Arbitration: One More Look at Its Virtues and Vices

In Rodriguez v. Tropical Smoothie Franchise Development Corp., 2012 WL 12770 (S.D. Ohio, Jan. 4, 2012), the court was faced with the question of whether an arbitration clause contained in a franchise agreement was invalid because it was both procedurally and substantively unconscionable. The court reviewed both types of unconscionability and concluded that the clause was not invalid. Under applicable law (Florida), a contract had to be both procedurally and substantively unconscionable in order to be invalidated. The court decided that the contract was substantively unconscionable, but also concluded that it clearly was not procedurally unconscionable, and thus the arbitration clause was not invalid, regardless of the court's conclusion as to substantive unconscionability.

The arbitration clause itself was unremarkable ' except for its length and how the filing fees and other costs of the arbitration would be handled. Under the franchise agreement, the party bringing the proceeding, which could be the franchisor or the franchisee, must pay the estimated costs of the arbitration upfront. This proved to be a hardship on the franchisee, who appeared to be on the verge of declaring bankruptcy.

The court observed that procedural unconscionability looked at the manner into which the contract was entered. The court found none of the typical indicators of unconscionability, such as the relative power of the parties, their ability to understand the contract, or whether the clause was hidden in “a maze of fine print.” The plaintiff had a college degree, and his excuse that he had failed to read the agreement was simply unacceptable in a commercial setting. Not surprisingly, recent literature has suggested that a large percentage of franchisees fail to read their franchise agreements or the FDD before they buy a franchise.

The plaintiff also claimed that there was fraud in connection with the franchisee's decision to purchase the franchise. The court rejected this argument, too. It distinguished between fraud in the inducement and fraud that related solely to the arbitration clause. The court held that a fraud claim that went to the entire circumstances surrounding the franchise sale was not relevant when determining whether the arbitration clause was procedurally unconscionable. Even nondisclosure of alleged rebates and the alleged providing of false sales projections were not enough, for this purpose, to throw out the arbitration clause altogether.

The court could have stopped here, but nevertheless addressed the issue of substantive unconscionability. Here, the court was more sympathetic toward the franchisee. The franchisee claimed that he was simply in no financial position to fund the arbitration costs upfront. Thus, the franchisee argued, this precondition to being able to pursue a claim in effect barred him from pursuing his rights and remedies. The required prepayment of costs had, what the court suggested in a footnote, the effect of chilling the franchisee's willingness to bring a claim. It does not appear in the precedent cited by the court for this proposition that the plaintiff had to pay any costs or expenses upfront. Rather, the language in the cited precedent seemed to deal with a payment of costs that might be required as a result of an arbitrator's decision in favor of the other party. If this is the correct rationale for finding unconscionability, it leads to the possibility that any contract that had such a provision might be invalidated upon evidence of inability to pay. Where does this leave the concept of freedom of contract ' is this a result that society should condone in light of the Federal Arbitration Act, which encourages arbitration proceedings?

Observations

So, what observations can be made about the importance of Rodriguez?

First, you cannot draft a perfect arbitration clause, as David Kaufmann and I implied in a paper we delivered at the 1995 Forum on Franchising, called “Crafting the Perfect ADR Clause.” In this paper, we demonstrated how an arbitration clause could be drafted so that the results would be a mini-version of the Rules of Civil Procedure. In other words, one could try to cover every contingency that could arise in the procedural aspects of an arbitration, but every time one issue would be covered, one could find two or more that remained unaddressed. In Rodriguez, the franchisor drafted one of the lengthiest arbitration clauses I have seen. However, even here it was far from perfect and, in my opinion, still did not cover myriad issues that incur in any commercial dispute, whether it is a judicial proceeding or an arbitration. Does Rodriguez suggest that making an arbitration clause more precise is a good idea?

Second, Rodriguez suggests that the franchisor's counsel must be cautious when drafting an arbitration to make it balanced not only in appearance, but also in its application. My opinion as to the arbitration provision in Rodriguez is that, on its face, the provision was neutral. However, as is often the situation, bad facts make for bad law. One of the consequences of Rodriguez is that franchisor lawyers must always keep in mind not only the drafted words, but also what happens in the real world when the provisions are applied to real facts. I never realized that clairvoyance was a factor needed to be a good lawyer, but that seems to be one result of Rodriguez.

Third, Rodriguez brings up, again, the whole issue of whether it is a good idea, from the franchisor's perspective, to provide for arbitration. As demonstrated by this precedent, arbitration provisions can often lead to sideshows rather than leading directly to the main event ' the merits of each party's position. In Rodriguez, which I understand is now on appeal to the Sixth Circuit, the parties have yet to address the question of who shot whom? Has it been worth the time and expense of both parties to argue a point that does not on the surface resolve the case? Would the franchisee's limited resources have been better spent addressing the substantive issues raised?

And, finally, there is the problem of the ever-changing factors that must be addressed in answering the question of whether an arbitration clause is a good idea. For example, a recent decision confirming that an arbitrator's powers arise out of the contract, rather than from judicial authority, means that an arbitrator may not conclude that a class-wide arbitration request can be granted if the contract is silent on that issue. This ruling makes an arbitration more attractive for a franchisor. On the other hand, since the laws of contract, even taking into account the patchwork of laws affecting franchising, usually favor the franchisor (for a variety of reasons, including the fact that the franchisor's lawyers drafted the document, and the documents are typically not significantly negotiated, and the principle that contracts should be enforceable and interpreted as written), is it a good idea in these circumstances to put one's fate in the hands of an arbitrator, whose decision is virtually final even if based on manifest error in applying the law as the law seems to read today?

For those representing franchisors, I am sure that many of you, like me, have also played the role of Hamlet when deciding if arbitration is attractive. You may be doing so for the rest of your career.

Rupert M. Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he chairs the firm's Franchise Practice Team. He is a regular contributor to FBLA's “Court Watch” column, a former chair of the American Bar Association's Forum on Franchising and is co-editor-in-chief of Fundamentals of Franchising, a primer for franchise lawyers. He can be reached at 404-815-6366 or [email protected].

For several years, I have felt like Hamlet when I ruminate on the subject of arbitration clauses: To include, or not to include, an arbitration clause in the franchise agreements I draft. We all know the pros of arbitration that have been recited for many years. It is faster, cheaper, and more private ' so they say. However, I sense that “anecdatal” (anecdote and data) experiences neither unequivocally affirm nor deny this contention. And I perceive that many franchisor-oriented lawyers now have a more jaundiced view of arbitration than was previously the case, as do many franchisee-oriented lawyers.

I have not researched whether my hypothesis about franchisor skepticism is true, but a recent decision from the U.S. District Court for the Southern District of Ohio shows at least one case where a franchisee lawyer, and presumably his franchisee client, preferred not to arbitrate.

Rodriguez v. Tropical Smoothie

In Rodriguez v. Tropical Smoothie Franchise Development Corp., 2012 WL 12770 (S.D. Ohio, Jan. 4, 2012), the court was faced with the question of whether an arbitration clause contained in a franchise agreement was invalid because it was both procedurally and substantively unconscionable. The court reviewed both types of unconscionability and concluded that the clause was not invalid. Under applicable law (Florida), a contract had to be both procedurally and substantively unconscionable in order to be invalidated. The court decided that the contract was substantively unconscionable, but also concluded that it clearly was not procedurally unconscionable, and thus the arbitration clause was not invalid, regardless of the court's conclusion as to substantive unconscionability.

The arbitration clause itself was unremarkable ' except for its length and how the filing fees and other costs of the arbitration would be handled. Under the franchise agreement, the party bringing the proceeding, which could be the franchisor or the franchisee, must pay the estimated costs of the arbitration upfront. This proved to be a hardship on the franchisee, who appeared to be on the verge of declaring bankruptcy.

The court observed that procedural unconscionability looked at the manner into which the contract was entered. The court found none of the typical indicators of unconscionability, such as the relative power of the parties, their ability to understand the contract, or whether the clause was hidden in “a maze of fine print.” The plaintiff had a college degree, and his excuse that he had failed to read the agreement was simply unacceptable in a commercial setting. Not surprisingly, recent literature has suggested that a large percentage of franchisees fail to read their franchise agreements or the FDD before they buy a franchise.

The plaintiff also claimed that there was fraud in connection with the franchisee's decision to purchase the franchise. The court rejected this argument, too. It distinguished between fraud in the inducement and fraud that related solely to the arbitration clause. The court held that a fraud claim that went to the entire circumstances surrounding the franchise sale was not relevant when determining whether the arbitration clause was procedurally unconscionable. Even nondisclosure of alleged rebates and the alleged providing of false sales projections were not enough, for this purpose, to throw out the arbitration clause altogether.

The court could have stopped here, but nevertheless addressed the issue of substantive unconscionability. Here, the court was more sympathetic toward the franchisee. The franchisee claimed that he was simply in no financial position to fund the arbitration costs upfront. Thus, the franchisee argued, this precondition to being able to pursue a claim in effect barred him from pursuing his rights and remedies. The required prepayment of costs had, what the court suggested in a footnote, the effect of chilling the franchisee's willingness to bring a claim. It does not appear in the precedent cited by the court for this proposition that the plaintiff had to pay any costs or expenses upfront. Rather, the language in the cited precedent seemed to deal with a payment of costs that might be required as a result of an arbitrator's decision in favor of the other party. If this is the correct rationale for finding unconscionability, it leads to the possibility that any contract that had such a provision might be invalidated upon evidence of inability to pay. Where does this leave the concept of freedom of contract ' is this a result that society should condone in light of the Federal Arbitration Act, which encourages arbitration proceedings?

Observations

So, what observations can be made about the importance of Rodriguez?

First, you cannot draft a perfect arbitration clause, as David Kaufmann and I implied in a paper we delivered at the 1995 Forum on Franchising, called “Crafting the Perfect ADR Clause.” In this paper, we demonstrated how an arbitration clause could be drafted so that the results would be a mini-version of the Rules of Civil Procedure. In other words, one could try to cover every contingency that could arise in the procedural aspects of an arbitration, but every time one issue would be covered, one could find two or more that remained unaddressed. In Rodriguez, the franchisor drafted one of the lengthiest arbitration clauses I have seen. However, even here it was far from perfect and, in my opinion, still did not cover myriad issues that incur in any commercial dispute, whether it is a judicial proceeding or an arbitration. Does Rodriguez suggest that making an arbitration clause more precise is a good idea?

Second, Rodriguez suggests that the franchisor's counsel must be cautious when drafting an arbitration to make it balanced not only in appearance, but also in its application. My opinion as to the arbitration provision in Rodriguez is that, on its face, the provision was neutral. However, as is often the situation, bad facts make for bad law. One of the consequences of Rodriguez is that franchisor lawyers must always keep in mind not only the drafted words, but also what happens in the real world when the provisions are applied to real facts. I never realized that clairvoyance was a factor needed to be a good lawyer, but that seems to be one result of Rodriguez.

Third, Rodriguez brings up, again, the whole issue of whether it is a good idea, from the franchisor's perspective, to provide for arbitration. As demonstrated by this precedent, arbitration provisions can often lead to sideshows rather than leading directly to the main event ' the merits of each party's position. In Rodriguez, which I understand is now on appeal to the Sixth Circuit, the parties have yet to address the question of who shot whom? Has it been worth the time and expense of both parties to argue a point that does not on the surface resolve the case? Would the franchisee's limited resources have been better spent addressing the substantive issues raised?

And, finally, there is the problem of the ever-changing factors that must be addressed in answering the question of whether an arbitration clause is a good idea. For example, a recent decision confirming that an arbitrator's powers arise out of the contract, rather than from judicial authority, means that an arbitrator may not conclude that a class-wide arbitration request can be granted if the contract is silent on that issue. This ruling makes an arbitration more attractive for a franchisor. On the other hand, since the laws of contract, even taking into account the patchwork of laws affecting franchising, usually favor the franchisor (for a variety of reasons, including the fact that the franchisor's lawyers drafted the document, and the documents are typically not significantly negotiated, and the principle that contracts should be enforceable and interpreted as written), is it a good idea in these circumstances to put one's fate in the hands of an arbitrator, whose decision is virtually final even if based on manifest error in applying the law as the law seems to read today?

For those representing franchisors, I am sure that many of you, like me, have also played the role of Hamlet when deciding if arbitration is attractive. You may be doing so for the rest of your career.

Rupert M. Barkoff, a member of this newsletter's Board of Editors, is a partner in the Atlanta office of Kilpatrick Townsend & Stockton LLP, where he chairs the firm's Franchise Practice Team. He is a regular contributor to FBLA's “Court Watch” column, a former chair of the American Bar Association's Forum on Franchising and is co-editor-in-chief of Fundamentals of Franchising, a primer for franchise lawyers. He can be reached at 404-815-6366 or [email protected].