Contractual penalties in franchising: how to set proportionate sanctions

When expanding an established business into a franchise network, you need to protect your brand, confidential processes and shared reputation. A contractual penalty can help, but it is not a universal solution to every operational mistake. Before offering your first franchise opportunity, identify which obligations need to be backed by penalties, how breaches will be proved and whether the proposed sanction reflects the actual risk. A well-drafted clause must be clear to both parties, not just the person who wrote the agreement.

1. Distinguish between operational mistakes and threats to the whole network

Start with a list of specific situations, rather than a list of amounts. Submitting a routine document late is quite different from disclosing a confidential recipe to an unauthorised third party. If both attract the same substantial penalty, the agreement will not properly reflect their different consequences.

Prepare a checklist for each proposed sanction:

• Obligation protected: exactly what the franchisee must do or refrain from doing.
• Interest protected: why the obligation matters to the franchisor and other members of the network.
• Typical consequence: whether the risk involves administrative complications, financial loss or disclosure of information that is difficult to undo.
• Scope for remedy: whether the breach can be remedied and within what timeframe.
• Evidence: which document or record will establish what happened.

Not every departure from a recommended procedure needs a contractual penalty. For minor mistakes that can be put right, a warning and additional training may be more appropriate. By contrast, remedial action after a one-off disclosure of confidential information may not eliminate the original risk. The sanction should reflect the obligation, rather than simply express the franchisor’s dissatisfaction.

2. Base the provisions on Czech law

The Czech Republic has no specific franchise legislation or mandatory state register of franchise systems. Franchise agreements are generally concluded as contracts not specifically defined by law under Section 1746(2) of Act No. 89/2012 Coll., the Civil Code. Sections 2048 to 2052 are particularly relevant to contractual penalties.

Under Section 2048, the parties may agree on a penalty for breach of a contractual obligation, either as a specified amount or by setting out a method of calculation. The creditor may claim it regardless of whether the breach caused any loss. This does not, however, mean that a vague expectation can be backed by a penalty: the clause must make clear which obligation it protects and when entitlement to the penalty arises.

Under Section 2049, paying the penalty does not in itself release the debtor from the obligation it secures. Under Section 2051, a court may reduce a disproportionately high contractual penalty at the debtor’s request. There is therefore no single amount or percentage that is automatically safe for every franchise system.

The European Code of Ethics for Franchising is a self-regulatory code, not Czech law. Its relevance may arise, for example, from association membership or a contractual commitment. It does not replace a review of the agreement’s compliance with the law. Nor can a contractual penalty make an unlawful requirement valid, such as an obligation to follow prohibited fixed resale prices.

3. Define the calculation, overlapping penalties and relationship with damages

Choose between a fixed sum and an accruing penalty according to the nature of the breach. A one-off amount may suit a one-off act. A daily rate may make sense for a continuing failure to fulfil an obligation, but the calculation needs a clear start and end point. Consider a cap as well, so that a prolonged delay does not produce an amount wholly out of proportion to the importance of the obligation.

State explicitly what counts as a single breach. If a franchisee sends one file to several recipients, will the penalty be based on the act of sending it, the number of recipients or the individual documents? An unclear basis for calculation can create a significant gap between the parties’ expectations. Similarly, check whether a single event could trigger several overlapping penalties at once.

Pay particular attention to damages. Under the default rule in Section 2050 of the Civil Code, the creditor is not entitled to damages for loss arising from a breach of an obligation covered by a contractual penalty. The parties may agree otherwise, for example by preserving the right to recover losses exceeding the penalty. If you want to claim damages as well as a penalty, the agreement must expressly provide for this.

The legal review should therefore go beyond the amount of the penalty alone. Have the calculation, cumulative penalties, damages provisions and any liability limits assessed together. One clause may unexpectedly weaken the effect of another.

4. Test the sanctions before signing

Review the proposed rules with someone who understands day-to-day operations but was not involved in drafting the agreement. Ask them to work through sample scenarios and decide whether a penalty is payable and, if so, how much. If they reach a different conclusion from the franchisor, revise the wording.

In particular, test a one-off breach, a prolonged delay, a repeated mistake and an event in which the franchisee could not fulfil an obligation because of an error by the franchisor. Also check whether the necessary evidence is available and who is authorised to claim the penalty on the franchisor’s behalf. A written penalty clause is not enough if applying it depends on an unverifiable impression.

Explain the penalty mechanism to the prospective franchisee before signing, including any possible overlap and its relationship with damages. The aim is not to create an atmosphere of mistrust, but to establish predictable terms for membership of the franchise network.

Practical takeaway: Link each penalty to one clear obligation, a justified calculation and verifiable evidence. Only then ask a lawyer to assess the proportionality and legal compliance of the mechanism as a whole.