Liquidated Damages - Friend or Foe? (Part Two)

In Part One of this topic, we discussed what Liquidated Damages are, how they may be a "penalty," and the potential risks involved in a franchise setting when there is no cap on damages upon an early termination.

This part, as promised, addresses why some franchise companies may want to use Liquidated Damages to their advantage and why franchisees may want to negotiate for a Liquidated Damages clause (even though it may sound counter-intuitive). Post-termination damages in franchise matters is complex and we will just scratch the surface here. (More detail can be found in this 2016 ABA Forum on Franchising's Annual Meeting article  - Show Me the Money! Maximizing Monetary Recovery in Franchise Cases - authored by Bethany Applebee (Subway's General Counsel) and me).

First, the idea of "legal damages" is to make an injured party whole without injecting speculation into the equation. When a franchise company seeks a wholesale remedy of "lost future royalties" for an extended term (let's say 5 years or more), it may be getting more than necessary. That is, many franchise systems seek to replace a terminated franchisee as soon as possible - akin to replacing a terminated tenant on a lease. And, as is the case with a lease, a franchisor has a duty to mitigate its damages by finding a replacement. The real measure of damages is the period of time it takes to find a replacement; so how do you calculate this in advance without some speculation.

Some excellent franchise-lawyers (Rupert M. Barkoff (recently passed away) and Christopher P. Bussert), posited this in their 2009 article: Can a Franchisor Recover Lost Future Royalties? The Debate Goes On, 12 The Franchise Lawyer 2 (Spring 2009):

In fact, when informally asked what "should" be a "fair" settlement of a lost future royalties dispute, many attorneys suggest that two or three years would be an appropriate level of compensation. These opinions may be anecdotal in nature, but they do demonstrate to some level what is considered reasonable in the franchise community on this issue. In addition, when franchise agreements provide for liquidated damages if the franchisee improperly terminates, two to three years of royalties is often offered (and upheld by courts) as a reasonable compromise.

The Barkoff-Bussert thinking was based on a reasonable time to replace a terminated franchisee. Not only is this a fair approach, on the franchisor-side, it eliminates arguments about speculation, lack of mitigation, and other defenses a terminated franchisee may raise. Thus, franchise companies may want to consider this shortcut to damage calculations... and as a means of keeping franchisees from seeking bankruptcy protection.

And, if a franchise company does not build a Liquidated Damages clause into its franchise agreement, should a franchisee negotiate for one? In states where courts have or may award damages for the FULL remaining term, it seems logical for franchisees to pursue this stop-gap clause. To determine if it is wise for a franchisee to negotiate for a Liquidated Damages clause, seek out an experienced franchise-lawyer in your area, preferably a member of the American Bar Association's Forum on Franchising.