Are Lost Future Royalties Awardable Damages?

The last of Meineke has yet to be heard, however. Absent settlement, there will be a trial in which the open issues will be put to a trier of fact. And despite the initial adverse decision by the trial judge, the appellate court's decision to remand and not dismiss nevertheless vastly improved Meineke's position if and when Meineke goes to trial. Thus, the proverbial Fat Lady has yet to make her appearance, but from Meineke's position, the song may be sweet.

Rupert M. Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he heads his firm's franchise practice. He is a former chair of the American Bar Association's Forum on Franchising, and co-editor-in-chief of the ABA's Fundamentals of Franchising, a primer on franchise law.

Over the last 16 years, there may have been no more-litigated franchise issue than the recovery of lost future royalties. Specifically, should the termination of, or by, a franchisee entitle the franchisor to recover lost future royalties from the former franchisee?

The trend toward unpredictability of how courts would address this issue began with the landmark case of Postal Instant Press, Inc. v. Sealy , 51 Cal. Rptr. 2d 365 (Ct. App. 1996). In Sealy, the California Court of Appeals held that the franchisor who terminated its franchisee because of the franchisee's failure to pay past due royalties was not entitled to recover lost future royalties for two reasons. First, contract law requires that in order for the franchisor to recover damages, the franchisee's breach must be the proximate cause of the damages. The Sealy court concluded that it was the franchisor's decision to terminate (as distinguished from its remedy of suing for damages as they accrued in the future) that caused the damages. Second, the court concluded that recovery of lost future royalties would be unconscionable. With respect to the first justification for its decision, the court noted that its holding might have been different if the franchisee, rather than the franchisor, had terminated the agreement.

Over the next decade and a half, the courts in various jurisdictions went in two different directions. One group followed Sealy ; see, e.g., Burger King Corp. v. Hinton, Inc. , 203 F.Supp.2d 1357 (S.D. Fla. 2002). The second group adhered to traditional contract principles, as demonstrated recently in Progressive Child Care Systems, Inc. v. Kids'R'Kids International, Inc. (No. 2-07-127-CV, 2008 WL 4831339 (Texas App. Nov. 6, 2008)). In Progressive Child, the Texas Court of Appeals, applying Georgia law, announced that awards of lost future profits were consistent with the contract remedial principle of making the aggrieved party to a contract whole. Franchise agreements are almost always for fixed terms, and if the franchisee does not operate until the end of the term as a result of its material breach, the franchisor must be awarded lost future profits in order to put it in the same position it would have found itself had the franchisee complied with the franchise agreement's terms ' if future damages could be proven with reasonable certainty. In Progressive Child, the court found that there were approximately 18 years and 22 years, respectively, remaining in the two franchise agreements under scrutiny; assumed that the franchisee's future sales would be consistent with past years' financial performances; and, after doing the arithmetic, concluded that the franchisor was entitled to recover almost $1.4 million from the franchisee, based on the remaining terms in the contracts.

At roughly the same time Progressive Child was decided, in Rocky Mountain Chocolate Factory, Inc. v. SDMS, Inc. (No. 06-cv-01212-PAB-BNB, 2009 WL 579516 (D. Colo. Mar. 4, 2009)), the U.S. District Court for the District of Colorado split the baby, but not in half. Here, the court seemed to accept the principle that lost future royalties were recoverable, but it concluded that while the franchisor produced evidence of the amount it would lose as a result of the franchisee's early termination of its franchise agreement, the franchisor did not prove the offsetting amounts it would save as a result of no longer having to service the terminated franchisee. The opinion only mentioned Sealy for its discussion of difficulties estimating net lost future royalties. Also, unconscionability, Sealy's second justification for its result, was not mentioned in Progressive Child and was only mentioned in an earlier Rocky Mountain opinion that determined the franchise agreement was not unconscionable (No. 06-cv-01212-WYD-BNB, 2007 WL 4268962, at *5-*6 (D. Colo. Nov. 30, 2007)). Additionally, this earlier opinion alternatively concluded that the UCC unconscionability provision did not apply to the franchise agreement.

Further, in the published opinions in Progressive Child and Rocky Mountain, neither court appeared to consider the issue of mitigation of damages. Based on the published opinion in Sealy, the Rocky Mountain court only noted the likelihood that franchisors would not mitigate damages if awarded lost future royalties, and did not mention any franchisor obligation to show mitigation of damages.

And thus the stage was set for Meineke Car Care Centers, Incorporated v. RLB Holdings, LLC, where the trial court's decision granting the franchisee summary judgment on issues supporting non-recovery of lost future royalties was reversed by the Fourth Circuit (No. 09-2030, 2011 WL 1422900 (4th Cir. Apr. 14, 2011), reversing Meineke Car Care Ctrs., Inc. v. RLB Holdings, LLC, No. 3:08cv240-RJC, 2009 WL 2461953 (W.D. N.C., Aug. 10, 2009)). In this case, the franchisee essentially shut down operations, and the franchisor brought suit, asking for lost future royalties for a three-year period. The decision was decided under North Carolina law; the contracts at issue were silent on the issue of the recovery of lost future profits. The trial court, on motions for summary judgment brought by both parties, granted the franchisee's motion asking that claims for lost future royalties be denied, and it dismissed Meineke's motion arguing that such damages were recoverable. On appeal, the Fourth Circuit reversed the trial court's ruling and remanded. The appellate court concluded that as a matter of law, the absence of a provision expressly permitting the recovery of lost future profits did not bar a franchisor from pursuing that theory. In the appellate court's eyes, absent an express provision in the contract, the intent of the parties was a material fact to be determined at trial; the intent was unclear from the terms of the agreement but should be ascertained by the jury or judge; and thus summary judgment was inappropriate. Meineke will now have an opportunity to prove its case, which the summary judgment in favor of the franchisee would have prohibited it from so doing.

Can Meineke Prove Its Damage Claim?

However, as the old saying goes, the proverbial Fat Lady has not yet made her appearance. Meineke must still prove its damage claim, and it is at this point that the Meineke case becomes extremely intriguing because of the appellate court's ruling. As in Rocky Mountain, the appellate court detailed who had the burden of proof with respect to each aspect of the damage claim, but the Rocky Mountain court, a district court, found that the franchisor had not sufficiently made its case; thus the damage claim was speculative. In Meineke, the appellate court noted several material issues of fact that must be resolved in Meineke's favor before Meineke can be awarded the big banana. The franchisor must prove reasonable certainty as to the amount of lost future royalties and present credible evidence as to any savings that might result from the franchisor not having to service the franchisee. The franchisor must also show that it was likely that the franchisee would remain in business. And finally, the franchisor must show that it had taken the necessary steps to mitigate damages resulting from the franchisee's breach.

While the appellate court was not in a position to resolve the controverted material facts, its decision suggests that Meineke is on track for success. The court essentially approved Meineke's method for determining the amount of royalties it would lose ' basically looking at historical performance and projecting the historical results into the future. The court also suggested that Meineke's methodology in proving that the franchisee would stay in business was persuasive. And the court also seemed to approve of Meineke's approach to mitigation. In Progressive Child, the franchisor won the full ball of wax ' asking for, and being awarded, royalties that would have been paid over a very long time (as much as 22 years). Meineke, on the other hand, limited its damage claim to three years, which is the period Meineke will have to prove is the time it will take it to find a substitute franchisee for the abandoned locations. Absent the appellate court's reversal, this would have been an aberration where the “hog” (the franchisor in Progressive Child) got rich, and the “pig” got slaughtered.

Mentioned above are two points that have not been emphasized in many, if not most, of the precedents that have addressed lost future royalties. The first is mitigation. As previously noted, mitigation balances the rights and wrongs of the parties and thus provides a rational business result: punish the franchisee for breach, but do not allow that to become a windfall for the franchisor. Mitigation is the tool that should allow courts to reach this result.

The second point of significance relates to the argument that if a franchisee would not have stayed in business, the franchisor might not be able to prove damages as being a reasonable certainty. I would predict that this point will become highlighted in the next set of decisions about lost future royalties. In some cases, when the franchisee has abandoned the business, the franchisor may be fighting an uphill battle. The Meineke appellate court itself suggests that this is an issue of material fact, and the franchisor must prove that unprofitability did not make certain that the franchisee would not have stayed open for the remainder of its term. On the other hand, when the situation involves a breakaway franchisee, the facts speak for themselves. Progressive Children, in which the franchisee broke away from the franchise system and continued to operate, suggests that a franchisee's staying in business puts one more arrow in a franchisor's quiver.

From the transactional lawyer's standpoint, there are also two points that Meineke teaches us. In drafting a franchise agreement, make sure to specifically note that lost revenues are a recoverable damage, as was noted in the Rocky Mountain franchise agreement. In other words, take away the issue of the parties' “intent” by making the intent clear from the outset. The second issue the transactional lawyer must consider is whether and what to say in his client's franchise disclosure document on the issue of lost future royalties. Silence is not a good strategy, but overemphasizing the risk of a large damage award for lost future royalties is certainly not appealing to the franchisor's sales department. Putting this risk in big, bold lettering may unnecessarily scare off prospective franchisees.

This problem of whether and how to disclose this risk also raises a philosophical issue for franchisor lawyers. How explicit must the franchisor be in explaining the consequences of its franchise agreement to its prospects? For example, franchisor lawyers typically do not recommend spelling out all the consequences of a franchisee violating its non-compete agreement ' such as it may cost a fortune to reconfigure the bricks and mortar for use in a different line of business. Why should they have to spell out the risks in this situation?

The last of Meineke has yet to be heard, however. Absent settlement, there will be a trial in which the open issues will be put to a trier of fact. And despite the initial adverse decision by the trial judge, the appellate court's decision to remand and not dismiss nevertheless vastly improved Meineke's position if and when Meineke goes to trial. Thus, the proverbial Fat Lady has yet to make her appearance, but from Meineke's position, the song may be sweet.

Rupert M. Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he heads his firm's franchise practice. He is a former chair of the American Bar Association's Forum on Franchising, and co-editor-in-chief of the ABA's Fundamentals of Franchising, a primer on franchise law.