Court Watch

CA District Court Confirms Unconscionability of Arbitration Provision

Franchisors have long been watching the California courts and their interpretation of arbitration provisions under California law. Since the Nagrampa v. MailCoups, Inc. decision in 2006, which found procedural and substantive unconscionability in a relatively standard franchise agreement arbitration provision, a real concern exists as to whether such arbitration provisions can be enforced in California.

The Northern District of California is the most recent court to weigh-in on the enforceability of arbitration provisions contained in franchise agreements under California law. In Bencharsky v. Cottman Transmission Systems, LLC, Bus. Franchise Guide, 14,045 (CCH) (D.C. Cal. 2008), the court determined that both procedural and substantive unconscionability existed in an arbitration provision, partly due to a lack of mutuality as to the availability of equitable relief for the franchisor and the franchisee.

In this case, the franchisor filed a demand for arbitration against one of its automotive repair franchisees, alleging unpaid franchise fees. The franchisor relied on a provision of the franchise agreement which stated that the parties should attempt to resolve all disputes in arbitration, but also reserved its right to obtain equitable relief in court. The franchisee then filed suit in court, alleging in part, breach of contract and violation of the California Franchise Investment Law (“CFIL”). The franchisor then moved to compel arbitration of the franchisee's claims.

Issue of Arbitrability. The court initially tackled the issue of whether an arbitrator, or the court itself, was the proper authority to determine whether the arbitration clause was enforceable. The court used the “crux of the complaint” test, meaning that when the “crux of the complaint” challenges only the arbitration provision and not the invalidity of the contract as a whole, it is up to the court to decide whether the arbitration provision is enforceable. In comparison, the issue of arbitrability is an issue for an arbitrator when the “crux of the complaint” is that the agreement as a whole is void and unenforceable.

Here, the court found that the “crux of the complaint” was that the arbitration provision itself was invalid. Thus, the plaintiff was seeking a determination as to the validity of the arbitration clause, and it was up to the court to decide the arbitrability issue. Interestingly, the fact that the plaintiff also sought rescission of the contract as a whole was not determinative in deciding the “crux of the complaint” test.

Choice of Law. The franchisor argued that the enforceability of the arbitration provision should be decided under Pennsylvania law, which was designated as the governing law in the franchise agreement. Even though the franchise agreement had been signed in Pennsylvania and the franchisor's home office was located in Pennsylvania (and thus a substantial relation to Pennsylvania existed), the court found that Pennsylvania law was contrary to the fundamental policy of the CFIL. To support this finding, the court pointed out two instances in which California law provided greater protection to franchisees than Pennsylvania law: 1) the CFIL allows franchisees to bring actions against individual defendants without requiring franchisees to pierce the corporate veil; and 2) California common law allows a franchisee to establish fraud if the franchisor provides information in a misleading manner, as opposed to Pennsylvania common law, which provides a defense to franchisors if the communication was factual. Therefore, the court rendered the choice-of-law provision in the franchise agreement unenforceable and applied California law to the interpretation of the arbitration clause.

Procedural Unconscionability. The court went on to find both procedural and substantive unconscionability in the arbitration provision of the franchise agreement and the factual circumstances surrounding the case, both of which must be present in order to render a provision of an agreement unenforceable. Procedural unconscionability was established based on the unequal bargaining power between the franchisor and franchisee. Under this interpretation, almost all franchise agreements would be tainted with procedural unconscionability due to the nature of the franchise relationship. The court did point out several mitigating factors, including that the franchisee had consulted with an attorney prior to signing the franchise agreement, that the arbitration clause was the same size font as the rest of the agreement, and that the words “mandatory arbitration” appeared as a distinct heading in the agreement; but these did not overcome the franchisee's claim of procedural unconscionability.

Substantive Unconscionability. The court found substantive unconscionability in the following provisions of the arbitration clause:

• Right to obtain equitable relief in court. The franchisor reserved the right to pursue equitable or injunctive relief in the event the franchisee breached the agreement. Rejecting the franchisor's argument that it needed access to the courts in order to protect its trademarks, the court found the lack of mutuality in this provision rendered it unconscionable, as the franchisor was the party with the most bargaining power in the relationship.
• Waiver of statutory rights. The court then found that two clauses in the arbitration provision limited rights that would otherwise be available to the franchisee under the CFIL: A clause providing for a shorter statute of limitations than that provided by statute was unconscionable; and a clause that provided that no punitive or exemplary damages could be awarded by the arbitrator (therefore limiting the type of recovery the franchisee could otherwise obtain under the statute). As the court stated in its decision, the arbitration agreement cannot be used as a mechanism for the franchisee to waive statutory rights.
• Arbitrator's authority. Finally, the court found that a provision stating that the arbitrator has no authority to alter or modify a provision of the franchise agreement was unconscionable, for the same reasons as stated above.

Just as interesting as the interpretation of the enforceability of the arbitration provision itself is the court's determination as to the franchisee's available remedies. Although the court found three circumstances of substantive unconscionability, as well as procedural unconscionability, the court ignored the franchisee's request that the entire arbitration provision be invalidated. Instead, the court found that the unconscionable provisions were severable from the remainder of the arbitration clause, and although each unconscionable provision itself was invalid, the dispute would otherwise go to arbitration.

Based on this decision, franchisors may want to consider modifying their franchise agreements if they are used in California. Many franchise agreements provide for arbitration, but allow the franchisor the option to seek equitable relief in court. If such a provision does not give the franchisee this same right, however, the franchisor risks a finding that the clause lacks mutuality, and is therefore unconscionable and unenforceable. Because the provision is severable from the remainder of the franchise agreement, the franchisor risks losing its access to the courts to obtain injunctive relief.

Lease of Franchised Location to a Competitor

The interesting factual circumstance in Gallagher's NYC Steakhouse Franchising Inc. v. 1020 15th St., Inc. et. al, Bus. Franchise Guide, 14,035 (CCH) (D.C. Col. 2008), highlights the importance of the specific wording of noncompetition provisions often contained in franchise agreements. After a steak restaurant franchisee breached its franchise agreement, the franchisor obtained a preliminary injunction prohibiting the franchisee from operating a restaurant or other steakhouse at the former franchised location, in accordance with the noncompete provision contained in the franchise agreement. Subsequently, the franchisee leased the former franchised location to a competitor, who opened a competitive steak restaurant in the same space.

The competitor had been the chef at the former franchised restaurant and was a business associate of the franchisee. Not only did the franchisee lease the space to the competitor, but the franchisee also assisted the competitor in forming an entity to operate the new restaurant, obtaining a liquor license, and transferring phone numbers. The new restaurant operated under almost an identical menu as the former franchise.

The franchisor brought suit for violation of the preliminary injunction and for violation of the franchisee's noncompete provision in the franchise agreement. The provision in question provided that the franchisee could not, directly or indirectly, engage in any other steakhouse restaurant business within a certain territory. The franchisor argued that the former franchisee was indirectly doing business at the former franchised location, and was “working in concert” with the competitor to violate the noncompete provision.

The court, interpreting Florida law, decided that because the franchisee did not have operational control or a right to profit in the competitive business, he was not directly or indirectly doing business at the former franchised location in violation of the noncompete provision or the preliminary injunction. Additionally, even though the franchisee would benefit from the operation of the restaurant through rent payments, this is not enough to show that the former franchisee was “in active concert or participation” with the competitive party. Also, the assistance provided by the former franchisee to the competitor was of a brief duration, and the court found that the former franchisee had a legitimate business reason for this assistance in that the franchisee needed to ensure the proper transfer of licenses and documents to the competitor.

Interestingly, the court noted that to guard against this situation, the franchisor should have included language in its franchise agreement prohibiting the franchisee from leasing the franchised location to a competitor.

Cynthia M. Klaus is a shareholder at Larkin Hoffman Daly & Lindgren Ltd. in Minneapolis. She can be contacted at [email protected] or 952-896-3392. Meredith A. Bauer is an associate at the firm. She can be contacted at [email protected] or 952-896-3263.

CA District Court Confirms Unconscionability of Arbitration Provision

Franchisors have long been watching the California courts and their interpretation of arbitration provisions under California law. Since the Nagrampa v. MailCoups, Inc. decision in 2006, which found procedural and substantive unconscionability in a relatively standard franchise agreement arbitration provision, a real concern exists as to whether such arbitration provisions can be enforced in California.

The Northern District of California is the most recent court to weigh-in on the enforceability of arbitration provisions contained in franchise agreements under California law. In Bencharsky v. Cottman Transmission Systems, LLC, Bus. Franchise Guide, 14,045 (CCH) (D.C. Cal. 2008), the court determined that both procedural and substantive unconscionability existed in an arbitration provision, partly due to a lack of mutuality as to the availability of equitable relief for the franchisor and the franchisee.

In this case, the franchisor filed a demand for arbitration against one of its automotive repair franchisees, alleging unpaid franchise fees. The franchisor relied on a provision of the franchise agreement which stated that the parties should attempt to resolve all disputes in arbitration, but also reserved its right to obtain equitable relief in court. The franchisee then filed suit in court, alleging in part, breach of contract and violation of the California Franchise Investment Law (“CFIL”). The franchisor then moved to compel arbitration of the franchisee's claims.

Issue of Arbitrability. The court initially tackled the issue of whether an arbitrator, or the court itself, was the proper authority to determine whether the arbitration clause was enforceable. The court used the “crux of the complaint” test, meaning that when the “crux of the complaint” challenges only the arbitration provision and not the invalidity of the contract as a whole, it is up to the court to decide whether the arbitration provision is enforceable. In comparison, the issue of arbitrability is an issue for an arbitrator when the “crux of the complaint” is that the agreement as a whole is void and unenforceable.

Here, the court found that the “crux of the complaint” was that the arbitration provision itself was invalid. Thus, the plaintiff was seeking a determination as to the validity of the arbitration clause, and it was up to the court to decide the arbitrability issue. Interestingly, the fact that the plaintiff also sought rescission of the contract as a whole was not determinative in deciding the “crux of the complaint” test.

Choice of Law. The franchisor argued that the enforceability of the arbitration provision should be decided under Pennsylvania law, which was designated as the governing law in the franchise agreement. Even though the franchise agreement had been signed in Pennsylvania and the franchisor's home office was located in Pennsylvania (and thus a substantial relation to Pennsylvania existed), the court found that Pennsylvania law was contrary to the fundamental policy of the CFIL. To support this finding, the court pointed out two instances in which California law provided greater protection to franchisees than Pennsylvania law: 1) the CFIL allows franchisees to bring actions against individual defendants without requiring franchisees to pierce the corporate veil; and 2) California common law allows a franchisee to establish fraud if the franchisor provides information in a misleading manner, as opposed to Pennsylvania common law, which provides a defense to franchisors if the communication was factual. Therefore, the court rendered the choice-of-law provision in the franchise agreement unenforceable and applied California law to the interpretation of the arbitration clause.

Procedural Unconscionability. The court went on to find both procedural and substantive unconscionability in the arbitration provision of the franchise agreement and the factual circumstances surrounding the case, both of which must be present in order to render a provision of an agreement unenforceable. Procedural unconscionability was established based on the unequal bargaining power between the franchisor and franchisee. Under this interpretation, almost all franchise agreements would be tainted with procedural unconscionability due to the nature of the franchise relationship. The court did point out several mitigating factors, including that the franchisee had consulted with an attorney prior to signing the franchise agreement, that the arbitration clause was the same size font as the rest of the agreement, and that the words “mandatory arbitration” appeared as a distinct heading in the agreement; but these did not overcome the franchisee's claim of procedural unconscionability.

Substantive Unconscionability. The court found substantive unconscionability in the following provisions of the arbitration clause:

• Right to obtain equitable relief in court. The franchisor reserved the right to pursue equitable or injunctive relief in the event the franchisee breached the agreement. Rejecting the franchisor's argument that it needed access to the courts in order to protect its trademarks, the court found the lack of mutuality in this provision rendered it unconscionable, as the franchisor was the party with the most bargaining power in the relationship.
• Waiver of statutory rights. The court then found that two clauses in the arbitration provision limited rights that would otherwise be available to the franchisee under the CFIL: A clause providing for a shorter statute of limitations than that provided by statute was unconscionable; and a clause that provided that no punitive or exemplary damages could be awarded by the arbitrator (therefore limiting the type of recovery the franchisee could otherwise obtain under the statute). As the court stated in its decision, the arbitration agreement cannot be used as a mechanism for the franchisee to waive statutory rights.
• Arbitrator's authority. Finally, the court found that a provision stating that the arbitrator has no authority to alter or modify a provision of the franchise agreement was unconscionable, for the same reasons as stated above.

Just as interesting as the interpretation of the enforceability of the arbitration provision itself is the court's determination as to the franchisee's available remedies. Although the court found three circumstances of substantive unconscionability, as well as procedural unconscionability, the court ignored the franchisee's request that the entire arbitration provision be invalidated. Instead, the court found that the unconscionable provisions were severable from the remainder of the arbitration clause, and although each unconscionable provision itself was invalid, the dispute would otherwise go to arbitration.

Based on this decision, franchisors may want to consider modifying their franchise agreements if they are used in California. Many franchise agreements provide for arbitration, but allow the franchisor the option to seek equitable relief in court. If such a provision does not give the franchisee this same right, however, the franchisor risks a finding that the clause lacks mutuality, and is therefore unconscionable and unenforceable. Because the provision is severable from the remainder of the franchise agreement, the franchisor risks losing its access to the courts to obtain injunctive relief.

Lease of Franchised Location to a Competitor

The interesting factual circumstance in Gallagher's NYC Steakhouse Franchising Inc. v. 1020 15th St., Inc. et. al, Bus. Franchise Guide, 14,035 (CCH) (D.C. Col. 2008), highlights the importance of the specific wording of noncompetition provisions often contained in franchise agreements. After a steak restaurant franchisee breached its franchise agreement, the franchisor obtained a preliminary injunction prohibiting the franchisee from operating a restaurant or other steakhouse at the former franchised location, in accordance with the noncompete provision contained in the franchise agreement. Subsequently, the franchisee leased the former franchised location to a competitor, who opened a competitive steak restaurant in the same space.

The competitor had been the chef at the former franchised restaurant and was a business associate of the franchisee. Not only did the franchisee lease the space to the competitor, but the franchisee also assisted the competitor in forming an entity to operate the new restaurant, obtaining a liquor license, and transferring phone numbers. The new restaurant operated under almost an identical menu as the former franchise.

The franchisor brought suit for violation of the preliminary injunction and for violation of the franchisee's noncompete provision in the franchise agreement. The provision in question provided that the franchisee could not, directly or indirectly, engage in any other steakhouse restaurant business within a certain territory. The franchisor argued that the former franchisee was indirectly doing business at the former franchised location, and was “working in concert” with the competitor to violate the noncompete provision.

The court, interpreting Florida law, decided that because the franchisee did not have operational control or a right to profit in the competitive business, he was not directly or indirectly doing business at the former franchised location in violation of the noncompete provision or the preliminary injunction. Additionally, even though the franchisee would benefit from the operation of the restaurant through rent payments, this is not enough to show that the former franchisee was “in active concert or participation” with the competitive party. Also, the assistance provided by the former franchisee to the competitor was of a brief duration, and the court found that the former franchisee had a legitimate business reason for this assistance in that the franchisee needed to ensure the proper transfer of licenses and documents to the competitor.

Interestingly, the court noted that to guard against this situation, the franchisor should have included language in its franchise agreement prohibiting the franchisee from leasing the franchised location to a competitor.

Cynthia M. Klaus is a shareholder at Larkin Hoffman Daly & Lindgren Ltd. in Minneapolis. She can be contacted at [email protected] or 952-896-3392. Meredith A. Bauer is an associate at the firm. She can be contacted at [email protected] or 952-896-3263.