Court Watch

First a little more background: A McDonald's franchise agreement normally runs for 20 years. The terms of five of the restaurants purchased by the plaintiffs had less than five years remaining. It was known that one restaurant would likely lose its lease and, as such, the franchise term would not be extended. The plaintiffs believed they had been assured that new terms would be granted, based on oral assurances received from McDonald's personnel, under McDonald's transfer policy, and by virtue of the language of a somewhat ambiguously written assignment agreement entered into between the sellers, the plaintiffs, and McDonald's.

It was shown during the hearing on the motion for preliminary injunction that it was McDonald's policy to rewrite a franchise agreement upon transfer where there was less than 10 years remaining on its term, subject to certain conditions, such as facility upgrades and fee payments. Some time passed between the purchase of the facilities in question and McDonald's decision not to rewrite the contracts; during that period, some issues arose, such as the plaintiffs' compliance under the franchise agreements and under the conditions required for the rewrite. It was apparent also that hard feelings had arisen between the parties. Ultimately, McDonald's refused to extend or rewrite the plaintiffs' agreements. McDonald's maintained, among other things, that the circumstances between the parties changed between the purchase of the restaurants and when McDonald's was considering rewriting the concerned franchise agreements, changes which made the plaintiffs ineligible for the revised terms. This lawsuit followed.

During the period between the filing of the lawsuit and the hearing on the preliminary injunction, the terms of several of the purchased restaurants expired. McDonald's, for its part, sought a declaration that those franchises were at an end and an injunction against the plaintiffs continuing to use the McDonald's names and marks.

The Superior Court granted the plaintiffs' motion for a preliminary injunction finding that a jury could find that the plaintiffs were eligible for rewritten terms, given the policy of McDonald's, the representations to the plaintiffs by McDonald's personnel, and the terms of the assignment agreement. It also held that changing the status quo would result in “serious and possibly catastrophic results” to the plaintiffs and, since the plaintiffs continued to comply with the terms of the now-expired franchise agreements, no harm to the defendant.

A key argument made by McDonald's on appeal was that the franchise agreements in question were “in essence” contracts for the personal services of the franchisees. Personal services contracts are not specifically enforceable by either party ' pesky Thirteenth Amendment after all. McDonald's based its position on a California appellate court case, Woolley v. Embassy Suites, Inc., 227 Cal.App.3d 1520 (1991), that held that certain hotel management contracts were personal services contracts. The management agreements called for the exercise of considerable discretionary decision-making in the operation of the hotels that required special skill and judgment, including, according to the Husain court, the “complexity and delicacy of the business decisions entrusted [to the managing entity].” On the contrary, the appellate court in Husain found that the McDonald's franchise agreement left very little to the discretion of the franchisees because most of the policies of the restaurants were dictated by McDonald's. The McDonald's agreement was designed to “ensure comprehensive control by McDonald's over every material aspect of the restaurant's operations.”

The court also pointed out that McDonald's was not paying the Husains for their special skills, but rather it relied on them to perform in accordance with the standards of McDonald's in order to secure for McDonald's expected revenues from the operation of the franchised units. In addition, truly unique skills were not required of the franchisees since there is a great demand for McDonald's units, and they could have been easily transferred to others by the plaintiffs.

The Husain decision was authorized for partial publication, including of the holdings described above. The reasoning of the court, including distinguishing seemingly contrary holdings elsewhere, should serve as a powerful precedent in cases with similar facts.

Incorporation of Arbitration Rules into Arbitration Provision Affects Enforceability of Class Action Waivers

Franchisors who have class action waiver provisions in their arbitration clauses need to take a second look at their agreements to determine which arbitration provider they have selected in light of a recent Missouri federal case, Medicine Shoppe International, Inc. v. Edlucy, Inc., Bus. Fran. Guide (CCH) '14,822 (U.S.D.C. E.D. Mo., May 14, 2012).

In the April 2012 issue of FBLA, we discussed Fantastic Sams Franchise Corp. v. FSRG Association, Ltd., 824 F.Supp.2d 221 (D. Mass 2011). In that case, a Massachusetts federal district judge held that a class action waiver provision would be enforced by the court with regard to a majority of the franchise agreements before it to enjoin a “collective” arbitration brought by a franchisee association before the American Arbitration Association (“AAA”) on behalf of its members. The court denied the motion to stay with respect to agreements which did not contain such a provision, thus leaving the decision on whether to allow a collective action to the arbitrator in those cases. The court relied heavily on the language contained in the majority of franchise agreements that prohibited class actions and required arbitration of individual claims only, and it rejected arguments that the arbitrator should decide the issue. Even though the majority of agreements did not prohibit a collective arbitration, the court's decision was influenced by the language that only individual arbitrations were permitted. The court made this determination even though the association argued that the provision was silent on whether a claim by an association, which was not a class claim, was precluded. The court also acknowledged the general rule, as it gleaned from Green Tree Financial Corp. v. Bazzle, 539 U.S. 444, (2003), that the question of whether class arbitration is forbidden is not a question of arbitrability, but initially a question of contract interpretation and should be decided in the first instance by an arbitrator. However, it appeared to ignore that rule in making its ruling. Since the minority of franchise agreements in Fantastic Sams were silent on the issue of class arbitration, the decision was left to the arbitrator as one of contractual interpretation.

Federal courts in Missouri have now joined the debate. In an almost identical case involving Medicine Shoppe International franchisees, a federal judge came to the opposite conclusion, based on an argument that was not raised in Fantastic Sams. See Medicine Shoppe International, Inc. v. Edlucy, Inc., Bus. Fran. Guide (CCH) '14,822 (U.S.D.C. E.D. Mo., May 14, 2012). There, like in Fantastic Sams, a franchisee association initiated an arbitration proceeding before the AAA on behalf of its members, and the franchisor moved the court to stay the claims based on a class waiver provision, just as Fantastic Sams had done. All but two of the arbitration agreements provided, in language similar to Fantastic Sams', that “arbitration shall be conducted on an individual, not a class-wide basis.”

The franchisor argued that the court should decide whether the group claim should be allowed to proceed in arbitration in light of the class action prohibition since it was a “gateway” issue under Howsam v. Dean Witter Reynolds, Inc., 537 U.S. 79, 84 (2002) because it affected the entire arbitration proceeding. Howsam involved the argument that the court, not the arbitrator, should decide whether the statute of limitations contained in the NASD rules had run because it was a gateway issue crucial to whether there was even a claim. The Howsam court noted that gateway issues usually involved questions about whether there was an agreement to arbitrate, and it rejected the claim that the court should resolve the issue.

However, the decision in Fantastic Sams was not brought to the attention of the court. The court declined to rule on whether it was a gateway issue because the parties had agreed by adoption of the AAA Commercial Rules in the arbitration provision to permit the arbitrator to make the determination of arbitrability, i.e., the parties had agreed that the arbitrator would decide gateway issues. Commercial Rule R-7, cited by the court, provides that “the arbitrator shall have the power to rule on his or her own jurisdiction, including any objections with respect to the existence, scope or validity of the arbitration agreement.”

In AT&T Technologies, Inc. v. Communications Workers of America, 475 U.S. 643, 648, the U.S. Supreme Court held that: “Unless the parties clearly and unmistakably provide otherwise, the question of whether the parties agreed to arbitrate is to be decided by the court, not the arbitrator.” The Medicine Shoppe court assumed that selection of the AAA Commercial Rules was a clear and unmistakable decision to allow the arbitrator to decide the scope. In this regard, it is more likely the franchisor, through counsel, would be aware of the significance of the selection of the AAA rules, and the franchisor's decision to be so bound would be clear and unmistakable. The same may not be true of the less-sophisticated franchisee, but that is a question for another day when the franchisor, rather than the franchisee, is claiming that the arbitrator has the power to decide questions of arbitrability.

The opinion in Medicine Shoppe noted that several other Missouri federal judges had granted motions to dismiss made by the Medicine Shoppe franchisee association on the ground that whether the agreement prohibited class arbitration was a procedural, rather than a gateway, issue. Medicine Shoppe Int'l, Inc. v. Prescription Shoppes, LLC, 2012 WL 1219438, at *2 (E.D. Mo. Apr. 10, 2012); Medicine Shoppe Int'l, Inc. v. Bill's Pills, Inc., 12-CV-158 AGT (E.D. Mo. May 11, 2012). As noted above, the court in Medicine Shoppe declined to go that route, basing its determination on the parties' incorporation of the AAA Commercial Rules into the arbitration provision.

The lesson is clear from these cases. While the current trend is to enforce class action waivers, a hiccup may occur in those cases in which the parties have agreed to incorporate the AAA or any other provider's arbitration rules that “unmistakably” give the arbitrator power to decide its jurisdiction (see, e.g., JAMS Comprehensive Arbitration Rules, Rule 11(c)). This does not mean that an arbitrator won't uphold the class action waiver ' just that it will take more time to get that decision, and if the decision is made against the franchisor, it would not be appealable.

In the cases to date, the challenge to the provision has come from a franchisee association lawsuit, which, arguably, is not a class action, although Fantastic Sams determined it was an end run to avoid the class action prohibition. Because of that potential ambiguity, it could be argued that the arbitrator needs to decide the issue as one of contract interpretation. It seems though, based on the reasoning of the Medicine Shoppe cases, that even if there is a clear prohibition against class or even collective arbitrations, if the parties have agreed that the arbitrator is to decide issues pertaining to the scope of the arbitration, then the arbitrator, not the court, must do so, even if it be deemed a gateway issue. Franchisors wishing to have class action waiver provisions speedily enforced must now make efforts to cleanse their agreements of provisions that incorporate arbitral provider rules that give arbitrators vast powers to decide their own jurisdiction.

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.

Franchise Agreement Is Not a Personal Services Contract

As previously reported in this publication, a dispute arose between McDonald's and certain transferee franchisees over whether McDonald's promised to extend the franchise terms of some of the assigned restaurants as part of the transfer. Husain et al. v. McDonald's Corporation, et al., Bus. Fran. Guide (CCH) '14,530 (FBLA, March 2011). Ultimately, McDonald's refused to grant the desired extensions and maintained that the concerned franchise agreements had expired when their terms ended. The franchisees sought a preliminary injunction to keep the agreements in effect pending trial, and McDonald's sought a declaration that the agreements had ended. The California Superior Court granted the franchisees' motion for a preliminary injunction and denied McDonald's request. The matter proceeded to appeal.

In Husain et al. v. McDonald's Corporation, et al., Bus. Fran. Guide (CCH) '14,819 (April 30, 2012), the Court of Appeal of California, First Appellate District, upheld the franchisees' preliminary injunction and dealt with a claim by McDonald's that the injunction was improper since the franchise agreements were personal services contracts and, as such, were not subject to specific enforcement.

First a little more background: A McDonald's franchise agreement normally runs for 20 years. The terms of five of the restaurants purchased by the plaintiffs had less than five years remaining. It was known that one restaurant would likely lose its lease and, as such, the franchise term would not be extended. The plaintiffs believed they had been assured that new terms would be granted, based on oral assurances received from McDonald's personnel, under McDonald's transfer policy, and by virtue of the language of a somewhat ambiguously written assignment agreement entered into between the sellers, the plaintiffs, and McDonald's.

It was shown during the hearing on the motion for preliminary injunction that it was McDonald's policy to rewrite a franchise agreement upon transfer where there was less than 10 years remaining on its term, subject to certain conditions, such as facility upgrades and fee payments. Some time passed between the purchase of the facilities in question and McDonald's decision not to rewrite the contracts; during that period, some issues arose, such as the plaintiffs' compliance under the franchise agreements and under the conditions required for the rewrite. It was apparent also that hard feelings had arisen between the parties. Ultimately, McDonald's refused to extend or rewrite the plaintiffs' agreements. McDonald's maintained, among other things, that the circumstances between the parties changed between the purchase of the restaurants and when McDonald's was considering rewriting the concerned franchise agreements, changes which made the plaintiffs ineligible for the revised terms. This lawsuit followed.

During the period between the filing of the lawsuit and the hearing on the preliminary injunction, the terms of several of the purchased restaurants expired. McDonald's, for its part, sought a declaration that those franchises were at an end and an injunction against the plaintiffs continuing to use the McDonald's names and marks.

The Superior Court granted the plaintiffs' motion for a preliminary injunction finding that a jury could find that the plaintiffs were eligible for rewritten terms, given the policy of McDonald's, the representations to the plaintiffs by McDonald's personnel, and the terms of the assignment agreement. It also held that changing the status quo would result in “serious and possibly catastrophic results” to the plaintiffs and, since the plaintiffs continued to comply with the terms of the now-expired franchise agreements, no harm to the defendant.

A key argument made by McDonald's on appeal was that the franchise agreements in question were “in essence” contracts for the personal services of the franchisees. Personal services contracts are not specifically enforceable by either party ' pesky Thirteenth Amendment after all. McDonald's based its position on a California appellate court case, Woolley v. Embassy Suites, Inc. , 227 Cal.App.3d 1520 (1991), that held that certain hotel management contracts were personal services contracts. The management agreements called for the exercise of considerable discretionary decision-making in the operation of the hotels that required special skill and judgment, including, according to the Husain court, the “complexity and delicacy of the business decisions entrusted [to the managing entity].” On the contrary, the appellate court in Husain found that the McDonald's franchise agreement left very little to the discretion of the franchisees because most of the policies of the restaurants were dictated by McDonald's. The McDonald's agreement was designed to “ensure comprehensive control by McDonald's over every material aspect of the restaurant's operations.”

The court also pointed out that McDonald's was not paying the Husains for their special skills, but rather it relied on them to perform in accordance with the standards of McDonald's in order to secure for McDonald's expected revenues from the operation of the franchised units. In addition, truly unique skills were not required of the franchisees since there is a great demand for McDonald's units, and they could have been easily transferred to others by the plaintiffs.

The Husain decision was authorized for partial publication, including of the holdings described above. The reasoning of the court, including distinguishing seemingly contrary holdings elsewhere, should serve as a powerful precedent in cases with similar facts.

Incorporation of Arbitration Rules into Arbitration Provision Affects Enforceability of Class Action Waivers

Franchisors who have class action waiver provisions in their arbitration clauses need to take a second look at their agreements to determine which arbitration provider they have selected in light of a recent Missouri federal case, Medicine Shoppe International, Inc. v. Edlucy, Inc., Bus. Fran. Guide (CCH) '14,822 (U.S.D.C. E.D. Mo., May 14, 2012).

In the April 2012 issue of FBLA , we discussed Fantastic Sams Franchise Corp. v. FSRG Association, Ltd. , 824 F.Supp.2d 221 (D. Mass 2011). In that case, a Massachusetts federal district judge held that a class action waiver provision would be enforced by the court with regard to a majority of the franchise agreements before it to enjoin a “collective” arbitration brought by a franchisee association before the American Arbitration Association (“AAA”) on behalf of its members. The court denied the motion to stay with respect to agreements which did not contain such a provision, thus leaving the decision on whether to allow a collective action to the arbitrator in those cases. The court relied heavily on the language contained in the majority of franchise agreements that prohibited class actions and required arbitration of individual claims only, and it rejected arguments that the arbitrator should decide the issue. Even though the majority of agreements did not prohibit a collective arbitration, the court's decision was influenced by the language that only individual arbitrations were permitted. The court made this determination even though the association argued that the provision was silent on whether a claim by an association, which was not a class claim, was precluded. The court also acknowledged the general rule, as it gleaned from Green Tree Financial Corp. v. Bazzle , 539 U.S. 444, (2003), that the question of whether class arbitration is forbidden is not a question of arbitrability, but initially a question of contract interpretation and should be decided in the first instance by an arbitrator. However, it appeared to ignore that rule in making its ruling. Since the minority of franchise agreements in Fantastic Sams were silent on the issue of class arbitration, the decision was left to the arbitrator as one of contractual interpretation.

Federal courts in Missouri have now joined the debate. In an almost identical case involving Medicine Shoppe International franchisees, a federal judge came to the opposite conclusion, based on an argument that was not raised in Fantastic Sams. See Medicine Shoppe International, Inc. v. Edlucy, Inc., Bus. Fran. Guide (CCH) '14,822 (U.S.D.C. E.D. Mo., May 14, 2012). There, like in Fantastic Sams, a franchisee association initiated an arbitration proceeding before the AAA on behalf of its members, and the franchisor moved the court to stay the claims based on a class waiver provision, just as Fantastic Sams had done. All but two of the arbitration agreements provided, in language similar to Fantastic Sams', that “arbitration shall be conducted on an individual, not a class-wide basis.”

The franchisor argued that the court should decide whether the group claim should be allowed to proceed in arbitration in light of the class action prohibition since it was a “gateway” issue under Howsam v. Dean Witter Reynolds, Inc. , 537 U.S. 79, 84 (2002) because it affected the entire arbitration proceeding. Howsam involved the argument that the court, not the arbitrator, should decide whether the statute of limitations contained in the NASD rules had run because it was a gateway issue crucial to whether there was even a claim. The Howsam court noted that gateway issues usually involved questions about whether there was an agreement to arbitrate, and it rejected the claim that the court should resolve the issue.

However, the decision in Fantastic Sams was not brought to the attention of the court. The court declined to rule on whether it was a gateway issue because the parties had agreed by adoption of the AAA Commercial Rules in the arbitration provision to permit the arbitrator to make the determination of arbitrability, i.e., the parties had agreed that the arbitrator would decide gateway issues. Commercial Rule R-7, cited by the court, provides that “the arbitrator shall have the power to rule on his or her own jurisdiction, including any objections with respect to the existence, scope or validity of the arbitration agreement.”

In AT&T Technologies, Inc. v. Communications Workers of America , 475 U.S. 643, 648, the U.S. Supreme Court held that: “Unless the parties clearly and unmistakably provide otherwise, the question of whether the parties agreed to arbitrate is to be decided by the court, not the arbitrator.” The Medicine Shoppe court assumed that selection of the AAA Commercial Rules was a clear and unmistakable decision to allow the arbitrator to decide the scope. In this regard, it is more likely the franchisor, through counsel, would be aware of the significance of the selection of the AAA rules, and the franchisor's decision to be so bound would be clear and unmistakable. The same may not be true of the less-sophisticated franchisee, but that is a question for another day when the franchisor, rather than the franchisee, is claiming that the arbitrator has the power to decide questions of arbitrability.

The opinion in Medicine Shoppe noted that several other Missouri federal judges had granted motions to dismiss made by the Medicine Shoppe franchisee association on the ground that whether the agreement prohibited class arbitration was a procedural, rather than a gateway, issue. Medicine Shoppe Int'l, Inc. v. Prescription Shoppes, LLC, 2012 WL 1219438, at *2 (E.D. Mo. Apr. 10, 2012); Medicine Shoppe Int'l, Inc. v. Bill's Pills, Inc., 12-CV-158 AGT (E.D. Mo. May 11, 2012). As noted above, the court in Medicine Shoppe declined to go that route, basing its determination on the parties' incorporation of the AAA Commercial Rules into the arbitration provision.

The lesson is clear from these cases. While the current trend is to enforce class action waivers, a hiccup may occur in those cases in which the parties have agreed to incorporate the AAA or any other provider's arbitration rules that “unmistakably” give the arbitrator power to decide its jurisdiction (see, e.g., JAMS Comprehensive Arbitration Rules, Rule 11(c)). This does not mean that an arbitrator won't uphold the class action waiver ' just that it will take more time to get that decision, and if the decision is made against the franchisor, it would not be appealable.

In the cases to date, the challenge to the provision has come from a franchisee association lawsuit, which, arguably, is not a class action, although Fantastic Sams determined it was an end run to avoid the class action prohibition. Because of that potential ambiguity, it could be argued that the arbitrator needs to decide the issue as one of contract interpretation. It seems though, based on the reasoning of the Medicine Shoppe cases, that even if there is a clear prohibition against class or even collective arbitrations, if the parties have agreed that the arbitrator is to decide issues pertaining to the scope of the arbitration, then the arbitrator, not the court, must do so, even if it be deemed a gateway issue. Franchisors wishing to have class action waiver provisions speedily enforced must now make efforts to cleanse their agreements of provisions that incorporate arbitral provider rules that give arbitrators vast powers to decide their own jurisdiction.

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.