Enforcing Arbitration Clauses in 'Hidden' or Unlawful Franchise Agreements

Licensors, manufacturers, and other businesses that find themselves as unwitting franchisors face interesting issues when they attempt to enforce an arbitration clause. Most registration states will usually have statutory provisions that declare that the sale of an unregistered franchise or the sale of a franchise without the required disclosure is unlawful. See, e.g., Cal. Corp. Code ” 31110, 31119; 815 Ill.Comp.Stat. ' 705/5; N.Y. Gen. Bus. Law ' 683.1; Wash. Rev. Code ' 19.100.020.(1). However, in the usual case, the sale is not declared to be void, but is voidable through an action for rescission. See, e.g. Cal. Corp. Code ” 31300; Wash. Rev. Code ' 19.100.190(2); N.Y. Gen. Bus. Law ' 691; 815 Ill.Comp.Stat. ' 705/26.

When the putative franchisee sues in court, it can be expected that it will attempt to maximize the remedies allowed by the registration laws, such as rescission and/or statutory penalties. If the challenged agreement has an arbitration clause, it is likely that the unwitting franchisor will petition a state or federal court to compel arbitration. It can be expected that the putative franchisee will resist such an attempt by claiming that the contract is an illegal franchise agreement and thus the arbitration clause cannot be enforced.

The cases that have dealt with the defense of illegality to enforcement of arbitration agreements usually follow the rules that have been developed with respect to allegations of fraud in the inducement, but there are some differences that should not be overlooked. The outcome of such a challenge will largely rise or fall on a determination of whether the agreement is void or voidable, whether the Federal Arbitration Act, 9 U.S.C. ” 1 et seq. (FAA) will apply, and if so, in what federal circuit the moving party lands.

In a recent federal district court decision, Solar Planet Profit Corp. v. Hymer, Bus. Fran. Guide (CCH) ' 12,454, 2002 WL 31399601 (N.D. Cal. 2002), a licensor of a trademark license was sued in state court by its licensee, who claimed, among other things, that the license agreement was a franchise under California law. The licensor filed a petition in federal court under 9 U.S.C. ' 4 to compel arbitration. The licensee argued that the petition should be denied because the agreement was an unlawful franchise agreement, and as a result of the illegality, the arbitration clause could not be enforced. The court rejected this argument on the basis that because the agreement was subject to rescission under Cal. Corp. Code ' 31300, it was voidable, not void, and thus the arbitration clause could be enforced. (The same licensor had lost a similar petition filed in the state court on the basis of a state court case, Green v. Mt. Diablo Hosp. Dist., 254 Cal.Rptr. 689; 207 Cal.App.3d 63 (1989). This serves to show that whenever possible, the moving party should seek relief in the federal court, which is clearly allowed by the FAA, even if a state court action is pending. See, 9 U.S.C. ' 4.)

The court found that: 'In the 9th Circuit, an arbitration clause in a voidable contract remains valid; only if the contract never existed or if there is some defect in the formation of the arbitration clause itself will the clause be invalid. Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967); Three Valleys Mun. Water Dist. v. E. F. Hutton & Co., Inc., 925 F.2d 1136 (9th Cir. 1991). Here, however, the contract was voidable and not void, and the arbitration clause remains in force.'

The Solar Planet decision is in line with a number of federal cases arising under the FAA that have held that a claim of illegality, like a claim of fraud in the inducement, would defeat a petition to compel arbitration only if the arbitration clause itself was tainted by the illegality. See Prima Paint Corp. v. Flood & Conklin Mfg., Co., 388 U.S. 395 (1967); Harter v. Iowa Grain Co., 220 F.3d 544 (7th Cir. 2000); Sweet Dreams Unlimited, Inc. v. Dial-A-Mattress Int'l Ltd., 1 F.3d 639 (7th Cir. 1993); Lawrence v. Comprehensive Bus. Services Co., 833 F.2d 1159, 1162 (5th Cir. 1987); Mesa Operating Ltd. P'ship v. Louisiana Intrastate Gas Corp., 797 F.2d 238, 243-244 (5th Cir. 1986).

This is part and parcel a result of the impact of the 'savings clause' contained in Section 2 of the Act, to the effect that an arbitration agreement is fully enforceable unless it can be revoked on grounds generally applicable to any contract. Thus, 'generally applicable contract defenses, such as fraud, duress or unconscionability, may be applied to invalidate arbitration agreements without contravening ' 2.' Doctor's Assoc., Inc. v. Casarotto, 517 U.S. 681, 687 (1996). The key to the 'savings clause' is that it is aimed at the arbitration agreement, not the agreement of which it is a part. Thus, it is not enough to allege that the agreement was induced by fraud, or is illegal; the fraud or illegality must taint the arbitration clause itself. Depending on the federal circuit, even a claim that fraud or illegality tainted the arbitration clause may not stop a petition to compel from being granted.

In Prima Paint, the Supreme Court held that if a party challenging arbitration on fraud grounds cannot show that the arbitration clause itself was fraudulently induced, then the party must arbitrate. Id. at 406. The circuits have, by analogy, applied Prima Paint to situations in which legality of the contract is raised as an issue. In those cases, courts have held that to avoid arbitration the challenging party must show that the arbitration clause is itself illegal or that there in effect was no agreement to arbitrate.

Harter involved a challenge to an arbitration clause based on an alleged claim that a 'hedge-to-arrive' contract for the sale of grain was 'illegal.' The court held: 'Courts will not allow a party to unravel a contractual arbitration clause by arguing that the clause was part of a contract that is voidable. ' The party must show that the arbitration clause itself, which is to say the parties' agreement to arbitrate any disputes over the contract that might arise, is vitiated by fraud, or lack of consideration or assent ” Harter, 220 F.2d at 550 (emphasis in original) (quotations omitted).

To the same effect was Sweet Dreams.

In Lawrence, 833 F.2d at 1162, plaintiffs challenged the enforceability of an arbitration clause on the grounds that the franchise contract in dispute violated the Texas accountancy law and was therefore unenforceable in all respects. Relying on Prima Paint, the court rejected that argument on the ground that in order to defeat an arbitration clause on a claim of illegality, the challenging party must show that the arbitration clause itself was illegal, not simply that the contract was illegal. Id. at 1161-1162. Once the court determines that there are no grounds in law or equity to defeat the arbitration clause itself, and that the parties, notwithstanding the 'illegality' of the underlying contract, agreed to arbitrate, the issue of the legality of the contract is to be decided by the arbitrator. Id. at 1162. Such a procedure makes sense given the fact that a determination of illegality (ie, whether a particular contract has violated any statute) is something an arbitrator is capable of determining like any other issue placed before him or her. Id. Indeed, parties are precluded from arguing that arbitration of an allegedly 'illegal' contract would effectuate the illegality because 'the legality of the contract has not yet been decided.' Id.

The franchisees in Lawrence also argued that the applicable Texas statute invalidated the contract as a whole and rendered the arbitration clause unenforceable. The court rejected this argument on the basis of Mesa Operating, 797 F.2d at 244, which involved a broad reading of Prima Paint. There, it was claimed, that the contract containing the arbitration clause was void ab initio because it had not been approved by certain state officials or had not followed public bidding procedures. The court, relying on Prima Paint, rejected such argument on the basis that there was no claim 'that the agreement to arbitrate is invalid separately from the entire contract.' Id.

Challenges to Existence or Making of Agreement

Most circuits have adopted the view that challenges to the existence of the agreement itself must be decided by the court, not the arbitrator. See, e.g., Large v. Conseco Finance Servicing Corp., 292 F.3d 49, 53-54 (1st Cir. 2002); Sandvik AB v. Advent Int'l Corp.' 220 F.3d 99, 100-01 (3rd Cir. 2000). The Ninth Circuit in Three Valleys Mun. Water Dist. v. E. F. Hutton & Co., Inc., 925 F.2d 1136, 1140 (9th Cir. 1991) adopted a similar view that challenges to the making or existence of the underlying contract containing an arbitration clause must be submitted to the court, rather than the arbitrator. This follows from the basic principle that an arbitrator's jurisdiction to decide issues is dependent on the existence of an agreement to submit disputes to arbitration. If there is no such agreement in the first place, then the dispute cannot go to arbitration. '[A] party who contests the making of a contract containing an arbitration provision cannot be compelled to arbitrate the threshold issue of the existence of an agreement to arbitrate.' Id. at 1140-41.

In Three Valleys, the matter was remanded for the district court to decide whether the signatory had authority to bind the other plaintiffs to the agreement, including the arbitration clause. Id. at 1144. The court noted, however, that where the challenge seeks to avoid or rescind the contract, the arbitrator, not the court, must decide the issue. 'If the dispute is within the scope of an arbitration agreement, an arbitrator may properly decide whether a contract is 'voidable' because the parties have agreed to arbitrate the dispute.' Id. at 1140.

Even if the claimed illegality rendered the contract void, that may not automatically equate to a challenge to the existence or making of the contract. The parties still intended to enter into a contract, although illegal by virtue of a statute or policy of which neither party was aware. On the other hand, it is generally held that contracts against public policy are unenforceable and of no effect, and courts will refuse to enforce them. Restatement (Second) of Contracts ' 178.

With respect to failure to comply with licensing or registration laws, enforcement is usually not allowed when the purpose of the statute is regulatory to prevent fraud for example. Id. at ' 181. By enforcing an arbitration clause, a court is certainly enforcing part of an illegal contract, although an arguably severable part. When parts of a contract are illegal, courts may sever those parts out in order to save the rest. Id. at ” 183, 184. Prima Paint as interpreted in Mesa Operating would seem to support the proposition that the arbitrator decide the issue of the claimed illegality, even if it would render the contract void, in the absence of any challenge to the making or existence of the contract in the first place.

In Burden v. Check Into Cash of Kentucky, LLC, 267 F.3d 483, 489-90 (6th Cir. 2001), the court noted the split in the circuits on the issue of illegal and void contracts, including Lawrence, but found that even though it was claimed that the underlying contract was 'void' under the relevant statute, the matter would be submitted to arbitration because the challenge was to 'the substance, rather than the existence, of the [underlying] agreements.' Id. at 490.

'Thus, the illustrations chosen by Three Valleys cast doubt on the position that challenges to the very existence of a contract, for purposes of distinguishing Prima Paint, include challenges from parties who intended to enter into a contract, but then subsequently discovered that the terms of the contract may violate state law. That is, the Three Valleys line of cases requires more than an allegation of statutory violation; the substance of the allegation must concern some 'misrepresentation as to the character or essential terms of a proposed contract.'  (citations omitted) Id. at 490.

There are still some state cases, like Green v. Mt. Diablo Hosp. Dist., 254 Cal.Rptr. 689, 207 Cal.App.3d 63 (1989) that must be reckoned with. Green on its face contains sweeping language that an arbitration clause contained in an unlawful contract is unenforceable. On close examination, however, Green involved a contract for payments to be made in violation of the state constitution, which made the contract void and unenforceable. Green did not discuss the FAA, which was probably inapplicable to a contract involving intrastate commerce at best. To the extent that the FAA is applicable, the case may have come out differently depending on how far the court wants to take Prima Paint.

Since questions of arbitrability under the FAA are to be determined by federal law [Three Valleys, 925 F.2d at 1138; Moses H. Cone Mem'l Hosp. v. Mercury Constr. Corp. 460 U.S. 1, 24 (1983)], a court applying the FAA will hold that the question of illegality should be decided by the arbitrator since the illegality was substantive.

Left for another day is the question of whether a challenge of illegality to an arbitration clause in a franchise agreement is a ground that exists at law or equity for the revocation of any contract. See, e.g., Southland Corp. v. Keating, 465 U.S. 1, 16, n. 11 (1984); Lawrence, 833 F.2d at 1162.

In the end, the decision of who decides the question of illegality, the court or the arbitrator, might simply come down to whether the parties intended to have the arbitrator decide such issues. See, Howsam v. Dean Witter Reynolds, Inc., 537 U.S. 79, 154 L.Ed.2d 491 (2002).

Charles G. Miller is a member of the San Francisco firm of Bartko, Zankel, Tarrant & Miller. Mr. Miller is a member of the Editorial Board of this newsletter.

Licensors, manufacturers, and other businesses that find themselves as unwitting franchisors face interesting issues when they attempt to enforce an arbitration clause. Most registration states will usually have statutory provisions that declare that the sale of an unregistered franchise or the sale of a franchise without the required disclosure is unlawful. See, e.g., Cal. Corp. Code ” 31110, 31119; 815 Ill.Comp.Stat. ' 705/5; N.Y. Gen. Bus. Law ' 683.1; Wash. Rev. Code ' 19.100.020.(1). However, in the usual case, the sale is not declared to be void, but is voidable through an action for rescission. See, e.g. Cal. Corp. Code ” 31300; Wash. Rev. Code ' 19.100.190(2); N.Y. Gen. Bus. Law ' 691; 815 Ill.Comp.Stat. ' 705/26.

When the putative franchisee sues in court, it can be expected that it will attempt to maximize the remedies allowed by the registration laws, such as rescission and/or statutory penalties. If the challenged agreement has an arbitration clause, it is likely that the unwitting franchisor will petition a state or federal court to compel arbitration. It can be expected that the putative franchisee will resist such an attempt by claiming that the contract is an illegal franchise agreement and thus the arbitration clause cannot be enforced.

The cases that have dealt with the defense of illegality to enforcement of arbitration agreements usually follow the rules that have been developed with respect to allegations of fraud in the inducement, but there are some differences that should not be overlooked. The outcome of such a challenge will largely rise or fall on a determination of whether the agreement is void or voidable, whether the Federal Arbitration Act, 9 U.S.C. ” 1 et seq. (FAA) will apply, and if so, in what federal circuit the moving party lands.

In a recent federal district court decision, Solar Planet Profit Corp. v. Hymer, Bus. Fran. Guide (CCH) ' 12,454, 2002 WL 31399601 (N.D. Cal. 2002), a licensor of a trademark license was sued in state court by its licensee, who claimed, among other things, that the license agreement was a franchise under California law. The licensor filed a petition in federal court under 9 U.S.C. ' 4 to compel arbitration. The licensee argued that the petition should be denied because the agreement was an unlawful franchise agreement, and as a result of the illegality, the arbitration clause could not be enforced. The court rejected this argument on the basis that because the agreement was subject to rescission under Cal. Corp. Code ' 31300, it was voidable, not void, and thus the arbitration clause could be enforced. (The same licensor had lost a similar petition filed in the state court on the basis of a state court case, Green v. Mt. Diablo Hosp. Dist., 254 Cal.Rptr. 689; 207 Cal.App.3d 63 (1989). This serves to show that whenever possible, the moving party should seek relief in the federal court, which is clearly allowed by the FAA, even if a state court action is pending. See, 9 U.S.C. ' 4.)

The court found that: 'In the 9th Circuit, an arbitration clause in a voidable contract remains valid; only if the contract never existed or if there is some defect in the formation of the arbitration clause itself will the clause be invalid. Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967); Three Valleys Mun. Water Dist. v. E. F. Hutton & Co., Inc., 925 F.2d 1136 (9th Cir. 1991). Here, however, the contract was voidable and not void, and the arbitration clause remains in force.'

The Solar Planet decision is in line with a number of federal cases arising under the FAA that have held that a claim of illegality, like a claim of fraud in the inducement, would defeat a petition to compel arbitration only if the arbitration clause itself was tainted by the illegality. See Prima Paint Corp. v. Flood & Conklin Mfg., Co., 388 U.S. 395 (1967); Harter v. Iowa Grain Co., 220 F.3d 544 (7th Cir. 2000); Sweet Dreams Unlimited, Inc. v. Dial-A-Mattress Int'l Ltd., 1 F.3d 639 (7th Cir. 1993); Lawrence v. Comprehensive Bus. Services Co., 833 F.2d 1159, 1162 (5th Cir. 1987); Mesa Operating Ltd. P'ship v. Louisiana Intrastate Gas Corp., 797 F.2d 238, 243-244 (5th Cir. 1986).

This is part and parcel a result of the impact of the 'savings clause' contained in Section 2 of the Act, to the effect that an arbitration agreement is fully enforceable unless it can be revoked on grounds generally applicable to any contract. Thus, 'generally applicable contract defenses, such as fraud, duress or unconscionability, may be applied to invalidate arbitration agreements without contravening ' 2.' Doctor's Assoc., Inc. v. Casarotto , 517 U.S. 681, 687 (1996). The key to the 'savings clause' is that it is aimed at the arbitration agreement, not the agreement of which it is a part. Thus, it is not enough to allege that the agreement was induced by fraud, or is illegal; the fraud or illegality must taint the arbitration clause itself. Depending on the federal circuit, even a claim that fraud or illegality tainted the arbitration clause may not stop a petition to compel from being granted.

In Prima Paint, the Supreme Court held that if a party challenging arbitration on fraud grounds cannot show that the arbitration clause itself was fraudulently induced, then the party must arbitrate. Id. at 406. The circuits have, by analogy, applied Prima Paint to situations in which legality of the contract is raised as an issue. In those cases, courts have held that to avoid arbitration the challenging party must show that the arbitration clause is itself illegal or that there in effect was no agreement to arbitrate.

Harter involved a challenge to an arbitration clause based on an alleged claim that a 'hedge-to-arrive' contract for the sale of grain was 'illegal.' The court held: 'Courts will not allow a party to unravel a contractual arbitration clause by arguing that the clause was part of a contract that is voidable. ' The party must show that the arbitration clause itself, which is to say the parties' agreement to arbitrate any disputes over the contract that might arise, is vitiated by fraud, or lack of consideration or assent ” Harter, 220 F.2d at 550 (emphasis in original) (quotations omitted).

To the same effect was Sweet Dreams.

In Lawrence, 833 F.2d at 1162, plaintiffs challenged the enforceability of an arbitration clause on the grounds that the franchise contract in dispute violated the Texas accountancy law and was therefore unenforceable in all respects. Relying on Prima Paint, the court rejected that argument on the ground that in order to defeat an arbitration clause on a claim of illegality, the challenging party must show that the arbitration clause itself was illegal, not simply that the contract was illegal. Id. at 1161-1162. Once the court determines that there are no grounds in law or equity to defeat the arbitration clause itself, and that the parties, notwithstanding the 'illegality' of the underlying contract, agreed to arbitrate, the issue of the legality of the contract is to be decided by the arbitrator. Id. at 1162. Such a procedure makes sense given the fact that a determination of illegality (ie, whether a particular contract has violated any statute) is something an arbitrator is capable of determining like any other issue placed before him or her. Id. Indeed, parties are precluded from arguing that arbitration of an allegedly 'illegal' contract would effectuate the illegality because 'the legality of the contract has not yet been decided.' Id.

The franchisees in Lawrence also argued that the applicable Texas statute invalidated the contract as a whole and rendered the arbitration clause unenforceable. The court rejected this argument on the basis of Mesa Operating, 797 F.2d at 244, which involved a broad reading of Prima Paint. There, it was claimed, that the contract containing the arbitration clause was void ab initio because it had not been approved by certain state officials or had not followed public bidding procedures. The court, relying on Prima Paint, rejected such argument on the basis that there was no claim 'that the agreement to arbitrate is invalid separately from the entire contract.' Id.

Challenges to Existence or Making of Agreement

Most circuits have adopted the view that challenges to the existence of the agreement itself must be decided by the court, not the arbitrator. See, e.g., Large v. Conseco Finance Servicing Corp., 292 F.3d 49, 53-54 (1st Cir. 2002); Sandvik AB v. Advent Int'l Corp.' 220 F.3d 99, 100-01 (3rd Cir. 2000). The Ninth Circuit in Three Valleys Mun. Water Dist. v. E. F. Hutton & Co., Inc., 925 F.2d 1136, 1140 (9th Cir. 1991) adopted a similar view that challenges to the making or existence of the underlying contract containing an arbitration clause must be submitted to the court, rather than the arbitrator. This follows from the basic principle that an arbitrator's jurisdiction to decide issues is dependent on the existence of an agreement to submit disputes to arbitration. If there is no such agreement in the first place, then the dispute cannot go to arbitration. '[A] party who contests the making of a contract containing an arbitration provision cannot be compelled to arbitrate the threshold issue of the existence of an agreement to arbitrate.' Id. at 1140-41.

In Three Valleys, the matter was remanded for the district court to decide whether the signatory had authority to bind the other plaintiffs to the agreement, including the arbitration clause. Id. at 1144. The court noted, however, that where the challenge seeks to avoid or rescind the contract, the arbitrator, not the court, must decide the issue. 'If the dispute is within the scope of an arbitration agreement, an arbitrator may properly decide whether a contract is 'voidable' because the parties have agreed to arbitrate the dispute.' Id. at 1140.

Even if the claimed illegality rendered the contract void, that may not automatically equate to a challenge to the existence or making of the contract. The parties still intended to enter into a contract, although illegal by virtue of a statute or policy of which neither party was aware. On the other hand, it is generally held that contracts against public policy are unenforceable and of no effect, and courts will refuse to enforce them. Restatement (Second) of Contracts ' 178.

With respect to failure to comply with licensing or registration laws, enforcement is usually not allowed when the purpose of the statute is regulatory to prevent fraud for example. Id. at ' 181. By enforcing an arbitration clause, a court is certainly enforcing part of an illegal contract, although an arguably severable part. When parts of a contract are illegal, courts may sever those parts out in order to save the rest. Id. at ” 183, 184. Prima Paint as interpreted in Mesa Operating would seem to support the proposition that the arbitrator decide the issue of the claimed illegality, even if it would render the contract void, in the absence of any challenge to the making or existence of the contract in the first place.

In Burden v. Check Into Cash of Kentucky, LLC, 267 F.3d 483, 489-90 (6th Cir. 2001), the court noted the split in the circuits on the issue of illegal and void contracts, including Lawrence, but found that even though it was claimed that the underlying contract was 'void' under the relevant statute, the matter would be submitted to arbitration because the challenge was to 'the substance, rather than the existence, of the [underlying] agreements.' Id. at 490.

'Thus, the illustrations chosen by Three Valleys cast doubt on the position that challenges to the very existence of a contract, for purposes of distinguishing Prima Paint, include challenges from parties who intended to enter into a contract, but then subsequently discovered that the terms of the contract may violate state law. That is, the Three Valleys line of cases requires more than an allegation of statutory violation; the substance of the allegation must concern some 'misrepresentation as to the character or essential terms of a proposed contract.'  (citations omitted) Id. at 490.

There are still some state cases, like Green v. Mt. Diablo Hosp. Dist., 254 Cal.Rptr. 689, 207 Cal.App.3d 63 (1989) that must be reckoned with. Green on its face contains sweeping language that an arbitration clause contained in an unlawful contract is unenforceable. On close examination, however, Green involved a contract for payments to be made in violation of the state constitution, which made the contract void and unenforceable. Green did not discuss the FAA, which was probably inapplicable to a contract involving intrastate commerce at best. To the extent that the FAA is applicable, the case may have come out differently depending on how far the court wants to take Prima Paint.

Since questions of arbitrability under the FAA are to be determined by federal law [Three Valleys, 925 F.2d at 1138; Moses H. Cone Mem'l Hosp. v. Mercury Constr. Corp. 460 U.S. 1, 24 (1983)], a court applying the FAA will hold that the question of illegality should be decided by the arbitrator since the illegality was substantive.

Left for another day is the question of whether a challenge of illegality to an arbitration clause in a franchise agreement is a ground that exists at law or equity for the revocation of any contract. See, e.g., Southland Corp. v. Keating , 465 U.S. 1, 16, n. 11 (1984); Lawrence, 833 F.2d at 1162.

In the end, the decision of who decides the question of illegality, the court or the arbitrator, might simply come down to whether the parties intended to have the arbitrator decide such issues. See, Howsam v. Dean Witter Reynolds, Inc., 537 U.S. 79, 154 L.Ed.2d 491 (2002).

Charles G. Miller is a member of the San Francisco firm of Bartko, Zankel, Tarrant & Miller. Mr. Miller is a member of the Editorial Board of this newsletter.