Franchisee Liability for Lost Future Profits: Another Blow to Sealy?

This posting was written by Bruce S. Schaeffer of Franchise Valuations, Ltd., co-author of CCH Franchise Regulation and Damages.

The Texas Court of Appeals for the Second District—applying Georgia law in a case of first impression for both Georgia and Texas—has held that a "terminated" franchisee was liable for lost future profits over the full remainder of a 25-year term (Progressive Child Care Systems, Inc. v. Kids `R' Kids International, Inc., CCH Business Franchise Guide ¶14,018).

Is this the death knell of Postal Instant Press, Inc. v. Sealy (CCH Business Franchise Guide ¶10,893), which invalidated an award of lost future royalties and advertising fees to a franchisor that had terminated a franchisee for failure to pay royalties? I think not.

For one thing, there was no possibility of the franchisor in the Texas case double-dipping or collecting royalties from the same site twice because the "terminated" franchisee simply stopped paying and kept his child care franchises running at the same sites under a different name—Legacy Learning Center, rather than Kids `R' Kids.

For another, the franchisee simply left the system, falling more under the abandonment justification for such lost future royalties found in other cases. See It's Just Lunch Franchise, LLC v. BLFA Enterprises, LLC, CCH Business Franchise Guide ¶12,620.

In that case, the court held that “under Sealy, a franchisor who has terminated the franchise agreement cannot recover for future profits,” but nevertheless found It’s Just Lunch to be outside Sealy. "The Sealy court expressly refused to consider whether damages for future profits would be available where, as alleged in It's Just Lunch's complaint, the franchisee terminated the agreement."

Attorney "Mal Practice"

There was a recent comment thread on "mal practice" on the ABA Franchise Forum's listserv (from whence comes the strange spelling in two words) concerning the practice of franchise law by the ignorant.

As one would expect from such a diverse crowd, the responses ranged from the learned to the mundane, from the sanctimonious to failed attempts at humor. But the point was well taken—proctologists should not perform brain surgery, and the lawyers who do house closings should not prepare franchise documents.

Proof of how bad an outcome can result from such ignorant representation is found in State of Nebraska ex rel Counsel for Discipline of the Nebraska Supreme Court v. Orr(Neb. S. Ct. January 30, 2009, CCH Business Franchise Guide ¶14,064).

As I have repeatedly said, the same problem—lack of expertise—can be extremely troubling when using generalized knowledge experts (as opposed to franchise valuation experts) to establish damages or value franchises in mediation, arbitration or litigation. See, e.g., Schaeffer and Ogulnick, “Why Valuing Franchise Businesses is Different from Valuing Other Businesses,” Institute of Business Appraisers, Business Appraisal Practice (Spring 2008).

Rescission as Punishment

A Colorado trial court in Quizno's Franchising II v. Zig Zag Restaurant Group (D. Colo. 2008) CCH Business Franchise Guide ¶14,046, used rescission as the measure of damages to punish a franchisor’s vendetta of “in-house pique” against a franchisee who was terminated as the result of one unreliable field test of the amount of meat in a sandwich.

The court held the sandwich shop franchisee was entitled to rescission-type damages in the amount of $349,797 and post-judgment interest at the rate of 24 percent for the franchisor’s wrongful termination.

Under well-settled Colorado law, contract damages are normally based on benefit-of-the-bargain. However, the court ruled that when there is a substantial breach with irreparable injury—and ordinary contract damages are inadequate, difficult, or impossible to assess—then it is appropriate to award rescission-type damages. The object was not just to return the parties to the moment before the breach, but to return them to the moment before the contract was entered into.

The franchisor's argument that it terminated the franchise because the franchisee breached its agreement by materially impairing its goodwill was rejected. To the contrary, the court held that the franchisor breached the agreement by wrongfully terminating the franchisee.