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Hotel Franchisee Pays Half A Million Dollars for Franchisor's Computer System

A recent case decided by the United States Circuit Court for the Sixth Circuit, La Quinta v Heartland Properties, shows again the animosity that most Courts, especially federal Courts, have towards franchisees. In this case, La Quinta, on behalf of Baymont, sued one of its former franchisees for breach of a hotel franchise agreement and federal trademark infringement seeking liquidated damages under the franchise agreement and treble damages under the Lanham Act. The costly litigation arose out of a dispute over whether the franchise agreement granted Baymont the right to add, amend, and/or delete System Standards, including the computer reservation system, and, if so, whether the agreement required Heartland to participate in and bear such costs.

After all was said and done, the court rendered a damages award in favor of the franchisor of a cool half of a million dollars, including: (1) $19,852.52 in unpaid recurring fees, (2) $111,325.37 in liquidated damages for early termination; (3) $117,866.16 in treble damages for willful, unauthorized use of Baymont's intellectual property in violation of the Lanham Act; and (4) $246,048.20 in attorney's fees and $8,835.74 in costs.

In 2004, Baymont adopted a new System Standard requiring the installation of a new computer software and hardware system known as the L.I.S.A. system. As part of the upgrade, Baymont required its franchisees to sign a software license agreement pursuant to which franchisees' payments for the acquisition, installation, and initial training on the system were amortized over a period of 120 months, commencing on installation of the new computer system. Under the terms of the L.I.S.A. Agreement, all franchisees, including Heartland, were to pay a total of $35,000 over the ten-year amortization term, and if the franchise agreement expired or was terminated for any reason, even if such expiration or termination occurred before the amortization period tolled, Heartland would be obligated to pay in full the remaining balance owed for the L.I.S.A. System. Heartland was terminated when it refused to install the computer system.

Heartland made the somewhat esoteric argument that the L.I.S.A. Agreement conflicted with its right to kick out of the franchise agreement at the ten-year anniversary date, a right that was explicitly set forth in the franchise agreement.  Heartland also cited the sloppy and disruptive installation of the computer infrastructure and related technical problems as factors in refusing to sign the L.I. S.A. Agreement.  Heartland also contended that the L.I.S.A. Agreement effected "significant changes" and imposed additional demands on franchisees beyond those contained in the franchise agreement. Heartland further argued that because it had not give its written consent to these material changes Baymont had anticipatorily breached the franchise agreement, thereby excusing any further performance by Heartland.

The Court began its analysis by examining Heartland’s argument that the L.I.S.A. Agreement imposed a penalty on its right to terminate the franchise at the time of the ten-year out, because in the event it opted not to renew its contract on the tenth anniversary of its opening date, but before the L.I.S.A. amortization period ended, it would have had to pay the remainder of the balance it owed for the L.I. S.A. System and thus would be charged for a reservation system that it was no longer using.

In rejecting the franchisee’s defense, the Court relied on three provisions in the franchise agreement to conclude that the implementation of the L.I. S.A. System with its attendant costs was “fully contemplated and permitted under the unambiguous terms of the franchise agreement.” Specifically the franchise agreement provided that Heartland would “at its sole expense to comply with all such System Standards, and System Manuals and Policy Statements”; that Baymont “shall have the right, from time to time to add, amend and/or delete System Standards, including without limitation”; and that Baymont has the right “by adoption or amendment of its ‘Systems Manuals’ and/or ‘Policy Statements,’ amend, modify, delete or enhance any portion of the System, including any of the Marks, System Standards and the Prototype Package, as may be desirable, in the sole judgment of [Baymont], to maintain or enhance the reputation of the System or improve System license marketability.

The Court also rejected Heartland’s argument regarding the alleged “penalty” pointing out that the franchise agreement stated that if it was "terminated for any reason" (even including Hearland’s exercise of its ten-year out), Heartland was required to "promptly pay all sums then owed to [Baymont]." There was no “inherent inconsistency” because at the time that the franchise agreement was terminated, "[t]he unamortized portion of the L.I. S.A. System cost simply became one of the sums owed."

Then the Court reached out for a few of the voluminous franchise cases holding that franchisors have the unfettered right to modify their franchise agreements through the back door, by simply modifying their system standards manuals, even at the sole expense of their franchisees. The Court found persuasive in particular the reasoning of a Burger King case from 1966 in which a Florida State Court had ruled that “It is clear from the language of the instrument that one of the objects is to provide uniformity among all franchised 'Burger-King' restaurants. [T]his uniformity is accomplished by providing that the defendant set and maintain standards and specifications which the plaintiff must follow or suffer termination of the agreement.”

After examining and rejecting all of the franchisee’s factual and legal arguments, the Court held that “In sum, we reject Heartland's assertion that Baymont breached the franchise agreement through its implementation of the L.I.S.A. System and insistence that Heartland adopt its new reservation system. Baymont did not breach the franchise agreement, but Heartland did when it failed to comply with its contractual obligation to adopt new System Standards.” 

The Court next turned to the issue of liquidated damages. The franchise agreement contained the traditional penalty formula under which the franchisee agreed to pay Baymont within 30 days following the termination of the franchise agreement an amount equal to 100% of the aggregate Recurring Fees which accrued with respect to Inn operations during the immediately preceding 36 full calendar months. In this case, however, the franchise agreement exempted the need for the franchisee to pay the penalty if “the licensee terminates the license term pursuant to … the non-renewal option at the ten-year anniversary of opening, which requires "12 months prior written notice to [Baymont]."

Using the thirty-six month formula, there was no dispute that the total liquidated damages due would have been $111,325.37.  However, the franchisee argued that this amount was unreasonable “in the light of the anticipated or actual harm caused by the breach, the difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy.” Specifically, Heartland argued that the thirty-six month time period was unreasonably long, and that it should therefore be shortened.  Because the termination occurred on March 25, 2006, and because the ten-year out was exercisable on September 25, 2006, Heartland contended that Baymont's maximum loss of royalties should be limited to the period of March 25, 2005, the termination date, until September 25, 2006, or eighteen months.

In finding that the liquidated damages formula passed muster, the Court first pointed out that the damages provided for in the contract were not “grossly disproportionate to the actual harm sustained.” In this regard, there was record evidence that Baymont’s lost royalties over the entire remaining term of the franchise agreement would have exceeded $430,000. Explaining why it did not require Baymont to actually introduce evidence of these damages to prevail, the Court stated: “Actual damages, in the context of the hospitality industry, are difficult to quantify and not strictly monetary; a franchise operation yields not only future royalties, but additional intangibles such as brand recognition and loyalty, and a competitive presence in a geographic region.” The Court continued stating that “Baymont conceivably could have had a presence in the Shepherdsville market through 2012, but lost these benefits through Heartland's breach. It was not an arbitrary calculation, but a "reasonable forecast" of the damages Baymont would sustain in the event of Heartland's breach.”

Last, Heartland argued that the district Court's award of treble damages for its Lanham Act violations (arising out of Heartland’s use of the name and marks after the termination) constituted an impermissible "penalty" under the trademark infringement statute. The Court set out the relevant legal standard for the inquiry, which is to weigh the equities of disputes on a case-by-case basis, “considering a wide range of factors including, inter alia, the defendant's intent to deceive, whether sales were diverted, the adequacy of other remedies, any unreasonable delay by the plaintiff in asserting its rights, the public interest in making the misconduct unprofitable, and "palming off," i.e., whether the defendant used its infringement of the plaintiff's mark to sell its own products to the public through misrepresentation.”

In this case, there was no dispute that the express language in the franchise agreement prohibited the use of Baymont's marks after termination. Even in the face of the termination letter, Heartland continued to use and display Baymont's marks in advertising and on its internet page until one year after the termination and two months after the district Court entered the preliminary injunction ordering it to cease. The Court found that Heartland’s post-termination use of the marks to operate its business was “in deliberate defiance of the franchise agreement.” The Court found it of no moment that Heartland claimed that the termination was wrongful.

Heartland attempted to deflect the punitive aspect of the trademark infringement statute by arguing that an award of both liquidated damages for breach of contract and treble damages for trademark infringement violated the Lanham Act because the statutory and contractual damages were duplicative. In rejecting this “double-recovery for a single injury” argument, the Court reasoned that liquidated damages were awarded because the franchisee breached the franchise agreement and trademark infringement damages were awarded because the franchisees continued to operate after the franchise agreement was terminated.

Although there might some overlap, the Court held that Baymont's claims for breach of contract and trademark infringement are distinct actions, based on separate conduct and addressing disparate harms. Further, in support of its ruling that a “double recovery” did not exist, the Court pointed out that the liquidated damages award fell short of the $430,000 in lost royalties that Baymont claimed it would have received over the remainder of the license term. “Given the abundant evidence that Heartland willfully infringed upon Baymont's trademarks, and that an award of royalties alone was inadequate to compensate Baymont for the true extent of its injuries, we find no abuse of discretion, or prohibited "penalty," in the district Court's award of treble damages.”

Although none of the legal rulings by the Court in this case was in any way surprising or unanticipated, the Court did refer to an argument made by a franchisee in a 1989 Quality Care-USA franchise case that I thought was funny. And, I say this being a franchise lawyer representing only franchisees. Specifically, the defendant-franchisee in that case argued in essence that it had the legal obligation to engage in trademark infringement after its termination since its franchise agreement required it to “return the franchise in the condition in which they had obtained it, trademark and all, after their claim for rescission was decided.” “They made me do it.” Great stuff.

About the author: Jeffrey M. Goldstein of GOLDSTEIN LAW GROUP, www.goldlawgroup.com, email: [email protected], phone: 202-293-3947

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