Penalty Clauses and Liquidated Damages Provisions in Franchise Agreements

  • January 26, 2021
  • Adrienne Boudreau and Jason Brisebois, Sotos LLP

When establishing a new franchise system, or updating a franchise agreement for an existing system, many franchisors consider what legal tools are available to them to encourage franchisees and their principals to comply with their contractual obligations.

One tool that many franchisors consider is the inclusion of “penalty clauses” in their franchise agreements. These are commonly understood as contractual provisions that permit franchisors to charge franchisees a prescribed monetary penalty in the event the franchisee breaches certain provisions of the franchise agreement. Such monetary penalties may be assessed daily, weekly, or monthly.

Although clauses specifying a monetary payment by the defaulting party may be attractive, franchisors should proceed with great caution when considering whether such provisions should be included in a franchise agreement.

The benefits of damages clauses

At first glance, it’s clear why such damages clauses may be attractive to franchisors.

First, the presence of these clauses can function as a deterrent to franchisees who are considering whether or not to abide by the terms of their franchise agreements. The prospect of a monetary penalty may provide disincentive to a franchisee that is considering shirking its contractual obligations.

Second, these clauses can afford franchisors a “self-help” remedy to cure franchisee non-compliance, without resorting to more serious, permanent, and expensive remedies, such as terminating a franchise agreement or initiating litigation against the franchisee.

Penalty clauses vs. liquidated damages provisions

To date, Canadian courts have provided limited insight to practitioners as to the enforceability of damages clauses in the franchise law context. We are not aware of any case that has directly considered the interplay of such clauses with provincial franchise legislation, and the obligations these acts impose on parties to a franchise relationship. Ontario’s franchise law legislation, the Arthur Wishart Act (Franchise Disclosure)2000, S.O. 2000, c. 3 is silent on the enforceability of such provisions.

Instead, judicial interpretation of contract law more generally must be considered in order to determine whether a damages clause in a franchise agreement would be enforceable. A franchise agreement is, at its core, a commercial contract. Accordingly, the general principles of contract interpretation continue to apply to the interpretation of a franchise agreement.

In Canada, the common law has made a distinction between “penalty clauses” and “liquidated damages clauses”. Historically, where the amount under a damages clause does not represent a “genuine, pre-estimate” of damages actually sustained, the court will find the clause in question to be a penalty clause.  Penalty clauses are presumptively unenforceable for public policy reasons.

A liquidated damages clause specifies a pre-determined monetary remedy, payable by the breaching party to the innocent party, in the event of contract breach. In the event the contemplated breach occurs, the harmed party would be able to seek the monetary amount estimated by the parties while avoiding the costly and time-consuming process of trying to establish the quantum of the monetary damages it has sustained.  

What distinguishes a liquidated damages clause from a penalty clause is that the quantum of the liquidated damages clause represents the product of a genuine, and good-faith attempt to accurately estimate the damages one party may suffer as a result of a breach by the offending party.

As was established in the 1915 Supreme Court of Canada decision, Canadian General Electric Co. v. Canadian Rubber Co., Canadian courts are generally willing to enforce such liquidated damages clauses in instances where the parties have estimated, in good-faith, the likely monetary damages a party would suffer as a result of the other party’s breach of the contract.

When a liquidated damages clause ceases being a legitimate, good-faith estimate of the potential losses that a party may suffer, and instead simply becomes a requirement for payment of an amount that is oppressive, unconscionable, or otherwise disproportionate to the actual harm a party may suffer, courts generally decline to enforce that provision. In Canadian General Electric Co., the court noted that “[a] penalty is the payment of a stipulated sum on breach of the contract, irrespective of the damage sustained…”, whereas “[t]he essence of liquidated damages is a genuine covenanted pre-estimate of damage.”[1]

In Ontario, Section 98 of the Ontario Court of Justice Act, for instance, states that “[a] court may grant relief against penalties and forfeitures, on such terms as to compensation or otherwise as are considered just.”[2]

Considering the franchise context

Not surprisingly, the ruling in Canadian General Electric Co. and subsequent case law has created a great deal of uncertainty for parties drafting commercial contracts. There are no hard and fast rules about when a clause will be found to be an unenforceable penalty clause, or a liquidated damages provision. The court will review the circumstances of each case.  Accordingly, it is very challenging to predict whether or not a specific clause may ultimately be enforceable.

In the franchise context, specifically, the court may be more inclined to find that damages clauses are not “genuine, pre-estimates of damages” but are, instead, unenforceable penalty clauses. This is because the body of franchise case law to date has repeatedly recognized the inequality of bargaining power between franchisors and franchisees. It has also acknowledged that, generally, franchise agreements are contracts of adhesion, presented to prospective franchisees on a “take it or leave it” basis.

In these circumstances, it may be more difficult for a court to accept a franchisor’s submission that a damages provision is a true and fair genuine pre-estimate of damages. At the very least, it is likely that, in the franchise context, such clauses will face heightened scrutiny, and the relative bargaining power between the parties will be considered in any analysis of the clause at issue.

To try to mitigate the possibility that such clauses will be found to be unenforceable penalty clauses, drafters should turn their minds to both the existing general body of case law and the particularities of the franchisor/franchisee relationship when drafting liquidated damages clauses. Given the recognized “power imbalance” in the franchise context, it may not be sufficient to simply include language in an agreement that the parties agree that the provision in question is not a penalty provision, and that the quantum of proposed liquidated damages is reasonable and proportionate in light of the potential financial loss the franchisor may incur in the event of a breach.  

When determining the quantum of a liquidated damages provision, the franchisor should carefully review any historical damages information available to it. The franchisor should also consider the circumstances of the specific grant, and the intended nature of the commercial relationship. For instance, where a grant of franchise is premised on the term being relatively lengthy, and where the franchisor cannot easily replace the franchisee, the imposition of a substantial fee in the event a franchisee seeks to end the relationship early may be completely reasonable and justifiable. 

A franchisor should also turn its mind to how it might demonstrate that the clause in question actually represents a good-faith attempt to estimate the monetary losses the franchisor will sustain as a result of the franchisee’s breach. Franchisor counsel may wish to consider the following, additional measures at the time of contract formation, to try and ensure damages clauses will be interpreted as liquidated damages provisions, and not as unenforceable penalty clauses:

  • Ensuring that, before entering into the agreement, the franchisee and its principal(s) have independent legal advice generally, and specifically with respect to the damages provision;
  • The franchisor may wish to limit the use of such clauses to those breaches that are more readily quantifiable in monetary terms;
  • The method of quantifying the amount payable should be clear, relate to the amounts payable under the agreement, and be objectively reasonable; and
  • The franchisor should consider the availability of historical or other evidence it may need to rely on to establish the true quantum of loss in the event of the contemplated breach.

For further information regarding penalty clauses and liquidated damages provisions, please contact the authors of this article.

About the authors

Adrienne Boudreau is a partner in the litigation group at Sotos LLP, Canada’s largest franchise law firm.  She provides counsel to many franchisors in various sectors of the franchise industry and to franchised businesses. Adrienne has most recently been recognized in Best Lawyers in Canada (2021), and Best Lawyers Global Business Edition (2020).  She is listed in Canadian Legal LEXPERT Director – Franchise (2020), and has been recognized as a “Legal Eagle” by Franchise Times Magazine for being a leading Canadian franchise law practitioner (2018-2020). Adrienne can be reached directly at 416-572-7321 or aboudreau@sotosllp.com.

Jason Brisebois is an associate with Sotos LLP in Toronto, Canada’s largest franchise law firm. He is head of the firm’s personal services franchise practice area, and practices business law with a focus on franchising, distribution, and licensing. He is admitted to practice law in both the Province of Ontario and State of New York. Jason has been recognized as a “Legal Eagle” by Franchise Times Magazine as a leading Canadian franchise law practitioner. Jason can be reached directly at 416-572-7323 or jbrisebois@sotosllp.com.

 

[1]  Canadian General Electric Co. v. Canadian Rubber Co. (1915), 1915 CanLII 45 (SCC), 52 S.C.R. 349

[2]  Courts of Justice Act, RSO 1990, c. C.43, s.98.

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