New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

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.

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Although the State of New Jersey is not a Franchise Registration State, over the years, the New Jersey State legislature has implemented laws pertaining to and affecting the legal rights between franchisors and franchisees.  The New Jersey Franchise Practices Act (NJSA 56:10-1)("NJFPA") adopts an extremely "paternalistic" approach to the franchisee / franchisor relationship and implements a number of legislated rights designed to benefit franchisees.

Both franchisors and franchisees with operations in the state of New Jersey should be aware of the NJFPA and its legislated rights, including NJFPA's  extremely vague "prohibition" against "unreasonable standards of performance".

Franchisor Standards of Performance must be "Reasonable".  Under the NJFPA franchisors are prohibited from imposing "unreasonable standards of performance on franchisees". This extremely vague "prohibition" is open to a broad range of interpretation and is designed, among other things, to prevent the termination of franchisee rights under the pre-text of "non-compliance".  

Relevance to Franchisees: This provision of the NJFPA, essentially, imposes a "reasonableness" standard when evaluating a franchisors attempted termination of a franchise relationship.  Under the NJFPA lawyers for the "terminated franchisee" are afforded the legal right to challenge, question and have the court evaluate the "reasonableness" of the franchisor's standards.

Relevance to Franchisors: Even if your system standards are well thought out, balanced and fair (as is typically the case with "successful" franchisors) when dealing with New Jersey franchisees, franchisors and their legal counsel must recognize that your system standards may be subject to interpretation and evaluation in a judicial proceeding.  To avoid unnecessary litigation costs and expenses, before terminating a franchise relationship take extra caution to document and communicate your performance standards and issues of non-compliance. 

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For existing franchisees and individuals considering the purchase of a franchise,anextremely instructive - but unfortunate - discussion appeared on the question and answer section of CNNMoney's Small Business website.  In the article, "Escaping a franchise deal gone bad", the franchisee of a children's entertainment franchise inquired about her legal options following what appears to have been the unsuccessful launch of her business.  In the article, the franchisee mentions a couple of important factors/issues that all prospective and current franchisees should consider:

Issue I  - Insure that You Possess Adequate Capital before Committing to a Franchise, In the article the franchisee mentions that to open the franchise, she needed $250,000.00 in capital.  She attributes a portion of her failure to her inability to raise adequate capital.  However, this franchisee readily admits that she did not "attempt" to raise capital until after paying her franchise fee and signing the franchise agreement.

• How this Issue Should be Approached by Prospective Franchisees - Do not commit to a franchise agreement or pay a franchise fee until you are certain that you will have access to adequate capital.  If this cannot be determined until you sign a franchise agreement then speak with your attorney about making the franchise agreement (and the payment or refund-ability of your franchise fee) conditional and subject to obtaining a specified amount of financing. 

Issue II - Be Cautious with "Light or Express" Versions of a Full Service Franchise Concept, Although specifics are lacking in the article, the franchisee mentions that since she did not possess the recommended level of capital, she was permitted by the franchisor to open a "smaller version of the franchise".

• How this Issue Should be Approached by Prospective Franchisees - Do not consider a "light" version of any full-service franchise concept unless the "light version" has been tested and successful in the marketplace.  In other words, don't become a Ginnie pig in an experiment where your life savings and financial stability is at stake.  Also, be cautious of any franchisor who is willing to modify the established capital criteria and requirements.

Issue III - Be Cautious of Post-Termination Restrictive Covenants and Obligations, The franchisee mentions that she is looking to get her money back and set up her own, non-franchised, competing business.  

• How this Issue Should be Approached by Prospective Franchisees - Initially it is critical to recognize that, as a franchisee, your obligations (including your non-compete) will, in most instances under most franchise agreements, exist for a set duration commencing from the date of termination of your franchise.  This is a critical and important protection necessary for franchisors to preserve the integrity of their franchise system.  For the prospective franchisee you must recognize - before signing a franchise agreement - that once you become a franchisee, your future actions will be restricted.  Always obtain a clear understanding as to the scope and extent of these restrictions.

For current franchisees who find themselves in a similar situation, the article offers some good advice from Ed Teixeira of franchiseknowhow and attorney Robin Day Glenn. For prospective franchisees, the critical factor remains "look before you leap", consult with an experienced franchise lawyer and do your homework.

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