Lost Future Royalties: Take the Money & Run?

When a franchisor terminates a defaulting franchisee, the franchisor can sue for past due royalties and prevail, if there are no legitimate defenses by the franchisee. Can the franchisor also recover lost future royalties resulting from the early termination of the franchise relationship? Ten years ago, the answer was probably yes. Today, the answer is much less certain.

This uncertainty first arose back in 1996 with the California decision in Postal Instant Press, Inc. v. Sealy, where a California appellate court held that lost future royalties were not recoverable where the franchisor terminated the franchise agreement. The court reasoned that the franchisor's decision to terminate, not the franchisee's failure to pay royalties, was the proximate cause of the franchisor's damages; thus, the franchisee should not be held liable for these damages. The court also noted that allowing recovery under these circumstances would have been unconscionable.

Sealy was generally viewed by the franchise bar as an anomalyóan aberration, so to speak. While a demonstrably interesting case for discussion at programs on franchise law, its importance, most lawyers felt, should not be overstated.

Then came Burger King Corp. v. Hinton. The issue before the federal district court for the Southern District of Florida (the same court that gave you Scheck and later Weaver) was precisely the same as in Sealy, and the trial court reached the same conclusion using the same logic (but without characterizing an award of lost future royalties as being unconscionable). While California courts are often thought of as being ìoff the markîóthat is, they sometimes do not follow normal jurisprudenceóthe Southern District of Florida is considered very mainstream. Thus, as I have written elsewhere, the California aberration, supported by this Florida precedent, started a trend.

And now it appears that there is a snowball effect taking place. In an even more recent decision, Kissinger, Inc. v. Singh, another federal district court, sitting in Michigan, has reached the same conclusion, relying on both Sealy and Hinton, as well as a couple of lesser known precedents. In this light, can it be said that a franchisor is likely to recover lost future royalties when it terminates a franchise agreement?

These precedents should make both franchisor and franchisee advocates uneasy, although less so for the franchisee advocates. For the attorney representing franchisees, they present a ray of hope in what have traditionally been dark situations. Where the franchise relationship had a lengthy term remaining, the terminated franchisee often faced significant damage claims if the franchisor were to prevail on the lost future damages claim. For instance, a franchised fast food franchisee, averaging $1 million dollars in annual sales and paying a 5% royalty, if terminated two years into a ten-year agreement, might be facing a claim of $50,000 per year for lost future royalties, or a total of $400,000 for the remaining eight-year period. Even if this amount were discounted to present value, it would remain substantial, and might well exceed the amount the franchisee had initially invested in the restaurant.

In light of Sealy, is the franchisee's exposure really that large? And yet, can an attorney whom the terminated franchisee approaches for representation comfortably advise his client not to worry about this exposure? In California, Michigan and Floridaóthe answer is yes, but it is still difficult to predict whether courts in other jurisidictions will follow this trend. This question becomes of particular importance where there are settlement discussions.

From the franchisor's perspective, the reason these precedents create uneasy feelings is self-evident. The franchisor anticipated that it would have an income stream for the remainder of the term of the franchise agreement, and that anticipation has now been put at risk.

The Sealy court was quick to note that the franchisor is not out in the cold: it may continue to sue periodically as the lost future royalties actually accrue. But is that a realistic solution or assessment of the situation? Does this suggestion assume that the franchisor should allow the franchisee to continue to operate using its trademarks, even though the franchisee is perpetually in default in its royalty payments? What if the franchisee shuts its doors, in which case there will be no income stream from which to calculate damages? Moreover, from society's standpoint, is this an efficient use of the courtsóencouraging continual litigation for the collection of debts?

There is one other principle of contract law that must be thrown into the picture, howeveróthe concept of mitigation. Generally, an aggrieved party has a duty to mitigate damages resulting from the breach of contract by the other party. Thus, where the franchisor terminates the agreement, there would have been a duty to mitigate the damages but only IFóand here's the kickeróthe franchisee had been granted an exclusive territory, as was the case in Sealy.

The rationale here is that once the franchise has been terminated, the franchisor now has the opportunity to recapture the benefits of being able to resell the territory. It should have been anticipated that the franchisor would not have been injured for the entire remaining term (eight years in the example above), but for some shorter timeóa period long enough to allows the franchisor to re-franchise the territory and get a new unit open. Consequently, why should the franchisor believe it is entitled to royalties for the full remainder of the term. And why did the Sealy court not invoke the mitigation doctrine?

What about the situation where there is no territorial exclusivity, as in Hinton? Generally, the courts have concluded that there is no duty to mitigate where a franchise contract does not provide for territorial exclusivity. Does this make sense? Think in terms not of restaurants, but cars, to understand the logic here. If GM loses a sale because of a buyer's breach, the law looks at that sale from a marginal viewpoint. Rather than having the opportunity to resell a particular car, GM is damaged because it would have been able to produce another car, and sold that second car, rather than the first one, to the next buyer.

In the franchise context where there is no territorial exclusivity, the argument translates into the following: Since the franchisor could have placed another unit anywhere it wanted, it has not recaptured anything; thus, like the car seller, it has lost that additional sale, and the loss of that sale should be the basis for the calculation of damages.

But in practical terms, this argument does not make sense either. Can it be said that the franchisor who refuses to grant exclusivity truly has the opportunity to put the next franchise anywhere it wants? Realistically, there are only so many Burger Kings or McDonald's restaurants that can be opened in a specific trade area. In effect, as long as there is one such restaurant in that territory, the franchisor is foreclosed from opening a second one there, even if it may have the legal right to do so. And if it does open that second restaurant, it becomes more likely that one of the two may fail, ultimately denying the franchisor a royalty stream from two units.

Invoking the concept of mitigation would have provided a realistic solution to the problem created by Sealy and its progeny. Instead, we have decisions that present the antithesis of a Solomon-like solution. Under Sealy, the franchisee may be viewed as getting a windfall since it does not have to pay a price for not keeping its share of the bargain. And franchisors are left out in the coldówith no recovery.

By asking for everything, they have suffered from the so-called ìbig pigî theory (i.e., pigs get fat; hogs get slaughtered). And franchisor attorneys and their clients are left with a dilemma. Should the franchisor go for the big banana and risk the application of the Sealy doctrine, or should it take a substantially reduced amount in settlement, or a less aggressive approach in litigation, and run? Had the mitigation doctrine been invoked by the courts, they could have reached a conclusion that made sure that the franchisee would pay an appropriate price for the breach, but not overcompensate the franchisor.

The good news from the franchisor's perspective is that Sealy and these other precedents are of limited application. The doctrine only applies where the franchisor terminates. It does not necessarily apply where the franchisee terminates the agreement. However, the bad news for franchisors, especially in the hotel sector, is that the doctrine raises issues about the viability of liquidated damage claims. How can liquidated damages be awarded as an ìapproximationî of actual damages, if no damages could have been recovered for lost royalties in the first place?

I will leave that question for the readership to answer.