Court Watch

When examining franchise agreements, a reader easily sees that arbitration clauses come in all shapes and sizes. Some clauses consist of one simple sentence that says, in effect, that the parties agree to arbitrate everything. It is more common, however, for arbitration clauses to set forth the ground rules of arbitration: how many arbitrators, where it will be held, whose rules will control the proceeding, what rules govern discovery, and so forth. The former simplicity of arbitration is being lost; we are constantly creeping toward the development of a system that more and more resembles the complex rules of civil procedure for traditional litigation.

Particularly disturbing is the fact that much of the dispute process in which arbitration clauses are involved today focuses not upon the substance of the dispute, nor traditional motion practice, but on issues relating solely to the arbitrability of disputes. Stated differently, rather than simplifying dispute resolution, arbitration clauses have made it more complicated.

The cases discussed below ' all recent decisions ' demonstrate this phenomenon. When reviewing these cases, the reader should ask: Has the introduction of the concept of arbitration made this case simpler, or has it complicated the process? I suggest that arbitration has created a whole new body of law ' sideshows for lawyers to fight about, rather than expediting the resolution of disputes.

The Kairy v. Supershuttle International Decision

Kairy v. Supershuttle International, Inc., Bus. Franchise Guide (CCH) ' 14,927 (N.D. Cal. Sept. 20, 2012) is the mother ship of the sideshow phenomenon created by arbitration clauses. The plaintiffs in this case were SuperShuttle franchisees who provided transportation services to the public, primarily to and from airports. Their claims were based upon alleged violations of federal and California labor laws. However, before the substantive issues could be addressed, the District Court for the Northern District of California was faced with a slew of issues caused by the franchise agreements' arbitration clauses.

The first of these issues was whether the court could compel the plaintiffs to arbitrate their issues on an individual basis, rather than on a class-wide basis. Under California law, the courts had previously found provisions in arbitration clauses that banned class-wide arbitration to be unconscionable. Recently, however, the U.S. Supreme Court in AT&T v. Concepcion, 131 S. Ct. 1740 (2011), had demonstrated its policy to enforce arbitration provisions unless defenses such as fraud and other traditional legal and equitable defenses were applicable. Thus, the court here ignored the plaintiffs' claim that banning class-wide arbitration was unconscionable.

The second question before the court was whether the defendant franchisor had waived its right to compel arbitration by failing to raise the issue earlier. The court found that three elements must be present in order to conclude that the right to compel arbitration had been waived: 1) the party must have known about its right to compel arbitration; 2) that party must have acted in a manner inconsistent with the exercise of that right; and 3) the party opposing the arbitration demand must be prejudiced if the arbitration will proceed. Here, the facts showed that some of the SuperShuttle franchise agreements in question had express clauses that prohibited class-wide arbitrations, but others were silent on the issue. When this case was initially filed, California law provided that waivers of class-wide arbitration rights were unconscionable. Thus, the franchisor's decision to litigate rather than arbitrate was the only alternative available when the franchisees commenced proceedings. Then, after the decision in Concepcion, the franchisor could file a motion to compel because this remedy was now available. The court noted that the franchisor filed the motion promptly after the Concepcion decision was issued, and thus, the franchisor did not waive its right to compel arbitration. The franchisor also benefited from another recent Supreme Court decision, Stolt-Nielsen S.A. v. AnimalFeeds International Corp., 130 S. Ct. 1758 (2010), in which the Court ruled that arbitration was derived from contractual agreements; therefore, an arbitrator could not compel class-wide arbitration unless the parties had expressly provided for that procedure in their agreements. Here in Kairy, class-wide arbitrations would not be permitted for any of these agreements, whether they prohibited it or were silent on the issue.

A third issue addressed by the district court was whether statutory claims, such as violations of labor laws, could be subjected to arbitration. On this issue, the court concluded that arbitration would be appropriate as long as the contractual right to arbitrate did not prohibit the plaintiff from prosecuting the claim.

Another issue presented to the court was whether arbitration was procedurally or substantively unconscionable for these plaintiffs. Procedural unconscionability is present when a franchisee is forced to enter or unknowingly enters into an agreement that requires arbitration. In this case, among other factors, the court found that the franchisees had been provided at least a 14-day waiting period, as required under federal and most applicable state franchise regulations and laws, before signing the agreement; the franchisees had been given disclosure documents, as legally required; and the arbitration clauses were not hidden within the agreements. Therefore, the court did not sense that the franchisees suffered any coercion or could claim ignorance that would call procedural unconscionability into play.

Substantive unconscionability focuses on the content of the arbitration clauses rather than the process surrounding the execution of the agreements. The plaintiffs raised several issues about the substance of their arbitration clauses. The court concluded that the requirement that arbitration fees and costs be split between the parties was unenforceable, but that the shortening of the statute of limitations and the cap on damages were not part of the arbitration clauses and therefore would have their enforceability determined in the arbitration.

Finally, the Kairy court was presented with the issue of whether the arbitration process could bind the “secondary drivers” ' drivers hired by the franchisees ' although they were not direct parties to the franchise agreements. The court concluded that because these drivers had been third-party beneficiaries of the franchise agreements, they should be obligated to abide by the arbitration process, rather than pursue judicial litigation, in prosecuting their claims.

The Everett v. Paul Davis Restoration Decision

Another nonsignatory issue appeared in Everett v. Paul Davis Restoration, Inc., Bus. Franchise Guide (CCH) ' 14,926 (E.D. Wis. Sept. 18, 2012). In Everett, the specific issue was whether the majority owner of a franchisee could be compelled to participate in the arbitration proceeding called for in the franchise agreement. The original owner had signed the agreement both individually and on behalf of his entity, the franchisee. He later transferred away all ownership of the entity, giving his spouse, who never signed the agreement, 95% ownership.

Initially, the court had concluded that under the so-called “direct benefit estoppel doctrine,” the spouse would be bound to participate in the proceeding because she knowingly received direct benefits from the franchise's operation ' i.e., the profits. In this decision, however, the court reconsidered its initial finding and concluded that the spouse would not be bound by the arbitration. The court concluded that her profits from owning the entity's equity were not the direct benefits of the franchise agreement itself. Thus, she was not subject to the arbitration clause.

The Cold Stone Creamery v. Nutty Buddies Decision

Cold Stone Creamery, Inc. v. Nutty Buddies, Inc., Bus. Franchise Guide (CCH) ' 14,916 (D. Ariz. Oct. 3, 2012) provides yet another example of how arbitration clauses can complicate disputes. Here, the Cold Stone franchisee association had brought a separate suit in Florida alleging that the franchisor, Cold Stone, had failed to provide certain information pertaining to money paid by the franchise system and designated for the benefit of franchisees. The franchisor subsequently filed this action asking an Arizona court to compel the defendant, Nutty Buddies, a member of the association, to arbitrate this dispute in Arizona. The court found that the broad arbitration provision contained in Cold Stone's franchise agreement called for arbitration in Arizona and therefore denied the franchisee's motion to dismiss. The franchisee had argued that the association's Florida suit should have trumped the franchisor's Arizona proceeding because it had been filed first. The court, however, noted that the association's suit (in which the association, not Nutty Buddy, was the plaintiff) had different parties than the Arizona proceeding, and therefore it ignored the “first-to-file rule.”

The Choice Hotels International v. Special Spaces Decision

In Choice Hotels International, Inc. v. Special Spaces, Inc., Bus. Franchise Guide (CCH) ' 14,960 (D. Md. Oct. 23, 2012), the plaintiff asked the court to confirm an arbitration decision despite the defendants' failure to participate in the arbitration proceeding. The defendant franchisees argued that they had been excluded from participating, but the court found the facts to be just the opposite. The franchisees had received notice of the proceeding and had asked to participate telephonically, but the arbitrator had denied their request. The franchisees subsequently did not appear at the hearing. The court concluded that the franchisees had voluntarily declined to appear. For this and other reasons, the court confirmed the arbitration award in favor of the plaintiff franchisor.

The CPR-Cell Phone Repair Franchise Systems, Inc. v. Nayrami Decision

In CPR-Cell Phone Repair Franchise Systems, Inc. v. Nayrami, Bus. Franchise Guide (CCH) ' 14,922 (N.D. Ga. Sept. 13, 2012), the franchisee initially brought suit in California, despite the franchise agreement's requirement that disputes be arbitrated in Georgia. The franchisor then filed this suit in Georgia to compel arbitration in Georgia. The franchisee first argued that the franchisor's California agent, who was a party to the California litigation, was a necessary party to adjudicate the issues before the Georgia court. The court, however, found that the agent was not indispensable because his presence was unrelated to the arbitration issue. The court also found that the venue requirements had been met because the suit's underlying events had sufficiently substantial connections with Georgia. Next, the franchisee argued that by appointing an agent for service of process in California, the franchisor consented to suit in California, and the arbitration provision became void under California law. The Georgia court ruled that this appointment of an agent for service of process did not preclude the possibility of arbitration, and specifically stated that the Federal Arbitration Act empowers federal district courts to compel arbitration when there is a written arbitration agreement. The court did not assess the franchisee's unconscionability argument, instead deferring to the agreement's delegation provision, which reserved questions of arbitrability and unconscionability for the arbitration proceeding itself.

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 former chair of the American Bar Association's Forum on Franchising and co-editor-in-chief of the Forum's Fundamentals of Franchising book. He can be reached at 404-815-6366 or at [email protected]. Barkoff would like to acknowledge the extensive editing assistance he received from Shiveh Roe, an associate with Kilpatrick Townsend & Stockton. Roe can be contacted at [email protected] or 404-541-6689.

Arbitration Clauses in Franchise Agreements: Franchise Law's Breeder Reactor

The literature on arbitration clauses promotes arbitration as a means of improving the process of dispute resolution. Arbitration has been touted as being less expensive, less complicated, quicker, and more private than traditional litigation. At one time, franchise agreements containing arbitration clauses were few and far between. Today, I sense that arbitration clauses are common in franchise agreements ' perhaps as many as half of franchise agreements call for arbitration.

A casual poll of franchise lawyers reveals that their attitudes toward arbitration as a dispute-resolution technique fall into several different camps. Some pro-franchisor lawyers like it; others do not. The same split can be found among pro-franchisee lawyers.

When examining franchise agreements, a reader easily sees that arbitration clauses come in all shapes and sizes. Some clauses consist of one simple sentence that says, in effect, that the parties agree to arbitrate everything. It is more common, however, for arbitration clauses to set forth the ground rules of arbitration: how many arbitrators, where it will be held, whose rules will control the proceeding, what rules govern discovery, and so forth. The former simplicity of arbitration is being lost; we are constantly creeping toward the development of a system that more and more resembles the complex rules of civil procedure for traditional litigation.

Particularly disturbing is the fact that much of the dispute process in which arbitration clauses are involved today focuses not upon the substance of the dispute, nor traditional motion practice, but on issues relating solely to the arbitrability of disputes. Stated differently, rather than simplifying dispute resolution, arbitration clauses have made it more complicated.

The cases discussed below ' all recent decisions ' demonstrate this phenomenon. When reviewing these cases, the reader should ask: Has the introduction of the concept of arbitration made this case simpler, or has it complicated the process? I suggest that arbitration has created a whole new body of law ' sideshows for lawyers to fight about, rather than expediting the resolution of disputes.

The Kairy v. Supershuttle International Decision

Kairy v. Supershuttle International, Inc., Bus. Franchise Guide (CCH) ' 14,927 (N.D. Cal. Sept. 20, 2012) is the mother ship of the sideshow phenomenon created by arbitration clauses. The plaintiffs in this case were SuperShuttle franchisees who provided transportation services to the public, primarily to and from airports. Their claims were based upon alleged violations of federal and California labor laws. However, before the substantive issues could be addressed, the District Court for the Northern District of California was faced with a slew of issues caused by the franchise agreements' arbitration clauses.

The first of these issues was whether the court could compel the plaintiffs to arbitrate their issues on an individual basis, rather than on a class-wide basis. Under California law, the courts had previously found provisions in arbitration clauses that banned class-wide arbitration to be unconscionable. Recently, however, the U.S. Supreme Court in AT&T v. Concepcion, 131 S. Ct. 1740 (2011), had demonstrated its policy to enforce arbitration provisions unless defenses such as fraud and other traditional legal and equitable defenses were applicable. Thus, the court here ignored the plaintiffs' claim that banning class-wide arbitration was unconscionable.

The second question before the court was whether the defendant franchisor had waived its right to compel arbitration by failing to raise the issue earlier. The court found that three elements must be present in order to conclude that the right to compel arbitration had been waived: 1) the party must have known about its right to compel arbitration; 2) that party must have acted in a manner inconsistent with the exercise of that right; and 3) the party opposing the arbitration demand must be prejudiced if the arbitration will proceed. Here, the facts showed that some of the SuperShuttle franchise agreements in question had express clauses that prohibited class-wide arbitrations, but others were silent on the issue. When this case was initially filed, California law provided that waivers of class-wide arbitration rights were unconscionable. Thus, the franchisor's decision to litigate rather than arbitrate was the only alternative available when the franchisees commenced proceedings. Then, after the decision in Concepcion, the franchisor could file a motion to compel because this remedy was now available. The court noted that the franchisor filed the motion promptly after the Concepcion decision was issued, and thus, the franchisor did not waive its right to compel arbitration. The franchisor also benefited from another recent Supreme Court decision, Stolt-Nielsen S.A. v. AnimalFeeds International Corp. , 130 S. Ct. 1758 (2010), in which the Court ruled that arbitration was derived from contractual agreements; therefore, an arbitrator could not compel class-wide arbitration unless the parties had expressly provided for that procedure in their agreements. Here in Kairy, class-wide arbitrations would not be permitted for any of these agreements, whether they prohibited it or were silent on the issue.

A third issue addressed by the district court was whether statutory claims, such as violations of labor laws, could be subjected to arbitration. On this issue, the court concluded that arbitration would be appropriate as long as the contractual right to arbitrate did not prohibit the plaintiff from prosecuting the claim.

Another issue presented to the court was whether arbitration was procedurally or substantively unconscionable for these plaintiffs. Procedural unconscionability is present when a franchisee is forced to enter or unknowingly enters into an agreement that requires arbitration. In this case, among other factors, the court found that the franchisees had been provided at least a 14-day waiting period, as required under federal and most applicable state franchise regulations and laws, before signing the agreement; the franchisees had been given disclosure documents, as legally required; and the arbitration clauses were not hidden within the agreements. Therefore, the court did not sense that the franchisees suffered any coercion or could claim ignorance that would call procedural unconscionability into play.

Substantive unconscionability focuses on the content of the arbitration clauses rather than the process surrounding the execution of the agreements. The plaintiffs raised several issues about the substance of their arbitration clauses. The court concluded that the requirement that arbitration fees and costs be split between the parties was unenforceable, but that the shortening of the statute of limitations and the cap on damages were not part of the arbitration clauses and therefore would have their enforceability determined in the arbitration.

Finally, the Kairy court was presented with the issue of whether the arbitration process could bind the “secondary drivers” ' drivers hired by the franchisees ' although they were not direct parties to the franchise agreements. The court concluded that because these drivers had been third-party beneficiaries of the franchise agreements, they should be obligated to abide by the arbitration process, rather than pursue judicial litigation, in prosecuting their claims.

The Everett v. Paul Davis Restoration Decision

Another nonsignatory issue appeared in Everett v. Paul Davis Restoration, Inc., Bus. Franchise Guide (CCH) ' 14,926 (E.D. Wis. Sept. 18, 2012). In Everett, the specific issue was whether the majority owner of a franchisee could be compelled to participate in the arbitration proceeding called for in the franchise agreement. The original owner had signed the agreement both individually and on behalf of his entity, the franchisee. He later transferred away all ownership of the entity, giving his spouse, who never signed the agreement, 95% ownership.

Initially, the court had concluded that under the so-called “direct benefit estoppel doctrine,” the spouse would be bound to participate in the proceeding because she knowingly received direct benefits from the franchise's operation ' i.e., the profits. In this decision, however, the court reconsidered its initial finding and concluded that the spouse would not be bound by the arbitration. The court concluded that her profits from owning the entity's equity were not the direct benefits of the franchise agreement itself. Thus, she was not subject to the arbitration clause.

The Cold Stone Creamery v. Nutty Buddies Decision

Cold Stone Creamery, Inc. v. Nutty Buddies, Inc., Bus. Franchise Guide (CCH) ' 14,916 (D. Ariz. Oct. 3, 2012) provides yet another example of how arbitration clauses can complicate disputes. Here, the Cold Stone franchisee association had brought a separate suit in Florida alleging that the franchisor, Cold Stone, had failed to provide certain information pertaining to money paid by the franchise system and designated for the benefit of franchisees. The franchisor subsequently filed this action asking an Arizona court to compel the defendant, Nutty Buddies, a member of the association, to arbitrate this dispute in Arizona. The court found that the broad arbitration provision contained in Cold Stone's franchise agreement called for arbitration in Arizona and therefore denied the franchisee's motion to dismiss. The franchisee had argued that the association's Florida suit should have trumped the franchisor's Arizona proceeding because it had been filed first. The court, however, noted that the association's suit (in which the association, not Nutty Buddy, was the plaintiff) had different parties than the Arizona proceeding, and therefore it ignored the “first-to-file rule.”

The Choice Hotels International v. Special Spaces Decision

In Choice Hotels International, Inc. v. Special Spaces, Inc., Bus. Franchise Guide (CCH) ' 14,960 (D. Md. Oct. 23, 2012), the plaintiff asked the court to confirm an arbitration decision despite the defendants' failure to participate in the arbitration proceeding. The defendant franchisees argued that they had been excluded from participating, but the court found the facts to be just the opposite. The franchisees had received notice of the proceeding and had asked to participate telephonically, but the arbitrator had denied their request. The franchisees subsequently did not appear at the hearing. The court concluded that the franchisees had voluntarily declined to appear. For this and other reasons, the court confirmed the arbitration award in favor of the plaintiff franchisor.

The CPR-Cell Phone Repair Franchise Systems, Inc. v. Nayrami Decision

In CPR-Cell Phone Repair Franchise Systems, Inc. v. Nayrami, Bus. Franchise Guide (CCH) ' 14,922 (N.D. Ga. Sept. 13, 2012), the franchisee initially brought suit in California, despite the franchise agreement's requirement that disputes be arbitrated in Georgia. The franchisor then filed this suit in Georgia to compel arbitration in Georgia. The franchisee first argued that the franchisor's California agent, who was a party to the California litigation, was a necessary party to adjudicate the issues before the Georgia court. The court, however, found that the agent was not indispensable because his presence was unrelated to the arbitration issue. The court also found that the venue requirements had been met because the suit's underlying events had sufficiently substantial connections with Georgia. Next, the franchisee argued that by appointing an agent for service of process in California, the franchisor consented to suit in California, and the arbitration provision became void under California law. The Georgia court ruled that this appointment of an agent for service of process did not preclude the possibility of arbitration, and specifically stated that the Federal Arbitration Act empowers federal district courts to compel arbitration when there is a written arbitration agreement. The court did not assess the franchisee's unconscionability argument, instead deferring to the agreement's delegation provision, which reserved questions of arbitrability and unconscionability for the arbitration proceeding itself.

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 former chair of the American Bar Association's Forum on Franchising and co-editor-in-chief of the Forum's Fundamentals of Franchising book. He can be reached at 404-815-6366 or at [email protected]. Barkoff would like to acknowledge the extensive editing assistance he received from Shiveh Roe, an associate with Kilpatrick Townsend & Stockton. Roe can be contacted at [email protected] or 404-541-6689.