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Liquidated damages are a form of monetary compensation that parties agree to when entering a contract. A liquidated damages clause in a franchise agreement generally specifies the circumstances under which a breaching party is required to pay liquidated damages, the amount due, and the terms of payment. As such, the purpose of this type of clause is to assure that the non-breaching party is compensated monetarily for the harm caused by the breach, This clause typically looks like this:
If the Franchisee breaches this Agreement by disclosing the Franchisor’s trade secret to a competitor, the Franchisee shall pay to the Franchisor as liquidated damages for the breach and not as a penalty, an amount equal to three times the continuing royalty fees payable to the Franchisor in respect to the last twelve months of the franchised business’ active operations or the total sum of $20,000, whichever is less.
Inherent in the franchisor-franchisee relationship, there are certain breaches that will cause economic harm to the franchisor. However, the amount of harm can be difficult to determine at the time a franchise agreement is made. For example, in a franchise agreement containing the clause above, if the franchisee reveals the franchisor’s trade secret to a competitor, the franchisee will have breached the franchise agreement and effectively destroyed the trade secret’s value.
Because there is no open market for the trade secret, its value, and the harm to the franchisor caused by the breach would be difficult to prove in a breach of contract claim. In this scenario, the liquidated damages clause provides the specific amount of monetary compensation due to the franchisor, saving costs for both the parties and the courts.
In North Carolina, a liquidated damages clause in a franchise agreement does not by itself assure that the franchisor will receive the stated amount. In the event the franchisee refuses to pay the amount due and litigation ensues, the clause must also be enforceable in court. Whether this clause is enforceable varies from state to state. However, courts will generally consider whether the parties intended to liquidate damages; the amount of monetary harm that the breach would cause was difficult to determine, and the amount of liquidated damages was a reasonable estimate of the actual monetary harm that a breach would cause.
To ensure that a franchise agreement evinces the parties’ intent to liquidate damages, it is best practice that this type of clause explicitly contains the term “liquidated damages,” and state the circumstances and terms under which they are to be paid. The monetary harm that a breach would cause must also be an amount that is difficult to determine at the time the parties enter the franchise agreement. The more difficult it is to determine the monetary harm that a breach may cause the more likely courts will consider the liquidated damages clause to be reasonable and enforceable.
A reasonable liquidated damages amount must not lead to a “penalty.” A court considers a damages amount as a penalty when it is disproportionate to the actual economic harm that the breach caused. If the amount constitutes a penalty, courts deem the clause unenforceable as a violation of public policy. To avoid this situation, the amount should be a reasonable estimate equal to the monetary harm that may occur in the event of a breach. A skilled franchise attorney from our firm can help someone draft an agreement that is enforceable under law.
A liquidated damages clause protects the franchisor from potential future breaches by the franchisee that can cause economic harm to the franchisor. Including a liquidated damages clause in a franchise agreement is a prudent way for a franchisor to protect its economic interests, provided it meets all of the necessary requirements. For help with your agreement, contact our office today.