What You Need to Know About Penalty Clauses in Franchise Agreements

Penalty clauses are important aspects of franchise agreements, particularly in jurisdictions where there is no franchising legislation in place. (In Canada, that includes Newfoundland & Labrador, Nova Scotia, Quebec, Saskatchewan and the territories.)
 
Despite their name, penalty clauses’ most important function isn’t actually to lay out the groundwork for penalties, according to Montreal attorney Jean Gagnon. Rather, they are there to act as a deterrent for franchisees who may be tempted to breach their franchising agreement.
 
Because having a penalty clause in a franchise agreement can dissuade potential franchisees, this makes including them more difficult, Gagnon says.
 
  1. Without any penalty clauses in place, the law provides that the franchisor has just two courses of action they can take against a franchisee who has breached their contract.
  2. The franchisor can try to get an injunction to compel the franchisee to comply with the franchise agreement or stop doing whatever it is they are doing that is in breach of the agreement.
 
The franchisor can try to collect compensation for damages caused by the breach of the agreement.
Franchisors can find it difficult to get a speedy injunction in cases of a breach of confidentiality or non-competition that deals with a franchisor’s confidential information or intellectual property rights, Gagnon says.
 
It also may find it difficult to prove in court the exact direct and indirect damages, which would indicate how much compensation the franchisor believes they are owed.
 
As an example, Gagnon points to the trouble a franchisor would have in proving damages for a franchisee who broke their non-compete clause and opened a similar business in their franchise location immediately after leaving the franchise.
 
Because the franchisor no longer has a point of sale in that area, it could not quantify the direct damages suffered from the breach and could not technically prove them in court. Another situation where it would be next to impossible for the franchisor to prove damages in court would be if a franchisee were to disclose the content of the franchisor’s operating manual to a competitor.

Although penalty clauses generally have amounts that the franchisee would have to pay in the case of such breaches, Gagnon believes their true value is as deterrents to franchisees from breaching their agreements.
 
“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,” he notes.
 
In Quebec, where Gagnon practices law, the court may reduce (but not increase) a stated penalty “if the creditor has benefited from the partial performance of the obligation or if the clause is abusive.”
 
This means it is imperative for franchisors to get their penalty clauses just right to act as enough of a deterrent without going overboard lest their court reduce the penalty.
 
Gagnon offers three practical tips for including penalty clauses in franchise agreements.

Penalty clauses should be drafted by a lawyer who is well experienced in this type of provision.

Because it’s a delicate choice to decide which clauses in the franchise agreement should include a penalty and how much that penalty should be, a lawyer who is well versed in the area should be employed. A weak penalty clause will be exposed only after a breach has occurred. 

Penalty clauses should not always be calculated on a per-day basis.

While a penalty for non-competition clause would make sense to calculate on a per-day basis because it can be easily measured in days, something like a breach of confidentiality covenant cannot be calculated in terms of days and thus should not be calculated this way.

The amount of the penalty should exceed any potential profit or gain that the franchisee may hope to obtain from their breach, but not by too much.

To maximize the deterrent effect of a penalty clause, Gagnon says, a franchisor needs to set the value of it to exceed any profit or gain that a franchisee would hope to get from breaching an agreement without having it be too excessive.
 
If the penalty does not exceed the gain the franchisee expects to get from a breach, then the franchisee may deem it worth it to eat the penalty and breach the agreement anyway.
 
Obviously, the best way to avoid any penalty clauses is to have a good working relationship with your franchisor and to have a lawyer who is experienced in franchising law inspect your agreement.
The best way to have a good working relationship with your franchisor is, of course, to choose the right one and that’s where FranNet can help you. Let us get you connected with the right franchisor for you with a free FranNet franchise search and consultation today.

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