To Pay Or Not To Pay . . . (Royalties) . . . That Is The Question!

By Robert Zarco, Esq.

AAHOA Hospitality, December 1999

You have signed a franchise agreement, paid the franchise fee and have contributed monthly fees in the form of royalties and advertising fund payments. Despite your contributions, your franchisor is not living up to its end of the bargain - the franchisor is not providing you with the appropriate level of service, support and assistance, the advertising is minimal, the QSC inspections are either nonexistent or not at all helpful, and the franchisor is allowing other units to run substandard operations, ruining the brand's image. What should you do? Your first impulse may be to stop paying royalties to your franchisor, since making these payments seems to be as helpful as throwing your money out the window. Resist the impulse - DO NOT STOP paying royalties!

At first, withholding royalties may seem like an effective way to get your franchisor's attention focused on your complaints. In the long run, however, withholding royalties is a very risky strategy which will undoubtedly cause you greater financial harm than you can presently imagine. Of course, no two franchisees are in exactly the same situation, so if your franchise relationship has become difficult, for whatever reason, your first act should be to consult an experienced franchise attorney who can advise as to your best alternative.

You should always keep in mind that a royalty obligation is a critical aspect of all franchise and trademark license agreements, and that failing to pay royalties is, among other things, a breach of that contract.

Most important, though, is that the royalty obligation exists independently of the rest of the franchise agreement. To the franchisor, the stream of incoming royalties is often essential to funding the services which the franchisor must provide to the overall franchise system. If a franchisee ceases paying royalties, the franchisor has the option of treating the franchise agreement as terminated by the franchisee. At the same time, the franchisor will withdraw its permission for the franchisee's use of the brand's trademarks. If the franchisee continues to use the trademarks without the owner/franchisor's approval, he or she is infringing  on the licensor's property rights.(1) 

Beyond the ramifications of having breached your franchise agreement for failing to pay royalties, there is a very potent federal statute called the Lanham Act which controls the registration and use of trademarks and service marks. The Lanham Act affords the trademark owner very powerful protection against unauthorized use of its intellectual property. A franchisee who uses the brand's trademarks without the licensor's approval is violating this statute. It makes no difference that the franchisee believes that he or she has valid claims against the franchisor which may offset or even exceed the sum of royalties he or she owes. Nor does the franchisee's pending lawsuit justify withholding royalty payments, regardless of how meritorious the issues. Put simply, the franchisee must continue to make the royalty payments until the end of the franchise agreement if he or she wishes to continue using the brand's trade or servicemarks.

The all-too-common result of a royalty strike is that the franchisee - not only loses the original dispute - but subjects himself to additional and extremely severe financial penalties for the illegal trademark use. The Lanham Act gives the courts a great deal of discretion in awarding damages in trademark infringement cases, including treble damages, or three times the actual damages which the licensor can prove it has suffered. In addition, the court may award an "accounting," or disgorgement of the terminated franchisee's profits earned during the period of trademark infringement. When the infringement is "deliberate" or "wilful," courts are also permitted to order the terminated franchisee to pay the franchisor's attorneys' fees in enforcing its trademark rights. (This, of course, is in addition to the franchisee's own legal expenses in defending against charges of trademark infringement.) A court may also award prejudgment interest on the damages, which may be significant if the case is not resolved promptly. Finally, in cases where the franchisee's actions have caused the termination of the franchise agreement, the franchisor may also seek lost future royalties (payment of royalties until the date of the natural end of the franchise agreement), which can add up to a significant sum.

The federal courts do not hesitate to impose these large damage awards, because they seek to discourage other would-be infringers from copying and profiting from property rightfully belonging to another. Unfortunately, these damage awards can easily annihilate a franchisee's business - simply because the franchisee did not realize, at the outset, the legal ramifications of his or her decision to stop paying royalties.

Although you should continue to pay royalties regardless of any other action you take, there exist other, viable legal alternatives if your franchisor is not living up to its end of the bargain. A better alternative is to consult your franchise attorney as soon as possible - while fulfilling all of your ongoing financial obligations. The attorney will likely attempt to negotiate with the franchisor on your behalf and attempt to resolve the problem without resorting to an extended legal battle, if at all possible. If extreme financial difficulties prevent you from timely paying your royalties, your attorney may be able to negotiate a restructured payment plan with the franchisor, while avoiding the termination of your franchise agreement. Do not write letters or memoranda to the franchisor without first having your counsel review the communication. Very frequently, franchisees make statements or admissions which may put them into a difficult legal position later on.

The critical distinction is that by remaining current with your royalty payments, you, the franchisees, remain in good standing. If the franchisor does not correct its deficiency or cure a default about which you have advised it within a commercially reasonable amount of time, you may still have the option of filing suit, and seeking various forms of relief including cancellation of the contract and/or money damages. In any event, you stand a far greater chance of preserving your legal rights and obtaining a favorable outcome if you remain in good standing, than if you were to withhold your payments.

The following two cases illustrate some of the other the potential legal difficulties involved in attempting to break away from a franchise agreement without following the appropriate procedure. There is a critical difference between the franchisee who "abandons" the franchise and one whose contract is "terminated" by the franchisor. Knowing how to handle these situations properly will determine your financial well-being and the fate of your franchise license.

In Burger King Corp. v. Barnes, Barnes, the franchisee, without advice from counsel, notified Burger King, that it intended to close his Burger King restaurant and suspend his performance under the franchise agreement. (Ultimately, a federal court characterized Barnes' action as both an "abandonment" and a breach of the franchise agreement.) At the time of Barnes's breach, 210 months' worth of future royalties remained in the term of the agreement. Burger King Corp. filed suit and the court allowed BKC to recoup its "lost profits:" the royalties it would have received through the natural end of the contract(2) - from 1995 through 2012 - subtracting only the costs BKC would have incurred to earn the royalties, i.e. maintain quality control at the franchisee's restaurant. Because Barnes' abandonment (as opposed to a termination by BKC) of the franchise agreement caused BKC's loss of future profits, he remained liable for some $ 247,870 worth of royalties, even though he was no longer using or profiting from the trademarks under the license agreement.

In Postal Instant Press, Inc. (PIP) v. Sealy, the Sealys, California franchisees, faced financial difficulties and could no longer timely make their royalty payments. PIP terminated the franchise agreement on this basis. Apparently, the Sealys closed their business and ceased using all PIP trade and/or service marks; the decision makes no reference to trademark infringement or Lanham Act claims.(3) After a bench trial, the trial court awarded various forms of relief to PIP, including an award of royalties for the remainder of the contract term - some seven (7) and one-half () years. The Sealys appealed this award.

The appellate court reduced the damages award to the franchisor because the Sealys' particular breach - failure to pay moneys owed for past performance - did not cause PIP's loss of future royalties in the legal sense. It was the franchisor's own decision to terminate the franchise agreement that deprived PIP of its entitlement to those future royalty payments. The Sealys lost the use of the trademarks and other benefits it had received under the franchise system. The Sealys, of course, would earn no further revenue from the franchise. Accordingly, PIP had no right to expect a continued royalty stream from the Sealys.

The California appellate court stated that an award of "lost future royalties" would have provided PIP with disproportionate compensation under these circumstances. For breach of contract, PIP was limited to recovering "reasonable" damages.

It is often difficult to know how to handle these situations when they arise. It bears repeating that you should continue to pay your royalty and advertising fund contributions, until you seek the advice of experienced franchise counsel immediately. Do not gamble with the substantial investment which you have made in your franchise license. Your attorney will be able to advise as to your best course of action and assist you in protecting your business.

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1. Additionally, once the franchise agreement is terminated, the franchisee will be expected to abide by post-termination covenants, such as noncompete clauses. The franchisee's continued operation will likely violate these provisions of the franchise agreement as well.

2.  The royalties were based on the average monthly sales of the restaurant to date and projected sales at the store as if it had continued to operate as a Burger King restaurant. 

3. The parties agreed that the contract's noncompete clause was invalid on public policy grounds and PIP did not seek to enforce its terms.

Robert Zarco is a nationally-recognized franchise legal expert and is a regularly-featured columnist of AAHOA's monthly publication, as well as a guest speaker on franchise issues at the AAHOA's regional conventions. He represents many hotel and restaurant franchisees in well over 150 different franchise systems, throughout the United States and internationally. AAHOA members are offered specially-reduced rates for legal services, including partial contingency fee arrangements under appropriate circumstances. Mr. Zarco is scheduled to speak at the AAHOA's annual convention in January, 2000, in Las Vegas. The author welcomes comments and suggestions pertaining to this column or to his presentations.