Court Watch

The franchisee also argued that Pennsylvania law should not apply because it would negate his California little FTC Act claim (based on fundamental public policy), which depended on application of California law. Interestingly, the court rejected this argument and found that the little FTC Act claim was nothing more than a restatement of the common law claims based on fraud, breach of contract, conversion, etc., and that plaintiff had failed to show that Pennsylvania law could not adequately address those claims.

Getting to the issue of unconscionability, the court determined that the arbitration clause was not procedurally unconscionable under Pennsylvania law, and thus never got to the issue of whether it was substantively unconscionable. Even though the contract was one of adhesion, the court said that it was not automatically unenforceable. The franchisee would still have to show that it was unconscionable due to the relative bargaining positions of the parties and the degree of economic compulsion placed on the adhering party. While there was a great imbalance in the bargaining position of the parties, the court held that there was no economic compulsion because the franchisee was not forced to buy a We The People franchise and could have “walked away from the Agreement and purchased another franchise if he so chose.”

Another Unconsconability Claim

In another recent case involving claims of unconscionability, the California Court of Appeal granted a writ and refused to enforce an arbitration clause in a precious metals investment contract because it determined that the requirement of having three JAMS arbitrators made the costs of the arbitration unconscionable. The case is important in the franchise context because it extended principles developed in the California employment cases to franchises, as was done earlier in Independent Assn. of Mailbox Center Owners, Inc. v. Superior Court (Mail Boxes Etc., USA, Inc.) (2005)133 Cal.App.4th 396, 34 Cal.Rptr.3d 659. The case is noteworthy because the decison was not expressly based on the ability of an investor to advance statutorily protected claims grounded in public policy (such as certain employment claims or Franchise Investment Law claims), but simply involved common law claims. There was an unfair competition claim under California's little FTC Act, presumably dependent on the common law claims, like in the Portnoy case above, but this did not drive the court's decision.

The decision also left open the door for a defendant to argue in a different case that the arbitrator must decide the issue of unconscionability. Observing that Howsam v. Dean Witter Reynolds, Inc. (2002) 537 U.S. 79, 83 indicated that the parties could relegate the issue to an arbitrator if their intent to do so was “clear and unmistabeable,” the court said that such clear intent was not present in the particular case before them because the “severability” provision in the contract gave the “trier of fact of competent jurisdiction” the power to sever any unenforceable provision. The court determined that the “trier of fact of competent jurisdiction” encompassed more than just an arbitrator or panel of arbitrators.

The court found the arbitration agreement procedurally unconscionable because it was part of an adhesion contract, but determined that it was of a low or medium degree of procedural unconscionability, due to the fact that the arbitration provisions were not hidden and the investors could have chosen other investments. On the latter note, contrary to the Portnoy decision above, the court determined, based on Nagrampa v. Mailcoups, Inc. (9th Cir. 2006) 469 F.3d 1257, 1283, that the existence of reasonable alternatives alone will not defeat a finding of procedural unconscionability.

Turning to the question of substantive unconscionability, the court undertook an excellent analysis of the various approaches taken by state and federal courts on the question of allocation or shifting of arbitration fees, and concluded that in the case at hand, the requirement of three JAMS arbitrators costing over $6,000 per day for each side was unconscionable, given the financial position of the plaintiffs and the inability of the defendant to articulate a reason for needing three arbitrators. The defendant even told the court it would agree to only one arbitrator, but the court rejected that because the arbitration clause must be tested as of the time the contract was entered into.

The court refused to sever the objectionable clauses (even after the franchisor said it would agree to one arbitrator) mainly because it found that the defendant might have drafted the non-consolidation provision together with the three-arbitrator requirement with knowledge that they might not withstand scrutiny, showing it did so for the improper purpose of discouraging the claimants from pursuing their legal rights.

Kodak-Based Lock-in Claim Allowed to Go Forward

In Burda, et al v. Wendy's International, Inc., et al Bus. Franchise Guide (CCH) 14,240 (USDC, S.D. Ohio, Sept. 21, 2009), the court heard the defendants' motion to dismiss a tying claim made by a multi-unit franchisee of Wendy's. When plaintiff Burda signed 13 Unit Franchise Agreements with Wendy's, Wendy's allowed various suppliers to provide products to its franchisees. Somewhat later, Wendy's designated a bakery operated by a Wendy's subsidiary as the exclusive source from which Wendy's franchisees in Burda's area could purchase their hamburger buns. Some years later, Wendy's also required its franchisees to purchase other food items only from a company in which Wendy's had an interest or, if they purchased those supplies elsewhere, required suppliers to add a 4% per case surcharge on items sold, making the cost of those items from alternate suppliers prohibitive.

The plaintiffs' complaint alleged that the above-described limitations and conditions amounted to a “lock-in” whereby Wendy's used its franchise rights to compel its franchisees to purchase buns and food items from Wendy's designees. Wendy's moved to dismiss the antitrust claims on the basis that the plaintiffs had failed to adequately plead a relevant market over which Wendy's had sufficient market power to compel the plaintiffs to purchase the designated products or that there was a lock-in which would take the place of market power. It also maintained that the plaintiffs' claims sounded only in contract since the requirement that the plaintiffs purchase designated items arose out of Wendy's standard unit franchise agreement and not from a tying arrangement. Wendy's also maintained that since the plaintiffs' franchise agreements were signed over four years prior to the complaint, the statute of limitations had lapsed on the claims.

Normally, in order for there to be an illegal tying arrangement, the seller of the tied product must have significant market power in the tying product in the relevant geographic market, and the arrangement must affect a substantial volume of commerce in the tied product. However, in Eastman Kodak Company v. Image Technical Services, Inc., 504 U.S. 451 (1992), the U.S. Supreme Court held that market power is inferred if a customer is “locked-in” by purchasing an expensive unique product which the vendor was later able to use to compel the purchase of other items that were previously available from other sources ' in the case of Kodak, it was parts used to repair its copiers. By not providing its unique repair parts to independent copier repair providers, Kodak, as a practical matter, compelled its copier owners to use its own repair service. The key in Kodak was that at the time its copier owners purchased their Kodak equipment, they were not made aware of the company's ability to cut independent repair providers out of the repair business by a later change of policy, and, thus, the copier buyers could not anticipate this more-expensive alternative in their initial purchasing decisions.

In Burda, the concerned provision in the Wendy's franchise agreement stated, in part, that franchisees could only purchase items from suppliers who satisfied Wendy's that they could meet its standards and were approved. While there is less-than-unanimous authority that a franchise can be a tying product, the Burda court concluded that the franchise rights were the tying product and the food items were the tied products. The issue then was whether the lock-in was obviated because the plaintiffs had notice that Wendy's could limit the plaintiffs' supplier options, based on the language of the franchise agreement, which informed the plaintiffs that Wendy's had control over which suppliers it approved. Since this issue is fact-based, it could not be disposed of in the context of a motion to dismiss. However, the court indicated that the concerned section of the franchise agreement gave no indication that competition could be limited at the whim of Wendy's, but rather that Wendy's standards and specifications, as well as a few other criteria, provided the only limitation on supplier competition.

A similar case, Queen City Pizza, Inc. et al v. Domino's Pizza, Inc., 124 F.3d 430 (USCA 3d Cir, 1997), was distinguished by the Burda court on the basis that the Domino's franchise agreement mentioned that Domino's could designate itself or its designees as exclusive distributors of specified items. As such, even though there was a lock-in after the Domino's franchise was purchased, prospective franchisees had sufficient information regarding this aspect of the franchise in order to determine whether they wanted to buy the franchise with those restrictions.

No mention was made in Burda about whether a UFOC (the franchise agreements at issue were dated in 1996) was provided to the plaintiffs and, if so, whether Item 8 disclosed that Wendy's could designate itself or a subsidiary as the only supplier. It would have been interesting to know whether the franchise agreements at issue in Burda contained an integration clause that caused the terms of the franchise agreement to supersede the UFOC, since the court could have commented on whether actual knowledge of the restrictions trumped the less-precise terms of the franchise agreement.

In sum, in order to prevent a Kodak lock-in claim, drafters of franchise contracts should make sure that the possibility of the franchisor, its subsidiary, or its designee becoming the sole supplier of some or all of the products its franchisees are required to purchase is set forth clearly in the agreement, as well as being disclosed in Item 8 of its accompanying FDD.

Pennsylvania Choice of Law Clause Works in California

In Portnoy v. Dollar Financial Corp., Bus. Franchise Guide (CCH), 14, 252 (C.D. Cal. Aug. 11, 2009), a We The People franchisee sued the franchisor and parent companies in California. The franchise agreement had a Pennsylvania choice-of-law provision because the franchisor and parent were Pennsylvania companies. It also had an arbitration agreement requiring arbitration in Pennsylvania. Under the arbitration clause, the arbitrator's authority was limited to the extent he or she could not extend, modify, or suspend the terms of the agreement or stay, rescind, or postpone any termination. Further, damages were limited to actual damages; no others, including punitive damages or lost profits, could be awarded. The franchisor moved to compel arbitration, and the franchisee argued that the arbitration agreement was unconscionable because it required arbitration in Pennsylvania, contrary to the California Franchise Relations Act, and because of the two other provisions discussed above. The court granted the motion and upheld the arbitration provision based on Pennsylvania law.

The franchisee argued that the court should not apply Pennsylvania law because it would violate the public policy of California evidenced by the California Franchise Relations Act, which voided clauses requiring franchisees to litigate in another state (Cal. Bus. & Prof. Code ' 20040.5). The court rejected this argument on the basis that the issue was not whether the franchisee had to arbitrate in Pennsylvania, but whether a fundamental California public policy was impacted simply as a result of applying Pennsylvania law to whether the franchisee had to arbitrate in Pennsylvania. The court also noted that adopting the franchisee's position would result in enforcing Business and Professions Code section 20040.5 in every instance, even though that provision has been preempted by the Federal Arbitration Act.

The franchisee also argued that Pennsylvania law should not apply because it would negate his California little FTC Act claim (based on fundamental public policy), which depended on application of California law. Interestingly, the court rejected this argument and found that the little FTC Act claim was nothing more than a restatement of the common law claims based on fraud, breach of contract, conversion, etc., and that plaintiff had failed to show that Pennsylvania law could not adequately address those claims.

Getting to the issue of unconscionability, the court determined that the arbitration clause was not procedurally unconscionable under Pennsylvania law, and thus never got to the issue of whether it was substantively unconscionable. Even though the contract was one of adhesion, the court said that it was not automatically unenforceable. The franchisee would still have to show that it was unconscionable due to the relative bargaining positions of the parties and the degree of economic compulsion placed on the adhering party. While there was a great imbalance in the bargaining position of the parties, the court held that there was no economic compulsion because the franchisee was not forced to buy a We The People franchise and could have “walked away from the Agreement and purchased another franchise if he so chose.”

Another Unconsconability Claim

In another recent case involving claims of unconscionability, the California Court of Appeal granted a writ and refused to enforce an arbitration clause in a precious metals investment contract because it determined that the requirement of having three JAMS arbitrators made the costs of the arbitration unconscionable. The case is important in the franchise context because it extended principles developed in the California employment cases to franchises, as was done earlier in Independent Assn. of Mailbox Center Owners, Inc. v. Superior Court (Mail Boxes Etc., USA, Inc.) (2005)133 Cal.App.4th 396, 34 Cal.Rptr.3d 659. The case is noteworthy because the decison was not expressly based on the ability of an investor to advance statutorily protected claims grounded in public policy (such as certain employment claims or Franchise Investment Law claims), but simply involved common law claims. There was an unfair competition claim under California's little FTC Act, presumably dependent on the common law claims, like in the Portnoy case above, but this did not drive the court's decision.

The decision also left open the door for a defendant to argue in a different case that the arbitrator must decide the issue of unconscionability. Observing that Howsam v. Dean Witter Reynolds, Inc. (2002) 537 U.S. 79, 83 indicated that the parties could relegate the issue to an arbitrator if their intent to do so was “clear and unmistabeable,” the court said that such clear intent was not present in the particular case before them because the “severability” provision in the contract gave the “trier of fact of competent jurisdiction” the power to sever any unenforceable provision. The court determined that the “trier of fact of competent jurisdiction” encompassed more than just an arbitrator or panel of arbitrators.

The court found the arbitration agreement procedurally unconscionable because it was part of an adhesion contract, but determined that it was of a low or medium degree of procedural unconscionability, due to the fact that the arbitration provisions were not hidden and the investors could have chosen other investments. On the latter note, contrary to the Portnoy decision above, the court determined, based on Nagrampa v. Mailcoups, Inc. (9th Cir. 2006) 469 F.3d 1257, 1283, that the existence of reasonable alternatives alone will not defeat a finding of procedural unconscionability.

Turning to the question of substantive unconscionability, the court undertook an excellent analysis of the various approaches taken by state and federal courts on the question of allocation or shifting of arbitration fees, and concluded that in the case at hand, the requirement of three JAMS arbitrators costing over $6,000 per day for each side was unconscionable, given the financial position of the plaintiffs and the inability of the defendant to articulate a reason for needing three arbitrators. The defendant even told the court it would agree to only one arbitrator, but the court rejected that because the arbitration clause must be tested as of the time the contract was entered into.

The court refused to sever the objectionable clauses (even after the franchisor said it would agree to one arbitrator) mainly because it found that the defendant might have drafted the non-consolidation provision together with the three-arbitrator requirement with knowledge that they might not withstand scrutiny, showing it did so for the improper purpose of discouraging the claimants from pursuing their legal rights.

Kodak-Based Lock-in Claim Allowed to Go Forward

In Burda, et al v. Wendy's International, Inc., et al Bus. Franchise Guide (CCH) 14,240 (USDC, S.D. Ohio, Sept. 21, 2009), the court heard the defendants' motion to dismiss a tying claim made by a multi-unit franchisee of Wendy's. When plaintiff Burda signed 13 Unit Franchise Agreements with Wendy's, Wendy's allowed various suppliers to provide products to its franchisees. Somewhat later, Wendy's designated a bakery operated by a Wendy's subsidiary as the exclusive source from which Wendy's franchisees in Burda's area could purchase their hamburger buns. Some years later, Wendy's also required its franchisees to purchase other food items only from a company in which Wendy's had an interest or, if they purchased those supplies elsewhere, required suppliers to add a 4% per case surcharge on items sold, making the cost of those items from alternate suppliers prohibitive.

The plaintiffs' complaint alleged that the above-described limitations and conditions amounted to a “lock-in” whereby Wendy's used its franchise rights to compel its franchisees to purchase buns and food items from Wendy's designees. Wendy's moved to dismiss the antitrust claims on the basis that the plaintiffs had failed to adequately plead a relevant market over which Wendy's had sufficient market power to compel the plaintiffs to purchase the designated products or that there was a lock-in which would take the place of market power. It also maintained that the plaintiffs' claims sounded only in contract since the requirement that the plaintiffs purchase designated items arose out of Wendy's standard unit franchise agreement and not from a tying arrangement. Wendy's also maintained that since the plaintiffs' franchise agreements were signed over four years prior to the complaint, the statute of limitations had lapsed on the claims.

Normally, in order for there to be an illegal tying arrangement, the seller of the tied product must have significant market power in the tying product in the relevant geographic market, and the arrangement must affect a substantial volume of commerce in the tied product. However, in Eastman Kodak Company v. Image Technical Services, Inc. , 504 U.S. 451 (1992), the U.S. Supreme Court held that market power is inferred if a customer is “locked-in” by purchasing an expensive unique product which the vendor was later able to use to compel the purchase of other items that were previously available from other sources ' in the case of Kodak, it was parts used to repair its copiers. By not providing its unique repair parts to independent copier repair providers, Kodak, as a practical matter, compelled its copier owners to use its own repair service. The key in Kodak was that at the time its copier owners purchased their Kodak equipment, they were not made aware of the company's ability to cut independent repair providers out of the repair business by a later change of policy, and, thus, the copier buyers could not anticipate this more-expensive alternative in their initial purchasing decisions.

In Burda, the concerned provision in the Wendy's franchise agreement stated, in part, that franchisees could only purchase items from suppliers who satisfied Wendy's that they could meet its standards and were approved. While there is less-than-unanimous authority that a franchise can be a tying product, the Burda court concluded that the franchise rights were the tying product and the food items were the tied products. The issue then was whether the lock-in was obviated because the plaintiffs had notice that Wendy's could limit the plaintiffs' supplier options, based on the language of the franchise agreement, which informed the plaintiffs that Wendy's had control over which suppliers it approved. Since this issue is fact-based, it could not be disposed of in the context of a motion to dismiss. However, the court indicated that the concerned section of the franchise agreement gave no indication that competition could be limited at the whim of Wendy's, but rather that Wendy's standards and specifications, as well as a few other criteria, provided the only limitation on supplier competition.

A similar case, Queen City Pizza, Inc. et al v. Domino's Pizza, Inc. , 124 F.3d 430 (USCA 3d Cir, 1997), was distinguished by the Burda court on the basis that the Domino's franchise agreement mentioned that Domino's could designate itself or its designees as exclusive distributors of specified items. As such, even though there was a lock-in after the Domino's franchise was purchased, prospective franchisees had sufficient information regarding this aspect of the franchise in order to determine whether they wanted to buy the franchise with those restrictions.

No mention was made in Burda about whether a UFOC (the franchise agreements at issue were dated in 1996) was provided to the plaintiffs and, if so, whether Item 8 disclosed that Wendy's could designate itself or a subsidiary as the only supplier. It would have been interesting to know whether the franchise agreements at issue in Burda contained an integration clause that caused the terms of the franchise agreement to supersede the UFOC, since the court could have commented on whether actual knowledge of the restrictions trumped the less-precise terms of the franchise agreement.

In sum, in order to prevent a Kodak lock-in claim, drafters of franchise contracts should make sure that the possibility of the franchisor, its subsidiary, or its designee becoming the sole supplier of some or all of the products its franchisees are required to purchase is set forth clearly in the agreement, as well as being disclosed in Item 8 of its accompanying FDD.