Editor’s note: The author was a lawyer in the two cases mentioned in this article.
Franchise fees are said to be the lifeblood of the franchise system. If the royalties are not paid, does it constitute a claim for money damages or does it create grounds for injunctive relief? Most courts ultimately find this can result in a claim for injunctive relief because money damages are inadequate. This article examines the reasoning of such courts and other defaults in the franchise relationship that constitute irreparable harm.
The franchisees pay royalties and the franchisor reinvests in the brand. The royalties support the brand and improve brand equity, the value of the enterprise and the value of each franchisee that uses the brand. The royalties are part of the consideration for the trademark license and the confidential information licensed to the franchisee. Each franchise agreement provides that if the royalties are not paid, then the franchise agreement is subject to default. Nonpayment of royalties can constitute a material breach of the franchise agreement because it goes to the essence of the agreement.
Congress granted trademark holders a broad range of remedies for trademark disputes and unfair competition under the federal Lanham Act, 15 U.S.C. Section 1051, et. seq. The drafters realized that commerce depends on the accurate identity of the source and affiliation of products, and that the good will of the proprietary marks depends on the ability of the holder to control and shape how proprietary marks are used. Whether the name is to be used as a product or a service, or combined or built into a brand, is the commercial prerogative of the trademark holder. Congress protects those rights with Lanham Act remedies.
In the franchise setting, the franchisor licenses the mark to the franchisee to use in connection with a system of stylized appearances and methods of doing business. Franchise agreements recite that every element of the franchise system is important. Typical language states that as a result of an investment of time and effort, the franchisor has developed skill and incorporated it into a system of design, business methods, specifications, standards, development, operation and marketing of the franchised concept. The franchise agreement will further state that the franchisor has the right to license certain intellectual property to be used with the system, which can include patents, trademarks, trade secrets and know-how. The franchise agreement will then state that the franchisee has day-to-day control over its licensed business but that the franchisor must control the good will associated with the system.
Courts differ in this analysis depending on whether the impairment is a material breach of the franchise agreement. Often the question of material breach is determined by state law. For franchises protected under the New Jersey Franchise Practices Act, the legislature defined material breach as the failure of the franchisee to comply with the essential requirements of the franchise agreement. For example, even though a franchisee protected under the act may have violated the express provisions of the act, and the franchise agreement expressly allows termination, the legislature has provided additional protections and the franchisor must prove the franchisee breached the essence of the contract. So, if a franchisee had failed to pay a month of royalties, and had not heeded the notice to cure default under the express terms of the franchise agreement, then a court applying the act may still ask whether this is a material default that goes to the essence of the agreement. Absent a finding of material nonperformance by the franchisee, a court may not enforce the termination of the franchise agreement, and may not grant an injunction. The harm is deemed compensable in money damages if the franchisee can cure the short period of default, rather than losing its livelihood.
In S&R v. Jiffy Lube International, 968 F.2d 371 (3d Cir. 1992), the franchisee stopped paying rent and royalties on the Jiffy Lube stores, but continued to use the trademark. The franchisee stated that he was justified in halting payment because Jiffy Lube breached some of its contractual obligations under the franchise agreement. The franchisor, Jiffy Lube, terminated the agreement because the franchisee failed to pay royalties and then sought a preliminary injunction for the use of the trademark. The U.S. Court of Appeals for the Third Circuit found that the franchisee’s failure to pay royalties and use the mark in an "innovative" way warranted the injunction in favor of Jiffy Lube. The court held that by reference to contract and trademark principles, "once a franchise is terminated, the franchisor has the right to enjoin unauthorized use of its trademark under the Lanham Act." The court held that because the terminated franchisee and Jiffy Lube were using the same legally protectable trademark, owned by Jiffy Lube, their concurrent use was highly likely to cause consumer confusion about the terminated franchisee’s affiliation with the franchise. The circuit court granted the injunction.
Recently, in Dunkin’ Donuts Franchised Restaurants LLC v. Claudia I LLC, 2013 U.S. Dist. LEXIS 70025 (E.D.Pa. May 17, 2013), a Dunkin’ Brands franchisee cleverly sought to distinguish the Jiffy Lube case by claiming that royalties were not withheld and were up to date, so the failure to pay rent for two years and the failure to remodel the premises was merely a monetary default fully compensable in money damages and did not amount to a trademark issue warranting an injunction. The plaintiffs argued that the franchise agreement allowed the franchise agreement to terminate if the lease were terminated, and the franchisee’s lease was terminated due to the nonpayment of rent as well as the failure to remodel. The district court adopted the general contract principles stated in Jiffy Lube, which allow a nonbreaching party to either stop performance and assume the contract is avoided or continue its performance and sue for damages. "Under no circumstances may the nonbreaching party stop performance and continue to take advantage of the contract’s benefits," the opinion said. The court stated that, "Plaintiffs’ arguments focus on the nonmonetary damages they allege are being inflicted, such as loss of good will and reputation due to their failure to control what the plaintiff is doing with the ‘Dunkin’ mark. Plaintiff contends that these immeasurable damages warrant the injunction. It is important to note that trademark infringement amounts to irreparable injury as a matter of law." Based on well-settled law in the Third Circuit, the district court granted the injunction.
As the case demonstrates, the appearance and nature of the leasehold is an important element of the franchise system. The failure to comply with a lease, if sufficiently material, can be irreparable harm sufficient to terminate a franchise agreement and constitute irreparable harm to support an injunction.
Craig R. Tractenberg is the team leader of the franchise practice at Nixon Peabody and an adjunct professor of franchise law at Temple University’s Beasley School of Law.