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Ruling Denies Liquidated Damages with Favorable End for Franchisors

A district court in Ohio denied a campground franchisor’s request for liquidated damages against a terminated franchisee, but with a possible favorable outcome for franchisors. It approved as “reasonable” a provision making the franchisee responsible for the discounted present value of all anticipated royalties through the term of the franchise agreement. That opinion refutes claims that such provisions constitute an unenforceable penalty.

Michael L Sturm of Wiley Rein explained in a recent article published on Lexology.com that the background of the decision is “straightforward and characteristic of many franchise disputes.”  He states,

Leisure Systems terminated the defendants’ three franchise agreements for non-payment of royalties.  The court upheld the termination notwithstanding the franchisee’s claim that the contractual notice provisions had not been scrupulously followed.  

The franchise agreement dictated that, in the event of termination, the franchisee would owe liquidated damages as calculated by the franchisor.

(1) all sums then currently due and owing, plus the monthly average royalty and service fees paid or due to LSI from FRANCHISEE for the three (3) year period immediately preceding the effective date of termination . . .;

(2) shall be multiplied by the number of months remaining in the term of this Agreement;

(3) which amount shall be reduced to the present value of such payments as of the date of termination . . . utilizing an interest rate of five percent (5%).

The franchisee acknowledged that the franchisor’s losses would be difficult to ascertain and the formula calculated by Leisure Systems was a reasonable estimate of damages and would “not constitute a penalty or forfeiture.”

Nevertheless, taking advantage of the law that deems such admissions to be non-controlling, the franchisee argued that the formula it had previously agreed to was an unenforceable penalty. The court proceeded to consider the question under governing Ohio law.

The court found that it was reasonable to use historic payments owed by a franchisee to predict the future amounts that would be payable . . . by the franchisee absent the breach. It rejected the franchisee’s contention that damages should be calculated based on profits, rather than revenues, noting that a revenue-based calculation was consistent with the operation of the franchise agreement during its term. It also noted that the use of a monthly average of royalties due over a three-year period was appropriate to smooth out any seasonal effects or other aberrations. 

The court concluded that this calculated average royalty payment “provides a reasonable correlation to potential actual damages that could be sustained by a breach.”

Attorney Sturm said the ruling could be important for franchisors because the court specifically approved using the full number of months remaining on the franchise agreement as a multiplier.  If the franchise owner had fully performed, Leisure Systems would have been entitled to royalties and fees for the entire term of the agreement.

Sturm said it appears likely that the franchisor could have been entitled to a judgment for liquidated damages in the amount of (1) average monthly royalties and fees; (2) multiplied by the number of months remaining on the franchise agreement; (3) discounted to present value.

Unfortunately for the franchisor, the liquidated damages provision in the agreement also provided that the amount due and owing at the time of the termination would be added to the calculated monthly average of royalties due, prior to the multiplication by the number of months remaining on the term of the agreement.  It is unclear why this term was included in the calculation, and, according to the court, the franchisor made no attempt to defend it.

The amount due at the time Leisure Systems terminated the franchisee, which was collectible separately, did not bear a reasonable relationship to the amount of additional damages that the franchisor was likely to incur in the future. 

The inclusion of a provision that the court found to be overreaching prevented what otherwise would have been a significant victory for franchisors in attempting to obtain liquidated damages on franchise agreements that are terminated by the franchisor as a consequence of the franchisee’s breach.  Nevertheless, the court’s determination that a provision based on the net present value of the future royalty stream for the entire length of the franchise agreement could be reasonable should provide additional support for franchisors seeking to enforce such provisions.

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