Canada: Do Penalty Clauses Really Belong In A Franchise Agreement?

Last Updated: June 7 2018
Article by Jean H. Gagnon

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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions