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Franchise Charges – Are they legal?

Franchise Charges – are they legal?

The nature of the charge

It is not uncommon to see, in a franchise agreement, an obligation for the franchisee to pay a sum of money upon a certain eventuality occurring.  These franchise charges may not necessarily be recoverable as a matter of law, even if agreed in the franchise agreement itself, and this article provides a brief overview of the relevant law.

Some common examples of the obligation to for the franchisee to pay a sum might be:

  • where the franchisee misses training events;
  • where the franchisee breaches the agreement and fails to put right his wrong;
  • where the franchisee fails to report royalties or their basis for calculation;
  • where the franchisee breaches post-termination restrictions, such as where they carry on trading in the same type of business.

Importantly, all of the examples that can be thought of fall into one of two categories.  They are either franchise charges which are payable upon some breach of the franchise agreement by the franchisee (all of the above are likely to fall into this category) or they are payable by the franchisee without them being in breach of the agreement.

Only those franchise charges which are payable upon breach of the franchise agreement are caught by the rules discussed in this article.

Penalties or liquidated damages?

The old law

Where there is a sum payable upon breach of the franchise agreement, the law has long held that, in order to be enforceable, the sum  must be a genuine pre-estimate of loss.  That is to say, a sum which the franchisor is likely to lose by reason of the breach of the franchise agreement.  In Dunlop Pneumatic Tyre Co Limited -v- New Garage and Motor Company Limited [1915] The House of Lords stated the distinction in the following terms:

“The essence of a penalty is a payment of money stipulated as in terrorem of the offending party; the essence of liquidated damages is a genuine covenanted pre-estimate of damage.

It will be held to be penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be proved to have followed from the breach”

To be enforceable therefore, the sum sought upon breach of the agreement would have to be set by reference to the amount of the loss to be sustained and, if excessive, the clause would not be enforceable.

The new law

In Cavendish Square Holding BV -v- Talal El Makdessi and Parking Eye Limited -v- Beavis [2015], the Supreme Court reconsidered whether the old law, as stated in Dunlop Penumatic, was outdated and difficult to apply and whether, in consequence, it should re-formulate the test.  It concluded that it was, and stated that the new test for differentiating whether a payment was a penalty clause (and therefore unenforceable) is essentially whether the sum sought is out of all proportion to the loss likely to be sustained upon the breach.

What is the effect of this new law?

It is often incredibly difficult for a franchisor, when setting franchise charges, to identify what financial loss it might sustain by reason of the franchisee breaching the agreement in any given circumstance.  How can a franchisor, for example, ascertain at the outset when financial loss it might suffer in 10 years time by the franchisee breaching his post-termination covenants, or indeed, should it not turn up to a franchise training seminar?  As to the latter, that could depend on such things as whether external companies might deliver the training, whether others turned up, where the training was held, and so on, and identifying a “genuine pre-estimate” of that loss is always difficult.

So now, with the new law, of the sum payable not being “out of all proportion” to the interests the franchisor seeks to protect, this is likely to result in far more clauses of this type being considered liquidated damages clauses and therefore becoming enforceable.  It is not, however, a license to impose any charge – they still have to be within reason.  That said, it is true to say that the courts have long adopted an approach of allowing businesses to contract as such terms as they might please, the rationale being that they ought to be able to look out for themselves.  This is different to the approach adopted for consumers, which has been much more protective and interventionist.

Can I amend my franchise agreement?

If you intend to alter your franchise agreement template to include more of these type of charges, or increase the amounts sought, then you should be aware that the Supreme Court recognised, in El Makdessi, that the parties were large commercial businesses and that they had been advised by legal representatives.  However, this may not always be so with franchise agreements, which are often standard form documents with very minimal (if any) adaptation for specific franchisees.

It remains to be seen how the lower courts apply the new law and whether there is more of a hands-off approach by the courts in commercial cases.  This is expected to be the case, although franchisors would be best placed to adopt an approach of erring on the side of ensuring that they can justify (within reason) the charges likely to be imposed.  In reality, however, a more light-touch approach from the courts is expected.

This also means that those franchisees whom had sought to oppose payment of these franchise charges can expect to be in a weaker position to refuse payment based on the sums being penal in nature.