Court Watch

Ninth Circuit Opinion Might Shift Many Unconscionability Claims to Arbitrator

In Nagrampa v. Mailcoups, Inc., 40 F.3d 1024 (9th Cir. 2005), Bus. Fran. Guide (CCH) '13,034 (March 21, 2005), the Ninth Circuit decided a case of first impression involving a franchise agreement with a standard arbitration clause: whether the arbitrator or the court decides the question of unconscionability. The answer depends on the nature of the challenge. The arbitration clause in Nagrampa was contained on the 25th page of a 30-page franchise agreement and covered all disputes, although there was a carve-out for intellectual property injunctive relief actions brought by the franchisor.

The agreement also contained a forum selection clause choosing Boston as the venue. Nonetheless, Mailcoups initiated an arbitration in California, which arbitration was thereafter moved, at the franchisee's request, to Boston. After almost a year of arbitrating in Los Angeles and Boston, the franchisee decided she had enough and sued Mailcoups in California, along with the American Arbitration Association (“AAA”), claiming that the franchise agreement was induced by fraud. Mailcoups moved to compel arbitration or dismiss. The franchisee opposed the motion on the basis that the arbitration clause was unconscionable. The district court ruled in favor of the franchisor, and dismissed the case rather than compel arbitration due to the Boston venue clause (see, 9 U.S.C. '4).

The court of appeals relied on the seminal case of Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967) (dealing with fraud in the inducement) to hold that where the unconscionability challenge is made to the agreement as a whole, it must be decided by the arbitrator and if made to the arbitration clause itself, it must be decided by the court. The rationale of Prima Paint and its progeny is that under the Federal Arbitration Act (“FAA”), 9 U.S.C. '4 et seq., a court can only decide whether there is an enforceable agreement to arbitrate. If there is no challenge to the agreement to arbitrate, then the parties are deemed to have agreed to arbitrate all disputes, including claims of fraud in the inducement or even unconscionability (which includes adhesion claims). In the case at hand, the Ninth Circuit split the baby. Because Nagrampa claimed that the contract as a whole was adhesive, the court held that such a claim must be decided by the arbitrator. However, it did decide whether the arbitration agreement was procedurally unconscionable, rejecting the franchisee's claims that she should have been advised of an arbitration clause located toward the end of a lengthy agreement that nonetheless she should have read.

A petition for rehearing has been filed and responded to, and is pending as of May 13, 2005. The petition argues that the opinion ignored, and was inconsistent with, prior decisions, including Ticknor v. Choice Hotels Int'l, Inc., 265 F.3d 931 (9th Cir. 2002) and Ting v. AT&T, 319 F.3d 1126 (9th Cir. 2002). However, in neither of those cases, or the others cited, did the court specifically address the issue of “who” decides the unconscionability issue.

The Nagrampa case will affect many unconscionability challenges and relegate them to the arbitrators. Nagrampa will undoubtedly lead to a shift in strategy from those challenging arbitration clauses to focus their attack on the arbitration clause itself, and it can be expected that claims will be made that the arbitration clause itself is adhesive in some way separate and apart from the agreement as a whole. This may be difficult to do when the arbitration clause is part of the franchise agreement, as opposed to a stand-alone clause found in many employment and consumer agreements that have been struck down as unconscionable.

Court Upholds Arbitrators' Disregard of Damages Limitation Clause in Contract

Many franchise agreements contain clauses that attempt to limit damages or other remedies in the event of disputes between a franchisor and its franchisees. In Jacada (Europe), Ltd. v. International Marketing Strategies, Inc., 401 F.3d 701 (March 18, 2005), a divided panel of the U.S. Court of Appeals, Sixth Circuit, affirmed a decision by the U.S. District Court, Western District of Michigan, upholding an arbitration award that significantly exceeded the amount specified by such a clause in a Distribution Agreement between a British software development company and a marketing firm located in Michigan.

A dispute arose over the sale of the developer's software to a customer to which both parties had been seeking to sell. The distributor claimed it was due a commission of several million dollars on the sale, but the developer claimed no commission was due. A damages limitation clause in the Distribution Agreement capped the distributor's damages in any dispute with the developer to amounts it had actually paid to the developer. In this case, that amounted to a liability ceiling of $126,000. Under the contract, disputes were to be submitted to arbitration in Michigan under the commercial arbitration rules of the AAA. The contract contained a Michigan choice of law clause.

After a 5-day hearing, an arbitration panel awarded the distributor a one-time payment of $401,299 and also one-half of the developer's nine remaining payments of '208,333 each. The panel found that the damages limitation provision was unconscionable and would not be enforced. The arbitrators noted that to do otherwise would “exclude damages for a large breach of the agreement while permitting damages for a small breach of contract.” The arbitrators stated that if the limited liability provision were allowed to stand, it would leave the distributor without an effective remedy for the wrong it suffered and, thus, would render its rights under the agreement meaningless.

The court noted that while a court review of the arbitration award would be more extensive under Michigan law than under the standards of the AAA, it found that the “generic” choice of law provision in the Distribution Agreement would not override the AAA's limited standards for vacating an arbitration award in the absence of a more specific expression of the parties' desire to apply Michigan's arbitration law. The court then discussed the Michigan standards for finding unconscionability and concluded the arbitrators did not disregard clearly established legal precedent in finding the damages limitation clause unconscionable. In fact, under Nagrampa v. Mailcoups, Inc., 401 F.3d 1024 (9th Cir. 2005), also discussed in this Court Watch column, the arbitrators should decide issues involving unconscionability, unless the challenge is made to whether the parties ever agreed to the limitations clause.

The dissent agreed that an arbitrator could refuse to apply an unconscionable damages limitation clause, but disputed whether there was unconscionability in this case. The dissent noted that this agreement was made between business entities, for which the standards for procedural unconscionability ' inequality of bargaining power ' are more strict.

As in most cases involving issues of unconscionability, it can be argued that procedural unconscionability and substantive unconscionability ' the harshness of the complained-of terms ' lie in the eye of the beholder. Issues of fairness may have also been involved. In Jacada, enforcing the damages limitation clause may have provided the software developer with a windfall at the expense of its distributor, by depriving the distributor of its multimillion-dollar commission on the disputed sale. Neither the arbitrators, the district court, nor the appellate court apparently wanted to see this happen. Although courts normally insist on arbitrators not exceeding the authority granted to them in the governing contract, this may be why the courts considering this case chose to uphold the arbitrators' overturning of the clearly stated provision of the agreement limiting damages.

Franchisors should be cautious when seeking to limit their liability and the remedies of their franchisees since, as here, an arbitrator or court could find the provisions unconscionable and refuse to enforce them. Depending on the jurisdiction, it may not be very difficult to find a particular franchise agreement procedurally unconscionable because it could be found to be an adhesion contract, notwithstanding the fact that the franchisee is not at all forced to sign or in desperate need of the franchise. Therefore, the substance of provisions in franchise agreements limiting a franchisor's liability, or restricting a franchisee's remedies, must be considered carefully when seeking to craft enforceable contracts.

Quizno's Case Brings Several Issues to Light

In a lawsuit brought by several franchisees against Quizno's and related parties (collectively, “Quizno's”), the U.S. District Court for the District of Colorado considered many issues that typically arise in franchise litigation. In most respects, the court's conclusions were based on the principle that the unambiguous terms of a franchise agreement should be enforced. See C.K.H., L.L.C. v. The Quizno's Master, L.L.C., et al. Bus. Fran. Guide (CCH) '13,025 (D.CO. March 25, 2005).

Plaintiffs entered into, and/or guaranteed, franchise agreements to operate Quizno's restaurants in the Phoenix area. The gist of plaintiffs' claims were that Quizno's: 1) permitted other franchises to open “too close” to their restaurants despite having orally promised otherwise; 2) had not obtained the best possible pricing for goods and equipment from vendors and had not passed on volume discounts to the franchisees; and 3) had misused advertising funds. The plaintiffs asserted a variety of claims, including breach of contract, fraud, breach of fiduciary duty, and tortious interference with prospective economic advantage.

Quizno's attacked plaintiffs' claims by filing a comprehensive motion to dismiss, a motion for summary judgment as to the claims of one group of franchisee plaintiffs, and a motion to sever the claims of the various plaintiffs.

The court granted Quizno's motion to dismiss the encroachment claim, noting that the franchise agreements provided that: “the franchise granted herein is nonexclusive and … Franchisor retains the right, among others: (1) to use, and to license others to use, the Marks and Licensed Methods for the operation of Restaurants at any location other than the Franchised Location.” The court quickly disposed of plaintiffs' breach of contract claim arising out of the same clause. The court similarly disposed of the breach of the duty of good faith and fair dealing claim on the ground that a party cannot attempt to modify, vary, or contradict the express terms of a contract by using such a claim and concluded that the purported oral promises regarding the “proximity” did not amount to a modification of the franchise agreements. Under Colorado law, “later oral agreements are effective only if they are not inconsistent with the contract and are made for a separate consideration or are otherwise such as might be naturally made by separate agreement.” C.K.H., L.L.C., supra, at p. 39,008 [citations omitted].

As to the breach of contract claims, the court found that these claims contradicted the express provisions in the franchise agreements and, therefore, were barred by virtue of the franchise agreement's integration clause. The court dismissed plaintiffs' breach of contract claim against Quizno's for failure to pass on discounts (based in large part on statements in the UFOC which the court assumed, but did not decide, would be deemed part of the contract) on the ground that the contract specifically allowed Quizno's to use these discounts as it saw fit. The court allowed the misuse of advertising funds claim to proceed since it was based on contractual promises relating to how the funds would be used.

The plaintiffs also asserted causes of action for negligent and intentional misrepresentation. The court dismissed that part of the claim based on Quizno's failure to disclose the receipt of rebates from suppliers, saying that plaintiffs were essentially attempting to impermissively state a private cause of action under FTC Franchise Rule. The court found that the integration and “no fraud” provisions in the franchise agreements precluded plaintiffs' other fraud claims.

The court dismissed plaintiffs' breach of fiduciary duty claim stating that: 1) the franchise agreement expressly disclaimed such a relationship; 2) Colorado courts have generally refused to impose such a duty in the franchisee context; and 3) plaintiffs failed to allege facts sufficient to show the type of “close, confidential” relationship that would have “induced [them] to relax the care and diligence [they] would ordinarily exercise in dealing with a stranger.”

Finally, the court dismissed plaintiffs' claim of tortious interference with economic advantage on the ground that a party cannot assert such a claim when the defendant has an absolute legal right ' in this case a contractual right ' to engage in the activity that is asserted to be the interference.

The court also granted summary judgment as to all of the claims asserted by one group of plaintiffs on the ground that they had signed a valid and enforceable release. In an effort to circumvent the terms of the release, plaintiffs claimed both economic duress and fraud. As to the economic duress claim, the court noted that since the franchise agreement specifically required a franchisee to execute a release prior to any transfer of its interest in the franchise, there could be no economic duress because the franchisor was legally entitled to refuse to permit the transfer if no release was signed. With respect to the fraud claim, the court found that plaintiffs had neither alleged nor proffered any evidence to show that the release was procured by fraud.

Finally, Quizno's sought to sever the various plaintiffs' claims on the grounds that the franchise agreement specifically provided that “any proceeding will be conducted on an individual, not a class-wide basis, and that a proceeding … may not be consolidated” with another proceeding involving the franchisor and a franchisee. The court denied the motion, agreeing with the franchisees that this provision did not preclude the joinder of claims in a single proceeding, but only precluded joinder of separate cases or proceedings. The court also denied Quizno's motion to sever what was left of the case ' the misappropriation claims ' on the ground that they arose out of the same transactional nexus.

Lessons to be learned: 1) Careful drafting precluded encroachment, fraud, breach of contract, and good faith claims; 2) Care should be given in structuring no-class action and anti-consolidation clauses to ensure that the intended purpose is clear.

Ninth Circuit Opinion Might Shift Many Unconscionability Claims to Arbitrator

In Nagrampa v. Mailcoups, Inc., 40 F.3d 1024 (9th Cir. 2005), Bus. Fran. Guide (CCH) '13,034 (March 21, 2005), the Ninth Circuit decided a case of first impression involving a franchise agreement with a standard arbitration clause: whether the arbitrator or the court decides the question of unconscionability. The answer depends on the nature of the challenge. The arbitration clause in Nagrampa was contained on the 25th page of a 30-page franchise agreement and covered all disputes, although there was a carve-out for intellectual property injunctive relief actions brought by the franchisor.

The agreement also contained a forum selection clause choosing Boston as the venue. Nonetheless, Mailcoups initiated an arbitration in California, which arbitration was thereafter moved, at the franchisee's request, to Boston. After almost a year of arbitrating in Los Angeles and Boston, the franchisee decided she had enough and sued Mailcoups in California, along with the American Arbitration Association (“AAA”), claiming that the franchise agreement was induced by fraud. Mailcoups moved to compel arbitration or dismiss. The franchisee opposed the motion on the basis that the arbitration clause was unconscionable. The district court ruled in favor of the franchisor, and dismissed the case rather than compel arbitration due to the Boston venue clause (see, 9 U.S.C. '4).

The court of appeals relied on the seminal case of Prima Paint Corp. v. Flood & Conklin Mfg. Co. , 388 U.S. 395 (1967) (dealing with fraud in the inducement) to hold that where the unconscionability challenge is made to the agreement as a whole, it must be decided by the arbitrator and if made to the arbitration clause itself, it must be decided by the court. The rationale of Prima Paint and its progeny is that under the Federal Arbitration Act (“FAA”), 9 U.S.C. '4 et seq., a court can only decide whether there is an enforceable agreement to arbitrate. If there is no challenge to the agreement to arbitrate, then the parties are deemed to have agreed to arbitrate all disputes, including claims of fraud in the inducement or even unconscionability (which includes adhesion claims). In the case at hand, the Ninth Circuit split the baby. Because Nagrampa claimed that the contract as a whole was adhesive, the court held that such a claim must be decided by the arbitrator. However, it did decide whether the arbitration agreement was procedurally unconscionable, rejecting the franchisee's claims that she should have been advised of an arbitration clause located toward the end of a lengthy agreement that nonetheless she should have read.

A petition for rehearing has been filed and responded to, and is pending as of May 13, 2005. The petition argues that the opinion ignored, and was inconsistent with, prior decisions, including Ticknor v. Choice Hotels Int'l, Inc., 265 F.3d 931 (9th Cir. 2002) and Ting v. AT&T, 319 F.3d 1126 (9th Cir. 2002). However, in neither of those cases, or the others cited, did the court specifically address the issue of “who” decides the unconscionability issue.

The Nagrampa case will affect many unconscionability challenges and relegate them to the arbitrators. Nagrampa will undoubtedly lead to a shift in strategy from those challenging arbitration clauses to focus their attack on the arbitration clause itself, and it can be expected that claims will be made that the arbitration clause itself is adhesive in some way separate and apart from the agreement as a whole. This may be difficult to do when the arbitration clause is part of the franchise agreement, as opposed to a stand-alone clause found in many employment and consumer agreements that have been struck down as unconscionable.

Court Upholds Arbitrators' Disregard of Damages Limitation Clause in Contract

Many franchise agreements contain clauses that attempt to limit damages or other remedies in the event of disputes between a franchisor and its franchisees. In Jacada (Europe), Ltd. v. International Marketing Strategies, Inc., 401 F.3d 701 (March 18, 2005), a divided panel of the U.S. Court of Appeals, Sixth Circuit, affirmed a decision by the U.S. District Court, Western District of Michigan, upholding an arbitration award that significantly exceeded the amount specified by such a clause in a Distribution Agreement between a British software development company and a marketing firm located in Michigan.

A dispute arose over the sale of the developer's software to a customer to which both parties had been seeking to sell. The distributor claimed it was due a commission of several million dollars on the sale, but the developer claimed no commission was due. A damages limitation clause in the Distribution Agreement capped the distributor's damages in any dispute with the developer to amounts it had actually paid to the developer. In this case, that amounted to a liability ceiling of $126,000. Under the contract, disputes were to be submitted to arbitration in Michigan under the commercial arbitration rules of the AAA. The contract contained a Michigan choice of law clause.

After a 5-day hearing, an arbitration panel awarded the distributor a one-time payment of $401,299 and also one-half of the developer's nine remaining payments of '208,333 each. The panel found that the damages limitation provision was unconscionable and would not be enforced. The arbitrators noted that to do otherwise would “exclude damages for a large breach of the agreement while permitting damages for a small breach of contract.” The arbitrators stated that if the limited liability provision were allowed to stand, it would leave the distributor without an effective remedy for the wrong it suffered and, thus, would render its rights under the agreement meaningless.

The court noted that while a court review of the arbitration award would be more extensive under Michigan law than under the standards of the AAA, it found that the “generic” choice of law provision in the Distribution Agreement would not override the AAA's limited standards for vacating an arbitration award in the absence of a more specific expression of the parties' desire to apply Michigan's arbitration law. The court then discussed the Michigan standards for finding unconscionability and concluded the arbitrators did not disregard clearly established legal precedent in finding the damages limitation clause unconscionable. In fact, under Nagrampa v. Mailcoups, Inc., 401 F.3d 1024 (9th Cir. 2005), also discussed in this Court Watch column, the arbitrators should decide issues involving unconscionability, unless the challenge is made to whether the parties ever agreed to the limitations clause.

The dissent agreed that an arbitrator could refuse to apply an unconscionable damages limitation clause, but disputed whether there was unconscionability in this case. The dissent noted that this agreement was made between business entities, for which the standards for procedural unconscionability ' inequality of bargaining power ' are more strict.

As in most cases involving issues of unconscionability, it can be argued that procedural unconscionability and substantive unconscionability ' the harshness of the complained-of terms ' lie in the eye of the beholder. Issues of fairness may have also been involved. In Jacada, enforcing the damages limitation clause may have provided the software developer with a windfall at the expense of its distributor, by depriving the distributor of its multimillion-dollar commission on the disputed sale. Neither the arbitrators, the district court, nor the appellate court apparently wanted to see this happen. Although courts normally insist on arbitrators not exceeding the authority granted to them in the governing contract, this may be why the courts considering this case chose to uphold the arbitrators' overturning of the clearly stated provision of the agreement limiting damages.

Franchisors should be cautious when seeking to limit their liability and the remedies of their franchisees since, as here, an arbitrator or court could find the provisions unconscionable and refuse to enforce them. Depending on the jurisdiction, it may not be very difficult to find a particular franchise agreement procedurally unconscionable because it could be found to be an adhesion contract, notwithstanding the fact that the franchisee is not at all forced to sign or in desperate need of the franchise. Therefore, the substance of provisions in franchise agreements limiting a franchisor's liability, or restricting a franchisee's remedies, must be considered carefully when seeking to craft enforceable contracts.

Quizno's Case Brings Several Issues to Light

In a lawsuit brought by several franchisees against Quizno's and related parties (collectively, “Quizno's”), the U.S. District Court for the District of Colorado considered many issues that typically arise in franchise litigation. In most respects, the court's conclusions were based on the principle that the unambiguous terms of a franchise agreement should be enforced. See C.K.H., L.L.C. v. The Quizno's Master, L.L.C., et al. Bus. Fran. Guide (CCH) '13,025 (D.CO. March 25, 2005).

Plaintiffs entered into, and/or guaranteed, franchise agreements to operate Quizno's restaurants in the Phoenix area. The gist of plaintiffs' claims were that Quizno's: 1) permitted other franchises to open “too close” to their restaurants despite having orally promised otherwise; 2) had not obtained the best possible pricing for goods and equipment from vendors and had not passed on volume discounts to the franchisees; and 3) had misused advertising funds. The plaintiffs asserted a variety of claims, including breach of contract, fraud, breach of fiduciary duty, and tortious interference with prospective economic advantage.

Quizno's attacked plaintiffs' claims by filing a comprehensive motion to dismiss, a motion for summary judgment as to the claims of one group of franchisee plaintiffs, and a motion to sever the claims of the various plaintiffs.

The court granted Quizno's motion to dismiss the encroachment claim, noting that the franchise agreements provided that: “the franchise granted herein is nonexclusive and … Franchisor retains the right, among others: (1) to use, and to license others to use, the Marks and Licensed Methods for the operation of Restaurants at any location other than the Franchised Location.” The court quickly disposed of plaintiffs' breach of contract claim arising out of the same clause. The court similarly disposed of the breach of the duty of good faith and fair dealing claim on the ground that a party cannot attempt to modify, vary, or contradict the express terms of a contract by using such a claim and concluded that the purported oral promises regarding the “proximity” did not amount to a modification of the franchise agreements. Under Colorado law, “later oral agreements are effective only if they are not inconsistent with the contract and are made for a separate consideration or are otherwise such as might be naturally made by separate agreement.” C.K.H., L.L.C., supra, at p. 39,008 [citations omitted].

As to the breach of contract claims, the court found that these claims contradicted the express provisions in the franchise agreements and, therefore, were barred by virtue of the franchise agreement's integration clause. The court dismissed plaintiffs' breach of contract claim against Quizno's for failure to pass on discounts (based in large part on statements in the UFOC which the court assumed, but did not decide, would be deemed part of the contract) on the ground that the contract specifically allowed Quizno's to use these discounts as it saw fit. The court allowed the misuse of advertising funds claim to proceed since it was based on contractual promises relating to how the funds would be used.

The plaintiffs also asserted causes of action for negligent and intentional misrepresentation. The court dismissed that part of the claim based on Quizno's failure to disclose the receipt of rebates from suppliers, saying that plaintiffs were essentially attempting to impermissively state a private cause of action under FTC Franchise Rule. The court found that the integration and “no fraud” provisions in the franchise agreements precluded plaintiffs' other fraud claims.

The court dismissed plaintiffs' breach of fiduciary duty claim stating that: 1) the franchise agreement expressly disclaimed such a relationship; 2) Colorado courts have generally refused to impose such a duty in the franchisee context; and 3) plaintiffs failed to allege facts sufficient to show the type of “close, confidential” relationship that would have “induced [them] to relax the care and diligence [they] would ordinarily exercise in dealing with a stranger.”

Finally, the court dismissed plaintiffs' claim of tortious interference with economic advantage on the ground that a party cannot assert such a claim when the defendant has an absolute legal right ' in this case a contractual right ' to engage in the activity that is asserted to be the interference.

The court also granted summary judgment as to all of the claims asserted by one group of plaintiffs on the ground that they had signed a valid and enforceable release. In an effort to circumvent the terms of the release, plaintiffs claimed both economic duress and fraud. As to the economic duress claim, the court noted that since the franchise agreement specifically required a franchisee to execute a release prior to any transfer of its interest in the franchise, there could be no economic duress because the franchisor was legally entitled to refuse to permit the transfer if no release was signed. With respect to the fraud claim, the court found that plaintiffs had neither alleged nor proffered any evidence to show that the release was procured by fraud.

Finally, Quizno's sought to sever the various plaintiffs' claims on the grounds that the franchise agreement specifically provided that “any proceeding will be conducted on an individual, not a class-wide basis, and that a proceeding … may not be consolidated” with another proceeding involving the franchisor and a franchisee. The court denied the motion, agreeing with the franchisees that this provision did not preclude the joinder of claims in a single proceeding, but only precluded joinder of separate cases or proceedings. The court also denied Quizno's motion to sever what was left of the case ' the misappropriation claims ' on the ground that they arose out of the same transactional nexus.

Lessons to be learned: 1) Careful drafting precluded encroachment, fraud, breach of contract, and good faith claims; 2) Care should be given in structuring no-class action and anti-consolidation clauses to ensure that the intended purpose is clear.