Arbitration: Franchisor's Friend or Foe?

In addressing the issue of whether an arbitration clause made sense for a franchisor client, for years I have waffled on how to advise that client. In informal discussions with my colleagues, I have discovered that I am not alone on this problem.

I recall several years ago managing a piece published in the Franchise Law Journal where four prominent franchise attorneys were asked to pontificate on the issue ' two represented primarily franchisors, and two represented franchisees. Intentionally, we chose from each camp advocates who had differing views on the issue. I have since observed that this group was more representative of the split within the franchise lawyer community on this issue than I would have predicted at that time. My anecdotal experiences over the last two decades confirm this sharp split. The truth is that this question is not simple to answer. There are many factors that come into consideration, including the size and strength of the franchisor as compared with its franchisees; the complexity of the issues that are likely to arise in disputes; the projected costs of judicial litigation as compared with arbitration; whether prompt adjudication is important; and the number of disputes anticipated ' to name only some of the more key considerations.

Two recent developments in the law relating to franchising, as well as my observation about how an arbitration clause affects the adjudication process, have influenced my thinking on the subject, and I am now more skeptical about arbitration clauses than ever, whether I would be representing a franchisor or a franchisee. Arbitration ' the fair-haired child of the 80s ' may have been more a Siren than a panacea for dispute resolution in a franchise environment.

How the Dispute Is Processed

My first concern is that if we look back over cases involving arbitration during the last decade or so, we observe that most of the reported decisions relate not to the substance of the dispute, but to how the dispute is processed. Some of the roadblocks that have appeared in the reported decisions include:

• How do you force a party into arbitration when the other party has ignored the presence of an arbitration clause and has instead filed suit?
• Who makes the determination about forcing the other party into arbitration?
• Where should the arbitration be adjudicated?
• Is the arbitration clause procedurally or substantively unconscionable? And if it is, should the objectionable provisions be severed and the remainder of the clause enforced, or should the whole provision be tossed?
• Complicated litigation may make it difficult to distinguish what issues should be arbitrated and which should be sent before a court when the arbitration clause states that some issues should be left for court resolution.

These are only some of the sideshows that can develop when an arbitration clause is introduced into a franchise or, for that matter, any other agreement.

There are two ways to eliminate this problem. The first is: Don't include an arbitration clause in the agreement. The second approach is: Keep the arbitration clause simple. The American Arbitration Association has for many years suggested something like the following as a model arbitration clause:

Any and all disputes between the parties shall be resolved through mandatory arbitration conducted in accordance with the rules of the American Arbitration Association.

But instead, many of us, when drafting arbitration clauses, have tried to tilt the playing field. We try to give the franchisor home-court advantage; we carve out certain subjects from the arbitration requirement, such as disputes involving trademark validity; or we make the choice whether to arbitrate an option for the franchisor, but don't give the franchisee a reciprocal choice. I am not suggesting that any of these provisions are illegal, immoral, or bad lawyering. I am suggesting, however, that whenever we add bells and whistles to arbitration clauses, the probability that sideshows ' issues that move the proceeding laterally rather than toward conclusion ' will correspondingly increase.

The Stolts-Nielsen Decision

A second recent development that influences my opinion is the U.S. Supreme Court decision in Stolts-Nielsen S.A. v. Animalsfeeds International Corp., 552 U.S. 576 (2008), where the Court ruled that class arbitrations were not permitted unless the arbitration clause so provided. Many, but not all, franchisors have recently provided in express terms in their agreements that no class arbitrations may be brought by their franchisees. What the Stolts-Nielsen decision does is blanket the situation where the franchise agreement may be silent on this issue. The decision is clearly pro-franchisor, but I question to what degree, by itself, it would make me advise my franchisor that arbitration clauses are the better course to follow. Stolts-Nielsen does not prevent franchisees from banding together and bringing collectively 100, 200, or even more individual proceedings against the franchisor at the same time. This strategy, of course, would be expensive for franchisees and difficult to orchestrate, but it would also be expensive and managerially challenging for the franchisor to
defend against.

The Federal Arbitration Act

There is another factor ' a subtle one ' that would more likely influence the way I counseled a franchisor client with respect to arbitration. The Federal Arbitration Act, which governs most arbitration disputes, names only four grounds for challenging an arbitration award. These are:

1. where the award was procured by corruption, fraud, or undue means;
2. where there was evident partiality or corruption in the arbitrators, or either of them;
3. where the arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights of any party have been prejudiced; or
4. where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.

(Source: Federal Arbitration Act, 9 U.S.C.A. ' 10.)

Over time, some courts have ruled that manifest disregard of the law would also be grounds to set aside an arbitration award. However, in Hall Street Associates, Inc. v. Mattel, Inc., 130 S. Ct. 1758 (2010), the U.S. Supreme Court ruled that the grounds for challenging an arbitration clause were limited to those delineated in the Federal Arbitration Act. Thus, if the arbitrator decides to go on a “frolic and detour” and ignore precedent, the parties will almost always be saddled with his or her off-base ruling. In theory, this could cut in favor of the franchisor, or it could end up working to a franchisee's advantage.

Why Give Up an Advantage?

However, my last observation ignores the fact, as most lawyers will concede ' irrespective of whom their client base may be ' that the scales of justice usually tip in favor of the franchisor. Franchise disputes typically arise either out of fraud in connection with the sale of the franchise, or out of a contractual dispute of some sort. Fraud claims are very hard to prove, absent very evil acts. Fraud must be pled with particularity, and there are several challenging elements that must be proved: 1) a statement was made; 2) the statement was false or materially misleading; 3) the franchisor knew that to be the case or demonstrated callous disregard as to the veracity of the statement when the statement was made; 4) the franchisee relied upon the statement; 5) the reliance was reasonable; 6) the statement and the subsequent reliance were the proximate cause of the franchisee's suffering; and 7) in a damage case, the amount of the resulting damages. This is no easy task, especially when the franchise agreement contains franchisor-favorable waivers and disclaimers.

In a contract dispute, a franchisee is similarly disadvantaged because the contract is drafted by the franchisor and consequently weighs in its favor. In particular, the franchisor's obligations, especially post-opening, are often vague in nature and grant the franchisor considerable discretion. In contrast, the franchisee's obligations are typically described in detail.

Thus, in either contract or fraud cases, from a purely jurisprudential analysis, the advantage lies with the franchisor. That, of course, is one reason that many states have adopted statutes governing franchise sales and franchise relationships.

But given this advantage, why should a franchisor give it up and instead choose arbitration as the required method to resolve disputes, where the decision maker can simply ignore this advantage by ruling without regard to precedent? If an arbitrator is likely to go “off the ranch” and ignore the law, and that decision will be non-appealable, from an actuarial standpoint, I suspect that mandating arbitration should make franchisors uncomfortable.

This analysis, I confess, is somewhat superficial. As I noted above, there are many factors that should be taken into account in deciding whether mandating arbitration is a wise choice. However, in my mind, it certainly is one major factor that must go into the decision-making process.

Conclusion

In closing, I might add that courts, rather than an arbitration hearing, may also be the better forum for franchisees, as illustrated by the recent attempts by franchisees and others to limit the use of arbitration through the proposed Arbitration Fairness Act of 2009 (S. 931, 111th Cong. (2009). If this is true, what does that mean for the future of arbitration? Arbitration may have been the perceived best remedial method for franchise dispute resolution in the 1980s, but has this so-called fair-haired child gone bald with age?

Rupert M. Barkoff, a member of this newsletter's Board of Editors, is a partner in Kilpatrick Stockton LLP's Atlanta office, where he chairs the firm's Franchise Practice. He is a past chair of the ABA Forum on Franchising, and co-editor-in-chief of Fundamentals of Franchising. He can be reached at [email protected] or 404-815-6366.

In addressing the issue of whether an arbitration clause made sense for a franchisor client, for years I have waffled on how to advise that client. In informal discussions with my colleagues, I have discovered that I am not alone on this problem.

I recall several years ago managing a piece published in the Franchise Law Journal where four prominent franchise attorneys were asked to pontificate on the issue ' two represented primarily franchisors, and two represented franchisees. Intentionally, we chose from each camp advocates who had differing views on the issue. I have since observed that this group was more representative of the split within the franchise lawyer community on this issue than I would have predicted at that time. My anecdotal experiences over the last two decades confirm this sharp split. The truth is that this question is not simple to answer. There are many factors that come into consideration, including the size and strength of the franchisor as compared with its franchisees; the complexity of the issues that are likely to arise in disputes; the projected costs of judicial litigation as compared with arbitration; whether prompt adjudication is important; and the number of disputes anticipated ' to name only some of the more key considerations.

Two recent developments in the law relating to franchising, as well as my observation about how an arbitration clause affects the adjudication process, have influenced my thinking on the subject, and I am now more skeptical about arbitration clauses than ever, whether I would be representing a franchisor or a franchisee. Arbitration ' the fair-haired child of the 80s ' may have been more a Siren than a panacea for dispute resolution in a franchise environment.

How the Dispute Is Processed

My first concern is that if we look back over cases involving arbitration during the last decade or so, we observe that most of the reported decisions relate not to the substance of the dispute, but to how the dispute is processed. Some of the roadblocks that have appeared in the reported decisions include:

• How do you force a party into arbitration when the other party has ignored the presence of an arbitration clause and has instead filed suit?
• Who makes the determination about forcing the other party into arbitration?
• Where should the arbitration be adjudicated?
• Is the arbitration clause procedurally or substantively unconscionable? And if it is, should the objectionable provisions be severed and the remainder of the clause enforced, or should the whole provision be tossed?
• Complicated litigation may make it difficult to distinguish what issues should be arbitrated and which should be sent before a court when the arbitration clause states that some issues should be left for court resolution.

These are only some of the sideshows that can develop when an arbitration clause is introduced into a franchise or, for that matter, any other agreement.

There are two ways to eliminate this problem. The first is: Don't include an arbitration clause in the agreement. The second approach is: Keep the arbitration clause simple. The American Arbitration Association has for many years suggested something like the following as a model arbitration clause:

Any and all disputes between the parties shall be resolved through mandatory arbitration conducted in accordance with the rules of the American Arbitration Association.

But instead, many of us, when drafting arbitration clauses, have tried to tilt the playing field. We try to give the franchisor home-court advantage; we carve out certain subjects from the arbitration requirement, such as disputes involving trademark validity; or we make the choice whether to arbitrate an option for the franchisor, but don't give the franchisee a reciprocal choice. I am not suggesting that any of these provisions are illegal, immoral, or bad lawyering. I am suggesting, however, that whenever we add bells and whistles to arbitration clauses, the probability that sideshows ' issues that move the proceeding laterally rather than toward conclusion ' will correspondingly increase.

The Stolts-Nielsen Decision

A second recent development that influences my opinion is the U.S. Supreme Court decision in Stolts-Nielsen S.A. v. Animalsfeeds International Corp. , 552 U.S. 576 (2008), where the Court ruled that class arbitrations were not permitted unless the arbitration clause so provided. Many, but not all, franchisors have recently provided in express terms in their agreements that no class arbitrations may be brought by their franchisees. What the Stolts-Nielsen decision does is blanket the situation where the franchise agreement may be silent on this issue. The decision is clearly pro-franchisor, but I question to what degree, by itself, it would make me advise my franchisor that arbitration clauses are the better course to follow. Stolts-Nielsen does not prevent franchisees from banding together and bringing collectively 100, 200, or even more individual proceedings against the franchisor at the same time. This strategy, of course, would be expensive for franchisees and difficult to orchestrate, but it would also be expensive and managerially challenging for the franchisor to
defend against.

The Federal Arbitration Act

There is another factor ' a subtle one ' that would more likely influence the way I counseled a franchisor client with respect to arbitration. The Federal Arbitration Act, which governs most arbitration disputes, names only four grounds for challenging an arbitration award. These are:

1. where the award was procured by corruption, fraud, or undue means;
2. where there was evident partiality or corruption in the arbitrators, or either of them;
3. where the arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights of any party have been prejudiced; or
4. where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.

(Source: Federal Arbitration Act, 9 U.S.C.A. ' 10.)

Over time, some courts have ruled that manifest disregard of the law would also be grounds to set aside an arbitration award. However, in Hall Street Associates, Inc. v. Mattel, Inc., 130 S. Ct. 1758 (2010), the U.S. Supreme Court ruled that the grounds for challenging an arbitration clause were limited to those delineated in the Federal Arbitration Act. Thus, if the arbitrator decides to go on a “frolic and detour” and ignore precedent, the parties will almost always be saddled with his or her off-base ruling. In theory, this could cut in favor of the franchisor, or it could end up working to a franchisee's advantage.

Why Give Up an Advantage?

However, my last observation ignores the fact, as most lawyers will concede ' irrespective of whom their client base may be ' that the scales of justice usually tip in favor of the franchisor. Franchise disputes typically arise either out of fraud in connection with the sale of the franchise, or out of a contractual dispute of some sort. Fraud claims are very hard to prove, absent very evil acts. Fraud must be pled with particularity, and there are several challenging elements that must be proved: 1) a statement was made; 2) the statement was false or materially misleading; 3) the franchisor knew that to be the case or demonstrated callous disregard as to the veracity of the statement when the statement was made; 4) the franchisee relied upon the statement; 5) the reliance was reasonable; 6) the statement and the subsequent reliance were the proximate cause of the franchisee's suffering; and 7) in a damage case, the amount of the resulting damages. This is no easy task, especially when the franchise agreement contains franchisor-favorable waivers and disclaimers.

In a contract dispute, a franchisee is similarly disadvantaged because the contract is drafted by the franchisor and consequently weighs in its favor. In particular, the franchisor's obligations, especially post-opening, are often vague in nature and grant the franchisor considerable discretion. In contrast, the franchisee's obligations are typically described in detail.

Thus, in either contract or fraud cases, from a purely jurisprudential analysis, the advantage lies with the franchisor. That, of course, is one reason that many states have adopted statutes governing franchise sales and franchise relationships.

But given this advantage, why should a franchisor give it up and instead choose arbitration as the required method to resolve disputes, where the decision maker can simply ignore this advantage by ruling without regard to precedent? If an arbitrator is likely to go “off the ranch” and ignore the law, and that decision will be non-appealable, from an actuarial standpoint, I suspect that mandating arbitration should make franchisors uncomfortable.

This analysis, I confess, is somewhat superficial. As I noted above, there are many factors that should be taken into account in deciding whether mandating arbitration is a wise choice. However, in my mind, it certainly is one major factor that must go into the decision-making process.

Conclusion

In closing, I might add that courts, rather than an arbitration hearing, may also be the better forum for franchisees, as illustrated by the recent attempts by franchisees and others to limit the use of arbitration through the proposed Arbitration Fairness Act of 2009 (S. 931, 111th Cong. (2009). If this is true, what does that mean for the future of arbitration? Arbitration may have been the perceived best remedial method for franchise dispute resolution in the 1980s, but has this so-called fair-haired child gone bald with age?

Rupert M. Barkoff, a member of this newsletter's Board of Editors, is a partner in Kilpatrick Stockton LLP's Atlanta office, where he chairs the firm's Franchise Practice. He is a past chair of the ABA Forum on Franchising, and co-editor-in-chief of Fundamentals of Franchising. He can be reached at [email protected] or 404-815-6366.