California and Michigan Courts Examine Recovery of Lost Future Royalty Damages

By Lewis G. Rudnick, Lee J. Plave and Tara Cope

In a recent case from California, a federal trial court in California re-examined an issue that was central to a headline-making decision from the state courts of California in 1996. In July 2003, the U.S. District Court for the Southern District of California addressed whether a franchisor could seek compensation for future lost royalties from a franchisee after the franchise agreement between the two was terminated. It’s Just Lunch Franchise, LLC v. BLFA Enterprises, LLC and Angela Stephens, 2003 WL 21735005 (S.D. Cal. July 21, 2003).

In 1996, a California state court held that California law prohibits a franchisor from recovering damages for lost future royalties when the franchisee fails to make royalty payments and the franchisor subsequently terminates the franchise agreement. Postal Instant Press, Inc. v. Sealy, 51 Cal.Rptr.2d 365 (1996). In that case, Sealy, a franchisee, failed to make several royalty payments as required by her franchise agreement. Postal Instant Press, the franchisor, declared Sealy to be in breach of the franchise agreement and terminated the agreement. The court held that the franchisor could not recover future profits (in the form of future royalties) because it had been the party to terminate the agreement, and because the damage (the loss of future royalties) was therefore proximately caused by the franchisor’s termination, rather than by the franchisee’s breach. Also, the court found that an award of future profits under those circumstances would amount to unreasonable, unconscionable, or grossly oppressive damages. The court noted that allowing an award of lost future royalties would give the franchisor too much leverage in every contract dispute, because, unless the franchisee complied, it would be faced with the threat of the franchisor terminating the agreement and being awarded future profits. The Sealy reasoning was adopted the next year by a federal court in Colorado, in I Can't Believe It's Yogurt v. Gunn, Bus. Franchise Guide (CCH) ¶ 11,197 (D. Colo. April 15, 1997), a case with very similar facts.

In the It’s Just Lunch case, the plaintiff, a franchisor of a dating and matchmaking business, brought suit against its franchisee seeking compensation for past-due royalties and for future lost royalties. The franchisor alleged damages of approximately $10,500 in past-due royalties and $463,850 in future royalties computed over the remaining nine years of the ten-year term of the terminated franchise agreement. The franchisee filed a motion to dismiss the franchisor’s claims for lack of diversity jurisdiction, claiming that, under California law, as stated in the Postal Instant Press case discussed above, a franchisor cannot recover future royalties; the franchisee then claimed that the amount in controversy therefore failed to meet the diversity jurisdiction threshold of $75,000. The court disagreed and denied the franchisee’s motion.

The factual background of this case is as follows. In October 2002, the parties entered into a franchise agreement. The franchisee failed to make the required royalty payments. The franchisor alleged that the franchisee terminated the franchise agreement in a letter dated in February 2003. However, the franchisee alleged that it was the franchisor who terminated the franchise agreement, in a letter dated in March 2003.

The franchisee argued that the court must follow the ruling in Sealy and deny recovery of lost future profits. The court disagreed, noting that the Sealy court expressly refused to consider whether damages for future profits would be available where, as alleged in the franchisor’s complaint, the franchisee terminated the agreement. The court further noted that the Sealy court did not preclude the award of future royalties, even if the franchisor terminates the agreement, if the franchisee’s conduct proximately caused the damages, and the award is neither excessive, oppressive, nor disproportionate. Thus, because the Sealy precedent did not preclude an award of future royalties under the facts as pled by It’s Just Lunch, the court denied the franchisee’s motion to dismiss.

This decision revives under California law an issue that has been debated in the franchise community since the Sealy decision in 1996. The It’s Just Lunch decision holds that a franchisor may be able to recover future royalties if it is the franchisee, rather than the franchisor, who terminates the franchise agreement. A franchisor faced with a recalcitrant franchisee with uncured defaults will not find much comfort in this decision to the extent that it is construed merely to distinguish Sealy on the basis of termination by the franchisee rather than the franchisor. The Sealy court explicitly stated that Postal Instant Press could have refrained from terminating and could have sued for each royalty payment after it became past due, a clearly unsatisfactory option for a franchisor. If the It’s Just Lunch court’s decision does no more than distinguish Sealy because, in the current case, the franchisee terminated the franchise agreement, then under California law a franchisor continues to risk losing its ability to collect future royalties whenever it terminates the franchise agreement. However, the It’s Just Lunch decision would appear to support the proposition that, in some instances, such as franchisee’s abandonment of the franchise business, the franchisor may be entitled to recover future royalties even if it terminates the franchise agreement.

In contrast to Sealy, and the limited exceptions to Sealy that may be derived from It’s Just Lunch, consider the decision in American Speedy Printing Centers, Inc. v. AM Marketing, Inc., Mary Bennett, et al., U.S. App. LEXIS 13871 (6^th Cir. July 8, 2003) (designated not for publication by the court). In this case, the Court of Appeals for the 6^th Circuit affirmed a ruling of the U.S. District Court for the Eastern District of Michigan awarding future royalties to American Speedy, a franchisor of print shops. American Speedy and the franchisee entered into a twenty-year franchise agreement. With nine years remaining on the term of the agreement, the franchisor terminated the franchise agreement based on the franchisee’s failure to pay royalties. The trial court granted summary judgment in favor of the franchisor based upon the franchisee’s failure to provide any evidence that created an issue of material fact regarding the allegations in the franchisor’s pleadings. The trial court awarded American Speedy $55,789 for past-due royalties and $115,616 in future royalties. In affirming the trial court’s award, the appellate court held that the franchisor was entitled to all damages necessary to put itself in a position equivalent to that in which it would have found itself if the franchise agreement had continued in effect for the full twenty-year term.

As if to prove that this remains an unsettled area of the law, shortly after the federal appellate court for Michigan affirmed the American Speedy Printing ruling from the District Court for the Eastern District of Michigan, the District Court for the Western District of Michigan reached the opposite conclusion on similar facts. See Kissinger, Inc. v. Singh, 2003 U.S. Dist. LEXIS 23265 (W.D. Mich. November 25, 2003). In the American Speedy Printing case discussed above, the Eastern District of Michigan granted (and the appellate court affirmed) an award of lost future royalties to a franchisor that terminated a franchise agreement. However, four months later, the District Court for the Western District of Michigan held that a franchisor was not entitled to lost future royalties after terminating a franchise agreement for failure to pay royalties. The Kissinger court summarized and followed the reasoning of the Sealy case. The court cited two cases that had followed the Sealy ruling, and, interestingly, noted that it had not found any case that reached the opposite result. Then, relying on the Sealy analysis, the court held that the franchisor was not entitled to recover lost future royalty payments as damages because the proximate cause of any such loss was the franchisor’s decision to terminate the franchisee, rather than the franchisee’s failure to pay royalties.

Other courts have adopted reasoning similar to that of the court that decided the American Speedy Printing case, such as Maaco Enterprises, Inc. v. Cintron, 2000 U.S. Dist. Lexis 6911 (E.D. Pa., May 17, 2000). In Cintron, even though the franchisor was the party that terminated the franchise agreement, it was nonetheless awarded $164,326 in lost future royalties that the court found "it would have received but for defendants' continuing defaults which led to the termination of the Franchise Agreement nine years early." The court further observed that "[u]nless required to pay future royalties, [the former franchisee] will have derived a great deal of benefit from Maaco and use of its business system without paying the bargained for consideration." A federal bankruptcy court reached a similar result and awarded Postal Instant Press $273,337 in lost future royalties – a case in which the franchisor claimed that it was the party that terminated the franchise yet the franchisee claimed it had earlier terminated the relationship. In re Montcastle, Bus. Franchise Guide (CCH) ¶ 10,534 (W.D.N.C. Sept. 2, 1994). Moreover, in Sparks Tune-Up Centers, Inc. v. Addison, Bus. Franchise Guide (CCH) ¶ 9439 (E.D. Pa., June 30, 1989), aff’d, Bus. Franchise Guide (CCH) ¶ 9563 (3d Cir. Jan. 29, 1990) (not for publication), the court rejected the former franchisee’s claims that it was not liable for payment of overdue royalties, ad funds, and lost future royalties due to alleged fraud by the franchisor.

As is apparent from the cases discussed above, the recovery of future royalties from a franchisee whose rights have been terminated by the franchisor remains uncertain. In the Sealy decision, the court elevated form over substance in basing its decision largely on the fact that the franchisor’s termination of the franchise, rather than the franchisee’s default, was the precipitating cause of the franchisor’s loss of future royalties. Under traditional contract law principles, if one party materially breaches a contract, the other party can terminate and generally sue for the benefit of the bargain damages. Though Sealy has been followed in a few cases outside California (such as the Gunn case in Colorado), it has been rejected by others, as did the district court and court of appeals in American Speedy Printing, the district courts in Cintron and Sparks, and the bankruptcy court in Montcastle. Perhaps the It’s Just Lunch decision marks the evolution of a reassessment of Sealy under California law.

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