The penalty clause in the franchise agreement

They appear in almost every franchise agreement: penalty clauses.

Usually, they are written to ensure that the franchisee fulfills its obligations under the franchise agreement to the franchisor. In practice, it also appears to be an effective threat to the franchisor to call the – in his eyes – out-of-sync franchisee back to order. But practice also shows that the content of the penalty clause – often a final element of the franchise agreement – is neglected by the parties. The formulation of the penalty clause, with all its legal consequences, is often not properly thought through.

In short, although in practice the penalty clause is often an important source of discussion and fulfills a useful function, the penalty clause is often treated as a neglected child.

WHAT IS THE IMPORTANCE OF A PENALTY PROVISION IN A FRANCHISE AGREEMENT?

They usually sanction actions by the franchisee in violation of the franchise agreement with regard to various subjects, with a (high) fine per violation and/or a fine per day as long as the violation continues. The fact that such violations are sanctioned can be of great importance to the franchisor.

FUNCTION OF THE PENALTY PROVISION

The function of the penalty clause – in addition to the incentive for parties to comply with their agreements (the incentive function) – lies in the fact that the actual damage suffered does not have to be proven by the franchisor. This function of the penalty clause is also referred to as the damage fixing function. In most cases, the penalty clause has both functions (inducement and damage fixing function).

LEGAL PRINCIPLES AND DEVIATIONS

The law has a number of principles for the penalty clause. These principles are of regulatory law. This means in the first place that both the franchisor and the franchisee must take these principles into account. In the second place, this means that the parties can make deviating agreements. Three legal principles are important in this regard.

Principle 1: fine instead of compensation

Pursuant to Article 6:92 paragraph 2 of the Dutch Civil Code, the law takes the starting point that the fine replaces the compensation. The parties can deviate from this starting point, but then they will have to explicitly include this in the penalty clause. Parties can do this in different ways. This can be done, for example, by stipulating that the franchisor:

• has the choice between fine and statutory compensation;
• can claim the fine in addition to statutory damages; or
• that the penalty only replaces compensation for damage due to delay (for example statutory interest), but that a penalty and replacement compensation (money instead of performance) can be claimed at the same time.

If the parties do not expressly deviate from this, the main rule that the fine replaces the compensation applies in full. If the actual damage is much higher than the fine, this can have dire consequences for the franchisor in question.

Principle 2: notice of default required for invoking penalty clause

The second starting point of the law is pursuant to Article 6:93 of the Dutch Civil Code that a notice of default is required for invoking the penalty clause. In concrete terms, this means that the franchisor must give the franchisee a second chance and therefore a term within which he must cease the violation(s). If the franchisor does not do so, the franchisee will not be in default, the penalty will not be due and payable, the claim under the penalty clause will in principle not be due and payable and the claim will be rejected in legal proceedings. However, one can deviate from this starting point by including in the penalty clause that the penalty (without notice of default) is immediately due and payable, so that the risk of rejection due to the lack of notice of default is minimised.

Principle 3: exclusion of mitigation of the fine

The third principle is that pursuant to Article 6:94 paragraph 1 of the Dutch Civil Code, the court can moderate the fine at the franchisee’s request. The judge will treat this with restraint. After all, the court can only use its power to mitigate if the application of the penalty clause leads to an excessive and therefore unacceptable result in the given circumstances, for example because the actual damage is a fraction of the penalty. The parties can also deviate from this starting point by including in the penalty clause that the penalty cannot be mitigated by the court. However, situations are conceivable in which this is (for example) contrary to the law, as a result of which the franchisee can invoke the nullity of the penalty clause. In view of that risk, it is not recommended for the franchisor to include such an exclusion in the penalty clause.

When entering into a franchise agreement, it is important for both franchisee and franchisor to be aware of the consequences that a certain formulation of a penalty clause entails, so that the parties agree on a balanced and well-considered penalty clause, which prevents unpleasant surprises afterwards.

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