La Quinta decision on enforcing system changes

We wanted to pass along the attached decision from the Sixth Circuit Court of Appeals yesterday involving La Quinta Inns and a former franchisee that we thought might be of interest to you. The Sixth Circuit reached some helpful conclusions regarding enforcing system change in hotel systems, enforcing liquidated damages in hotel franchise agreements, and the availability of treble damages against holdover franchisees.

The background of the case is as follows: the dispute arose out the franchisee’s refusal (or delay) in implementing La Quinta’s new reservation system. La Quinta had required that its franchisees execute an agreement in connection with implementing the system, which the franchisee contended would modify the terms of its franchise agreement, including, according to the franchisee, eliminating the franchisee’s option not to renew. The franchisee essentially asserted that La Quinta had anticipatorily breached the franchise agreement by attempting to impose obligations in conflict with its franchise agreement in the reservation system agreement. La Quinta defaulted the franchisee for failing to implement the new reservation system and terminated the agreement. The franchisee sued for breach (while continuing to operate under the marks) and La Quinta counterclaimed for trademark infringement and breach, seeking to recover damages for willful infringement as well as liquidated damages under the franchise agreement resulting from the termination. The district court ruled in favor of La Quinta on all counts, awarding liquidated damages and treble damages for willful infringement.

The Sixth Circuit held the following:

First, the Sixth Circuit held that La Quinta was authorized to require the franchisee to update and implement the reservation system, based on the language of the franchise agreement requiring the franchisee to use the reservation system La Quinta selected. The Court noted other decisions in which courts have upheld a franchisor’s right to affect system change. As a result, the Court rejected the franchisee’s claim of anticipatory breach and affirmed the lower court’s finding that it was the franchisee who had breached by failing to adopt the new reservation system. In conjunction with that conclusion, the Court rejected the franchisee’s claims that La Quinta had breached the implied covenant of good faith and fair dealing because the contract authorized La Quinta to implement the reservation system.

Second, the Court upheld the award of liquidated damages. This holding is notable because the liquidated damages provision in that case is almost identical to the language we’ve seen in several of the Hilton agreements (average monthly fees that would have been due over a thirty-six month period, based on prior operations). While the court analyzed the provision under Wisconsin law (pursuant to the contract’s choice of law provision), the Court found compelling the fact that the estimated lost royalties over the entire remaining term of the franchise agreement would have been far in excess of the calculated liquidated damages amount

Third, the Court upheld the award of treble damages for willful infringement. The lower court had accepted the franchisee’s calculation of royalties that would have been due during the time after termination that it continued to use the marks (which excluded revenues from sales at the hotel restaurant, from pay-per-view movies, and charges associated with use of the hotel pool and attached water park), and then trebled that amount. The Court found that that the franchisee’s continued use was willful and defiant (based on the contractual obligation to cease using the marks and the fact that use continued for a year after termination and two months after the lower court entered a preliminary injunction) and that the award was not a “penalty.” The Court also reasoned that awarding treble damages for willful infringement was not duplicative of the liquidated damages award because the wrongs were separate: La Quinta was entitled to liquidated damages upon early termination irrespective of later infringement and damages arising out of that willful conduct.

While none of the Court’s holdings is particularly earth-shattering, having a federal Court of Appeals weigh in on these issues is always beneficial, as it is obviously binding case law in the Sixth Circuit (Ohio, Michigan, Kentucky and Tennessee) and is certainly persuasive in other jurisdictions. I know Jim plans to use it in his discussions with Ambama’s attorney in the Norfolk Doubletree matter.