Buying a franchise: check the contract’s penalty clauses

A missed report, a change to opening hours or an incorrectly used image: under a franchise agreement, any of these could trigger a penalty. Clear rules are needed within a franchise network to protect the franchise concept. But you must also be able to understand and comply with any penalty clause. Before buying, look beyond the amount payable: establish exactly when a penalty is triggered, how it accumulates and what opportunities you have to put a mistake right.

1. Gather all the penalty clauses

Penalties do not always appear under a heading labelled ‘penalties’. They may be scattered across the franchise agreement, general terms and conditions, confidentiality agreements and appendices. A general contractual clause may also attach a penalty to an obligation set out in the operations manual.

Ask for the full set of documents and search for terms such as penalty, sanction, breach, per day and without prejudice to the right to damages. If reviewing Dutch documents, the corresponding terms include boete, sanctie, overtreding, per dag and onverminderd schadevergoeding. Then check which documents will form part of your agreement and which wording takes precedence if provisions conflict.

For each clause, make a note of:

• the obligation to which the penalty relates;
• the act or omission that triggers it;
• the amount payable per incident and any daily increases;
• any cap;
• any prior warning and period allowed to remedy the breach;
• any additional rights to require performance or claim damages.

Pay particular attention to broad wording such as ‘any breach of the manual’. This can give very different mistakes the same financial consequences. Ask for a distinction between administrative failings and serious breaches, such as deliberately sharing confidential franchise know-how.

2. Understand the legal protection — and its limits

In the Netherlands, the Dutch Franchise Act (Wet franchise) is incorporated into Book 7 of the Dutch Civil Code, Articles 7:911 to 7:922. Before the agreement is signed, the franchisor must provide, among other things, the draft contract and its appendices. Any penalty provisions in those documents therefore form part of the information you must be able to assess in advance. You must also take the steps reasonably necessary to avoid signing on the basis of incorrect assumptions.

The franchisor and franchisee must also behave as a good franchisor and a good franchisee respectively. However, this does not mean that a stringent penalty clause is automatically invalid. The Dutch Franchise Act does not set a general maximum for contractual penalties.

Penalty clauses are also subject to the general rules in Articles 6:91 to 6:94 of the Dutch Civil Code. Under the statutory default rule, a penalty replaces damages payable by law. In principle, a creditor also cannot demand both the penalty and performance of the obligation to which that penalty relates. The contract can depart from these rules. This is precisely why wording such as ‘without prejudice to the right to performance and full damages’ deserves attention.

A court may, on request, reduce a penalty where fairness manifestly requires it. This is a high threshold. Do not rely on a court reduction as a financial safety net. Ask a lawyer specialising in Dutch franchise law to assess how the statutory rules apply to the precise wording of your contract.

3. Test the clause against everyday business mistakes

Read a penalty clause not just from a legal perspective, but also in the context of your future working day. Who needs to do what? Can your accountant submit a report on time? Are you dependent on a central point-of-sale system? And what happens if there is a system failure for which you are not responsible?

Work through this example: your monthly report is late because data is missing from the mandatory system. Is the penalty triggered immediately, only after a warning, or once a period for remedying the breach has expired? Does each missing report count separately? Does a daily penalty continue to accrue while you wait for technical support?

Also calculate what a single breach could cost over an extended period. The initial amount is not the only concern: an uncapped daily increase can have a greater financial impact.

Ask how the franchisor identifies and records breaches. A verbal assurance that penalties are ‘never enforced’ does not change the contract. If restrained enforcement really is the policy, ask for specific conditions to be put in writing.

4. Negotiate opportunities to remedy breaches, limits and a dispute process

A workable negotiating proposal protects both the franchise concept and your business. Do not simply ask for lower amounts; ask for a fair, clearly defined process:

• Clear definitions: specify exactly which breaches attract which penalties.
• Written warning: require written notice explaining what has gone wrong and the grounds for that conclusion.
• Reasonable time to remedy a breach: where appropriate, agree on time to correct a breach that can be put right.
• Limits: discuss caps and prevent penalties from unintentionally stacking up for the same incident.
• Dispute procedure: specify whom you should contact to dispute a penalty and what happens to collection and further accrual while the dispute is being considered.

A period for remedying a breach may be less appropriate for a serious, irreversible breach. Distinguish between breaches according to their nature and severity, rather than accepting one rule for every mistake. Make sure any agreed changes appear in the final agreement, not just in separate correspondence.

Practical conclusion: only sign once you can explain, for every penalty clause, what triggers the penalty, how much it could accumulate to, and how you can remedy a mistake or dispute a claim.