Licensor May Forfeit Rights to Future Guaranteed Royalties Under California Law by Terminating a License Agreement for Less than a “Total Breach”

Licensor May Forfeit Rights to Future Guaranteed Royalties Under California Law by Terminating a License Agreement for Less than a “Total Breach”

Josh Warrum

www.Beanstalk.com

I. Introduction

Since at least as early as 1931, licensees have challenged a licensor’s right to demand payment of all future minimum guaranteed royalties upon terminating a license agreement due to licensee’s breach.[1] Most recently, in February 2008, the US Court of Appeals for the Ninth Circuit addressed a licensor’s right to post-termination royalties under California law.[2] This article summarizes the guidelines set forth by California courts in determining when a licensor may collect post-termination royalties after terminating a license agreement.

II. Background

Most license agreements require the licensee to make minimum guaranteed royalty payments to the licensor regardless of the licensee’s actual sales of licensed products.[3] Such minimum guaranteed royalty payments are often spread throughout the term of the license agreement. For example, a license agreement may require the licensee to pay the licensor $100,000 on the first day of each contract year of the term of the agreement, which may be applied to royalties otherwise payable to licensor during the applicable contract year.

Most license agreements also contain a provision permitting the licensor to terminate the license agreement upon the licensee’s breach and failure to cure within a specified amount of time.[4] The termination provision usually makes the remaining minimum guaranteed royalty payments due in full immediately upon termination of the license agreement notwithstanding the original due date of the guaranteed royalty payments.[5] These accelerated guaranteed royalty payments are the source of much controversy in California courts. Terminating the license agreement also terminates the licensee’s right to manufacture and sell licensed products. However, the licensee is still forced to pay royalties on licensed products it expected to sell, but now legally cannot.

III. General Rule

If a licensor elects to terminate a license agreement upon licensee’s breach, the obligation to pay future royalties ceases as well.[6]

Fagol & Tate v. Baird-Bailhache Co. is regularly cited in California cases for the rule that a non-breaching party’s termination of a license agreement due to the other party’s breach, also terminates the breaching party’s obligation to pay future royalties.[7] In Fageol, a licensor granted a license to manufacture and sell heating devices covered by the licensor’s patents.[8] The license agreement required the licensee to pay the licensor minimum royalties every month throughout the term.[9] Under the agreement, the license agreement automatically terminated if the licensee failed to make any minimum royalty payment and did not cure the breach within 30 days of notice.[10]

The licensee eventually failed to make a minimum royalty payment and the licensor gave notice of default.[11] The licensee’s failure to cure the breach led to termination of the agreement and the licensor suing the licensee for past due royalties and future minimum guaranteed payments due under the agreement.[12]

The court noted that, upon the licensee’s breach, the licensor could either terminate the agreement or continue the agreement and insist on payment of future royalties as they became due.[13] However, they could not do both.[14] The court held that a properly terminated licensee is no longer liable for royalties that did not accrue before termination of the license.[15]

There is a line of cases applying a similar rule to franchise agreements.[16] In Postal, PIP, a printing business franchisor, entered into a long term franchise agreement with Sue and Steve Postal.[17] The agreement stated that the franchisor had the right to terminate the franchise agreement and recover damages, including the benefit of its bargain, if the franchisee committed a “material breach”.[18] The agreement explicitly stated that a “material breach” included any failure to make a monthly royalty or advertising fee due under the agreement within 10 days after notice of failure to do so.[19] After several years of properly operating under the Agreement, the franchisee failed to make several of their monthly payments.[20] PIP terminated the franchise agreement and sued Postal for breach of contract and was awarded damages for past and future royalties.[21]

On appeal, the Court of Appeal of California considered whether a licensee’s breach of a franchise agreement by failing to pay past royalties entitled a franchisor to terminate the franchise agreement and collect future royalties.[22] The court stated that a nonbreaching franchisor could only recover lost future profits that were proximately caused by the franchisee’s specific breach.[23] The court reasoned that the franchisor chose to forfeit its right to future royalties by terminating the agreement and that decision to terminate, not the licensee’s breach, was the “natural and direct” cause of franchisor’s loss of future royalty payments.[24] Therefore, PIP’s termination of the agreement, not Postal’s breach, was the proximate cause of PIP’s lost future profits and so Postal was not responsible for any future royalty payments.[25]

Despite involving a franchise agreement, the Postal rule that only those damages which are proximately caused by the breach may be recovered by a nonbreaching franchisor is relevant to cases involving lost future royalties under license agreements.[26] Most recently, a California US District Court applied the Postal rule to a license agreement in Susteen Inc. v. Sourcenext Corporation.[27]

Susteen involved a computer software license agreement in which Susteen licensed to Sourcenext the right to sell copyrighted computer software products in exchange for royalties.[28] Susteen accused Sourcenext of breaching the license agreement by sub-licensing to third parties in violation of a provision in the agreement prohibiting sub-licensing.[29] Consequently, Susteen terminated the license agreement and demanded immediate payment of all minimum annual royalty payments required during the entire term of the agreement.[30] Sourcenext refused to pay and so Susteen filed suit to compel payment of post-termination royalties.[31]

In a Motion for Summary Judgment, Sourcenext argued that California law prohibited post-termination royalties under a breach of contract claim where the licensor choose to terminate the contract.[32] The District Court applied the Postal rule to the facts of Susteen and focused on the causal relationship between the licensee’s breach and post-termination royalties the licensor sought.[33] As in Postal, the court found that the licensee’s breach of the agreement, sublicensing the software, was unrelated to future royalty payments due under the agreement.[34] Therefore, licensee’s breach was not the proximate cause of the lost future royalties and so was not liable for such royalties.[35]

IV. Exception to the General Rule

A non-breaching licensor is entitled to post-termination future royalties after terminating a license agreement only when the licensee commits a “total breach” of the agreement that prevents the licensor from the benefit of the agreement.[36]

In both Postal and Susteen, the plaintiffs argued that the defendants committed a “total breach” of their respective agreements and so the plaintiffs were entitled to post-termination future royalties.[37] In determining what constituted a “total breach”, the courts considered two California cases over 60 years old.

In Hollywood Cleaning & Pressing Co. v. Hollywood Laundry Service, Inc., the defendant agreed to exclusively promote the plaintiff’s dry cleaning and laundry service in exchange for a percentage of the defendant’s proceeds as a commission.[38] Both parties performed as required under the agreement for a short time until the defendant eventually breached the agreement by refusing to send any of its business to the plaintiff.[39] The trial court found that the defendant “totally breached” the contract by completely refusing to send any of its business to plaintiff as required under the agreement and so awarded the plaintiff future damages.[40]

In Gold Min. & Water Co. v. Swinerton, the lessor granted the lessee the right to extract minerals from the lessor’s land in exchange for royalties on the sale of the minerals the lessee extracted.[41] The lessee initially breached the lease by not entering the leased land and commencing mining within the required time frame.[42] Then, upon lessor’s refusal to allow the lessee to assign the lease, the lessee repudiated the lease by telling the lessor that they would not perform their obligations under the lease.[43]

The court stated that a “total breach” occurs where (1) “the promisor without justification and before he has committed a breach, makes a positive statement to the promisee indicating that he will not or cannot substantially perform his contractual duties” or (2) “there has been a partial breach by the promisor accompanied or followed by a repudiation of the contact by the promisor”.[44]

The court found that the lessee committed a total breach of the lease by never mining the leased land as required under the lease and then subsequently repudiating the lease by refusing to perform any of its obligations under the lease.[45] Therefore, the court found that the lessor was entitled to recover lost future royalties it would have earned had the lessee performed its obligations under the lease.[46]

In Susteen, the court distinguished Gold Mining and Hollywood Cleaning from the case at bar on the basis that both of those cases involved a “total breach” based on repudiation of the contract.[47] In contrast, the licensee in Susteen did not repudiate the agreement by completely refusing to perform all of its contractual obligations.[48] In fact, the licensee continued to perform under the agreement, including paying royalties, until the licensor terminated the agreement.[49] Thus, the court found that the licensee’s breach in sublicensing did not rise to the level of a “total breach” where the licensee did not repudiate the contract and continued to perform under the agreement (e.g., continued paying royalties until the licensor terminated the agreement).[50]

Similarly, the court in Postal distinguished Gold Mining and Hollywood Cleaning from Postal on the fact that both of those cases involved the breaching party’s complete failure to perform as opposed to the defendant in Postal, who failed to make several payments, but otherwise performed under the agreement.[51] Thus, the court found that the defendant’s failure to make several royalty and advertising payments was not a “total breach” because it did not involve a total failure to perform which directly prevented the plaintiff from receiving royalties.[52]

V. Conclusion

In both Postal and the District Court ruling in Susteen, the court focused on whether the defendant’s breach was the proximate cause of the plaintiff’s damages in determining whether to award post-termination future royalties.[53] These two opinions suggest that neither sublicensing in violation of a license agreement nor failing to make timely royalty payments are proximate causes of lost future royalties where the breaching party otherwise performs under the agreement.[54] Therefore, in both cases, post-termination future royalties are not appropriate.[55]

In Susteen, the US Court of Appeals did not address the proximate cause issue in affirming the District Court’s denial of post-termination royalty payments.[56] In a three page unpublished memorandum, the court simply stated that the licensee did not commit a “total breach” of the agreement because sublicensing did not preclude the licensor from receiving the benefit of the bargain.[57] This seems to suggest that the court may focus on whether there was a “total breach” of the agreement instead of whether the breaching party’s breach was the proximate cause of the plaintiff’s damages in determining whether to award post-termination future damages. However, it is important to note that the appellate court’s decision in Susteen is unpublished and so is not precedent for future cases.[58]

Whether the court will apply a proximate cause test or “total breach” test in actions seeking post-termination future royalties is likely only academic as it is hard to image a “total breach” (i.e., repudiation or complete failure to perform) that is not also the proximate cause of a licensor’s loss of future royalties. Similarly, it is hard to image a breach of contract that is the proximate cause of a licensor’s loss of future royalties that is not also a “total breach” of the contract.[59] Thus, it appears that under California law, a licensor may only be entitled to post-termination future royalties where a licensee has committed a “total breach” of the license agreement or committed a breach that is the proximate cause of the licensor’s loss of future royalty payments.[60]

©2008 Josh Warrum. Josh Warrum is an attorney at The Beanstalk Group, an Omnicom Group-owned brand licensing agency and consultancy. The views expressed in this article are those of the author and are not intended to represent the views of The Beanstalk Group or Omnicom Group.


[1] Fageol & Tate v. Baird-Bailhache Co., 138 Cal. App. 1 (1931).

[2] Susteen Inc. v. Sourcenext Corp., No. 06-56040, 2008 U.S. App. LEXIS 3358 (9th Cir. Feb. 14, 2008). (unpublished)

[3] Example of minimum guarantee provision in a license agreement – “Licensee agrees to pay Licensor the difference between (i) the minimum guaranteed Royalty Payments (“Minimum Royalties”) set forth in Exhibit X; and (ii) running Royalty Payments actually paid in accordance with the applicable sections of this Agreement.”

[4] Example of a termination provision in a license agreement – “Without prejudice to any other rights, Licensor may terminate this Agreement upon written notice at any time, if Licensee fails to perform any of its obligations under this Agreement or is otherwise in breach of this Agreement. Licensee will have a period of Ten (10) days after receipt of written notice to cure the breach. If Licensee fails to do so, Licensor may immediately terminate the License.”

[5] Example of accelerated minimum guaranteed royalty provision – “Upon the termination of the license granted herein, all royalties on sales theretofore made shall become immediately due and payable and no previously paid Minimum Royalties will be repayable to Licensee. Any balances owing on the Minimum Royalties for the balance of the Term will be immediately due and payable.”

[6] Susteen Inc. v. Sourcenext Corp., No. 06-56040, 2008 U.S. App. LEXIS 3358 (9th Cir. Feb. 14, 2008). (unpublished)

[7] Fageol & Tate v. Baird-Bailhache Co., 138 Cal. App. 1, 4 (1931).

[8] Id. at 2.

[9] Id.

[10] Id. at 3.

[11] Id.

[12] Id.

[13] Id. at 4.

[14] Id.

[15] Id.

[16] Robert L. Ebe, L. Steinberg, and Brett R. Waxdeck, “Radison and the Potential Demise of the Postal-Barnes-Hinton Rule”, Franchise L. J. 27 ( Summer 2007), at 3.

[17] Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704, 1706 (1996).

[18] Id. at 1707.

[19] Id. at 1707.

[20] Id. at 1707.

[21] Id. at 1707-1708.

[22] Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704, 1706 (1996).

[23] Id. at 1708.

[24] Id. at 1713.

[25] Id. at 1713.

[26] Id. at 1712.

[27] Order Denying Defendant’s Motion to Dismiss on the Grounds of Forum Non Convenience and Granting in Part and Denying in Part Defendant’s Motion for Summary Judgment, Susteen Inc. v. Sourcenext Corp., SA CV 05-90 DOC ( C.D. Cal. December 20, 2005).

[28] Id.

[29] Id.

[30] Id

[31] Id.

[32] Id.

[33] Id.

[34] Id.

[35] Id.

[36] See Susteen Inc. v. Sourcenext Corp., No. 06-56040, 2008 U.S. App. LEXIS 3358 (9th Cir. Feb. 14, 2008). (unpublished)

[37] Sealy, 43 Cal. App. 4th at 1711.; Order Denying Defendant’s Motion to Dismiss on the Grounds of Forum Non Convenience and Granting in Part and Denying in Part Defendant’s Motion for Summary Judgment, Susteen Inc. v. Sourcenext Corp., SA CV 05-90 DOC ( C.D. Cal. December 20, 2005).

[38] Hollywood Cleaning & Pressing Co. v. Hollywood Laundry Serv., Inc., 17 P.2d 712 (Cal. 1932) (per curiam).

[39] Id. at 713.

[40] Id.

[41] Gold Mining & Water Co. v. Swinerton, 23 Cal. 2d 19, 23 (Cal. 1943).

[42] Id. at 26.

[43] Id. at 27.

[44] Id. at 29.

[45] Id. at 28.

[46] Id. at 43.

[47] Order Denying Defendant’s Motion to Dismiss on the Grounds of Forum Non Convenience and Granting in Part and Denying in Part Defendant’s Motion for Summary Judgment, Susteen Inc. v. Sourcenext Corp., SA CV 05-90 DOC ( C.D. Cal. December 20, 2005).

[48] Id.

[49] Id.

[50] Id.

[51] Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704, 1711-12 (1996).

[52] Id. at 1713.

[53] Order Denying Defendant’s Motion to Dismiss on the Grounds of Forum Non Convenience and Granting in Part and Denying in Part Defendant’s Motion for Summary Judgment, Susteen Inc. v. Sourcenext Corp., SA CV 05-90 DOC ( C.D. Cal. December 20, 2005).; Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704, 1709 (1996).

[54] Order Denying Defendant’s Motion to Dismiss on the Grounds of Forum Non Convenience and Granting in Part and Denying in Part Defendant’s Motion for Summary Judgment, Susteen Inc. v. Sourcenext Corp., SA CV 05-90 DOC ( C.D. Cal. December 20, 2005).; Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704, 1710-1711 (1996).

[55] Id.

[56] Susteen Inc. v. Sourcenext Corp., No. 06-56040, 2008 U.S. App. LEXIS 3358 (9th Cir. Feb. 14, 2008). (unpublished)

[57] Id.

[58] Unpublished dispositions are not precedent except as provided by 9th Cir. R. 36-3 (i.e., when relevant under the doctrine of law of the case or rules of claim preclusion or issue preclusion).

[59] The courts in both Susteen and Postal both found that the defendant’s breach, sublicensing and failure to pay royalties respectively, was neither a “total breach” of the agreement nor the proximate cause of the plaintiff’s loss of future royalties.

[60] Susteen Inc. v. Sourcenext Corp., No. 06-56040, 2008 U.S. App. LEXIS 3358 (9th Cir. Feb. 14, 2008). (unpublished); Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704, 1708 (1996).

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2 Responses

  1. As a Licensor and a Licensee, it should be clear that if the Licensee does not live up to the full agreement, they are in breach – period.

    If the Licensee is not able to correct the problem within the agreed upon time frame, then they are in breach and the Licensor may take legal action to either have the Licensee correct the breach or terminate the licensing contract.

    What we do is ensure that within our licensing contracts there are clauses that plainly state what consequences will happen if a, b or c breach is not corrected. This way it is clear to all parties involved what will happen and it helps judges with their decision making process.

    The other way to solve this matter is to have the Licensee agree that all the possible breaches are considered total breaches of the contract and to have the penalties defined for each breach clause. It is hard for either party to argue in court that they were not in a total breach if the phrase is stated that it is (in every breach clause) and what exactly will happen if this breach is not corrected within the proper time limit.

    Of course, the best case scenario is to have both parties live up to the agreement in full.

  2. There’s a great article on the Franchise Foundations.com website about franchising vs. licensing differences (franchise vs. license) from a legal and business perspective. Go to:

    franchise vs. license

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