Franchise & Distribution Developments

Case law developments since our last issue include a major ruling on arbitration clauses sure to generate much discussion, plus further developments in the most litigated areas of franchise law. Here are the highlights:

Arbitration

The biggest franchise litigation news of this past quarter was made — and not for the first time — by the Ninth Circuit. In Nagrampa v. MailCoups, Inc., 469 F.3d 1257 (9th Cir., December 4, 2006) a divided en-banc panel voided a franchise agreement's arbitration provision as both procedurally and substantively unconscionable under California law. The clause was procedurally unconscionable, said the majority, because it was presented to the franchisee on a take-it-or-leave-it basis. It was substantively unconscionable because it lacked mutuality. (The franchisor — but not the franchisee — had the right to seek provisional court relief to protect its trademark and trade secrets pending arbitration.) The majority also objected to the contractual forum designation (Massachusetts, not California) and arbitration cost-sharing provisions as further indicia of unconscionability.

The question is what effect Nagrampa, will have outside of California. We do not believe that the analysis in Nagrampa, disturbing as it is, foreshadows significant problems for franchisors enforcing commitments to arbitrate. First, it is widely perceived that the Ninth Circuit tends to decide cases differently from most other federal and state courts; the sharply dissenting group of four judges in Nagrampa may well be more in step with the rest of the bench nationally. The Nagrampa majority's paternalistic view of franchisees, common in the early days of modern franchising, is not popular with the majority of courts. (Ironically, plaintiff Nagrampa herself — a sophisticated businesswoman who had earned $100,000 per year in a direct mail business similar to the franchisor's — was hardly the classic poster child for franchisees needing court protection.) Next, the court relieved the franchisee of its burden and required MailCoups to prove that the challenged clause did not diminish the plaintiff's substantive rights. It is unlikely that other courts will follow suit. Finally, the majority's conclusion that the commitment to arbitrate lacked mutuality is in tension with the many courts already determining that lack of mutuality does not generally void an arbitration clause. Furthermore, the support for an attack on mutuality was thin: the MailCoups' reservation of the right to seek provisional relief from the courts to protect its mark and trade secrets.

Franchisors always face the risk of court refusal to enforce an agreement deemed oppressive. We do not believe, however, that the arbitration commitment in Nagrampa crossed the line, and we do not recommend that franchisors make dramatic changes for franchisees outside of California as a result of the decision. As a general rule, franchisors should continue to avoid negotiating the terms of franchise agreements and should provide for their right to move a court for injunctive relief to protect their mark, trade secrets and similar assets pending arbitration. Franchisors should, as much as possible, make rights and obligations mutual, even if it is only a matter of lip service. Lastly, they should also continue to select their home state as the forum for arbitrating claims. (Please see Forum Selection Clauses, below, for more on this topic.)

In another arbitration-related decision, the Eighth Circuit Court of Appeals proved again just how hard it is to overturn an arbitration award. Twin Cities Galleries v. Media Arts Group, Ltd., is a case handled by Faegre & Benson. The plaintiff in Media Arts was a Minnesota distributor of Thomas Kinkade art. When Media Arts filed an arbitration demand in California to recover the unpaid balance on artwork it sold to Twin Cities, the distributor argued that it was a "franchisee" under Minnesota law and entitled to damages itself for violations of the Minnesota Franchise Act. Applying a California choice of law provision in the distribution contract, the panel held that Twin Cities was not a "franchisee" under California law and awarded substantial damages in favor of Media Arts.

The distributor brought an action to vacate the award in Minnesota federal court, and Media Arts brought its own motion to confirm the award. The district court vacated the award, finding that the panel violated Minnesota public policy when it applied California law, instead of Minnesota law, to determine whether Twin Cities was a franchisee. Media Arts appealed. The Eighth Circuit reversed the trial court, holding that Twin Cities must show "that California law is materially different from Minnesota law, such that the arbitrators' use of California law actually undermined the asserted Minnesota public policy to protect the franchisees." The court then compared the California and Minnesota statutes and found no material difference in their definition of a franchise, particularly a franchise fee.

Media Arts is one more case illustrating just how reluctant courts are to interfere with arbitration awards. This reticence is, of course, good for parties who prevail in arbitration, but not always satisfying for those who do not. Some franchisors are reluctant to include within their agreement a commitment to arbitrate because of a concern that arbitration decisions are essentially beyond review. We believe this is the proverbial throwing of the baby out with the bath water. Rather than abandon arbitration altogether, franchisors can specify an expanded scope of review. (But beware, there is a split among the federal circuit courts over whether parties can contract for a standard of review greater than set forth in the Federal Arbitration Act.) Another alternative is to require that arbitrators follow the law and apply the contract, thus permitting the franchisor (and franchisee, for that matter) to argue that the arbitrator exceeded her authority if she fails to do so.

Forum Selection Clauses

Courts generally have refused to enforce forum selection where an applicable franchise statute contains an anti-waiver provision. But, as illustrated in Best Western Int'l, Inc. v. Govan, 05-3247-PHX-RCB, 2006 WL 2523460 (D. Ariz. Aug. 29, 2006), franchisors still find ways to keep claims in their home state.

Both franchisee Govan and the hotel property were located in California, and the franchisor's cause of action arose there. The franchisor sued in Phoenix, which the forum selection clause designated as the locale for any action. While the California Franchise Relations Act provides that "a provision in a franchise agreement restricting venue to a forum outside [California] is voided with respect to any claim arising under or relating to a franchise agreement involving a franchise business operating within [California]," the Arizona court rejected the argument that California's strong public policy required transfer of the action to California, noting that a motion to transfer venue was "within the broad discretion of the district court," the franchisor was based in Phoenix, most of the franchisor's employees were in Phoenix, the franchise agreement was executed in Phoenix, and, of course, the contract contained the parties' agreement that Phoenix was the most convenient forum.

The federal district court in New Jersey in Bonanno v. Quiznos Master LLC, 06-CIV-01415 (DMC), 2006 WL 3359673 (D.N.J. Nov. 17, 2006), applied New Jersey law to enforce a Colorado forum selection clause where the franchisees asserted nothing more than common law claims. The franchisees in Bonanno sued in New Jersey but also specifically withdrew their claims under the New Jersey Franchise Practices Act. Still they alleged that the contractual choice of a Colorado forum was unenforceable because they were, after all, franchisees under the Act. Agreeing with the franchisor that the case could only go forward in Colorado, the Bonanno court interpreted a New Jersey Supreme Court case striking down a forum selection clause as merely creating an exception to New Jersey's general policy of upholding such clauses.

Vicarious Liability

We reported in our first issue of the FaegreFranchiseForeword that enlightened courts are rejecting the restatement of torts test for vicarious liability. Under the restatement, a franchisor is vicariously liable for the acts of its franchisee where it controls (or has the right to control) the franchisee's day-to-day operations, without regard to whether its controls have anything to do with the harm to the plaintiff. We have observed that the current trend among the courts is to focus on whether the franchisor controlled the instrumentality resulting in the harm to the plaintiff as opposed to day-to-day operations. The Mississippi Court of Appeals has now joined the growing number of jurisdictions embracing the new test in a must-read decision for franchisors facing claims of vicarious liability.

The court in Allen v. Choice Hotels Int'l, 942 So. 2d 817 (Miss. Ct. App. 2006), affirmed the summary judgment dismissing a wrongful death and personal injury suit arising from a robbery at a Comfort Inn hotel. The court first applied the restatement test to conclude that Choice did not control the day-to-day operations of the franchisee and so could not be vicariously liable under a "traditional agency analysis." The court then distinguished vicarious liability in a traditional master-servant relationship and addressed "liability in the franchise context." Because it found that extensive controls are a necessary by-product of a business format franchise, the court limited its analysis to "whether Choice exercised control over, or had the right to control, the hotel security."

While many cases have stopped there, the Allen court went on to observe that, although Choice required a minimum door width, a deadbolt lock, a peephole, and a security bar on sliding doors, this was not enough to establish vicarious liability. "We are not persuaded that these requirements show enough control to shift responsibility for safety to Choice," the panel wrote. "We note again that it is not only results that a franchisor must control, but also the means to those ends. These few requirements regarding hotel doors do not show that Choice had the right to control both the means and the ends of security at the Comfort Inn."

This analysis is spot-on. It correctly focuses the vicarious franchisor liability inquiry on the control of the instrumentality that results in the harm. It is not enough that a franchisor has established a few rules and regulations that touch on security and safety; the franchisor must control both the "means and the ends" of the instrumentality. The Allen decision does not, however, constitute a clean break from the restatement test. We are still waiting for a decision holding, unequivocally, that the control of day-to-day operations is irrelevant in the franchise context.

Definition of a Franchise

It is typically of no legal consequence whether those involved in a product distribution or other commercial relationship believe or act as if they are parties to a "franchise." It is what the court says that matters. And whether any commercial relationship rises to the level of a "franchise" typically depends on whether the "franchisee" pays a "franchise fee" to the "franchisor."

The big problem for the "franchisor" is that almost any payment by a supposed franchisee for the use of the franchisor's mark is a "franchise fee." As we discussed in the first issue of the FaegreFranchiseForeword, the typically conservative-leaning Seventh Circuit Court of Appeals found in To-Am Equip. Co. v. Mitsubishi Caterpillar Forklift Am., Inc., 152 F.3d 658 (7th Cir. 1998), that a forklift distributor was a franchisee because it had purchased more than $500 worth of sales and services manuals over an eight-year period in order to satisfy the manufacturer's requirement of an adequate supply of manuals.

Some courts are beginning to put a little more meat on the bare-bones definition of what constitutes a franchise fee. California in particular has produced recent cases holding that a franchise fee must, in some fashion, constitute an unrecoverable investment in a franchise opportunity. This is the holding of the courts in various Avis Rent-a-Car cases decided in 2003 in California and Washington. (See 26 Franchise Law Journal 3 [Summer 2006]).

A California court of appeal joined the growing trend in November. In Thueson v. U-Haul Int'l, Inc., 144 Cal. App. 4th 664, 50 Cal. Rptr. 3d 669 (Cal. App. 1 Dist. 2006), the court refused to treat a U-Haul dealer as a franchisee because it paid, voluntarily, a monthly charge for a computer terminal and for a dedicated phone line. According to the court:

[W]e conclude, as did the trial court, that no amounts paid by appellant, directly or indirectly, can be reasonably characterized as franchise fees. Appellant invested nothing in return for the right to enter into business with or for U-Haul. He made no required contribution of capital, made no unrecoverable investment in the franchisor, was not required to purchase any inventory, and was not required to purchase services from U-Haul in order to become a dealer. He placed none of his own funds, even the de minimum amounts required under the CFIL or the CFRA, at risk in exchange for the dealership. Our statutes define a franchise fee as a fee paid for the right to do business, not ordinary business expenses paid during the course of business.

Thueson, 50 Cal. Rptr. 3d at 676. (Emphasis added.)

Conversely, in Bly & Sons, Inc. v. Ethan Allen Interiors, 05-668-GPM, 2006 WL 2547202 (S.D. Ill. Sept. 1, 2006), the court said nothing about an "investment" in the franchise opportunity and had little difficulty concluding that an advertising contribution of 2% of sales constituted a franchise fee. Citing the To-Am decision of its appellate court, the court said that "it is difficult to see how the mandatory contribution of 2% of a licensee's invoices to an advertising fund that was required of all licensees does not constitute a franchise fee." The court rejected the franchisor's arguments that the fee was not required to enter into the franchise relationship, but arose only after the dealer became a franchisee, because a franchise fee includes a payment for the right to continue as a dealer.

Relationship Statutes

The Eighth Circuit's lengthy decision in Minnesota Supply Company v. Raymond Corporation, __ F.3d __, 2006 WL 3802156 (8th Cir. Dec. 28, 2006), touched on the interplay between a restrictive state relationship statute and contractual exclusive-dealing and performance provisions. The statute—the Minnesota Heavy Utility Equipment Manufacturers and Dealers Act—prohibits manufacturers from coercing dealers into refusing to purchase equipment made by another manufacturer. The statute also requires good cause before a manufacturer can change the competitive circumstances of a dealer, terminate a dealership arrangement, or fail to renew it.

The dealer and manufacturer in Minnesota Supply operated under a 1990 contract that, among other things, allowed for termination if the dealer sold competitive products without the manufacturer's consent. The dealer did sell a competitive line and, in 1993, the parties negotiated a contract amendment that allowed the sale of competitive products to continue subject to certain conditions. A key condition was that the dealer would maintain its existing market share numbers for Raymond or face termination.

The dealer's market share declined thereafter, the manufacturer terminated the dealer, and the dealer sued under the state statute. On appeal of a jury verdict for the dealer, the Eighth Circuit Court of Appeals concluded that the original 1990 contract provision—allowing termination for unauthorized nonexclusive dealing—was not voided by the statute, and that Raymond's threat to exercise the 1990 provision (made while negotiating the 1993 amendment) was not improper coercion under the statute. Further, while the 1993 amendment constituted changed circumstances under the statute, the Eighth Circuit concluded that there was "good cause" for the change based on the dealer's earlier failure to comply with the "essential and reasonable" 1990 exclusive dealing provision. (The court nevertheless affirmed much of the award to the dealer below, finding sufficient evidence in the record that the market share requirements in the 1993 amendment were not "essential and reasonable" under the particular facts.)

Franchisor Recovery of Lost Future Royalties

We identified in our last issue ways in which franchisors might diminish the impact of PIP-type decisions. PIP refers to Postal Instant Press, Inc. v. Sealy, 51 Cal. Rptr. 2d 365 (Cal. Ct. App. 1996), where a California appeals court held that a franchisor who terminates a franchise agreement may not recover future lost royalties. We noted in our first issue of the Foreword that a number of courts outside of California had, to our surprise, followed PIP. We recommended that franchisors deal with PIP by spelling out their right to recover lost profits where they terminate an agreement for cause or, alternatively, franchisors consider using liquidated damages provisions as a method to compensate for future lost royalties. At the time, we were not aware of any decisions that had addressed whether PIP applies to a liquidated damages clause. We now have one.

The franchise agreement involved in Radisson Hotels Int'l, Inc. v. Majestic Towers, Inc., No. 06-4956 (C.D. Cal. filed Jan. 25, 2007), contained a liquidated damages clause allowing the franchisor to recover double the amount of royalty fees payable by the franchisee during the 12-month period preceding termination. Radisson terminated the franchise agreement because of the franchisee's failure to pay ongoing royalties. Relying on the PIP decision, the franchisee argued that Radisson could not recover past-due royalties because the proximate cause of the loss of royalties was Radisson's termination of the agreement and not the franchisee's default. The court granted summary judgment to Radisson distinguishing PIP on a number of grounds. First, the court said that the franchise agreement in PIP "only vaguely stated that the franchisor would be entitled to the ‘benefit of the bargain' in the event of the franchisee's material breach." In contrast, the Radisson/Majestic franchise agreement had a specific contractual provision making Majestic liable for lost future profits attributable to the franchisor's termination of the agreement for cause. This, the court held, made the commitment in the Radisson agreement akin to a promise to indemnify the franchisor for lost future profits, a provision readily enforceable under California law. Finally, the court held, in the alternative, that the PIP "decision is mistaken." Finding that it was not bound to accept as precedent an intermediate court's opinion, the judge said he did not find PIP "persuasive." "In this Court's view, the Sealy [PIP] Court's holding that a franchisor has no remedy but to sue the franchisee over and over again as lost profits accrue is simply untenable."

The moral remains the same: (1) argue that PIP is not good law — not even in California; (2) spell out the franchisor's right to recover lost future royalties, even if it terminates the agreement; and (3) use liquidated damages clauses as added protection.

Fraud

A carefully worded disclaimer continues to serve as a franchisor's best defense to a fraud claim. The franchisee in Kieland v. Rocky Mountain Chocolate Factory, Inc., 05-150 DWF/SRN, 2006 WL 2990336 (D. Minn. October 18, 2006), advanced various claims under the Minnesota Franchise Act, including "earnings claims." The franchisor's UFOC, however, contained a typical disclaimer that the franchisor made no representations regarding sales, costs, income or profits and that sales personnel were not authorized to make such claims. The franchise agreement contained similar disclaimers. The court found that "on this record, the [franchisees'] claim fails as a matter of law."