Court Watch

Laxmi Redux

The second California state court case involved California Business and Professions Code '20040.5, a section of the California Franchise Relations Act (“CFRA”), which provides that a provision in a Franchise Agreement restricting venue to a forum outside of California in a dispute involving a California franchise is void.

For many years, the administrative rules promulgated by the California Commissioner of Corporations required franchisors whose Franchise Agreements contained an arbitration provision to state in their Franchise Offering Circular that the arbitration clause “may not be enforceable under California law.” Attorneys who draft franchise agreements were taken aback in 1999 when the United States Court of Appeals for the Ninth Circuit handed down Laxmi Investments, LLC v. Golf USA, 193 F.3d 1095 (9th Cir., 1999), declaring that the language required by the Department of Corporations prevents a “meeting of the minds” concerning arbitration venue ' despite what the Franchise Agreement may say, and despite the argument that the Federal Arbitration Act, 9 U.S.C. '1 et seq (“the FAA”), favors the enforcement of arbitration provisions as written. Since there was no meeting of the minds, the court held that there was no agreement regarding arbitration venue, and there was no agreement to which the FAA should be applied. The Laxmi court indicated that perhaps the result could have been obviated if, despite the state-mandated language, the franchisor made clear that it would insist on the out-of-state forum.

Taking note of the Laxmi court's admonition concerning qualifying language, many attorneys began adding to their California Franchise Offering Circulars language to the effect that the franchisor considered the arbitration provision valid as written and would seek to enforce its out-of-California venue clause despite the state-mandated language. Some California state franchise examiners permitted this additional language, but some did not. In an effort make California registration review uniform, the word came from on high in the California Department of Corporations that the regulation would have to be quoted without change or additional language, concretizing the Laxmi result by administrative fiat.

After the Laxmi decision, Bradley v. Harris Research, Inc., 275 F.3d 884 (9th Cir., 2001) addressed the FAA issue head on and made clear that the California Franchise Relations Act provision was, indeed, preempted by the FAA. However, while the Bradley court acknowledged Laxmi, it said that since a “meeting of the minds” argument had not been made below and the concerned UFOC was not in the record, it would not decide the matter based on Laxmi. The California Code of Regulations was subsequently amended to remove the enforceability language, advising prospective franchisees, instead, to consult their attorneys about applicable state and federal law dealing with arbitration.

The holding in Laxmi was revisited on Aug. 19, 2008, when the California Court of Appeal for the Fifth Appellate District filed its opinion in Winter v. Window Fashions Professionals, Inc. et. al 2008 WL 3845229 (Cal.App. 5th Dist.). The Franchise Agreement in Winter was apparently entered into during the time California franchise regulations required that franchisors put in their offering circulars that arbitration clauses in Franchise Agreements “may not be enforceable under California law.” The regulations also required, as they do now, that if the law of a state other than California is specified for the interpretation of the Franchise Agreement, the circular must state that the selection of such law may not be enforceable under California law. The plaintiff filed a lawsuit in California alleging, among other things, a violation of the California Franchise Investment Law. The defendant sought to enforce the Franchise Agreement's arbitration provision, which required arbitration in Texas. Citing Laxmi, the California Court of Appeal held that the “may not be enforceable” language in the Franchise Offering Circular resulted in the absence of mutual agreement, not only to the venue provision, but to the entire arbitration provision.

The defendant also apparently argued that the issue of venue should be decided under Texas law, the choice of law specified in the Franchise Agreement. The California court held that since there was language in the California circular, as required by the Corporation Commissioner's regulations, that a choice of foreign law may not be enforceable under California law, there was no meeting of the minds on that issue as well, and California law could be applied. In response to the argument that Bradley v. Harris Research nullified the California-venue statute, the court held that because Bradley did not address the meeting of the minds issue of Laxmi, which the court found applicable to the Winter facts, Bradley was not applicable.

Winter, a state court decision, confirms the continuing availability of the federal appellate court's analysis in Laxmi when dealing with a California Franchise Offering Circular containing the “may not be enforceable under California law” language. It also stands for the proposition that an entire arbitration clause can be voided as a result of that language, rather than just the venue selection issue raised in Laxmi. Also, it is important because it throws into doubt the enforceability of choice-of-law clauses in current franchise offerings because the Department still requires the “may not be enforceable under California law” language if there is a non-California choice of law provision.

Leading Case on Insurance Agents As Franchisees Reversed

A case of great interest to the franchising community a few years ago was Charts, et. al v. Nationwide Mutual Insurance Co., 397 F. Supp 2d 357 (USDC D.Conn. 2005), in which a jury found that the agency agreement between an insurance agent and an insurance company constituted a franchise. As a result, the insurance company was found to have violated the Connecticut Franchise Act by terminating the broker without “good cause,” and several million dollars were awarded to the agent in damages and attorneys' fees. Since Connecticut is home to many leading insurance companies, the decision was significant to those in the industry. The jury found in Charts that the agent was granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by the insurance company, and the operation of the agent's business was substantially associated with the franchisor's name and marks ' the factors that are considered in determining whether a relationship in Connecticut constitutes a franchise. There is no “franchise fee” element under the Connecticut Franchise Act, which has often used to remove such an agency relationship from the application of most franchise laws.

One issue that was raised in the long history of the Charts story was whether the claim for improper termination belonged to Charts or to his bankruptcy estate. Charts had formed, but not filed, a new corporation prior to his bankruptcy petition. The certificate of organization of the new entity was filed the month after the bankruptcy filing, and Charts did not list the new entity as part of his bankruptcy estate. The new entity basically took over the accounts and operation of the bankrupt business and signed a new agency agreement with the insurance company several months after its papers were filed with the state. The new agency agreement was made retroactive to 1980 when Charts first began selling Nationwide policies. A month before Charts's discharge in bankruptcy, his agency agreement was terminated by Nationwide, giving rise to the earlier action.

In Chartschlaa, et. al v. Nationwide Mutual Insurance Company, et. al, 2008 WL 3480844 (2nd Cir, Aug. 14, 2008), the United States Court of Appeal for the Second Circuit again considered ' it had done so before ' whether the claims in the original lawsuit belonged to Charts or to the new entity. Without going in to detail about its procedural history, the crux of the instant matter was that Charts had not listed the new entity on his list of assets. Complicating the matter, the bankruptcy trustee had notified the bankruptcy court that the trustee planned to abandon Charts's claim against Nationwide and, later, that the trustee planned to sell the claim to Nationwide and requested the court to take no action on the abandonment issue. Neither the sale nor the abandonment was ever completed. While the procedural issues are probably of greater interest to
bankruptcy lawyers than to franchise lawyers, the net effect is that the court found that the claim should have belonged to the bankruptcy estate and not to Charts and, as such, Charts did not have standing to bring the matter in the first place. The judgment in the 2005 District Court case was reversed, with directions to the lower court to enter judgment for the insurance company. As a result, Charts can no longer be cited for the proposition that insurance agents may be franchisees.

Darryl A. Hart is an attorney with Bartko, Zankel, Tarrant & Miller in San Francisco. He can be contacted at 415- 956-1900 or at [email protected].

In two recent cases, California state courts considered issues that have been the subject of federal court opinions interpreting California law. In both cases, there was no clear guidance from California courts on the issues prior to the federal decisions. Under appropriate circumstances, federal courts will apply state law to a dispute. In order to determine what the applicable state law may be, federal courts look first to state court cases. In the absence of definitive state court cases on the issue, a federal court will make its own interpretation of what it considers the applicable state law to be.

Federal courts had engrafted a “partial restraint” exception to California Business & Professions Code '16600's prohibition against covenants not to compete. In Edwards v. Arthur Andersen, LLP , 44 Cal.4th 937, 81 Cal.Rptr.3d 282 (Aug. 7, 2008) the California Supreme Court made clear that there is no such exception under Section 16600. The court considered the validity of a covenant against competition that restrained a former employee of the defendant from working for or soliciting certain clients of the defendant for a limited period following the termination of his employment. California Business and Professions Code '16600 prohibits contracts restraining anyone from engaging in a lawful profession, trade, or business except in limited circumstances prescribed by statute, such as upon the sale of a business, corporation, or limited liability company, or the dissolution of a partnership. However, federal cases interpreting California law had decided that there was also a “narrow restraint” exception to Section 16600 allowing a limited restraint on competition as long as it did not completely prohibit someone from practicing their profession, trade, or business. See Comedy Club, Inc. et. al v. Improv West Associates, et. al, 502 F.3d 1100 (9th Cir., 2007) amended 514 F.3d 833, (9th Cir., Jan. 23, 2008), discussed in Franchising Business & Law Alert, Oct. 2007, pages 5-6.

The Edwards court pointed out that, despite the federal cases finding a narrow restraint exception to Section 16600, no California state court decision has endorsed the federal courts' reasoning. It then proceeded to hold that the strong public policy of California embodied in that section should not be diluted by judicial fiat, citing, interestingly, a federal case. The court stated that if the state legislature had intended that the concerned statute apply other than as written, it could have limited its reach as it did with the limited exceptions contained in the statutes. As such, the California Supreme Court made clear that in California there is no limited restraint exception to Business and Professions Code '16600. Despite the federal cases which preceded Edwards, the federal courts are now obligated to follow the Edwards ruling when interpreting a non-competition covenant under California law.

Laxmi Redux

The second California state court case involved California Business and Professions Code '20040.5, a section of the California Franchise Relations Act (“CFRA”), which provides that a provision in a Franchise Agreement restricting venue to a forum outside of California in a dispute involving a California franchise is void.

For many years, the administrative rules promulgated by the California Commissioner of Corporations required franchisors whose Franchise Agreements contained an arbitration provision to state in their Franchise Offering Circular that the arbitration clause “may not be enforceable under California law.” Attorneys who draft franchise agreements were taken aback in 1999 when the United States Court of Appeals for the Ninth Circuit handed down Laxmi Investments, LLC v. Golf USA , 193 F.3d 1095 (9th Cir., 1999), declaring that the language required by the Department of Corporations prevents a “meeting of the minds” concerning arbitration venue ' despite what the Franchise Agreement may say, and despite the argument that the Federal Arbitration Act, 9 U.S.C. '1 et seq (“the FAA”), favors the enforcement of arbitration provisions as written. Since there was no meeting of the minds, the court held that there was no agreement regarding arbitration venue, and there was no agreement to which the FAA should be applied. The Laxmi court indicated that perhaps the result could have been obviated if, despite the state-mandated language, the franchisor made clear that it would insist on the out-of-state forum.

Taking note of the Laxmi court's admonition concerning qualifying language, many attorneys began adding to their California Franchise Offering Circulars language to the effect that the franchisor considered the arbitration provision valid as written and would seek to enforce its out-of-California venue clause despite the state-mandated language. Some California state franchise examiners permitted this additional language, but some did not. In an effort make California registration review uniform, the word came from on high in the California Department of Corporations that the regulation would have to be quoted without change or additional language, concretizing the Laxmi result by administrative fiat.

After the Laxmi decision, Bradley v. Harris Research, Inc. , 275 F.3d 884 (9th Cir., 2001) addressed the FAA issue head on and made clear that the California Franchise Relations Act provision was, indeed, preempted by the FAA. However, while the Bradley court acknowledged Laxmi, it said that since a “meeting of the minds” argument had not been made below and the concerned UFOC was not in the record, it would not decide the matter based on Laxmi. The California Code of Regulations was subsequently amended to remove the enforceability language, advising prospective franchisees, instead, to consult their attorneys about applicable state and federal law dealing with arbitration.

The holding in Laxmi was revisited on Aug. 19, 2008, when the California Court of Appeal for the Fifth Appellate District filed its opinion in Winter v. Window Fashions Professionals, Inc. et. al 2008 WL 3845229 (Cal.App. 5th Dist.). The Franchise Agreement in Winter was apparently entered into during the time California franchise regulations required that franchisors put in their offering circulars that arbitration clauses in Franchise Agreements “may not be enforceable under California law.” The regulations also required, as they do now, that if the law of a state other than California is specified for the interpretation of the Franchise Agreement, the circular must state that the selection of such law may not be enforceable under California law. The plaintiff filed a lawsuit in California alleging, among other things, a violation of the California Franchise Investment Law. The defendant sought to enforce the Franchise Agreement's arbitration provision, which required arbitration in Texas. Citing Laxmi, the California Court of Appeal held that the “may not be enforceable” language in the Franchise Offering Circular resulted in the absence of mutual agreement, not only to the venue provision, but to the entire arbitration provision.

The defendant also apparently argued that the issue of venue should be decided under Texas law, the choice of law specified in the Franchise Agreement. The California court held that since there was language in the California circular, as required by the Corporation Commissioner's regulations, that a choice of foreign law may not be enforceable under California law, there was no meeting of the minds on that issue as well, and California law could be applied. In response to the argument that Bradley v. Harris Research nullified the California-venue statute, the court held that because Bradley did not address the meeting of the minds issue of Laxmi, which the court found applicable to the Winter facts, Bradley was not applicable.

Winter, a state court decision, confirms the continuing availability of the federal appellate court's analysis in Laxmi when dealing with a California Franchise Offering Circular containing the “may not be enforceable under California law” language. It also stands for the proposition that an entire arbitration clause can be voided as a result of that language, rather than just the venue selection issue raised in Laxmi. Also, it is important because it throws into doubt the enforceability of choice-of-law clauses in current franchise offerings because the Department still requires the “may not be enforceable under California law” language if there is a non-California choice of law provision.

Leading Case on Insurance Agents As Franchisees Reversed

A case of great interest to the franchising community a few years ago was Charts, et. al v. Nationwide Mutual Insurance Co., 397 F. Supp 2d 357 (USDC D.Conn. 2005), in which a jury found that the agency agreement between an insurance agent and an insurance company constituted a franchise. As a result, the insurance company was found to have violated the Connecticut Franchise Act by terminating the broker without “good cause,” and several million dollars were awarded to the agent in damages and attorneys' fees. Since Connecticut is home to many leading insurance companies, the decision was significant to those in the industry. The jury found in Charts that the agent was granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by the insurance company, and the operation of the agent's business was substantially associated with the franchisor's name and marks ' the factors that are considered in determining whether a relationship in Connecticut constitutes a franchise. There is no “franchise fee” element under the Connecticut Franchise Act, which has often used to remove such an agency relationship from the application of most franchise laws.

One issue that was raised in the long history of the Charts story was whether the claim for improper termination belonged to Charts or to his bankruptcy estate. Charts had formed, but not filed, a new corporation prior to his bankruptcy petition. The certificate of organization of the new entity was filed the month after the bankruptcy filing, and Charts did not list the new entity as part of his bankruptcy estate. The new entity basically took over the accounts and operation of the bankrupt business and signed a new agency agreement with the insurance company several months after its papers were filed with the state. The new agency agreement was made retroactive to 1980 when Charts first began selling Nationwide policies. A month before Charts's discharge in bankruptcy, his agency agreement was terminated by Nationwide, giving rise to the earlier action.

In Chartschlaa, et. al v. Nationwide Mutual Insurance Company, et. al, 2008 WL 3480844 (2nd Cir, Aug. 14, 2008), the United States Court of Appeal for the Second Circuit again considered ' it had done so before ' whether the claims in the original lawsuit belonged to Charts or to the new entity. Without going in to detail about its procedural history, the crux of the instant matter was that Charts had not listed the new entity on his list of assets. Complicating the matter, the bankruptcy trustee had notified the bankruptcy court that the trustee planned to abandon Charts's claim against Nationwide and, later, that the trustee planned to sell the claim to Nationwide and requested the court to take no action on the abandonment issue. Neither the sale nor the abandonment was ever completed. While the procedural issues are probably of greater interest to
bankruptcy lawyers than to franchise lawyers, the net effect is that the court found that the claim should have belonged to the bankruptcy estate and not to Charts and, as such, Charts did not have standing to bring the matter in the first place. The judgment in the 2005 District Court case was reversed, with directions to the lower court to enter judgment for the insurance company. As a result, Charts can no longer be cited for the proposition that insurance agents may be franchisees.

Darryl A. Hart is an attorney with Bartko, Zankel, Tarrant & Miller in San Francisco. He can be contacted at 415- 956-1900 or at [email protected].