Penalty Clauses and Your Franchise Agreement


Penalty clauses are an often-overlooked but important aspect of any franchise agreement, particularly in the areas of Canada that do not currently have franchise legislation in place. Despite the name, these clauses are mainly aimed at deterring franchisees from breaching the franchise agreement. Without penalty clauses in an agreement, the franchisor generally only has two ways to take action against a franchisee who has breached the contract: a court injunction and/or an attempt to collect damages caused by the agreement breach. Because those routes can cost the franchisor time and money, penalty clauses that spell out the consequences of a breach are usually included in the franchise agreement itself. 

A penalty clause usually states the amounts the franchisee would be obligated to pay in the event of the associated breach. In some provinces, such as Quebec, these penalty amounts can be reduced - but not increased - if the franchisor benefited from a partial performance of the franchisee's obligation or if the court finds the breach abusive. Therefore, it is important for a franchisor to set penalties that are large enough to deter the behavior without going so far that the court may reduce the penalty in a future action. 

Penalty clauses will vary by franchisor, but there are some common tips legal professionals offer when the franchisor is drafting the penalty portion of their agreement. A per-day penalty basis, for example, doesn't apply to every situation. A calculation of a penalty per day during the breach makes sense for a non-competition clause, for example, because that is easy to measure in days. Something like a breach of confidentiality, on the other hand, would be very difficult to calculate on a daily basis. 

Penalty amounts should be more than any gain or profit the franchisee was seeking to get from the breach, but not by too much. Naturally, the penalty is unlikely to be effective if it is less than what the franchisee could realize from the breach. However, if it goes overboard, the court will end up reducing it and it will not be effective as a deterrent in the future. 

Since you, as a franchisee, would be subject to the penalties in your agreement in the event of a breach, it's vital that you understand what the penalties are and when they apply before you sign on with a franchisor. By being well-versed in this area, you can avoid any behaviors that could end up costing you later.