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Liquidated Damages Revisited

December 5, 2012

In a lengthy and considered opinion, a U.S. District Court in Ohio recently denied a campground franchisor's request for an award of liquidated damages against a terminated franchisee. Leisure Systems, Inc. v. Roundup LLC, No. 1:11-cv-384, Bus. Franch. Guide ΒΆ 14,929 (S.D. Ohio Oct. 31, 2012). But while the result is adverse to the franchisor, the court's opinion is favorable in most respects for franchisors that may seek to enforce liquidated damages provisions in their franchise agreements. In particular, the court approves as “reasonable” a provision making the terminated franchisee responsible for the discounted present value of all anticipated royalties through the end of the term of the franchise agreement. The decision refutes claims that such provisions constitute an unenforceable penalty.

The background of the Leisure Systems decision is straightforward and characteristic of many franchise disputes. Plaintiff Leisure Systems, Inc. (LSI), is the franchisor of Yogi Bear-identified campgrounds. LSI 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 provided that, in the event of termination, the franchisee would owe liquidated damages calculated as follows: “(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 franchise agreement also included an acknowledgement by the franchisee that the franchisor's losses would be difficult to ascertain and that the amount calculated under the formula was a “reasonable estimate” of actual 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.

Significantly, the court analyzed each aspect of the challenged provision separately. The court found that it was “reasonable to use historic payments owed by a franchisee to predict the future amounts that would be payable to [the franchisor] by the franchisee absent the breach.” The court 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. The court 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. Thus, the court concluded that this calculated average royalty payment “provides a reasonable correlation to potential actual damages that could be sustained by a breach.”

In a ruling that could be important for franchisors, the court also specifically approved using the full number of months remaining on the franchise agreement as a multiplier. The court noted that if the franchisee had fully performed, the franchisor would have been entitled to royalties and fees for the entire term of the agreement. In addition, the breach of the franchise agreement could cause a number of “intangible issues” that would take time for the franchisor to resolve; thus, using the number of months remaining on the term of the agreement was a reasonable proxy. Finally, although not specifically addressed by the court, the discounting of the calculated amount to a net present value using a defined interest rate apparently was deemed acceptable. Thus, 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. As the court noted, the amount due at the time of the termination (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. Moreover, the calculation as set out in the agreement would give the franchisor an incentive to postpone termination so as to increase the amount of liquidated damages. Finding this provision to be “disproportionate and unreasonable when compared to probable actual losses to be sustained,” the court declined to enforce the liquidated damages provision. Although it is not clear whether the court was asked to do so, it did not “blue pencil” the provision as might be done, for example, with an excessively broad covenant not to compete. Rather, the court deemed the entire provision to constitute an unenforceable penalty, notwithstanding the conclusion that most aspects of the calculation were reasonable.

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.