According to a recent survey of franchise agreements reported in the Hofstra Law Review,(1) 43.7% of surveyed franchise agreements required disputes to be resolved through arbitration. In the United States, the U.S. Federal Arbitration Act(2) encourages resolution of disputes through arbitration, and establishes standards for determining whether controversies may be subject to arbitration.
Generally, all disputes may be arbitrated, unless the arbitration agreement (rather than the entire agreement in question) was induced by fraud, or where the agreement would not be enforceable as a contract under applicable state laws.(3)
If a party to a contract containing an arbitration agreement initiates litigation in court, the other party(ies) may move the court to stay the litigation and compel arbitration as specified in the parties' agreement.(4) The courts then are authorized to determine whether the arbitration agreement in question is valid and enforceable.
Recent California court cases call into question the continued viability of enforcing pre-dispute arbitration clauses contained in franchise agreements. Applying their standards related to the enforceability of contracts, California courts now examine arbitration clauses to determine if they are procedurally and substantively unconscionable. For example, in ILJ Dominicana S.A. v. It's Just Lunch Int'l, LLC, 2009 U.S. Dist. LEXIS 13689, *9-13 (C.D. Ca. 2009), the U.S. District Court for the Central District of California held the following standard provisions of franchise arbitration clauses to be substantively unconscionable under California law, and refused to compel the parties to arbitrate their dispute:
- a reduction of the statute of limitations for bringing a claim;
- a waiver of the right to seek or obtain punitive damages; and
- a waiver of the right to have claims decided in a class action.(5)
The seminal case that began this recent trend is Nagrampa v. MailCoups, Inc., 469 F.3d 1257 (9th Cir. 2006). In Nagrampa, the Ninth Circuit Court of Appeals, applying California law, invalidated a specific arbitration provision in a franchise agreement on the grounds that it was procedurally and substantively unconscionable.(6) The court held that the provision was procedurally unconscionable because the franchisor had overwhelming bargaining power, drafted the contract, and presented it to the franchisee on a take-it-or-leave-it basis.(7) The court further held that the arbitration clause was substantively unconscionable because, among other things, it: 1- lacked mutuality by reserving the franchisor's right to bring intellectual property actions against the franchisee in court, while requiring the franchisee to submit all claims against the franchisor in arbitration; and 2- contained a forum selection clause designating the franchisor's home state, Massachusetts, as the forum for arbitration. The arbitration clause was found to be oppressive to the franchisee due to the parties' unequal bargaining power. The clause would require the franchisee, who resided in California, to fly across the country to Massachusetts, thereby incurring additional travel and living expenses and increased costs associated with having counsel familiar with Massachusetts law, to arbitrate a contract signed and performed in California.(8)
In a case applying Montana law, the Ninth Circuit has found that a Maryland choice of law clause in the arbitration provision in an agreement for the establishment and operation of a hotel franchise in Montana was unconscionable and would contradict Montana public policy. Ticknor v. Choice Hotels International, Inc., Business Franchise Guide (CCH) ¶12,156 (9th Cir. 2001). In that case, the franchisee had signed a franchise agreement with Choice Hotels International, Inc. and subsequently breached his franchise agreement by suspending his payment of franchise fees. Choice Hotels then suspended the franchise agreement and demanded arbitration, pursuant to the arbitration clause in the parties' agreement. Applying Montana state law, the Ninth Circuit found that the arbitration provision was unconscionable because the franchisor reserved for itself the right to litigate certain matters, while the franchisee was required to arbitrate all disputes, thus the arbitration provision lacked mutuality of obligation, was one-sided, and contained terms that were unreasonably favorable to the drafter - the franchisor. The court also found that the franchise agreement was one of adhesion under state law. Thus, the court concluded that because the franchise agreement was an adhesion contract, the unconscionable arbitration provision was unenforceable.
Most franchise agreements designate a forum, which is typically where the franchisor has its principal place of business, although international franchise agreements sometimes designate a 'neutral' forum in a country where neither the franchisor nor the franchisee reside. Moreover, because decisions relating to ownership of intellectual property are critical to franchise companies and because no right of appeal from arbitral decision is generally allowed, franchisors normally exclude disputes relating to intellectual property from arbitration. To further facilitate protection of intellectual property rights and to take advantage of the speed of interlocutory remedies which are readily available through courts, franchisors regularly expressly reserve the right to seek preliminary injunctions and other interlocutory relief in courts. The Ninth Circuit in Nagrampa and Ticknor has concluded that under laws of California and Montana these practices are substantively unconscionable because only franchisors are allowed access to courts and franchisees may resort only to arbitration for resolution of their claims. Thus, the arbitration clauses have been rendered unenforceable.
It is too early to tell if these decisions will be followed by courts in other states. However, counsel for franchisors doing business with franchisees in the United States should evaluate these decisions and any arbitration clauses they use to determine whether they will likely be enforceable as they are drafted. They also should evaluate the costs and benefits of using arbitration to resolve disputes in the United States.
Carl E. Zwisler, IDI franchising Country Expert for U.S.A. and Katherine L. Wallman, associate in the Washington, DC office of Gray Plant Mooty.
(1) CHRISTOPHER R. DRAHOZAL AND QUENTIN R. WITTROCK, Is There A Flight From Arbitration?,37 Hofstra L. Rev. 71, 74 (2008).
(2) Federal Arbitration Act, 9 U.S.C. §§ 1-16.
(3) Arbitration agreements governed by the Federal Arbitration Act are 'valid, irrevocable, and enforceable' unless grounds to revoke the contract exist at law or in equity. 9 U.S.C. § 2; see Doctor's Assocs., Inc. v. Casarotto, 517 U.S. 681, 687 (1996) (holding 'contract defenses, such as fraud, duress, or unconscionability, may be applied to invalidate arbitration agreements without contravening § 2.'); First Options of Chicago, Inc. v. Kaplan, 514 U.S. 938, 944 (1995) (finding courts should apply state contract principles to determine whether a valid and enforceable arbitration agreement exists and applies to the parties' disputes).
(4) 9 U.S.C § 3.
(5) ILJ Dominicana S.A. v. It's Just Lunch Int'l, LLC, 2009 U.S. Dist. LEXIS 13689, *9-13 (C.D. Ca. 2009) (finding waiver of punitive damages and bar on class actions in arbitration provision of franchise agreement to be substantively unconscionable and that the restriction on the statute of limitations for brining a claim added to the unconscionability of the Franchise Agreement).
(6) Although most state courts have yet to interpret their laws relating to arbitration clauses as California has, California contains twenty percent of the U.S. population, and its decisions often are followed by courts in other states. Approximately twenty percent of U.S. franchisors are based in California and virtually all major U.S. franchisors have franchisees in California.
(7) Nagrampa, 469 F.3d at 1284.
(8) Id. at 1286-88.