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Do Penalty Clauses Really Belong in a Franchise Agreement?

Reading Time 6 minute read

Franchising Bulletin

Some franchisors, and even some legal advisors who are retained to draft franchise agreements, are reluctant to stipulate penalty clauses.

Penalty clauses in a franchise agreement might arouse fear on the part of potential franchisees and their legal and financial advisors, and so this makes it a little more difficult to negotiate a franchise agreement containing them.

Is it really worthwhile, then, to include penalty clauses in a franchise agreement?

Do they really protect you, or do they merely provide you with an illusion of security?

In my opinion, penalty clauses are an excellent risk management tool and provide a disincentive for franchisees who might be considering breaching their undertakings.

What sets franchise agreements apart from many other types of contracts is the number and importance of the positive and negative covenants they contain.

If there is no penalty clause, the law provides that the franchisor has only two remedies available against a franchisee in case of breaches a positive or negative covenant:

  • an action for an injunction to compel the franchisee to comply with the franchise agreement or cease to do things that are in breach of its obligations; and
  • an action in damages to compensate for the losses caused by the breach.

In the case of a breach of a confidentiality or non-competition covenant or of any provision dealing with the protection of the franchisor's confidential information and intellectual property rights, it is often difficult for the franchisor to obtain effective injunctions and orders to adequately protect the franchisor's rights (and especially to do so speedily).

In addition, there are undertakings in relation to which the franchisor may find it very difficult to prove, in court, the direct and foreseeable damages suffered by reason of breach (those being the only damages for which a court, except in some exceptional circumstances, may order compensation).

For example, is the case of a former franchisee that decides to flout its non-competition undertakings by continuing to operate a similar establishment in the same premises as its franchise.

When the franchisor no longer has any points of sale in that same market (since its one was the one operated by the former franchisee), how can it quantify the direct damages suffered as a result of the breach, and, most importantly, how can it prove these damages in court?

Another example of this difficulty is how a franchisor can quantify the direct damages suffered in the case of a franchisee that has disclosed the content of the franchisor's operating manual to a competitor.

The first reason for penalty clauses is to resolve those kinds of problems by providing, in the agreement itself, amounts that the franchisee will have to pay in such cases.

However, the most important role played by penalty clauses is not that one.

The primary purpose of any penalty clause is to act as a deterrent.

When a franchisee is contemplating breaching a provision of the franchise agreement, it will often assess the advisability of doing so by considering the foreseeable consequences of the breach.

The seriousness of the foreseeable consequences, together with the perceived probability that the franchisee will suffer those consequences, will be major factors in its decision as to whether to breach, or not, its undertaking.

A well-written penalty clause will operate on both these levels and, therefore, will make more difficult any decision to breach a provision of the franchise agreement.

However, it must be noted that, under article 1623 of the Civil Code of Québec, a court may reduce (but not increase) a penalty stipulated in a contract "if the creditor has benefited from partial performance of the obligation or if the clause is abusive".

It is therefore important to calibrate the penalty carefully in order to achieve the full deterrent effect without it being perceived as excessive or extreme (which would diminish the deterrent effect because of the almost certainty that a court would reduce it as being abusive).

In deciding whether to include a penalty clause in a franchise agreement, consideration must also be given to the fact that the clause may lessen the possibility of obtaining an injunction order promptly to put a halt to the conduct that is in breach of the contract provisions.

Two of the important criteria for obtaining an injunction relate to the difficulty of quantifying the harm and whether the harm is irreparable.

In a way, penalty clause constitutes a form of advance quantification of the damages suffered as a result of the breach in issue; accordingly, insofar as the franchisee is capable of paying the penalty stipulated, it offers a method of compensating for the harm suffered.

Nonetheless, the presence of a penalty clause is not, in itself, an insurmountable obstacle to obtaining an injunction in cases where that remedy is appropriate, particularly where the clause clearly reserves the franchisor's right to seek an injunction to enforce its rights.

It must also be noted, however, that under article 1622 of the Civil Code of Québec, a franchisor in whose favour a penalty clause has been stipulated "in no case may … exact both the performance and the penalty, unless the penalty has been stipulated for mere delay in the performance of the obligation". In clearer terms, this means that the franchisor may not both claim the penalty stipulated in the penalty clause and seek an injunction to compel its franchisee to comply with the obligation that is the subject of the clause. The franchisor must choose between the two remedies, with the sole exception of a case in which the penalty relates to the failure to perform the obligation in a timely manner.

Three practical tips

Have your penalty clauses drafted by a lawyer who is well experienced in this type of provision

The decision to include a penalty clause in a franchise agreement, the choice of which clauses in the franchise agreement should be made subject to a penalty, and the determination of (and method of calculating) an appropriate penalty (one that will be a deterrent without being abusive) are delicate decisions for which it is crucial to have the assistance of a lawyer with experience in this area.

It is very risky for a person without experience to try to draft these kinds of clauses, particularly since the risk will become apparent only when it is too late (since the deficiencies and weaknesses of the clause will materialize only after a breach has been committed).

Pay close attention to a penalty that is calculated on a per-day basis: it may contain a serious pitfall. Some agreements stipulate a penalty calculated on the basis of the days that a breach persists

Although that kind of penalty is appropriate for several undertakings (for example, a non-competition clause), it is not the case for others where the consequences of a breach are not dependent on how long it lasts, such as in the case of the breach of a confidentiality covenant.

For example, a franchisee can very well, in a single day, disclose to a competitor your entire operating manual and all of your advertising and promotional programs and projects.

The amount of your penalty should exceed any potential profit or gain that the franchisee may hope to obtain from its breach (but not by too much)

One way to maximize the deterrent effect of a penalty clause is to set the penalty at a value that exceeds any potential profit or gain that the franchisee may hope to obtain from its breach, while not being excessive.

If the franchisee believes that its potential profit or gain from a breach exceeds the amount of the penalty, the penalty may become an "entrance fee" that the franchisee may well be prepared to pay (often with the assistance of others who might benefit from the breach).

On the other hand, the higher the penalty, the greater the risk that it will be reduced by a court. In my experience, the more excessive a penalty is considered to be in relation to the harm resulting from the breach, the greater the amount by which it will be reduced.

Fasken has all the expertise and resources that are needed to help you draft agreements, including appropriate penalty clauses, that protect your rights and to ensure that they are and continue to be genuinely tailored to meet your needs.


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