FaegreFranchiseForeword

What's New in Franchise Law

Arbitration remains the hot topic in franchising. The 9th Circuit again found a commitment to arbitrate procedurally and substantively unconscionable (and unenforceable), this time in an employment setting. A California state court followed suit and struck down as unconscionable the arbitration commitment in the Cold Stone Creamery franchise agreement.

In contrast to the west coast's jaundiced view of arbitration clauses in franchise agreements, a Connecticut federal court compelled a Subway franchisee association to arbitrate claims against Doctor's Associates, Inc. (DAI), although the association itself had not agreed to arbitration.

The other significant decision this past quarter came from a Minnesota federal court that summarily rejected the efforts of Domino's to sole-source its point-of-sale (POS) computer system.

As an added bonus in this issue of FaegreFranchiseForeword, we share with our clients and friends "Faegre & Benson's Top Ten Rules for Franchisors to Reduce Litigation Risks."

Arbitration

Unconscionability: The big news last quarter was the 9th Circuit's en banc decision refusing to enforce an arbitration commitment in Nagrampa v. MailCoups, Inc., 469 F.3d 1257 (9th Cir. Dec. 4, 2007) (analyzed in our Feb. 21, 2007, issue). A 9th Circuit panel again struck down an arbitration commitment, this time in the employment context.

The plaintiff in Davis v. O'Melveny & Meyers, 2007 WL 1394530 (9th Cir. May 14, 2007), alleged that the O'Melveny law firm violated the Federal Fair Labor Standards Act by failing to pay for her overtime work as a paralegal. The plaintiff claimed that her promise to arbitrate was unconscionable. The 9th Circuit, following the California two-step approach to evaluating unconscionability (the existence of procedural and substantive unconscionability), voided the entire arbitration commitment. According to the court, enforcement was procedurally unconscionable because the arbitration commitment was not negotiable. The court acknowledged that the "marketplace alternatives" theory might save an arbitration agreement from procedural unconscionability. (Under this theory, a contract party with a reasonably available alternative source of supply of a good or service may not claim procedural unconscionability.) Relying on Nagrampa, however, the 9th Circuit rejected O'Melveny's claim that the employee had marketplace alternatives. Like the franchisee in Nagrampa, the employee in O'Melveny, according to the court, was not a sophisticated party to the agreement, thus precluding application of the marketplace alternatives theory.

Having found procedural unconscionability, the court next examined substantive unconscionability. Under this test, the court looks for terms that are so one-sided as to "shock the conscience" and be "unduly harsh or oppressive." The court found that four dispute resolution provisions met the test: (1) the requirement that the employee demand mediation within one year of actual or constructive notice, which the court likened to a one-year limitations period; (2) the requirement of confidentiality, which allowed O'Melveny to remain the only party informed about the history of other employment dispute resolutions; (3) the right of O'Melveny to seek equitable relief to protect confidential information, a right which was not mutual; and (4) provisions that had the effect of voiding statutory rights. Finally, the court concluded that the number of unconscionable provisions (four) was so great as to preclude severance of the offending provisions, thus making the commitment to arbitrate as a whole unenforceable.

What are some lessons that franchisors can draw from the O'Melveny decision? First, the court does state that a party may have an exclusive right to resort to a judicial remedy (such as injunctive relief) as long as the right is based on a legitimate commercial need or business reality. Most franchisors would undoubtedly consider the protection of confidential information sufficient justification, but the court held otherwise in Nagrampa and reiterated in O'Melveny that "protecting against breaches of confidentiality alone does not constitute a sufficient justification." Notwithstanding this admonition, franchisors should not give up on persuading a California court that interim relief is indeed essential to the continued preservation of the franchise system, including avoiding disclosure of confidential information. After all, once the proverbial cat is out of the bag (namely, confidential information), there is no getting it back in again.

A second lesson from O'Melveny is that abbreviated limitations periods will jeopardize an arbitration commitment, at least under California law as interpreted by the 9th Circuit. Franchisees may argue that a one-year period is substantively unconscionable in light of O'Melveny, but the counterargument is that the O'Melveny court was concerned about "continuing wrongs" that may arise in the employment context. Similar concerns may not apply to franchising. Nevertheless, the prudent franchisor doing business in California may want to use a contractual limitations period greater than one year from actual or constructive notice of a claim.

Third, take-it-or-leave-it contracts are not per se procedurally unconscionable. If the plaintiff is "sophisticated" and if there are marketplace alternatives to signing an agreement, then a non-negotiable contract is not procedurally unconscionable. The sophistication of the franchisee thus becomes a threshold issue when dealing with a claim of unconscionability.

A final lesson is that enforceability is apparently a numbers game. Four unconscionable provisions precluded severance of the offending sections in O'Melveny. In the Cold Stone Creamery case summarized below, a total of three was enough. So far, California courts have provided little guidance on when an arbitration commitment is so offensive that it is beyond saving. Here are some drafting tips, however, for lawyers writing arbitration commitments subject to challenge under California law:

• An arbitration commitment may properly define procedures that will control the arbitration process.
• The arbitration clause should not deprive a party of substantive rights under a statute.
• To the extent a court might conclude that a clause effectively deprives a party of a substantive right, do not put the provision in the commitment to arbitrate. Place it in other parts of the franchise agreement.

On a more positive note, the court in O'Melveny, as in Nagrampa, does express skepticism over claims of a "repeat player" effect, namely, that arbitration is suspect because an employer (or franchisor) knows more than the other side about the pool of arbitrators available to hear a dispute. According to the court in O'Melveny, the "repeat player" effect is offset by the ability of the employee to learn about other arbitration against the employer. Where, as in O'Melveny, the proceedings must be kept confidential, the ability of the employee to level the playing field by learning about past arbitration is lost, according to the 9th Circuit.

A California state court also refused to enforce a commitment to arbitrate contained in the Cold Stone Creamery franchise agreement. The court in Meyers v. Conehead Investments Inc., No. BC358836 (Los Angeles Co., Calif., Super. Ct., filed April 18, 2007), first found procedural unconscionability because the plaintiff had demonstrated both "oppression" and "surprise." The oppression consisted of "an inequality of bargaining power of the parties to the contract in an absence of real negotiation or meaningful choice on the part of the weaker party" because the agreement was presented on a take-it-leave-it basis. Further, according to the court, "surprise is a function of disappointed reasonable expectations of the weaker party." Here, the franchisee "did not reasonably expect that the arbitration provision therein to amount to a unilateral agreement to arbitrate on her part."

The court addressed the "unilateral" nature of the agreement as a part of its discussion of substantive unconscionability. The court found that the agreement completely lacked mutuality by requiring only the franchisee to arbitrate claims. In fact, Cold Stone Creamery was contractually bound to arbitrate claims, although it did have the right to seek provisional and injunctive relief from the court. The court nevertheless deemed this "tantamount to a unilateral agreement to arbitrate on the part of plaintiffs, which is unconscionable," citing the Nagrampa decision.

The court buttressed its finding of unconscionability based on an "unconscionable waiver of statutory rights," namely, the right under the California Franchise Investment Law (CFIL) to seek consequential damages. The arbitration provision purported to waive consequential damages. Finally, the court found the arbitration commitment substantively unconscionable because the plaintiff had to pay a filing fee of $8,000, plus a case service fee of $3,250, as well as face exposure to costs and expenses of the arbitration should she not be the prevailing party. "The amount of this ‘entry fee' effectively precludes franchisees, such as Meyers, from seeking legal redress of her claims, including any claims under the CFIL," said the court. Because of the "multiple substantively unconscionable terms," the court struck the entire commitment to arbitrate as "permeated with substantive unconscionability."

Carried to its extreme, the decision stands for the proposition that any franchise agreement that is not subject to negotiation is procedurally unconscionable, plus anytime the franchisee is required to pay filing fees and is exposed to costs and expenses, the commitment is substantively unconscionable. Further, like the 9th Circuit's decision in O'Melveny, enforceability of the commitment as a whole in California is about counting the number of unconscionable provisions in the commitment to arbitrate. In O'Melveny, four unconscionable provisions compelled the court to obviate the entire arbitration commitment; three met the test in the Cold Stone Creamery case.

One way to deal with cases like Nagrampa, O'Melveny, and Meyers is to put limitations on remedies in parts of the franchise agreement other than the commitment to arbitrate. In this way, the arbitrator determines whether a particular provision is unconscionable and the limitation does not count when the court decides substantive unconscionability. The selection of the franchisor's home state as the venue/locale for arbitration and the preclusion of joinder of parties should remain in the arbitration clause.

Cold Stone has appealed the order denying its petition to compel arbitration. Faegre & Benson plans to file on behalf of the IFA an amicus brief supporting reversal of the order.

Non-Parties to Arbitration Agreement: Doctor's Associates, Inc. (DAI), was back in court again seeking to compel arbitration in its Subway franchise system—this time not against individual franchisees, but against a franchisee association. Doctor's Associates, Inc. v. Downey, Bus. Franchise Guide (CCH) ¶ 13,580 (D. Conn. Feb. 12, 2007).

DAI created the Subway Franchisee Advertising Fund Trust (SFAFT) in 1990 to fund group advertising and promotion of Subway sandwich shops. The trust agreement placed control of marketing dollars and programs principally in the hands of Subway franchisees. Prior to 2006, the standard Subway franchise agreement required that franchisees pay marketing fees into the SFAFT. Beginning with the 2006 form of franchise agreement, DAI required that new and renewal franchisees make the marketing contribution directly to it. The obvious upshot of requiring such franchisees to make payments to DAI is the eventual shifting of control of such funds from franchisees to the franchisor.

The change did not sit well with some franchisees. In fact, the North American Association of Subway Franchisees (NAASF) started a lawsuit in Connecticut state court claiming that DAI's modification of the form franchise agreement constituted a breach of the SFAFT. DAI responded by filing a petition to compel arbitration, naming as defendants franchisees who were also members of the NAASF Board of Directors. The petition came before Judge Peter Dorsey, the same federal judge who has authored other Subway decisions involving commitments to arbitrate. Judge Dorsey had no problem rejecting the franchisees' claim that they had not filed the underlying action and that the party that did, NAASF, had not agreed to arbitrate disputes. According to the judge, a petition to compel arbitration turns on whether the claims in dispute are covered by the arbitration commitment, not on the identity of the parties. Because the claims in dispute fell within the broad commitment to arbitrate "any controversy or claim arising out of or relating to" the franchise agreement, the court held that all the claims are subject to arbitration. Further, the judge said that the association was suing in a representative capacity, and as such, any arbitration agreement that binds individual members also binds the association. Lastly, the court enjoined further proceedings in the state court action pending the conclusion of the arbitration proceeding.

FAA Jurisdiction: Most of us know that the Federal Arbitration Act (FAA) does not raise federal question jurisdiction. A federal district court must have an independent basis for subject matter jurisdiction to entertain a proceeding under the FAA. The obvious basis for jurisdiction is 28 U.S.C. § 1332, diversity jurisdiction. But what if the two parties are from the same state? What does it take to establish federal question jurisdiction under 28 U.S.C. § 1331?

For those interested in the answer, the 11th Circuit decision in Community State Bank v. Strong, 2007 WL 1225343 (11th Cir. April 27, 2007), makes a good read. Particularly instructive is the lengthy concurring opinion that outlines the split in the circuits on the question. The focus of the decision is on Section 4 of the FAA, which governs petitions to compel arbitration. The question is whether, under Section 4, the court must find a federal question within the four corners of the specific claim for which a petition seeks to compel arbitration. The 11th Circuit follows the minority view, the so-called "look through" doctrine. This doctrine "looks through" the theories actually advanced by the defendant to the petition to compel and asks whether the defendant could have raised a federal question based on the facts and theories alleged in the challenged proceeding. The majority view is that the court focuses solely on the claim of the opposing party to determine whether it raises a federal question. Of particular interest is that the underlying decision and the concurrence are written by the same judge, who suggests that the full court should consider the question en banc.

Supreme Court to Hear Case: The main problem franchisors have with arbitration is the courts' extremely limited review of an award under the default provisions of the FAA. Under the language of the FAA, a court may vacate an award where there is evident partiality on the part of the judge. In addition, the courts have grafted two other grounds for vacating an award onto the FAA—manifest disregard of the law and violation of public policy. We have recommended that franchisors consider creating additional grounds for review in the arbitration clause, including: (1) requiring courts to follow the contract and apply the law, thus allowing the parties to argue that the arbitrator abused her discretion by not following the contract or applying the law; (2) craft a provision in the agreement for an ADR form of appeal (e.g., a panel of arbitrators that acts like a court of appeals); and (3) creating grounds for vacator beyond the default provisions of the FAA (e.g., errors of law and capricious findings of fact). The problem with expanding review beyond the FAA default provisions is that is a split in the federal circuit courts over the enforceability of such a clause. The U.S. Supreme Court has now agreed to resolve the conflict in the circuits.

The court accepted cert in Hall Street Associates, LLC v. Mattel, Inc. The arbitration commitment in Hall stated that a district court judge could vacate, modify, or correct an arbitration award "where the arbitrator's conclusion of law are erroneous," a standard of review not set forth in the FAA. The 9th Circuit said that the FAA outlines the exclusive grounds for review and erroneous conclusions of law is not one of them. The 9th Circuit position is aligned with that of the 10th Circuit, but it conflicts with rulings of the 1st, 3rd, 4th, 5th, and 6th Circuits. We should know the answer in the next several months.

Fraud

The cases continue to teach us just how critical a detailed and specific disclaimer is to a franchisor's successful defense of a franchisee's fraud claim. Not just any disclaimer will do. Although the standard integration clause may well preclude a contract claim based on the parol evidence rule, almost all courts hold that the parol evidence rule does not preclude claims of fraud and misrepresentation. The key to winning these cases is to focus on the element of reasonable reliance. Most courts hold that state franchise acts, like common law fraud, require reasonable reliance upon an alleged representation. Where the representation is contradicted specifically and directly by a disclaimer, the great majority of courts find, as a matter of law, that the plaintiff could not have relied on the alleged misrepresentation. A quote from Lady of America Franchise Corp. v. Malone, Bus. Franchise Guide (CCH) ¶ 13,562 (S.D. Fla. Feb. 13, 2006), published in the most recent CCH Business Franchise Guide, makes the point in a most effective manner:

• In this case, Malone asserts that the integration and disclaimer clauses contained in her Franchise Agreement do not bar her from alleging reliance on statements made by LOA regarding the past performance of other LOA franchises. However, like the disclaimer in Hall, Malone's Franchise Agreement contains an extremely comprehensive and unambiguous disclaimer that directly addresses all the statements Malone seeks to introduce. The clause expressly disclaims any representations received regarding profits and successes. The clause also states the risk associated with entering into the franchise. Malone does not allege that this was anything but an arms-length transaction. The contract contained both a merger and integration clause and a complete disclaimer. The disclaimer appeared in all capital letters and there is no indication that LOA attempted to conceal its importance. It allowed for Malone to conduct an independent investigation. Malone has not alleged any facts which could lead the court to believe that LOA induced her to sign the agreement before conducting an independent review of LOA and its franchises. Additionally, the disclaimer provided an opportunity for Malone to expressly list any representations she received from LOA. Malone did not list the information she received via the internet or in-person meetings. Malone therefore disclaimed any reliance on these statements. Following the test in Travelodge, Malone cannot now establish that she relied on them to her detriment. Based on the narrow use of the parol evidence rule exception, Malone has failed to establish any set of facts which circumvent the unambiguous disclaimer contained in the Franchise Agreement. Therefore, Malone's claim for violation of the FFA is dismissed.

Little FTC Acts

Many of us know that the FTC Act does not establish a private cause of action for a franchisee. Although a franchisor may well incur the wrath of the enforcement division of the FTC when it fails to comply with the FTC Rule, franchisees are without a remedy unless the FTC acts. The hooker here, however, is the "Little FTC" Act adopted by a number of states, also known as Deceptive Trade Practices Acts. Claims under state Little FTC Acts may, in the words of the Florida statute, "be used based upon . . . any law, statute, rule, regulation, or ordinance which prescribes unfair methods of competition, or unfair, deceptive, or unconscionable acts or practices." The same court that gave us the nice decision on reasonable reliance, Lady of America Franchise Corp. v. Malone, Bus. Franchise Guide (CCH) ¶ 13,562 (S.D. Fla. Feb. 13, 2006), also found that the franchisee had a cause of action under the Florida Deceptive Trade Practices Act by reason of the alleged failure of the franchisor to comply with the FTC Rule. The key to the successful defense of these cases is to focus on the parties protected by the Little FTC Act. The act is designed to protect consumers and not businesses, and franchisees are more business than consumer.

Franchise cases and legislature often come down to whether a court views the franchisee as a business, a consumer, or a type of employee. Cases like O'Melveny may make sense when they protect employees from unfair contracts, but when this paternalistic view is applied to franchising, it creates absurd decisions like Nagrampa and Meyers/Cold Stone Creamery. This same attitude is sometimes evident when it comes to franchise noncompete cases, like the California Snelling cases where the noncompete is analyzed as if contained in an employment agreement as opposed to the sale of a business.

Termination

It looks from Zeidler v. A&W Restaurants, Inc., 2007 WL 723460 (N.D. Ill. Mar. 5, 2007), like A&W may finally be done with the Zeidler boys.

Russell Zeidler was the first of the two brothers to sue A&W. Russell Zeidler, along with his wife, opened an A&W restaurant in 1993 and promptly lost money every year of its operation. Finally, in March of 1999, Russell closed shop, claiming that A&W's bad faith threats of termination because of the quality of operations made it impossible for Zeidler to run the business. A few days later, A&W issued a letter formally terminating the franchise.

The big issue in Russell's case was whether A&W's alleged "bad faith" in calling him to account for the condition of his restaurant excused his breach of the agreement by abandoning the restaurant. Concluding that Russell had offered no evidence of bad faith on the part of A&W, the 7th Circuit held that Russell's closing down of the restaurant barred him from alleging wrongful termination in violation of the Illinois Franchise Act. Zeidler v. A&W Restaurants, Inc., 301 F.3d 572 (7th Cir. 2002).

In a twist on the old saw that the fruit does not fall far from the tree, Russell's brother James also lost money in his restaurant from the start. Like Russell, James ultimately abandoned the franchise business, laying blame at the feet of A&W. The problem with A&W this time was that it had supposedly duped James into purchasing the franchise at a time when A&W knew freestanding restaurants could not survive. Finding that A&W's view of the likely success of its restaurants had nothing to do with James' decision to become a franchisee, the court affirmed summary judgment, holding that a franchisee who abandons his restaurant by closing it before the end of the term of the franchise agreement cannot, as a matter of law, prevail on a wrongful termination claim under the Illinois Franchise Act.

In many ways, the Zeidler decisions do little more than repeat fairly well-established law. Where the decisions may be particularly helpful is in dealing strategically with PIP problems. As we have observed in prior issues of the Foreword, the California Court of Appeals in Postal Instant Press, Inc. v. Sealy, 43 Cal. App. 4th 1704 (1996), found that a franchisor could not recover lost future royalties because the cause of its loss was its decision to terminate the agreement, as opposed to a suit to specifically enforce payment of royalties. (PIP is addressed in each of our first two issues of the FFF.) The Zeidler case stands for the proposition that where a franchisee abandons a franchise, the franchisor cannot be liable for wrongful termination. Franchisors facing franchisees who have abandoned the franchise and wanting to preserve their right to recover future lost royalties should consider dispensing with a formal termination and merely confirm that the franchisee, through its abandonment, has effectively terminated the agreement. Then the cause of the loss of future royalties is unmistakably the franchisee's abandonment, not the franchisor's termination.

Franchisor Designation of Single Supplier of Products/Services

The ability of a franchisor to designate a single supplier of a product—especially itself—has been a bone of contention between franchisor and franchisee for a long time. Judge Richard Kyle of the Minnesota Federal District Court handed down the most recent decision on the subject.

At issue in Bores v. Domino's Pizza LLC, No. 05-2498 (D. Minn. May 23, 2007), was whether Domino's could, consistent with its standard franchise agreement, require its franchisees to purchase computers and software for its POS system called PULSE from a single source. As a part of the program, Domino's required that all of its franchisees purchase the hardware from IBM and the software from Domino's. A group of franchisees responded by filing a lawsuit, arguing that their franchise agreement specifically allowed them to purchase computers and software meeting Domino's specifications from "any source."

Judge Kyle defined the dispute as a "garden variety" breach of contract case. He said the franchise agreement gave franchisees the right to an alternative source of computers and software meeting Domino's specifications, and that is what they were going to get. The judge granted the franchisees summary judgment declaring that "Domino's must provide them with specifications for the PULSE hardware and software and that they may acquire hardware and software meeting those specifications from ‘any available source.'" Particularly compelling to the court was a provision in the franchise agreement that gave Domino's an express right to be the only source of some food products. According to the court, the preservation of the right to sole-source some products indicated that it did not have the right to do so for others.

The court's decision seems simple enough. The court certainly found no complexity in the issues. Domino's was not, however, without legal arguments supporting its position, including language in the franchise agreement requiring franchisees to comply with system standards and its establishment of a single line of computers and software as just such a standard. In any event, the implications of the decision are far reaching. An effective POS computer program is critical to the ability of most quick-serve franchises to compete today. There is certainly nothing uncommon about franchisors (inside or outside the quick-serve business) requiring franchisees to use proprietary software sold by a single supplier. There are also a number of compelling reasons for a franchisor to require the use of a single supplier of hardware and software. So, what is a franchisor to do?

Where the franchise agreement contains language seemingly allowing the franchisee to seek alternative sources of a product, the franchisor is stuck between the proverbial rock and a hard place. The franchisor may have compelling arguments for single sourcing (as did Domino's in the Bores case). The problem is getting a busy judge to look beyond the most simple language in the franchise agreement. The best approach, of course, is for the franchisor to have helpful language in the franchise agreement. We recommend that the franchisor preserve in its franchise agreements the right to designate a single source of any product or service, and specifically state that it may be the sole source. Further, the franchisor should give the franchisee notice that it may profit from the sale of a product or service and that the price of any product or service it may sell will be the "price in effect" or similar such language. The benefit of a phrase like "price in effect" is that it creates a safe harbor from an attack on the reasonableness of a price under the UCC. Even if the franchisor does not intend to use the right to sole-source now or in the foreseeable future, things change.

Even if this sort of language is not in existing agreements, starting to include it now will bind future new and renewal franchisees. Most existing franchisees will likely be content to purchase from the franchisor, and only the most aggressive will typically ask for an alternative supplier (especially if pricing is not out of line). Requiring the franchisee to sole-source may serve as a red flag in front of a bull. The combination of existing franchisees willing to buy from the franchisor-designated source and the requirement that new and renewal franchisees do so may have the same effect as compelling purchases at the start.

Where the franchisor's existing agreement clearly gives the franchisee the right to alternative suppliers of hardware and software, the difficult issue for the franchisor will be creating specifications for the software. The franchisor may have to share the software source code with third-party suppliers to assure the necessary uniformity or assure that the price of the software is so attractive that the franchisee has no reason to seek an alternative supplier. Franchisors creating proprietary software would do well to make sure that they in fact own or otherwise control the source code in case they must give it to franchisees to comply with their franchise agreements.