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
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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
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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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
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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
2 Massachusetts 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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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
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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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.
5 The 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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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.
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Judgment vacated. Remanded for further proceedings

consistent with this opinion.