United States Court of Appeals
For the First Circuit
No. 00-1300
HONEY DEW ASSOCIATES, INC.,
AND BOWEN INVESTMENT, INC.,
Plaintiffs, Appellants,
v.
M & K FOOD CORP., IRWIN KAY,
AND ADELE KAY,
Defendants, Appellees.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF RHODE ISLAND
[Hon. Ronald R. Lagueux, U.S. District Judge]
Before
Lynch, Circuit Judge,
Coffin, Senior Circuit Judge,
and Lipez, Circuit Judge.
Jack J. Mikels, with whom Linda J. Keogh and Jack Mikels &
Associates were on brief for appellants.
Irving Brodsky for appellees.
February 23, 2001
LIPEZ, Circuit Judge. The trial in the district court
was about the breach of a franchise agreement and the
reasonableness of a liquidated damages clause. The court
refused to enforce the liquidated damages clause, deeming it a
penalty. We conclude that the court misallocated the burden of
proof and lacked an adequate factual basis for its penalty
determination. We therefore vacate the judgment and remand for
further proceedings.
I.
Bowen Investment Inc. ("Bowen"), a sub-franchisor of
Honey Dew Associates, Inc. ("Honey Dew"), entered into a
franchise agreement with M & K Food Corporation ("M & K"), on
June 9, 1992. This contract included a "Supplemental
Agreement," which amended the principal document's statement of
damages in the event of breach. Irwin and Adele Kay were
guarantors of the agreement for M & K, which gave them the right
to establish and operate a Honey Dew donut shop in Providence,
Rhode Island. The term of the agreement was for 10 years. The
Kays expended over $240,000 to get the business up and running.
However, due to personal financial difficulties, M & K became
delinquent in weekly franchise royalties and service fees in
amounts running just over $300. Bowen also cited operational
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problems with the shop that breached the franchise agreement.
After several warnings, including issuance of a default notice
in February 1998, Bowen terminated the agreement on or about
March 2, 1998.
Despite receipt of the termination notice, M & K
continued using the Honey Dew trade marks and trade dress. This
practice continued until the district court preliminarily
enjoined it on February 22, 1999, after a hearing. M & K was
permitted to continue operation of a generic doughnut shop in
the same leased location.
The district court awarded summary judgment to the
plaintiffs on M & K's liability for trademark infringement and
breach of contract. The court determined that Bowen had validly
terminated the franchise agreement for M & K's chronic failure
to make timely royalty payments even after notice and expiration
of the cure period. The court also ordered a hearing on damages
and commented on the liquidated damages issue:
I recognize that plaintiffs want some sort
of remedy that is prescribed by the
franchise agreement. Whether that's
appropriate or not, whether it results in a
penalty or forfeiture, is something the
Court will decide at a later time. So I
will tell you now that I have no idea
whether I will impose damages on Count IV
[seeking enforcement of the supplemental
agreement on royalty payments in the event
of breach], and if I do what the amount will
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be. But that will be determined at a later
time after proof and argument.
The district court held a hearing on damages on April
14 and 15, 1999. The court said nothing about its expectations
for proof on the liquidated damages clause at the outset of the
hearing. In opening remarks, the plaintiffs said they would
present evidence on the calculation of liquidated damages
according to the formula established in the franchise agreement.
The court responded to this introduction by stating, "you've got
to prove your case. . . . You've got to make some proof here."
Bowen and Honey Dew sought liquidated damages for
breach in accord with the Supplemental Agreement entered into
with the franchisee. These damages included "all royalty and
other payments which, but for the termination, would have been
due through the intended expiration of this Agreement." These
damages were to be calculated as "the average of the royalties
due for the calendar year ending prior to termination." The
plaintiffs put on testimony to support this calculation of
damages, demonstrating how the average royalties from the
franchise's history should be applied to the liquidated damages
formula in the contract. The plaintiffs waived recovery for
trademark infringement, stating that "in light of the damages
already requested under the contract, we don't feel it's cost
effective to proceed on the Lanham Act statutory damages."
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In their case, the defendants did not challenge the
liquidated damages calculations of the plaintiffs and they
offered no evidence to show that the liquidated damages clause
worked a penalty. Instead, they concentrated on aspects of the
franchisee-franchisor relationship that may have contributed to
M & K's failure, including exclusion from promotions and the
proximity of other Honey Dew franchises. Both parties submitted
evidence as to the amount of counsel fees at issue.
At the close of the evidence, the court said that the
plaintiffs' "failure of proof" on the issue of actual damages
and mitigation raised "a question as to whether that clause is
valid and should be enforced, and I think that's an issue
neither side has truly addressed." During the plaintiffs' final
argument, the court said, "I don't know if it's valid . . . .
[I]t seems to me that there are penalty aspects to this."
Hearing this, the defendants echoed the judge's concern in their
closing argument: "I have now, of course, the benefit of your
Honor's expressions and thinking with reference to [the
liquidated damages clause], . . . this clause in the
supplementary agreement is nothing short of a confiscatory
nature and a penalty." In rebuttal, the plaintiffs complained
about this late injection of the penalty issue:
I assure the Court that had these issues
been raised prior to or during the trial, I
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not only feel comfortable that we would have
been able to convince the Court that these
were fair and reasonable provisions both
then and now, but our entire case would have
been extremely different, and I feel that
it's, although I understand the Court's
hesitation in enforcing the clause, I feel
it's only fair to take the case as it was
presented to you and not penalize us for the
fact that we weren't really given an
opportunity to make the appropriate
arguments as to those issues and present the
proof as to those issues.
In light of these arguments, the court required post-trial
memoranda on enforcing the liquidated damages clause and
calculating attorneys' fees.
The plaintiffs argued in their memorandum that the
defendants had waived the penalty as an affirmative defense.
"Significantly, the defendant in this litigation did not contest
the validity of the method of calculating liquidated damages. .
. . [A] party seeking to invalidate a liquidated damages clause
bears the burden of proving this affirmative defense." The
plaintiffs also reiterated that if they had known the validity
of the liquidated damages clause was in question, "the entire
case would have been litigated differently, with different
witnesses."
In their memorandum, the defendants asserted that the
plaintiffs "have the burden of demonstrating that the liquidated
damages provision is enforceable. . . . The plaintiffs failed to
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prove that either the amount fixed was a reasonable forecast of
just damages or that the harm caused would be incapable or
difficult to estimate." Additionally, they stated that the
damages formula acts as a penalty because "it is designed always
to assure the plaintiffs more than their actual damages."
Finally, the defendants asserted that, in seeking enforcement,
the plaintiffs failed to account for mitigation of damages by
the defendants.
After considering the evidence and the memoranda of
counsel, the court decided that the liquidated damages clause
was an unenforceable penalty and awarded nominal damages of one
dollar to Bowen and Honey Dew. The court made this
determination pursuant to the law of Massachusetts, as specified
by a choice of law provision in the contract. Because the term
specifying attorneys' fees and costs was part of the liquidated
damages clause in the supplemental agreement, the district court
ruled that it was also unenforceable. Both of these rulings
were erroneous.
II.
Plaintiffs argue on appeal that because M & K never
pled explicitly that the liquidated damages clause was an
unenforceable penalty, they have waived any claim to this
affirmative defense. Although failure to plead an affirmative
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defense generally "results in its waiver and exclusion from the
case," Boston Hides & Furs, Ltd. v. Sumitomo Bank, Ltd., 870 F.
Supp. 1153, 1161 (D. Mass. 1994), the defendants' pleadings in
this case provided notice of the penalty defense. They state
that the relief plaintiffs seek would "present a definite
forfeiture of defendants' business and their immense investment;
and by every principle of equity and justice, such forfeiture
should not be enforced." In context, this defense primarily
contests the fairness of stripping the franchise of the Honey
Dew trade name and prohibiting further operation of a doughnut
business at the existing site. Still, this statement indicates
the defendants' concern that the relief that could be awarded to
the plaintiffs would constitute a penalty. Moreover, the judge
understood the presence in this case of the penalty defense to
the claim of damages. Again, as the court stated at the close
of the liability phase of the case, almost three months before
the hearing on damages, "I recognize that plaintiffs want some
sort of remedy that is prescribed by the franchise agreement.
Whether that's appropriate or not, whether it results in a
penalty or forfeiture, is something the Court will decide at a
later time."
Under these circumstances, we conclude that the
defendants did not waive the penalty defense to the enforcement
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of the liquidated damages clause in their pleadings. At trial,
however, they failed to present evidence on the enforceability
of the liquidated damages clause. So did the plaintiffs. We
now assess the significance of this odd circumstance.
III.
Not surprisingly, the court revealed some uncertainty
about whether the plaintiffs had the burden of proving that the
liquidated damages clause in the franchise agreement did not
impose an unenforceable penalty, or whether the defendants had
the burden of proving that it did. In their post-trial
memorandum, the plaintiffs cited law from New Jersey and
Connecticut in support of their assertion that the defendants
had the burden of proving that the liquidated damages clause
imposed an unenforceable penalty. See Naporano Associates, L.P.
v. B & P Builders, 706 A.2d 1123 (N.J. Super. 1998); Norwalk
Door Closer Co. v. Eagle Lock & Screw Co., 220 A.2d 263 (Conn.
1966). Defendants cited law from Maine in support of their
insistence that the plaintiffs had to prove that a liquidated
damage clause did not impose such a penalty. See Pacheco v.
Scoblionko, 532 A.2d 1036 (Me. 1987).1 Neither party cited the
1
The court in this case recognized, however, that while few
jurisdictions have addressed the issue, "an apparent majority"
favor the view that the party challenging the liquidated damages
provision bears the burden of proof. Id. at 1038-39.
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law of Massachusetts. So far as we can discern, there is no
definitive statement by the Massachusetts courts on this issue.
At most, we find cases stating that defendants who challenged
contract enforcement on the basis of illegality or a violation
of public policy have the burden to raise and prove that
defense. See Fedenyszen v. Pollano, No. 9413, 1997 WL 382114 at
*2 (Mass. App. Ct. June 25, 1997) (relating to contract
enforcement: "The burden was on the defendant to raise and prove
the affirmative defense of illegality or a violation of public
policy.") We also find a federal district court case which
assigns the burden of demonstrating unenforceability to the
party hoping to avoid enforcement of the contract. See New
England Mut. Life Ins. Co. v. Stuzin, No. 86-2470-S, 1990 U.S.
Dist. Lexis 13137 *13 (D. Mass. Oct. 1, 1990) (regarding
material issues surrounding enforceability of liquidated damages
clauses, "defendants have the burden of proof.").
Our search of the treatises and academic literature
leads us to the conclusion that the prevailing rule is that the
party challenging the enforceability of a liquidated damages
clause has the burden of proving that it is a penalty. "[T]he
trend toward increased enforcement of stipulated damages is also
encouraged by a shifting of the burden of proof to the party who
asserts the existence of an unlawful penalty. The shifted
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burden of proof, enacted by statute in some states, has probably
now become the majority rule, replacing the earlier rule
requiring the enforcer of a contract to prove the absence of an
unlawful penalty." Joseph F. Brodley & Ching-to Albert Ma,
Contract Penalties, Monopolizing Strategies, and Antitrust
Policy, 45 Stan. L. Rev. 1161, 1179 (1993) (citing 25A C.J.S.
Damages § 144(f) (1966)). See also Melvin Aron Eisenberg, The
Limits of Cognition and the Limits of Contract, 47 Stan. L. Rev.
211, 236 (1995) ("[A] liquidated damages provision should
relieve the plaintiff of the burden of proving damages, by
shifting to the defendant the burden of establishing that the
liquidated damages provision is unenforceable.); 22 Am. Jur. 2d
Damages § 905 (1999) ("[W]here the contract contains a
liquidated damages clause, the party seeking to repudiate that
clause must show that agreed damage is so exorbitant as to be in
[the] nature of a penalty.").
Given this authority, and the Massachusetts precedents
cited above dealing with proof of the unenforceability of
contracts in other contexts, we conclude that if the
Massachusetts Supreme Court were required to decide the issue
before us definitively, it would assign the burden of proving
the unenforceability of a liquidated damages clause to the party
raising that defense (here, the defendants). See Losacco v.
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F.D. Rich Construction Co., Inc., 992 F.2d 382, 384 (1st Cir.
1993) ("When the highest state court has not issued a definitive
ruling on the precise issue at hand, the federal courts may
refer to analogous decisions, considered dicta, scholarly works,
or other reliable sources to ascertain how the highest court
would rule."). For that reason, we conclude that the trial
court erred in requiring that the plaintiffs prove that the
liquidated damages clause did not impose a penalty on the
defendants.
In addition, we note that the district court decided
the penalty issue without the benefit of any pertinent evidence.
For example, after observing that plaintiff Bowen “was relieved
of its duties under the Franchise Agreement as a consequence of
M & K's default and termination,” the court wrote in its opinion
that “[c]ommon sense dictates that Bowen will save an unstated
amount because it does not have to supervise the operation of
the shop and regularly send personnel to Rhode Island to ensure
that M & K complies with the Franchise Agreement (for example,
the sanitary standards set forth in Honey Dew's policies).” The
court similarly emphasized that the damages clause is an
unenforceable penalty “because, at the time the agreement was
made, it was not a reasonable estimation of the potential loss
which would occur if there was breach and termination of the
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Franchise Agreement.” The court explained this conclusion on
the basis of logic and inference:
Under the terms of the franchise agreement,
royalties were to be paid to plaintiffs on a
monthly basis to June 8, 2002. It was known
at the time of contracting that if M & K had
defaulted under the terms of the Franchise
Agreement and it was terminated, the loss
sustained by Bowen would be some small
unknown amount every month through to the
expiration date of the agreement. To
require M & K to make all of those future
payments in one lump sum as of the time of
termination cannot reasonably be viewed as
compensation for Bowen's loss, but rather as
a penalty for the breach since there is no
provision for discounting the amount to
present value. Consequently, the damages
clause calls for the payment of an
unconscionable penalty.
In the circumstances of this case, these judgments
based on common sense and logic should have been informed by an
understanding of the factual predicates for the liquidated
damages clause. Determining the validity of a liquidated
damages clause is usually a fact-specific exercise. See A-Z
Servicenter, Inc. v. Segall, 138 N.E.2d 266, 268 (Mass. 1956);
Zapatha v. Dairy Mart, Inc., 408 N.E.2d 1370, 1374-75 (Mass.
1980). In the relevant commercial code context, when there are
claims of unconscionable contract provisions, Massachusetts law
requires that “the parties shall be afforded a reasonable
opportunity to present evidence as to [the contract's or
clause's] commercial setting, purpose and effect to aid the
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court in making its determination.” Mass. Gen. Laws ch. 106, §
2-302(2).2
In their post-trial memorandum, the plaintiffs noted
correctly the absence in the record of evidence on the penalty
issue: "[A]t trial, there was no evidence presented as to either
negotiations or intention, making it virtually impossible to
second guess whether the provision was reasonable at the time it
was negotiated.”3 They go on to suggest the types of evidence
they would have offered to defend against a claim that the
clause constituted a penalty: "actual damages, the projected
royalty stream over the remainder of the contractual term, the
present value of the damages and the factors which were
considered in establishing the liquidated damages clause." In
2Massachusetts courts dealing with claims of unconscionable
contract terms have recognized the relevance of the Uniform
Commercial Code provisions in analyzing the claims before them
even if the contract was not covered by the Code. See Zapatha,
408 N.E.2d at 1374-75 (invoking the provisions of the sales
article regarding good faith and unconscionability by analogy,
while recognizing that franchise agreements may be distinct from
contracts for sale of items).
3 Under Massachusetts law, "a judge, in determining the
enforceability of a liquidated damages clause, should examine
only the circumstances at contract formation. Our position is
that 'where actual damages are difficult to ascertain and where
the sum agreed upon by the parties at the time of the execution
of the contract represents a reasonable estimate of the actual
damages, such a contract will be enforced.'" Kelly v. Marx, 705
N.E.2d 1114, 1117 (Mass. 1999) (quoting A-Z Servicenter, Inc. v.
Segall, 138 N.E.2d 266, 268 (Mass. 1956)).
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the plaintiffs' brief on appeal, they cite "a variety of factors
on both sides which could have been considered in selecting the
formula to which the parties agreed." The court needed to hear
evidence about these factors before deciding the penalty issue.4
We recognize that the defendants did not present any
evidence on the unenforceability of the liquidated damages
clause. Arguably, given this absence of evidence, and our
conclusion that the defendants have the burden of proving that
the clause imposes an unenforceable penalty, we should vacate
the judgment of the court and order the entry of judgment for
the plaintiffs. We reject that conclusion, however. The
confusion about the proper allocation of the burden of proof on
the enforceability of the liquidated damages clause hampered
both parties in properly addressing the issue. Indeed, the
court's insistence about the plaintiffs' responsibility to prove
that the clause was not a penalty may have lulled the defendants
into complacency about their evidentiary burden on this issue.
4
In characterizing the liquidated damages provision as an
acceleration clause, the court wrote, "it is well settled law
that other than in a mortgage or security agreement situation,
'an acceleration clause cannot be viewed as one for liquidated
damages if the full amount owing cannot be an estimate of the
true extent of the damages sustained upon the breach.'"
(citation omitted). Without considering evidence, the court
concluded that the liquidated damages clause could not be an
estimate of the true cost of the breach and thus was
unenforceable. Again, this conclusion required evidence.
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We conclude, therefore, that the fairest outcome to both parties
is a remand for further proceedings.
IV.
Fees and costs
The district court concluded that "[Bowen's] claim for
counsel fees is based solely on the last sentence of the damages
clause." Because it "declared that clause unenforceable and the
counsel fee provision is an integral part thereof, counsel fees
are not recoverable in this case." We disagree. The sentence
making the franchisee "liable for all costs resulting from its
default and all costs of collection including reasonable counsel
fees" is not integral to the liquidated damages clause. Indeed,
there was no indication at trial that this term was troubling to
the court, even if the liquidated damages clause was.5
Accordingly, with the plaintiffs having prevailed on liability,
the court should award reasonable costs and fees to the
plaintiffs on remand for the litigation to date, with additional
costs and fees to be awarded to the plaintiffs for the pending
penalty litigation if they prevail on that issue.
5The district court requested post-trial briefs from the
parties on whether the fees should be calculated pursuant to
Rhode Island or Massachusetts rates. Neither party indicated
that this term might be unenforceable as part of an invalidated
liquidated damages clause.
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Judgment vacated. Remanded for further proceedings
consistent with this opinion.
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