Honey Dew Assoc. v. M&K Food Corp, 00-1300

• Decision Date: 13 September 2000
• Docket Number: No. 00-1300,00-1300
• Citation: 241 F.3d 23
• Parties: (1st Cir. 2001) HONEY DEW ASSOCIATES, INC., AND BOWEN INVESTMENT, INC., Plaintiffs, Appellants, v. M & K FOOD CORP., IRWIN KAY, AND ADELE KAY, Defendants, Appellees. Heard
• Court: U.S. Court of Appeals — First Circuit

Page 23

241 F.3d 23 (1st Cir. 2001)

HONEY DEW ASSOCIATES, INC., AND BOWEN INVESTMENT, INC., Plaintiffs, Appellants, v. M & K FOOD CORP., IRWIN KAY, AND ADELE KAY, Defendants, Appellees.

No. 00-1300

United States Court of Appeals For the First Circuit

Heard September 13, 2000

Decided February 23, 2001

APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF RHODE ISLAND [Hon. Ronald R. Lagueux, U.S. District Judge] Jack J. Mikels, with whom Linda J. Keogh and Jack Mikels & Associates were on brief for appellants.

Irving Brodsky for appellees.

Before Lynch, Circuit Judge, Coffin, Senior Circuit Judge, and Lipez, Circuit Judge.

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 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 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."

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 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 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 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...