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Part II: The Most Potentially Dangerous Contract Clauses In Your Franchise Agreement

By Robert Zarco, Esq.

AAHOA Hospitality, A Magazine Dedicated to Asian American Hoteliers, November 1999

It bears repeating that the franchise agreement is the single most important document you will every sign---at least with regard to your investment in your franchise business.  Your first line of defense must be to avoid agreeing to anything that will potentially threaten your investment. Even if you have already signed a franchise agreement, it is not too late.  You must still be vigilant about knowing and fulfilling your own duties, and understand what you can reasonably expect from your franchisor.

This column is the second of a two-part series discussing the most dangerous contract clauses pertaining to your franchise investment.  The following clauses concern mainly post-termination issues--- what happens when the relationship between franchisor and franchisee ends.  Some partings are amicable, but most are not.  It is therefore in your best interest to know well in advance what obligations you have under your contract, should you contemplate the end of your franchise relationship.

LIQUIDATED DAMAGES

A "liquidated damages" clause provides the amount of, or formula for, computing monetary damages in the vent that one party breaches the contract. Instead of having a jury calculate the amount of damages the injured party has suffered, the contract itself will dictate the sum of money the breaching party must pay to the other (nonbreaching) party.  In the hotel industry, the liquidated damages "formula" is often a function of the number of rooms in a particular property; in other words, the larger your hotel, the greater your liability for damages.

Under most states' laws, a court may refuse to enforce the liquidated damages remedy only if it determines that the provision would truly be "unconscionable," or constitute a penalty.  Courts interpret this standard strictly i.e., that one party would suffer great hardship if the court enforced the provision.  The courts also take into account the potential difficulty of estimating the damages, should a breach occur.  If the damages which could be sustained are easily calculated, at the time of contracting, then the provision may be considered a penalty and thus, unenforceable.  On the other hand, if it is difficult to calculate such damages as determined at the time of the contracting, then the court may enforce the liquidated damages provision as written.

There are many cases dealing with the enforceability of liquidated damages provisions and, in most cases, the courts permit enforcement.  One such recent case involved a Ramada hotel franchisee in Connecticut.  The franchisee was a practicing physician who had been represented by counsel throughout the contract negotiations.  The parties' negotiations focused, in part, on Ramada's liquidated damages formula which amounted to approximately $200,000 or two years' worth of royalty payments in the event of the franchisee's breach.  In this case, however, the franchisee's attorney was successful in negotiating a "cap" on liquidated damages in the amount of $100,000.

The Ramada franchisee subsequently received a series of failing grades during the franchisor's property inspections, and Ramada began the franchise termination process.  The franchisor filed suit in federal court, seeking in part, to collect the liquidated damages of $100,000 under the contract.

The franchisee argued that enforcement of the liquidated damages provision would be unconscionable as a penalty, but the district court disagreed.  Rather, the court found that this liquidated damages formula was reasonable, and that without the liquidated damages provision, the amount of damages flowing from the breach would be very difficult to estimate.  The court emphasized the fact that the parties had specifically negotiated a reduction in the amount of liquidated damages called for in the franchisor's form franchise agreement.  Accordingly, the franchisee was required to pay the full $100,000 in liquidated damages.  Although this is a significant amount of money, liquidated damages awards can be, and frequently are, a great deal higher in proportion to the actual harm the nonbreaching party was suffered.  Thus, liquidated damages provisions are ultimately more of a burden than a benefit for the franchisee.

If, however, the franchisor breaches the contract, and the relationship ends, then the franchisee does not have to pay liquidated damages.  There are also certain situations in which liquidated damages may be reduced; for example, a court may reduce the amount of liquidated damages if the sum is greater than that which the franchisee would have to pay if he had actually finished the contract term.  Another mitigating factor as to the amount of liquidated damages to be paid may include the franchisor's immediate replacement of the franchisee with a new hotel property.

FUTURE ROYALTIES

If a franchisee abandons his franchisor and takes down the trademark flag, and the franchise agreement does not contain a liquidated damages clause, your franchisor may attempt to require you to keep paying royalties, throughout the term of the contract, even after you are no longer a franchisee!  Sound ridiculous and far-fetched?  It is not impossible - there are franchisors who attempt to require their franchisees to continue paying royalties until the end to the contract term, and well after the franchisee has left the system.  Often, the royalties will be calculated using a predetermined formula based on the number of rooms in your property, and years remaining in your franchise contract.  Clearly, this arrangement tends to prevent franchisees from prematurely and unjustifiably "breaking away," or leaving the franchise system after learning the business.

If however, the franchisee has a justifiable basis for terminating the contract because of the franchisor's non-performance, poor performance or other default of its obligations, the franchisee may be justified in terminating the relationship without subjecting himself to liability for future royalties.

MINIMUM ROYALTIES

A variation on the theme of "future royalties" is a franchisor's imposition of a "minimum royalty" requirement for the duration of your agreement, regardless of the actual occupancy rate of your hotel.  Essentially, this burden also ensures the franchisee's participation in the franchise system until the end of the agreement, and works as an added deterrent to premature and unjustified franchisee defections.  Ask your franchise attorney to remove these two provisions from your franchise agreement, if at all possible.

TELEPHONE NUMBER ASSIGNMENTS

Often, a hotel's local reservations telephone number is its link to the world.  A franchisor knows this will, and will often reserve the right, in the franchise agreement, to secure the local reservations telephone number for itself after the franchise relationship has ended.

The franchisor may also reserve the option of diverting the franchisee-hotel's previously made reservations to other chain facilities after the franchisor has determined that the franchisee is somehow in default.  In a case where the franchisee is already having difficulty making royalty payments, for example, this action would almost certainly be fatal to a struggling business.  Therefore, this is the type of clause which franchisee-counsel should seek to have removed, if at all possible, prior to the parties' signing the agreement.

THE NON-COMPETE CLAUSE (ALSO CALLED THE RESTRICTIVE COVENANT)

A free and open marketplace?  Not necessarily, if you are a franchisee.  Most franchisors will insert a "non-compete clause" into the franchise agreement, restricting its franchisees from competing with it, both during and after the franchise relationship. The impact of these one-sided provisions, depending on the precise language, is that you may not operate a similar business for competing brand.  They may also prohibit you from hiring or continuing to employ individuals who worked for you in the managerial capacity when you were operating as a franchisee if you have since left the system.

Non-compete clauses which apply during the time your are a franchisee are usually less problematic (and less unexpected) than the variety which affects your business after the contract has ended.  The non-compete clauses which only come to life after the relationship has ended are more troublesome.

Frequently they will prevent a franchisee from engaging in a similar business for a specified length of time, and in a specified area.  Courts of different states use various criteria to determine the "reasonableness" of these clauses in deciding whether to enforce them in the event of a dispute.  If the contractual prohibition is for a long period of time, or covers too large an area, under the local laws, a court may refuse to enforce them, or may require them to make them more reasonable.

There is no guarantee, however, as to what a court will do.  It is certainly far safer to attempt to negotiate during the contract negotiation process for removal of such restrictions altogether - or at least to narrow the area or period time the clause will affect.

LIMITATIONS ON DAMAGES

You have had a dispute with your franchisor, endured a long legal battle, and ultimately, you have won.  Sounds great.  But wait, your franchise agreement has limits on the amount of damages which you may recover for your trouble and their breach, or wrongful conduct.

Some franchise agreements contain damage recovery caps and/or prohibit punitive damages while others prohibit reimbursement for the injured parties lost profits.  These limitations have a significant impact on your potential recovery.  Normally, and without such limitations or caps, you would be entitled to actual damages, including out-of-pocket losses.  Without the potential to recover the profits which you may have lost as a result of the franchisor's conduct and/or the ability to recover punitive damages, you may well be deterred from enforcing your legal rights under the agreement down the road.  If possible, ask your franchise attorney to eliminate any restrictions on damages at the contract negotiation stage.

LEASE CONTROLS

The "lease controls" clause is among the most devastating of contract provisions, particularly for hotel franchisees who lease, rather that own, their property.  In this situation, the franchisor becomes the primary lessee to the lease of the hotel property.  The franchisor, in turn, sublets the property to the franchisee, and effectively becomes the franchisee's landlord.

In this scenario, the franchisor would insert a "cross-default provision" into the franchise agreement.  This cross-default mechanism would come into play if the franchisee somehow breaches the terms of the agreement, in failing to pay royalties, for example.  If the franchisee breaches the franchise agreement, the franchisee is automatically considered to be in default of the sublease as well because of the "cross-default provision" - subject to immediate eviction from the property.  The franchisor is thus able to remove franchisees from the premises in just a matter of months - much faster than the length of a lawsuit to recover any debts owed, and with minimal expense and effort as compared to a lawsuit.  The franchisee, on the other hand, is subject to losing its source of income and/or any additional financing.  For this reason, a franchisee quickly ends up in a much weaker bargaining position that if he or she were facing only the prospect of legal action against the franchisor.  The bottom line: Avoid this clause at all costs.

OPTION TO PURCHASE YOUR PROPERTY

Another franchisor tactic in maintaining control over its franchisees is to include a clause allowing the franchisor to purchase the hotel from you, at a predetermined formula.  This clause may apply if the franchisee defaults under the contract or on occasion, even if no default has taken place.  Of course, this formula always leads to a price far below the fair market value of your investment.  This option to purchase will loom over your franchise relationship and hamper all of your disputes with the franchisor.

LIENS ON YOUR HOTEL ASSETS

This provision gives the franchisor's property interest in your hotel assets.  If the franchisor believes that you, the franchisee are in default of your agreement, i.e., for nonpayment of royalties or other amounts owed, the franchisor can foreclose on or assert a lien against those assets.  Under these types of clauses, the franchisor's actions will likely deter prospective buyers because the franchisor's security interest will be superior to those which follow it. (In other words, you buyer will not actually be entitled to full ownership and possession of the asset he or she has purchased until you pay off the lien the franchisor has placed on the item.)

CONCLUSION

The franchise agreement will, for the most part, govern your relationship with your franchisor.  Although your state's franchise statute, franchise protection act, and/or unfair and deceptive trade practices act may afford you additional protection, it makes sense to start your relationship in as strong a position as possible because you are making a substantial investment and entering into a long-term business relationship.  You can achieve this objective with the advice of experienced franchise counsel - someone who is very familiar with the contents of franchise agreements and who knows how the courts interpret various clauses in the event of a legal dispute.

Even if you have already signed your franchise agreement, it is not too late to reread the document and to become familiar with its terms.  Your understanding of the agreement and its terms is critical to maintaining a strong position in your relationship with your franchisor.  Before you make any significant business decisions pertaining to your franchise, you should consult your franchise attorney, and review the agreement with him or her.

Robert Zarco is a regularly featured columnist of AAHOA's monthly publication and a guest speaker on franchise issues at AAHOA's regional conventions.  The author welcomes comments and suggestions pertaining to this column or to his presentations.