Penalty Clause in Franchise Agreement

Penalty Clause in Franchise Agreement

Penalty Clause in Franchise Agreement

Pureum Law Office (PLO) is committed to providing practical and valuable legal information to our clients, so we delve into the intricacies of a penalty clause in franchise agreements and explore the role of penalty clauses in resolving disputes.

Breach of Contract and Damages

In any contractual relationship, breaches can occur, leading to potential damages. Franchise agreements are no exception. When a franchisee unilaterally terminates the contract or violates operational guidelines, the franchisor may suffer financial losses. However, seeking compensation isn’t always straightforward.

Proving Damages

Consider a scenario where a franchisee leaks proprietary know-how or uses it for unauthorized business ventures. The core value of a franchise lies in the transfer of business knowledge, and unauthorized disclosure can significantly impact the franchisor’s revenue. Proving causation between the know-how leakage and a decline in sales is complex due to various factors affecting sales figures.

Presumed Damages and Legal Provisions

To address this challenge, various laws, including the Unfair Competition Prevention and Trade Secret Protection Act (Article 14-2), the Copyright Act (Article 125), and the Patent Act (Article 128), allow for presumed damages. Even if direct proof of losses is lacking, aggrieved parties can claim damages based on infringers’ profits. However, these presumptions apply only to legally recognized rights.

The Role of Penalty Clauses

Many contracts include penalty clauses to simplify compensation processes. These clauses allow the non-breaching party to claim a pre-agreed sum without proving actual damages or causation. Article 398 of the Civil Act deems such clauses lawful.

Civil Act Article 398 (Pre-arranged Compensation)

1. Parties may pre-arrange the amount of compensation for breach of contract.

2. If the pre-arranged amount is excessively high, the court may reduce it to a reasonable level.

3. Pre-arranged compensation does not affect claims for performance or contract termination.

4. Agreed penalties are presumed to be pre-arranged compensation.

5. Even if compensation is agreed upon in non-monetary terms, the preceding four paragraphs apply.

However, there are important considerations when including penalty clauses in franchise agreements.

First, the Franchise Business Act (Article 12, Paragraph 1, Subparagraph 5) prohibits imposing excessively high penalties, deeming it an unfair trade practice. Penalties that exceed common expectations or are actually imposed excessively can lead to administrative sanctions, including corrective orders, and potentially criminal penalties for non-compliance.

Franchise Business Act Article 12 (Prohibition of Unfair Trade Practices)

(1) Franchisors shall not engage in acts that unfairly hinder fair transactions in franchise business, including imposing excessive penalties relative to the contract’s purpose, content, and foreseeable damages.

5. Imposing excessive penalty fees compared to the standards set by the Presidential Decree, considering the purpose and content of the contract and the damages that may occur, thereby unfairly burdening the franchisee with compensation obligations.

Second, since franchise agreements are often standardized for multiple transactions, they are considered terms and conditions. The Act on Regulation of Terms and Conditions (Article 8) states that clauses imposing “unfairly excessive penalties” are void. Thus, even if penalty clauses are included in the franchise agreement, they may be invalidated if deemed excessively burdensome.

Act on Regulation of Terms and Conditions Article 8 (Pre-arranged Compensation)

Clauses imposing unfairly excessive delay damages or other compensations are void.

Third, relying on an invalid penalty clause in litigation can result in a complete loss. Typically, in cases of excessive penalties, courts reduce the amount to a reasonable level under Article 398, Paragraph 2 of the Civil Act (partial victory). However, in franchise cases, the court may dismiss the entire claim based on the clause’s invalidity, resulting in a complete loss.

Penalty Clause in Franchise Agreement

Ultimately, to protect their rights and business secrets in franchise relationships, franchisors must establish legally enforceable penalty clauses. These clauses should be meticulously crafted based on thorough analysis of precedents from the Fair Trade Commission and court rulings.

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