Court Watch

The Supreme Court, in a per curium opinion, reversed because, under the FAA, the state court had a duty to determine whether any of the claims were arbitrable and it could not ignore that duty as the state court did. Citing its decision in Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213 (1985), the Court emphasized that if any claim was arbitrable, the court had no discretion to refuse arbitration because other claims were not, even if “the result would be the possibly inefficient maintenance of separate proceedings in different forums.” Id. at 217. It remanded the case to the state court so it could determine whether the remaining claims were derivative. If so, those claims must be ordered to arbitration.

The result could thus be a war on two fronts for the auditor unless the state court could be convinced to stay the litigation pending the outcome of the “derivative” cases on the grounds that they involved common facts and would result in duplicative litigation. We do not know the basis for the misrepresentation claims against the auditors, but very likely they are based on the statements in the audit opinion which would dovetail with the malpractice claims to cause the state court to issue a stay.

It should be remembered that, under some state arbitration statutes, courts are given discretion to permit the court action of non-arbitrable claims to proceed and delay the ruling on the petition to compel arbitration. See, e.g., Cal. Code Civ. Proc. ' 1281.2. The KPMG case, due to federal pre-emption of the FAA, may render these statutes ineffective unless the court is convinced that the FAA is inapplicable.

Arbitration provisions found in most franchise agreements are extremely broad, usually using phrases such as “any and all claims relating to or arising from the franchise agreement/relationship.” In the typical case, then, the court will likely not find itself in the position of having non-arbitrable claims. The issue could arise in situations where the franchisee adds additional parties not related to the franchisor (i.e., other than corporate officers, directors, parent or subsidiary corporations). The KPMG case reminds us that under the FAA, arbitration will proceed even if there are non-arbitrable claims involving the same issues. So the battle to make the litigation efficient will be fought in the state or federal court, with the predominate test likely to be whether the arbitration result would affect the pending litigation in some way.

Attempt to Circumvent a 'Most Favored Nations' Clause in Franchise Agreement Raises Issues of Fact

MSI franchises The Medicine Shoppe stores. Its parent, Cardinal Health, acquired another company called Medicap, which became a subsidiary of MSI. Later, management of both MSI and Medicap became integrated with the same staff servicing both chains.

Traditionally, MSI franchisees paid a percent of sales to MSI, and MSI provided various services to its franchisees. However, changes in the health care industry prompted MSI to change its franchising program in 2009. Under the new program, franchisees paid a flat monthly fee rather than sales-based royalties, and most of the services provided by MSI were eliminated. In an effort to convert its existing franchisees to the new program while not totally losing the benefit of its royalty income, MSI offered most existing franchisees three options: 1) convert to its new license agreement by paying a discounted amount to cover the franchisee's projected future royalties; 2) pay MSI the projected future royalties under their existing license agreement and exit the system; or 3) continue under their existing license agreement, paying the royalties and receiving the services called for in the contract.

The plaintiffs in JMF, Inc. and WW, Inc. v. Medicine Shoppe International, Inc., Bus. Fran. Guide (CCH) ' 14,692 (Sept. 19, 2011) were The Medicine Shoppe store owners in North Dakota who had previously signed early renewal agreements in part because of a “most favored nations” clause contained in the renewal terms. Under that provision, if more beneficial terms were offered to a prospective franchisee in the state where the franchisee is operating, the existing franchisee will have the option to convert to the more favorable agreement at no cost. The language of the clause at issue in this case stated that “[t]his conversion right shall apply only to a new form of license agreement then being offered to new franchisees seeking to become members of the Franchise Network.”

Not willing to sustain the income loss that would result by allowing franchisees with agreements that contained the “most favored nations” clause to convert to the new terms at no cost, MSI withheld the offer of new The Medicine Shoppe franchises in states in which those franchisees were located.

MSI offered the plaintiffs in this case only the option to convert upon payment of discounted future royalties and not the other options described above. Seeking to avoid triggering the “most favored nations” provisions in the plaintiffs' license agreements, MSI began offering Medicap franchises, but not The Medicine Shoppe franchises, in North Dakota. However, it did file a Franchise Disclosure Document for The Medicine Shoppe franchises with the North Dakota Securities Commissioner, stating that it estimated it would open zero to one such franchise in the next fiscal year. The FDD indicated that rather than a continuing royalty, franchisees would be charged a $499.00 per month flat fee.

Upon learning of the FDD filing in North Dakota, the plaintiffs notified MSI that they elected to convert to the new franchise terms pursuant to the “most favored nations” provisions in their existing license agreements. MSI refused to allow them to do so, stating that MSI was not offering The Medicine Shoppe franchises in North Dakota. MSI stated that the FDD filing was merely a formality required by law and did not constitute an offer of the franchise described in the FDD. The plaintiffs then filed the above action for breach of contact and violation of N.D. Cent. Code ' 51-19-11 which, among other things, makes it unlawful to make or cause to be made any material false statement or representation in any application or other document filed under any provision of the North Dakota Franchise Investment Law. That section also makes it unlawful to employ in connection with the offer, sale or purchase of a franchise “any device, scheme or artifice to defraud” or to “engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person.”

MSI, in a motion for summary judgment, maintained that it was not offering franchises in North Dakota, and therefore, the “most favored nations” clause was not triggered. It sought to have the plaintiffs' claims under that provision, as well as various other claims made by the plaintiffs, dismissed by claiming there were no triable issues of fact, but only issues of law that the court could determine. The court held that there were fact issues and that a reasonable finder of fact could determine that the state FDD filing contained a material misstatement since the FDD indicated that MSI projected that a The Medicine Shoppe store might be opened during the next fiscal year; this contrasted with MSI's claim to its franchisees that none were intended. The court also held that it was a triable issue of fact whether the sale of Medicap franchises was a violation of the language in the “most favored nations” clauses since the Medicap franchises being sold could be deemed “members of the Franchise Network” because Medicap was a wholly owned subsidiary of MSI, as evidenced by: The Medicine Shoppe and Medicap having the same principal offices; offering similar goods and services; and both chains receiving support from MSI. It also held that a scheme to defraud or commit deceit could be found if MSI did not intend to honor its “most favored nations” agreements when they were made.

Since MSI has “most favored nations” provisions in its agreements with franchisees in 10 states, the outcome of this case could be significant. We will have to wait and see whether MSI bites the bullet and allows its franchisees with “most favored nations” provisions to convert without a fight, or whether some other outcome will occur. However, it is a good general rule that if you don't want to go in the front door, you probably can't go in the back door.

Charles G. Miller is a shareholder and director, and Darryl A. Hart is an attorney with Bartko, Zankel, Tarrant & Miller in San Francisco. They can be reached at 415-956-1900 or at [email protected] and [email protected], respectively.

Under the FAA, Courts Have Duty to Determine If Any Claims Are Arbitrable

In an interesting offshoot of the Bernie Madoff scandal, the U.S. Supreme Court weighed in to leave no doubt that the Federal Arbitration Act (“FAA”) required courts to order arbitration even where non-arbitrable claims remained that may result in inefficient or possibly duplicative litigation.

In KPMG, LLP v. Robert Cocchi, et al., __ U.S. __, 132 S.Ct. 23, __ L.Ed.2d __(2011), Madoff investors, who had purchased partnership interests, sued the auditors of the partnerships. The partnerships had an engagement agreement with the auditing firm that required arbitration. The action was filed in state court and alleged claims for negligent misrepresentation, violation of Florida's little FTC Act, professional malpractice, and aiding and abetting a breach of fiduciary duty. The state court decided that the negligent misrepresentation and little FTC Act claims were direct in the sense that the investors were not suing the auditor derivatively for wrongs to the partnership. It thus denied the motion to compel arbitration without deciding anything about the remaining claims.

The Supreme Court, in a per curium opinion, reversed because, under the FAA, the state court had a duty to determine whether any of the claims were arbitrable and it could not ignore that duty as the state court did. Citing its decision in Dean Witter Reynolds Inc. v. Byrd , 470 U.S. 213 (1985), the Court emphasized that if any claim was arbitrable, the court had no discretion to refuse arbitration because other claims were not, even if “the result would be the possibly inefficient maintenance of separate proceedings in different forums.” Id. at 217. It remanded the case to the state court so it could determine whether the remaining claims were derivative. If so, those claims must be ordered to arbitration.

The result could thus be a war on two fronts for the auditor unless the state court could be convinced to stay the litigation pending the outcome of the “derivative” cases on the grounds that they involved common facts and would result in duplicative litigation. We do not know the basis for the misrepresentation claims against the auditors, but very likely they are based on the statements in the audit opinion which would dovetail with the malpractice claims to cause the state court to issue a stay.

It should be remembered that, under some state arbitration statutes, courts are given discretion to permit the court action of non-arbitrable claims to proceed and delay the ruling on the petition to compel arbitration. See, e.g., Cal. Code Civ. Proc. ' 1281.2. The KPMG case, due to federal pre-emption of the FAA, may render these statutes ineffective unless the court is convinced that the FAA is inapplicable.

Arbitration provisions found in most franchise agreements are extremely broad, usually using phrases such as “any and all claims relating to or arising from the franchise agreement/relationship.” In the typical case, then, the court will likely not find itself in the position of having non-arbitrable claims. The issue could arise in situations where the franchisee adds additional parties not related to the franchisor (i.e., other than corporate officers, directors, parent or subsidiary corporations). The KPMG case reminds us that under the FAA, arbitration will proceed even if there are non-arbitrable claims involving the same issues. So the battle to make the litigation efficient will be fought in the state or federal court, with the predominate test likely to be whether the arbitration result would affect the pending litigation in some way.

Attempt to Circumvent a 'Most Favored Nations' Clause in Franchise Agreement Raises Issues of Fact

MSI franchises The Medicine Shoppe stores. Its parent, Cardinal Health, acquired another company called Medicap, which became a subsidiary of MSI. Later, management of both MSI and Medicap became integrated with the same staff servicing both chains.

Traditionally, MSI franchisees paid a percent of sales to MSI, and MSI provided various services to its franchisees. However, changes in the health care industry prompted MSI to change its franchising program in 2009. Under the new program, franchisees paid a flat monthly fee rather than sales-based royalties, and most of the services provided by MSI were eliminated. In an effort to convert its existing franchisees to the new program while not totally losing the benefit of its royalty income, MSI offered most existing franchisees three options: 1) convert to its new license agreement by paying a discounted amount to cover the franchisee's projected future royalties; 2) pay MSI the projected future royalties under their existing license agreement and exit the system; or 3) continue under their existing license agreement, paying the royalties and receiving the services called for in the contract.

The plaintiffs in JMF, Inc. and WW, Inc. v. Medicine Shoppe International, Inc., Bus. Fran. Guide (CCH) ' 14,692 (Sept. 19, 2011) were The Medicine Shoppe store owners in North Dakota who had previously signed early renewal agreements in part because of a “most favored nations” clause contained in the renewal terms. Under that provision, if more beneficial terms were offered to a prospective franchisee in the state where the franchisee is operating, the existing franchisee will have the option to convert to the more favorable agreement at no cost. The language of the clause at issue in this case stated that “[t]his conversion right shall apply only to a new form of license agreement then being offered to new franchisees seeking to become members of the Franchise Network.”

Not willing to sustain the income loss that would result by allowing franchisees with agreements that contained the “most favored nations” clause to convert to the new terms at no cost, MSI withheld the offer of new The Medicine Shoppe franchises in states in which those franchisees were located.

MSI offered the plaintiffs in this case only the option to convert upon payment of discounted future royalties and not the other options described above. Seeking to avoid triggering the “most favored nations” provisions in the plaintiffs' license agreements, MSI began offering Medicap franchises, but not The Medicine Shoppe franchises, in North Dakota. However, it did file a Franchise Disclosure Document for The Medicine Shoppe franchises with the North Dakota Securities Commissioner, stating that it estimated it would open zero to one such franchise in the next fiscal year. The FDD indicated that rather than a continuing royalty, franchisees would be charged a $499.00 per month flat fee.

Upon learning of the FDD filing in North Dakota, the plaintiffs notified MSI that they elected to convert to the new franchise terms pursuant to the “most favored nations” provisions in their existing license agreements. MSI refused to allow them to do so, stating that MSI was not offering The Medicine Shoppe franchises in North Dakota. MSI stated that the FDD filing was merely a formality required by law and did not constitute an offer of the franchise described in the FDD. The plaintiffs then filed the above action for breach of contact and violation of N.D. Cent. Code ' 51-19-11 which, among other things, makes it unlawful to make or cause to be made any material false statement or representation in any application or other document filed under any provision of the North Dakota Franchise Investment Law. That section also makes it unlawful to employ in connection with the offer, sale or purchase of a franchise “any device, scheme or artifice to defraud” or to “engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person.”

MSI, in a motion for summary judgment, maintained that it was not offering franchises in North Dakota, and therefore, the “most favored nations” clause was not triggered. It sought to have the plaintiffs' claims under that provision, as well as various other claims made by the plaintiffs, dismissed by claiming there were no triable issues of fact, but only issues of law that the court could determine. The court held that there were fact issues and that a reasonable finder of fact could determine that the state FDD filing contained a material misstatement since the FDD indicated that MSI projected that a The Medicine Shoppe store might be opened during the next fiscal year; this contrasted with MSI's claim to its franchisees that none were intended. The court also held that it was a triable issue of fact whether the sale of Medicap franchises was a violation of the language in the “most favored nations” clauses since the Medicap franchises being sold could be deemed “members of the Franchise Network” because Medicap was a wholly owned subsidiary of MSI, as evidenced by: The Medicine Shoppe and Medicap having the same principal offices; offering similar goods and services; and both chains receiving support from MSI. It also held that a scheme to defraud or commit deceit could be found if MSI did not intend to honor its “most favored nations” agreements when they were made.

Since MSI has “most favored nations” provisions in its agreements with franchisees in 10 states, the outcome of this case could be significant. We will have to wait and see whether MSI bites the bullet and allows its franchisees with “most favored nations” provisions to convert without a fight, or whether some other outcome will occur. However, it is a good general rule that if you don't want to go in the front door, you probably can't go in the back door.

Charles G. Miller is a shareholder and director, and Darryl A. Hart is an attorney with Bartko, Zankel, Tarrant & Miller in San Francisco. They can be reached at 415-956-1900 or at [email protected] and [email protected], respectively.