesota on January 19, 2011, for liquidated damages. The franchisee failed to begin construction of the hotel that it was to operate. This constituted a default under the license agreement and the franchisor terminated the license agreement with the franchisee.
Some franchisors are using buyback provisions as an alternative to liquidated damages. The buyback clause is a provision in a contract that grants to the franchisor the right or opportunity to repurchase the franchise under stated conditions. Using the buyback allows franchisors to place a predetermined penalty or discount to the repurchase of the franchise unit upon breach.
Liquidated damages provisions range from requiring payment of all remaining royalty payments due through the remainder of the term of the franchise agreement, to capping liquidated damages for a set period (e.g., one or two years) or a set amount (e.g., $50,000). Although recent rulings have held that liquidated damages are enforceable, the question remains: How far is too far?
Anthony J. Calamunci is partner-in-charge in the Toledo, Ohio office of Roetzel & Andress LPA. He practices in a wide range of business matters, with a focus on franchise law and franchise litigation. Contact him at 419-254-5247 or firstname.lastname@example.org.