Reviewing Penalty and Exclusion Clauses Before Franchising: A Framework for Fair Contracts

When turning an existing business into a franchise network, it is tempting to assume that hefty contractual penalties and broad exclusions of liability will protect the franchisor. Yet excessive clauses may be held unenforceable or escalate disputes. Sustained cooperation across a franchise network starts with deciding who controls each risk, how actual losses will be established and where each party’s responsibility ends. Before finalising your first agreement, drawing up a responsibility matrix is often more practical than compiling a list of breaches.

1. Review both franchise law and standard terms legislation

Franchise transactions in South Korea are governed by the Fair Transactions in Franchise Business Act. This legislation sets out requirements for registering and providing disclosure documents, as well as matters that must be included in franchise agreements. However, complying with these procedures does not automatically make every contractual provision valid. Terms prepared in advance by a franchisor for use with multiple franchisees also need to be reviewed under the Act on the Regulation of Terms and Conditions.

Article 6 of the latter Act renders void terms that breach the principle of good faith and are unfair. Particular care is needed with provisions that unfairly disadvantage the other party or restrict essential contractual rights. Under Article 7, clauses excluding legal liability arising from intentional misconduct or gross negligence by the franchisor, its employees or others assisting in the performance of its obligations are void. Article 8 renders void terms that impose unreasonably onerous obligations to pay damages.

The review should therefore go beyond asking, ‘Has the franchisee signed?’ You should also ask, ‘Is there a reasonable basis for placing this responsibility on the franchisee?’, ‘Are we shifting liability for the franchisor’s own failings?’ and ‘Is the disadvantage excessive in relation to the purpose of the agreement?’ A signature or separate acknowledgement does not, by itself, make an unfair provision valid.

Search the draft for every reference to penalties, damages, exclusions of liability, deductions and deposit settlements. Provisions serving the same purpose may be scattered across different sections. Bring together any financial obligations contained in annexed operating rules or acknowledgement forms as well, so that you can assess the risks across the agreement as a whole.

2. Base penalties on potential losses before setting amounts

Avoid simply copying the penalty amounts used by competing brands. Training arrangements, support costs, contract terms and costs already recovered by the franchisor will differ. Start by identifying, item by item, which breaches could cause which losses. The following points are practical checks for reviewing a draft agreement, not a statutory formula.

• Breach: Specify the circumstances, such as late payment or failure to return assets provided to the franchisee.
• Loss categories: Separate out identifiable costs, such as additional recovery costs or the cost of arranging replacement work.
• Basis of calculation: Check whether there are records of actual expenditure or other reasonable evidence supporting the calculation.
• Factors reducing the amount: Consider payments already received, assets recovered and costs that will no longer be incurred.
• Duplication: Check whether the same loss is being claimed again under another heading.

For example, if an agreement ends during preparations for opening, first establish whether training has begun and whether non-cancellable payments have been made to external suppliers. Treating a case in which no work has been carried out in the same way as one in which preparations are well advanced makes the amount difficult to justify. Equally, the existence of actual costs does not always entitle the franchisor to recover them in full: the reason for termination and the contractual terms must also be considered.

For late payments, check whether late-payment interest, a separate contractual penalty and deductions from the deposit overlap. Even where different labels are used, the arrangement may require the franchisee to compensate for the same loss more than once. In particular, review whether a clause requiring payment of all royalties for the remaining contract term takes account of support costs and other expenditure that the franchisor will no longer incur.

Nor does calling a payment a ‘penalty’ determine its legal character. Whether it constitutes agreed damages, a punitive contractual penalty or another type of payment may depend on its substance and purpose, and different legal principles may apply. It is prudent to have a lawyer review both the reasonableness of the amount and the legal nature of the clause.

3. Align exclusions of liability with who controls the risk

A sentence such as ‘The franchisee shall bear all losses arising from the operation of the outlet’ is simple, but it groups together incidents with different causes. Careless storage by the franchisee, incorrect guidance from the franchisor and failure of a mandatory system each require different facts to be examined when assessing liability. The agreement should distinguish who performed the relevant task and who was able to reduce the risk, rather than focusing solely on the outcome.

Start by categorising incidents and complaints previously encountered at company-owned outlets. Record the cause, who made the relevant decisions, the supporting evidence and the actual response costs. This will help distinguish risks controlled by the franchisor from those controlled by the outlet. If there have been no incidents yet, use hypothetical situations such as missed orders, equipment breakdowns and supply delays, and ask the relevant staff to explain how responsibility would be allocated.

Where a supplier is involved, do not simply conclude that ‘This is the external supplier’s responsibility, so the franchisor has no liability.’ Check who is party to the supply contract, the franchisor’s role in selection and instructions, the franchisee’s freedom to choose suppliers and the scope of support promised by the franchisor. Liability will depend on the specific facts, so it is better to set out clear fact-finding procedures and each party’s obligations than to rely on a blanket exclusion.

Also distinguish liability towards customers from the allocation of costs between franchisor and franchisee. Agreeing internally who bears a cost does not eliminate legal liability towards customers or other third parties. Consider a framework under which incident reporting, measures to prevent further harm and preservation of evidence happen first, with the final allocation of costs decided once the cause has been established.

4. Test the draft against real situations before finalising your first agreement

Once the draft is complete, ask the business owner, operations lead and finance lead to work through the same scenarios independently. Use cases with different causes, such as a project being abandoned before opening, late payment or a failure by the franchisor to provide support. If they arrive at different claim amounts or identify different parties as responsible, the wording may be ambiguous or essential calculation criteria may be missing.

In a review table, record the contractual provision, the circumstances in which it applies, the evidence supporting the calculation, exceptions to liability and the person responsible for approval. In particular, check whether the franchisee would face the same charge even where the franchisor is at fault. If scenario testing produces unreasonable results, amend the contractual wording itself rather than trying to explain the problem away in supporting materials.

Compare contractual provisions on financial obligations with the relevant entries in the disclosure document and with franchise recruitment materials. Avoid inconsistencies such as telling prospective franchisees that ‘only actual costs will be settled’ while including a separate fixed charge in the agreement. Once the final version is approved, withdraw earlier templates and introduce an approval process to prevent recruitment staff from independently promising waivers or reductions in liability.

Practical takeaway: Before signing your first franchise agreement, write a brief note for every penalty and exclusion clause covering ‘the basis of liability, the basis of calculation, duplicate charges and what happens if the franchisor is at fault’. A clause you cannot explain needs redesigning, not strengthening.