Franchise contractual penalties: what should you check before signing?

Franchise agreements often use contractual penalties to protect the network’s shared quality standards. As a prospective franchisee, however, you need to understand what payment obligations can arise from a correctable administrative error compared with a serious breach. Before signing, look beyond the initial franchise fee and ongoing payments: check the penalty provisions separately, including how penalties can accumulate and the procedure for challenging a claim.

1. Understand what a contractual penalty means under Hungarian law

Hungary has no single, comprehensive franchise act, but franchise agreements are not unregulated. Act V of 2013 on the Civil Code specifically recognises franchise agreements in Sections 6:376–6:381. The general rules on contracts also apply, including the provisions on contractual penalties in Sections 6:186–6:189.

A contractual penalty, known in Hungarian as kötbér, is an undertaking to pay a sum of money for a specified breach of contract. It must be agreed in writing, and the franchisor can claim it even without proving any loss. This distinguishes it from damages: arguing that your mistake caused no one any loss is not enough to defeat the claim.

Under the Hungarian Civil Code, the party in breach may be released from liability if they establish legally sufficient grounds for excusing the breach. Simply saying ‘it was not my fault’ does not satisfy those requirements. Assessing an external IT outage or supply disruption requires consideration of the obligation undertaken, the circumstances and the contract’s allocation of risk.

A court may reduce an excessive contractual penalty at the liable party’s request. This protection is not automatic, and it is unwise to base your business decision on the assumption that later proceedings will resolve a disproportionate clause.

2. Map out all contractual penalties

Do not read only the clause headed ‘Contractual penalties’. Payment consequences may also appear in provisions on brand standards, reporting duties, opening hours or a schedule to the agreement. The label alone is not decisive: the legal nature of a ‘sanction fee’ must likewise be assessed by its substance.

Create a table recording the following for each provision:

• the precise obligation and its deadline;
• the event that constitutes a breach;
• the amount payable or how it is calculated;
• whether the charge applies once, daily or per incident;
• when charges start and stop accruing;
• the cap per incident and per period.

Wording that imposes the same penalty for ‘any breach of network rules’ is particularly risky. A late report and a serious quality failure may warrant different consequences. Ask for clear categories rather than leaving the cost of each breach to become apparent later.

Also examine references to documents that can change. Clarify whether a subsequent amendment to operating standards can automatically create new penalty exposure, who may make amendments and how you will be notified. Have a lawyer check the scope of the contractual authority to make such changes.

3. Calculate the cumulative consequences

The real burden of a penalty often lies not in the individual amount but in how charges accumulate. The same failing might breach both a reporting deadline and a separate duty to co-operate. Ask whether this would attract one penalty or several, and record the answer in the contract.

Take a simple test case: a mandatory report remains incomplete for several days. Does the penalty accrue per report, per site or per day? Does sending the corrected version stop further charges, or do they continue until the franchisor approves it? What happens if the franchisor is slow to check the correction?

Include separate lines in your financial model for:

• the contractual penalty arising from the incident;
• your own cost of putting the problem right;
• any business interruption;
• any other claims that may lawfully be enforced.

A contractual penalty does not necessarily cap your total financial exposure. Under the Hungarian Civil Code, the party entitled to the penalty may also claim damages for losses exceeding it. A penalty cap and an overall liability cap are therefore two separate matters; one does not automatically replace the other.

Penalties for delay, defective performance and failure to perform also differ in their legal effects on the underlying obligation. Do not accept the simplistic interpretation that paying a penalty always releases you from the original obligation.

4. Ask for a verifiable procedure and an opportunity to put things right

The aim of negotiations should not be to remove every consequence of a breach. It is also in the franchise network’s interests for agreed rules to be workable and consistently enforced. A well-drafted agreement, however, distinguishes between a correctable error, repeated non-compliance and a serious incident requiring immediate intervention.

For correctable failings, ask for written notice identifying the precise provision breached and a reasonable period to remedy the problem before a penalty applies. Also agree how you can demonstrate that the issue has been resolved and when the franchisor must respond. This is a negotiating proposal, not a statutory grace period that automatically applies in every case.

Make sure it is clear who determines that a breach has occurred, what documents they rely on and how you can submit your comments or objections. If the franchisor can recover the claim from security you have provided, or exercise a right of set-off, check those conditions separately too. An immediate deduction of a disputed amount could jeopardise the cash flow needed for day-to-day operations.

Practical takeaway: before signing, make sure every penalty has a clear trigger, calculation method and procedure. Clarify open-ended or cumulative provisions with a lawyer experienced in franchise agreements before joining the network.