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.