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On October 31, 2012, the United States District Court for the Southern District of Ohio denied a franchisor’s demand for liquidated damages against two franchisees. The case, Leisure Systems, Inc. v. Roundup LLC, provides guidelines for determining whether liquidated damages clauses are reasonably correlated to potential actual damages that could result from a breach of the franchise agreement or whether such provisions constitute an unenforceable penalty.

The dispute involved plaintiff, Leisure Systems, Inc. (LSI), a franchisor and exclusive licensee of the name, character, symbol, and design of “Yogi Bear” and related trademarks and service marks used in connection with “Yogi Bear’s Jellystone Park Camp-Resorts.” The defendants were three franchisees that operated campgrounds in Ohio, Michigan and Indiana. The franchise agreements required the defendants to pay certain royalty and advertising fees to LSI. The defendants failed to make such payments and LSI terminated their franchise agreements. Two of the franchise agreements contained a liquidated damages clause providing for the calculation of damages based on a pre-determined formula. These franchise agreements were governed by Ohio law.

This case illustrates the need for Ohio franchisors to carefully evaluate liquidated damages clauses in their franchise agreements to make sure that such clauses are reasonably correlated to potential actual damages that could result from a breach of the franchise agreement.

Background

The district court considered whether the stipulated damages provisions of the franchise agreement should be enforced as liquidated damages or whether such provisions were unenforceable as a penalty. Under Ohio law, parties are generally free to enter into contracts that contain provisions to apportion damages upon the occurrence of an event of default. However, Ohio law does not permit stipulated damages provisions in circumstances where the stipulated damage clause constitutes a penalty. In re Graham Square, Inc., 126 F.3d 823, 829 (6th Cir. 1997). The Ohio Supreme Court has set forth the following test for determining whether a stipulated damages clause is enforceable:

  • Where the parties have agreed on the amount of damages, ascertained by estimation and adjustment, and have expressed this agreement in clear and unambiguous terms, the amount so fixed should be treated as liquidated damages and not a penalty, if the damages would be:
    • uncertain as to amount and difficult to prove;
    • the contract as a whole is not so manifestly unconscionable, unreasonable and disproportionate in amount as to justify the conclusion that it does not express the true intention of the parties; and
    • the contract is consistent with the conclusion that it was the intention of the parties that damages in the amount stated should follow the breach thereof.

Samson Sales, Inc. v. Honeywell, Inc., 12 Ohio St. 3d 27, 29 (Ohio 1984).

After conducting its analysis, the district court held that the stipulated damages provisions were unreasonable and so disproportionate in amount that the provisions operated as an unenforceable penalty. The formula contained in the two franchise agreements for calculating the stipulated damages was:

  1. All sums then currently due and owing
  2. Plus, the monthly average royalty and service fee paid or due by the franchisee for the three years immediately preceding termination
  3. Multiplied by the number of months remaining on the franchise agreement
  4. The total amount, which is then reduced to present value

The first question the court addressed is whether it was unreasonable and unconscionable to use historic figures of royalties and fees instead of calculating the royalties and fees based on actual current financial results. The court held the use of a monthly average royalty and service fee to calculate stipulated damages provides a reasonable correlation to potential actual damages that could be sustained by a breach of contract. The court then considered whether the use of the number of months remaining on the franchise agreements as a multiplier was reasonably correlated to a probable actual loss by the franchisor for a breach of the agreements. The court found that this portion of the formula was fair and reasonable. The court then focused its analysis on the “use of all sums then currently due and owing” portion of the formula. The court considered how the inclusion of all past due amounts in the formula correlated to actual losses that could result from a breach of the franchise agreement. The court was troubled by the fact that if the past due amounts covered multiple months, then the franchisee would be required to pay multiple months’ worth of royalties and fees for each month left on the franchise agreement, plus the average monthly fee already being paid under the second prong of the formula. Ultimately, the court concluded that the all sums then currently due and owing portion of the formula was not reasonable and held the liquidated damages clause acted as penalty, and therefore, it was unenforceable.

McDonald Hopkins has a team of skilled franchise, small business and litigation professionals who can help tailor a specific solution for your company's needs.

For more information, please contact:

Scott N. Opincar
216.348.5753
sopincar@mcdonaldhopkins.com

Franchise Practice

We represent manufacturers, distributors, dealers, franchisors, franchisees, licensors, licensees, sales representatives, franchisor and franchisee investors, and franchisee associations in all aspects of franchising. We also assist franchise suppliers, such as banks, insurers, brokers and consultants. When appropriate, we work in close contact with a client’s business lawyer as special counsel.

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