Liquidated Damages - Friend or Foe? (Part One)

This topic has only been mentioned tangentially in this blog some time ago -- Franchisees - Damages Warning: Lost Future Royalties (see the last paragraph of that post)

In my experience, Liquidated Damages are most commonly found in construction contracts, where damages can be imposed for delays in completion or other material breaches. But we jump the gun. What are Liquidated Damages and what the heck do they have to do with franchising?

Simply stated, Liquidated Damages is the amount of money that both parties in a contract agree upon if a breach of contract occurs or legal action arises as a result of a contract breach. That is, if there is a breach by one party, instead of arguing about the potential actual damages that may result, the parties agree in advance at the time of the contract is signed  that the damages will be predetermined. Sounds simple enough ...

But, Liquidated Damages has a checkered past and, if applied in a punitive or excessive manner, can be challenged as an unenforceable "penalty," even though the parties "agreed" in advance. Therein lies the rub: agreed? Oftentimes Liquidated Damage provisions are imposed by one party and, when that occurs, the "penalty" argument ensues. Although there is more legal nuance to how Liquidated Damages work, let's turn to how Liquidated Damages are used in franchising.

The post mentioned above Franchisees - Damages Warning: Lost Future Royalties summarizes the hazards that can ensue when a franchise agreement is terminated by a franchisee prematurely (i.e. before the full contractual term is fulfilled) and the franchise company seeks damages in the form of "lost future royalties" and other lost fees the company expected. If there is no Liquidated Damages clause, some franchise companies believe they are entitled to the lost royalties and fees for the entire remaining balance of the contract term (think: a 20-year term with 10 years left to go). This can be a hefty amount! And some courts have granted these types of damages. Very bad for franchisees.

Of course, the higher the amount sought, the greater the likelihood that a franchisee will fight or perhaps seek the shelter of a bankruptcy court. This increases the franchise company's legal fees and may leave the company holding an empty bag. Very bad for a franchise company.

So there are risks on both sides.

Stayed tuned for Part Two of this post where we will discuss how some companies may use Liquidated Damages to their advantage and why franchisees may want to negotiate for a Liquidated Damages clause (even though this may sound counter-intuitive).