Penalty Clauses – Franchising Considerations

When drafting a franchise agreement, it’s important to consider the inclusion of penalty clauses and their potential legal ramifications. Franchise lawyers must be particularly mindful of these clauses as they can have serious consequences. This article explores what a penalty clause is at law, how it interrelates with Unfair Contract Term (UCT) laws, and offers examples of clauses found in franchise agreements that could be deemed penalties. When drafting franchise agreements, it is crucial to avoid including penalty clauses that could expose franchisors to legal risk.

A. What Is a Penalty Clause at Law?

A penalty clause is a contractual provision that imposes a financial penalty on a party for breaching the contract. Courts view these clauses as punitive rather than compensatory. The purpose of a contract is to balance the parties’ obligations and provide remedies for breaches. However, penalty clauses go beyond this and seek to punish one party, usually disproportionately.

At law, if a court determines a clause is a penalty, it may deem that clause unenforceable. This can have serious consequences for franchisors who rely on these provisions to enforce compliance with their franchisees. Instead of serving their intended purpose, penalty clauses can lead to disputes, litigation, and even damage to a franchisor’s reputation. When drafting franchise agreements, it is essential to focus on clauses that reflect a genuine pre-estimate of loss, not punishment. The basis of estimation should be recorded and proper.

If a clause is challenged, the court will consider whether the clause seeks to penalize or fairly compensate. Franchise lawyers should ensure that any provisions imposing financial consequences are reasonable and aligned with the franchisor’s actual loss from a breach. A careful balance is required to ensure enforceability while protecting the franchisor’s interests.

B. Penalty Clauses and UCT Laws: Similarities and Differences

There is an interrelationship between penalty clauses and Unfair Contract Term (UCT) laws, though they are not entirely the same. Both legal concepts serve to protect parties—particularly those with less bargaining power—from unfair or unjust contract terms. However, there are distinctions in their application.

UCT laws apply to standard-form contracts, such as franchise agreements. These laws aim to prevent unfair terms that create significant imbalance between the parties’ rights and obligations. A term is considered unfair if it causes a detriment to the franchisee that is unjustifiable. On the other hand, penalty clauses specifically address the issue of imposing an unfairly high financial consequence for breaching a contract.

While there is overlap between penalty clauses and UCT laws, they address different concerns. A penalty clause may be deemed unfair under UCT laws, but not all unfair terms are necessarily penalty clauses. For example, a clause that allows a franchisor to vary terms unilaterally may be unfair but not a penalty. Franchise lawyers must assess both UCT laws and the legal principles regarding penalties when drafting franchise agreements to ensure compliance and avoid legal challenges.

C. Examples of Clauses That Could Be Deemed Penalty Clauses

Below are some examples of clauses found in franchise agreements or related agreements that could be seen as penalty provisions. These clauses may trigger issues under both penalty clause law and UCT laws, highlighting the need for careful drafting.

(i) Significant Fees for Issuing Breach Notices
Some franchise agreements impose substantial fees on franchisees when the franchisor issues a breach notice. These fees can be excessive and may not reflect the actual administrative costs incurred by the franchisor. If these fees are disproportionate, a court may view them as a penalty clause. Franchise lawyers should ensure that such fees are reasonable and justifiable, as excessive fees may not be enforceable.

(ii) Termination Fees Disregarding Mitigation
In certain franchise agreements, termination fees are imposed on franchisees if they exercise their right to terminate the agreement. In many cases, these fees do not account for the franchisor’s obligation to mitigate its loss. Under contract law, a party must take reasonable steps to reduce its loss after a breach. Imposing high, fixed termination fees without considering mitigation can be seen as a penalty, especially if the fee bears no relation to actual damages. Franchise lawyers should carefully assess the quantum of termination fees and their alignment with mitigation principles when drafting franchise agreements.

(iii) High Retainable Sums Upon Cooling-Off Rights
Franchise agreements often include retainable sums that the franchisor can keep if the franchisee exercises their cooling-off rights. These sums should reflect actual costs incurred by the franchisor, such as expenses for initial support or training. However, some agreements impose large, unparticularised lump sums that could deter franchisees from exercising their statutory cooling-off rights. If a franchise agreement allows the franchisor to retain a significant sum without providing a breakdown, it could be considered a penalty and breach the Franchising Code of Conduct. Such clauses could also be challenged under UCT laws.

How to Avoid Clauses Being Deemed Penalty Clauses

To avoid clauses being deemed penalty clauses, franchisors should ensure that any financial consequence imposed for a breach represents a genuine pre-estimate of loss. The key is to align the quantum of any fee or sum with the actual damages or costs the franchisor would incur from the breach. When drafting franchise agreements, franchisors should take care to document their estimation process and ensure that the amount stipulated is reasonable and proportionate to the loss or expense suffered. This approach not only helps avoid the clause being unenforceable but also demonstrates a good-faith effort to comply with legal principles. Keeping detailed records of the rationale behind each figure can also provide valuable evidence if the clause is ever challenged.


Franchise lawyers need to be diligent when drafting franchise agreements to avoid including clauses that could be deemed penalties. The examples above illustrate how certain provisions can risk being invalidated or lead to legal disputes. To protect both the franchisor and franchisee, it is vital to ensure that any financial consequences imposed are fair, reasonable, and justifiable. Carefully worded, transparent terms can help safeguard the franchisor’s interests without crossing into penalty territory.

Disclaimer: This article contains general information only and does not constitute legal advice. Magnolia Legal disclaims any liability arising from reliance on this article. Our terms of use apply