Court Watch

In Days Inn Worldwide, Inc. v. BFC Management, Inc., 544 F. Supp. 2d 401 (D.N.J. March 4, 2008), the United States District Court for New Jersey upheld a liquidated damages clause in a license agreement as reasonable. The franchisor sought liquidated damages for breach of the licensing agreement. The liquidated damages clause in the license agreement provided for: “an amount equal to the sum of accrued Royalties and Basic Reservation Charges during the immediately preceding 24 full calendar months ' Liquidated Damages will not be less than the product of $2,000 multiplied by the number of guest rooms in the Facility.”

The franchisee argued that a large discrepancy existed between the actual damages sustained by the franchisor and the amount stipulated in the liquidated damages clause; thus, the liquidated damages clause was unreasonable and unenforceable.

Under New Jersey law, courts use a totality of the circumstances approach in ascertaining the reasonableness of a liquidated damages clause. The difficulty in assessing damages, intention of the parties, actual damages sustained, and the bargaining power of the parties affect the validity of the liquidated damages clause.

The Days Inn court rejected the franchisee's argument after examining the reasonableness of the liquidated damages clause. The court found that the parties were of comparable bargaining power, and the parties intended that the franchisor receive at a minimum $204,000 in the event of a breach of the franchise agreement. Because the contract explicitly stated that damages would not be less than the product of $2,000 multiplied by the 102 guest rooms in the facility, the court concluded that the parties agreed to a minimum of $204,000 as the liquidated damages amount.

Further, the court found that actual damages were difficult to ascertain, given the nature of the hotel business. With gross room revenues fluctuating from month to month depending on the national and local economy, the liquidated damages clause provided a reasonable estimate of damages where actual damages would have been difficult to prove. The court was also moved by the franchisor's argument that the liquidated damages amount represented a reasonable compromise between the three years typically required to bring a new construction replacement into the Days Inn chain and the 18 months required to build up the revenue stream of a conversion replacement. In considering the totality of the circumstances, the Days Inn court found that the liquidated damages clause was reasonable, and it awarded $204,000 in liquidated damages. The Days Inn court was not troubled by the fact that the actual damages were substantially lower than the $204,000 amount.

The decision in Days Inn illustrates the constantly moving target of reasonableness in enforcing liquidated damages clauses. The enforceability of the clause is fact-sensitive, and what is reasonable in one context can be unreasonable in another. While it is interesting to note how the court justified its conclusion, Days Inn can be somewhat of a nightmare in that it fails to give certainty as to whether a court will enforce a liquidated damages clause. In that respect, the decision might be viewed as disconcerting to a franchisor.

Greater Deference Showed in Florida Court

In Country Inns & Suites By Carlson, Inc. v. Interstate Properties, LLC, No. 6:07-cv-104-ORL-28DA, 2008 WL 2782683 (M.D. Fla. July 16, 2008), the court showed even greater deference to the parties' contractual agreement than did the Days Inn court. The Florida court upheld a liquidated damages clause that required payment of three years of royalty and marketing fees.

In Country Inns, the franchisee argued that the liquidated damages formula gave the franchisor more than it would have reasonably expected to receive under the contract, and that the clause did not account for the point-in-time the agreement was terminated.

However, the Country Inns court rejected both of the franchisee's arguments as being without merit. First, the court noted that fee-based formulas have been upheld by other courts in the hotel franchising context. Although the royalty and marketing fees accounted for 85% of the total fees, the court seemed swayed by the fact that the liquidated damages clause was reasonable because the franchisee was not required to pay the equivalent of all fees over a three-year period, but only a portion of the fees.

The fact that the liquidated amount was not reduced to its present value also did not render the clause invalid or unreasonable. The court distinguished cases where liquidated damages clauses were invalid and unreasonable for failing to discount the amount of any liquidated damages agreed to as to their present value. The court found that those cases were not applicable to the facts by taking a narrow interpretation of the cases that had required discounting. The court stated that those cases typically involved leases with acceleration of scheduled payments, rather than, as in the present case, formulas based on past revenues where the actual amounts could be more or less depending on economic conditions. Thus, the court's reasoning on present value can be interpreted as showing greater deference to the parties by enforcing the liquidated damages clause.

Moreover, the Country Inns court rejected the franchisee's argument that the liquidated damages clause was punitive for failing to take into account the time of termination ' that is, the liquidated damages amount was determined on a three-year look-back even though the remaining term of the contract might be less than this length of time. The court was unmoved by the franchisee's argument because the franchisee breached the 15-year licensing agreement after only two and a half years. This was not a case where the time remaining on the contract was less than the number of months used in calculating the amount of liquidated damages.

In upholding the liquidated damages clause, the Country Inns court exercised great deference by focusing on the conduct of the parties and the context surrounding the breach rather than examining the per se validity of the clause. The court noted that the trend in hotel franchising cases appears to be that fee-based damages over a period of years is reasonable and enforceable. It remains to be seen whether courts will be so liberal in enforcing such formulas in other contexts.

Alternative Remedies Found in Other Courts

Although courts appear to be exercising greater deference to parties by enforcing the contractually agreed upon liquidated damages clauses, two recent cases illustrate how courts have interpreted such clauses to reach different, and sometimes unintended, outcomes than those intended by the parties.

In Matter of Fein, Bus. Franchise Guide (CCH), 13,951 (Bankr. D. Mass. May 5, 2008), the bankruptcy court found that the contractually agreed-to liquidated damages provision was an inadequate remedy for a breach of the covenant not to compete, and it awarded equitable relief. In Fein, the parties specifically pre-estimated the liquidated damages and the royalty and advertising loss of the breach, and they established how long the payments were to continue. Although the parties agreed that a breach would give rise to monetary payments and the threat of injunctive relief, the contract did not explicitly state that the franchisor would be entitled to injunctive relief. Moreover, the agreement did not suggest that monetary damages would be an insufficient remedy.

Despite the parties' agreement as to monetary damages, the Fein court was not constrained by the liquidated damages clause in awarding a remedy. The Fein court found that the franchisee did more than merely open a competing business in violation of the covenant not to compete. The franchisee actively solicited former employees and customers, and it secretly intruded on the franchisor's business strategies by attending a strategy session. The court stated that the franchisee intentionally converted the goodwill and customers of the franchisor. Because such a loss was incalculable, the court concluded that money damages would be an insufficient remedy, and, following traditional equitable principles, the court granted an injunction enforcing the covenant not to compete.

Sensormatic Sec. Corp. v. Sensormatic Electronics Corp., 273 F. App'x 256 (4th Cir. March 31, 2008) illustrates how a liquidated damages clause was used by the court to allow termination of a licensing agreement without cause, which appears to have been contrary to the parties' agreement.

In Sensormatic, the court found that the franchisor was entitled to a declaration under Florida law that a provision in the licensing agreement constituted a liquidated damages clause, allowing it to terminate the agreement without cause and to pay only the contractually agreed amount. The franchisor pointed to a clause that provided: “the termination of this Agreement for any reason whatsoever shall not terminate the obligations of the parties ' and, in particular, shall not terminate the obligation of the Franchisor to make” certain specified payments. In contrast, the franchisee argued that this so-called liquidated damages clause could only be invoked by the franchisor pursuant to the reasons enumerated in the agreement, which stated that the franchisor shall have the right to terminate the agreement if “the franchisee fails in its marketing commitments, defaults on specified covenants in the Agreement, becomes insolvent, or ceases to continue in the business of selling or servicing the equipment covered by the Agreement.”

The Sensormatic court reconciled the two seemingly inconsistent provisions by looking for the plain meaning of the contract. The court found that the plain meaning of the right to terminate “for any reason whatsoever” permits the parties to terminate for good cause, bad cause, or no cause. Despite the enumerated reasons for termination, the court found that the liquidated damages clause allowed the franchisor to terminate the agreement without cause and pay only the specified damages.

The ruling in Sensormatic poses problems for franchise agreements where provisions of the contract provide broad liquidated damages clauses for any breach and where specific reasons for termination are outlined in the contract. Courts may reach differing conclusions by finding that liquidated damages apply to any breach or only to the enumerated reasons. Further, considering that good cause for termination is required in many franchising statutes, parties may try to use liquidated damages clauses to circumvent these good cause requirements.

Conclusion

The decisions in Days Inn and Country Inns seem to suggest that courts are becoming increasingly deferential to party intent and enforcing liquidated damages clauses. Although the decisions of recent cases show a trend toward greater predictability in enforcing liquidated damages clauses, these cases occur mainly in the hotel franchising context. It remains to be seen whether courts will enforce similar liquidated damages clauses in other contexts.

Another lesson from these cases is that liquidated damages clauses may be used by the courts to achieve unanticipated ends. The Fein case illustrates that courts may not give effect to party intent and may award a remedy that was unanticipated by either party. Moreover, the Sensormatic case illustrates that liquidated damages clauses can be interpreted broadly to negate the intent of both parties. The lessons to be learned from these cases are that there is no golden rule for drafting a liquidated damages clause that will always be reasonable and enforceable, and even if it is reasonable, courts may effectuate a different remedy than what the parties originally intended.

Rosaleen Chou is an associate in the Atlanta office of Kilpatrick Stockton. She can be contacted at [email protected]

Over the years, liquidated damages clauses have continually been the subject of judicial controversy. In the franchising context, a liquidated damages clause is intended to represent an agreement between the parties as to what amount a franchisee should pay to a franchisor when the franchise agreement is terminated before its expiration, usually as a result of a breach of the agreement by the franchisee. The general rule is that payments required under liquidated damages clauses must be a reasonable approximation of the actual damages that might have been occurred, rather than a penalty.

Generally, courts have enforced liquidated damages in franchise agreements more often than not, but they have kept a close eye on these agreements, looking out for overreaching terms by the franchisor. The exact parameters as to what is unreasonable, and what is not, have been moving targets.

Two recent cases, one applying New Jersey law and the other the laws of Florida, suggest that courts are tending to look at these cases with a greater degree of deference to the parties. Both cases held that the liquidated damages clauses were enforceable. In each case, defenses to, or rationales against, enforcement often raised by franchisees were rejected.

In Days Inn Worldwide, Inc. v. BFC Management, Inc. , 544 F. Supp. 2d 401 (D.N.J. March 4, 2008), the United States District Court for New Jersey upheld a liquidated damages clause in a license agreement as reasonable. The franchisor sought liquidated damages for breach of the licensing agreement. The liquidated damages clause in the license agreement provided for: “an amount equal to the sum of accrued Royalties and Basic Reservation Charges during the immediately preceding 24 full calendar months ' Liquidated Damages will not be less than the product of $2,000 multiplied by the number of guest rooms in the Facility.”

The franchisee argued that a large discrepancy existed between the actual damages sustained by the franchisor and the amount stipulated in the liquidated damages clause; thus, the liquidated damages clause was unreasonable and unenforceable.

Under New Jersey law, courts use a totality of the circumstances approach in ascertaining the reasonableness of a liquidated damages clause. The difficulty in assessing damages, intention of the parties, actual damages sustained, and the bargaining power of the parties affect the validity of the liquidated damages clause.

The Days Inn court rejected the franchisee's argument after examining the reasonableness of the liquidated damages clause. The court found that the parties were of comparable bargaining power, and the parties intended that the franchisor receive at a minimum $204,000 in the event of a breach of the franchise agreement. Because the contract explicitly stated that damages would not be less than the product of $2,000 multiplied by the 102 guest rooms in the facility, the court concluded that the parties agreed to a minimum of $204,000 as the liquidated damages amount.

Further, the court found that actual damages were difficult to ascertain, given the nature of the hotel business. With gross room revenues fluctuating from month to month depending on the national and local economy, the liquidated damages clause provided a reasonable estimate of damages where actual damages would have been difficult to prove. The court was also moved by the franchisor's argument that the liquidated damages amount represented a reasonable compromise between the three years typically required to bring a new construction replacement into the Days Inn chain and the 18 months required to build up the revenue stream of a conversion replacement. In considering the totality of the circumstances, the Days Inn court found that the liquidated damages clause was reasonable, and it awarded $204,000 in liquidated damages. The Days Inn court was not troubled by the fact that the actual damages were substantially lower than the $204,000 amount.

The decision in Days Inn illustrates the constantly moving target of reasonableness in enforcing liquidated damages clauses. The enforceability of the clause is fact-sensitive, and what is reasonable in one context can be unreasonable in another. While it is interesting to note how the court justified its conclusion, Days Inn can be somewhat of a nightmare in that it fails to give certainty as to whether a court will enforce a liquidated damages clause. In that respect, the decision might be viewed as disconcerting to a franchisor.

Greater Deference Showed in Florida Court

In Country Inns & Suites By Carlson, Inc. v. Interstate Properties, LLC, No. 6:07-cv-104-ORL-28DA, 2008 WL 2782683 (M.D. Fla. July 16, 2008), the court showed even greater deference to the parties' contractual agreement than did the Days Inn court. The Florida court upheld a liquidated damages clause that required payment of three years of royalty and marketing fees.

In Country Inns, the franchisee argued that the liquidated damages formula gave the franchisor more than it would have reasonably expected to receive under the contract, and that the clause did not account for the point-in-time the agreement was terminated.

However, the Country Inns court rejected both of the franchisee's arguments as being without merit. First, the court noted that fee-based formulas have been upheld by other courts in the hotel franchising context. Although the royalty and marketing fees accounted for 85% of the total fees, the court seemed swayed by the fact that the liquidated damages clause was reasonable because the franchisee was not required to pay the equivalent of all fees over a three-year period, but only a portion of the fees.

The fact that the liquidated amount was not reduced to its present value also did not render the clause invalid or unreasonable. The court distinguished cases where liquidated damages clauses were invalid and unreasonable for failing to discount the amount of any liquidated damages agreed to as to their present value. The court found that those cases were not applicable to the facts by taking a narrow interpretation of the cases that had required discounting. The court stated that those cases typically involved leases with acceleration of scheduled payments, rather than, as in the present case, formulas based on past revenues where the actual amounts could be more or less depending on economic conditions. Thus, the court's reasoning on present value can be interpreted as showing greater deference to the parties by enforcing the liquidated damages clause.

Moreover, the Country Inns court rejected the franchisee's argument that the liquidated damages clause was punitive for failing to take into account the time of termination ' that is, the liquidated damages amount was determined on a three-year look-back even though the remaining term of the contract might be less than this length of time. The court was unmoved by the franchisee's argument because the franchisee breached the 15-year licensing agreement after only two and a half years. This was not a case where the time remaining on the contract was less than the number of months used in calculating the amount of liquidated damages.

In upholding the liquidated damages clause, the Country Inns court exercised great deference by focusing on the conduct of the parties and the context surrounding the breach rather than examining the per se validity of the clause. The court noted that the trend in hotel franchising cases appears to be that fee-based damages over a period of years is reasonable and enforceable. It remains to be seen whether courts will be so liberal in enforcing such formulas in other contexts.

Alternative Remedies Found in Other Courts

Although courts appear to be exercising greater deference to parties by enforcing the contractually agreed upon liquidated damages clauses, two recent cases illustrate how courts have interpreted such clauses to reach different, and sometimes unintended, outcomes than those intended by the parties.

In Matter of Fein, Bus. Franchise Guide (CCH), 13,951 (Bankr. D. Mass. May 5, 2008), the bankruptcy court found that the contractually agreed-to liquidated damages provision was an inadequate remedy for a breach of the covenant not to compete, and it awarded equitable relief. In Fein, the parties specifically pre-estimated the liquidated damages and the royalty and advertising loss of the breach, and they established how long the payments were to continue. Although the parties agreed that a breach would give rise to monetary payments and the threat of injunctive relief, the contract did not explicitly state that the franchisor would be entitled to injunctive relief. Moreover, the agreement did not suggest that monetary damages would be an insufficient remedy.

Despite the parties' agreement as to monetary damages, the Fein court was not constrained by the liquidated damages clause in awarding a remedy. The Fein court found that the franchisee did more than merely open a competing business in violation of the covenant not to compete. The franchisee actively solicited former employees and customers, and it secretly intruded on the franchisor's business strategies by attending a strategy session. The court stated that the franchisee intentionally converted the goodwill and customers of the franchisor. Because such a loss was incalculable, the court concluded that money damages would be an insufficient remedy, and, following traditional equitable principles, the court granted an injunction enforcing the covenant not to compete.

Sensormatic Sec. Corp. v. Sensormatic Electronics Corp. , 273 F. App'x 256 (4th Cir. March 31, 2008) illustrates how a liquidated damages clause was used by the court to allow termination of a licensing agreement without cause, which appears to have been contrary to the parties' agreement.

In Sensormatic, the court found that the franchisor was entitled to a declaration under Florida law that a provision in the licensing agreement constituted a liquidated damages clause, allowing it to terminate the agreement without cause and to pay only the contractually agreed amount. The franchisor pointed to a clause that provided: “the termination of this Agreement for any reason whatsoever shall not terminate the obligations of the parties ' and, in particular, shall not terminate the obligation of the Franchisor to make” certain specified payments. In contrast, the franchisee argued that this so-called liquidated damages clause could only be invoked by the franchisor pursuant to the reasons enumerated in the agreement, which stated that the franchisor shall have the right to terminate the agreement if “the franchisee fails in its marketing commitments, defaults on specified covenants in the Agreement, becomes insolvent, or ceases to continue in the business of selling or servicing the equipment covered by the Agreement.”

The Sensormatic court reconciled the two seemingly inconsistent provisions by looking for the plain meaning of the contract. The court found that the plain meaning of the right to terminate “for any reason whatsoever” permits the parties to terminate for good cause, bad cause, or no cause. Despite the enumerated reasons for termination, the court found that the liquidated damages clause allowed the franchisor to terminate the agreement without cause and pay only the specified damages.

The ruling in Sensormatic poses problems for franchise agreements where provisions of the contract provide broad liquidated damages clauses for any breach and where specific reasons for termination are outlined in the contract. Courts may reach differing conclusions by finding that liquidated damages apply to any breach or only to the enumerated reasons. Further, considering that good cause for termination is required in many franchising statutes, parties may try to use liquidated damages clauses to circumvent these good cause requirements.

Conclusion

The decisions in Days Inn and Country Inns seem to suggest that courts are becoming increasingly deferential to party intent and enforcing liquidated damages clauses. Although the decisions of recent cases show a trend toward greater predictability in enforcing liquidated damages clauses, these cases occur mainly in the hotel franchising context. It remains to be seen whether courts will enforce similar liquidated damages clauses in other contexts.

Another lesson from these cases is that liquidated damages clauses may be used by the courts to achieve unanticipated ends. The Fein case illustrates that courts may not give effect to party intent and may award a remedy that was unanticipated by either party. Moreover, the Sensormatic case illustrates that liquidated damages clauses can be interpreted broadly to negate the intent of both parties. The lessons to be learned from these cases are that there is no golden rule for drafting a liquidated damages clause that will always be reasonable and enforceable, and even if it is reasonable, courts may effectuate a different remedy than what the parties originally intended.

Rosaleen Chou is an associate in the Atlanta office of Kilpatrick Stockton. She can be contacted at [email protected]