A Powerful Tool for Franchisors: "Liquidated Damages"
The typical franchise agreement is representative of the disproportionate bargaining power between the franchisor and franchisee. That is, franchise agreements favor franchisors. One such favorable clause contained in franchise and license agreements relates to "liquidated damages".
The typical franchise agreement will contain a "liquidated damages" provision whereby the franchisee agrees to pay, as damages, a fixed sum or a sum based on a fixed formula in the event of a court's finding of a breach of the franchise agreement. If the franchisor is successful in a lawsuit against a franchisee, the liquidated damages provision may clear a path for a Court (without any further detailed inquiry) to award substantial monetary damages. Similarly, when dealing with trademark license agreements, licensees may be subject to severe damages based on the liquidated damages clause contained in the license agreement.
Although presumptively valid in most jurisdictions, the enforcement of liquidated damage clauses is not universal and courts in states such as New York and New Jersey will make an inquiry as to the "reasonableness" of the liquidated damages and the "bargaining power" between the parties at the time of contracting.
So what do franchisors, franchisees and licensees need to know:
- Franchisors: For franchisors, liquidated damage provisions are critical components to your franchise agreement and serve as a significant tool when faced with franchisee litigation. When drafting liquidated damages into your franchise agreement insure that the method of calculating damages is not arbitrary, based on tangible factors and is not inconsistent with your royalty structure.
- Franchisees: recognize that a possible "liquidated damage" clause in your franchise agreement may expose you to substantial liability should the franchisor prevail. When negotiating your franchise agreement discuss the liquidated damage clauses with your franchise lawyer and try to cap your financial obligations and the accrual of royalties and other fees after any alleged event of default and the termination of the franchise agreement.
Isn't it true that most franchisees don't understand that the "optional" liquidated damages terms in the contract are premeditated to give the franchisor the advantage when the franchisee fails to thrive? The failure fee is hidden within the contract from the view of franchisees.
Do attorneys point this "failure fee" out to their clients?
Most franchisees don't understand that "termination" by the franchisee because of failure to thrive is considered "abandonment" by the franchisor and that the liquidated damages clauses kick in!
While franchisors always reserve their option within the franchise agreement to directly acquire "failing" units if they want them (which is misleading to prospective franchisees) the "optional" liquidated damages clauses provides an "inducement" for "startup" franchisees to cooperate with third-party takeovers of their businesses through a managerial arrangement with the third party.
The third party, who is abetted by the franchisor, gets to try the business out while the original franchisee remains responsible to the Landlord and remains on the hook for all of the personal guarantees that have been signed but can escape the "failure fee" that is said to immediately be due at the time the franchisee terminates operations.
The franchisor, on paper, doesn't look like he is involved and third-party churning remains somewhat invisible, doesn't it?
Carol,
Thanks for your insightful input. I believe that your comment and analysis is right on target. To answer your question, as a franchise lawyer - when representing franchisees - one of the most significant franchise agreement provisions that I discuss with my comments is "liquidated damages". My position, basically is that for a franchisee liquidated damages should be removed for instances involving franchise business failure. That is, if you buy a franchise, work hard but the business fails you shoult NOT be penalized again by paying damages to the franchisor. We have been successful in having these provisions removed from our clients franchise agreements.
Another point is that even if there is not an "affirmative" liquidated damages provision in the franchise agreement a franchisee who closes his or her franchise business, may nevertheless be sued by the franchisor for future lost royalties.
Thanks again for that great input.
Thanks for the response. I wish that my "insight" had not come about because of my desire to understand the malicious legal trap, i.e., the standard boilerplate franchise agreement that enables and protects franchisors from fraudulent inducement claims in the sale of franchises to the American public.
Obviously, the offering circulars are carefully designed, expensive, and voluminous red herrings that allow franchisors, who pick up their option NOT to make earnings claims, to hype and sell their franchises without making ANY written earnings claims within the FDD or the actual contract with the view of protecting themselves 100% from fraud claims.
While the risk factors are pointed out within the circulars and must be acknowledged by new buyers, the franchisors appear to be enabled by the circulars to withhold MATERIAL risk factors such as the historical UNIT performance statistics that would disclose unprofitability and high failure of "founding" franchisees.
There are sure lots of "pigs" and "dogs" available on the SBA Franchise Registry eligible for 90% guaranteed loans because government remains deaf, dumb and blind about all of the fraud going on, or what? The lack of transparency is highly suspicious but The Congress appears unwilling to clean up the flaw in the FTC Rule that so cruelly injures naive and good faith franchisees. Apparently, fixing the flaw would result in the disclosure of "churning" and "pumping and dumping" of franchise units within the system.
The failure fees are hidden deep within the contracts. I notice that the glossary which explains words and terms within the circular I have doesn't explain "abandonment" and "franchisee termination."
In retrospect, every time I look at the Offering Circular with my growing knowledge of the malice involved, and the cooperation of the regulators with the special interests, it gives me new resolve to try to warn prospective franchises.
Thanks again for publishing my posts!