Enforcing Your Arbitration Agreements

May 2009 Franchising World

Given the growing antipathy in some segments toward arbitration, it is not surprising that 2008 was a challenging year for those who sought to enforce arbitration agreements. This was especially true in California, which continued to take the lead in finding new ways to strike down arbitration agreements.

By Joel D. Siegel and Norman M. Leon

In Bencharsky v. Cottman Transmission Systems, LLC,1 the court determined that an arbitration agreement was substantively unconscionable   because it lacked mutuality. This lack of mutuality arose from the fact that the arbitration agreement specifically granted the franchisor the right to seek injunctive relief in court in certain circumstances (such as when its trademarks were being infringed), while the franchisee’s only option was arbitration. Decisions such as these remain puzzling, as they apply a standard of enforceability that applies only to arbitration agreements, which is the very thing the Federal Arbitration Act has said courts may not do. Nonetheless, this principle seems firmly entrenched in California jurisprudence, and has gained some traction in a few other jurisdictions. While enforcing arbitration agreements in California will remain a difficult proposition, losing the battle over a non-mutual injunctive relief provision seems unnecessary. It is generally well-settled that a court has the inherent authority to grant injunctive relief to preserve the status quo pending arbitration even if the arbitration agreement does not specifically grant the court that power. It would therefore seem advisable to draft an arbitration agreement to make clear that both parties have the right to seek injunctive relief in the appropriate case.

Where Will Arbitration Take Place?
A substantial body of case-law has developed over the years which makes clear that the FAA preempts any state law that attempts to override a forum selection clause in an arbitration provision. In the wake of Nagrampa v. MailCoups, Inc.,2 the California courts have issued a series of decisions that haven stricken arbitral forum selection clauses in a manner that (in the opinion of the California courts) circumvents the preemptive effect of the FAA. In Bridge Fund Capital Corp. v. Fastbucks Franchise Corp.,3 the court struck down as unconscionable a provision which required that arbitration take place in Texas because the Court could not be assured that the franchisees’ “rights under the CFIL [California Franchise Investment Law] would be protected in a Texas forum applying Texas law.” While this decision is currently up on appeal, enforcing an arbitral forum selection provision in California will be challenging at best. Drafting your forum selection clause to specify that the application of a chosen law will not be deemed to constitute a waiver of non-waivable statutory rights–a step that should be unnecessary given the language of the applicable statutes–might address the concerns that underlie the decision in Fastbucks. However, given the ever-moving nature of these decisions, there does not appear to be any surefire way to guarantee enforcement.

Attempts to Avoid the Application of California Law
In 2007, after the Ninth Circuit issued its opinion in Nagrampa v. MailCoups, Inc.,4 practitioners worked on ways to counter the reach of that decision, which deemed substantively unconscionable several provisions that are typically found in arbitration agreements (such as a provision requiring that arbitration take place where the franchisor’s principal place of business is located). One suggested approach was to specify the law of a state other than California as the governing law. One recent decision brings into question the viability of that approach. In Bencharsky v. Cottman Transmission Systems, LLC,5 the franchisor argued that the court had to apply Pennsylvania law in determining whether any provisions of the arbitration agreement were unconscionable, as that was the law specified in the parties’ choice-of-law provision. The court rejected this argument. Relying on the policy underlying the application of the California Franchise Investment Law, the court concluded that Pennsylvania law was contrary to the fundamental public policy of California embodied in the CFIL and that, as a result, “the choice-of-law provision in the parties’ agreement [was] unenforceable for purposes of determining the validity of the arbitration provision.”

A different conclusion was reached by another California federal court, only seven months earlier, in Smith v. Paul Green School of Rock Music Franchising, LLC.6 In that case, the franchisee claimed that a Pennsylvania choice-of-law clause was unconscionable, as enforcement of that clause would effectively “negate” the CFIL, which states that it may not be waived. Noting that the franchisor had conceded that the CFIL would apply in arbitration notwithstanding the choice-of-law clause, the court rejected the franchisee’s argument and found the choice of Pennsylvania law enforceable.

Avoiding the Courts Altogether
Given the tenor of certain recent rulings and the increasingly unpredictable nature of challenges to the enforceability of arbitration agreements, some parties are seeking to take challenges to the enforceability of arbitration agreements out of the courts and place them in arbitration. Almost 15 years ago, in First Options of Chicago, Inc. v. Kaplan,7 the U.S. Supreme Court made clear that while a court ordinarily addresses challenges to the validity of an arbitration agreement, such challenges must be referred to the arbitrator if there is “clear and unmistakable evidence” that the parties intended to refer those challenges to arbitration. This evidence will exist where, for example, an arbitration agreement specifies that all questions regarding the validity of the arbitration agreement are to be submitted to arbitration. But that evidence will also exist where an arbitration agreement provides that arbitration will be governed by a set of rules (such as the Commercial Rules of the American Arbitration Association) which provide that the arbitrator has the power to address any objections to the existence, scope or validity of an arbitration agreement.

In Awuah v. Coverall North America, Inc.,8 the franchisor argued that, because the parties had incorporated the AAA’s Commercial Arbitration Rules into their arbitration agreements, any challenges the franchisees had with respect to the enforceability of those agreements needed to be submitted to arbitration. The district court rejected that argument, and the franchisor appealed. While it concluded that the incorporation of the Commercial Arbitration Rules constituted clear and unmistakable evidence that the parties intended to submit claims regarding the enforceability of the arbitration agreements to arbitration, the court held that the franchisees were entitled to have a court determine whether the costs of arbitration rendered it impossible for the franchisees to present their challenges to the arbitrator. Proving that the costs of arbitration are so high as to render an arbitration agreement illusory is a very difficult burden, and one that necessarily depends on the finances of the franchisees in question. Depending on the nature of your system, and the finances of your franchisees, seeking to push challenges regarding the enforceability of your arbitration agreement into arbitration may be the likeliest way of both enforcing your agreement and avoiding a costly legal battle.

How Strong is Your Contract?
Courts came out mixed this year when faced with allegations of fraud. In Westerfield v. Quizno’s Franchise Co., LLC,9 the plaintiff franchisees alleged that the franchisor, through intentional misrepresentations and omissions, fraudulently induced the plaintiffs to enter into agreements pursuant to which the franchisor could require them to purchase goods and services at grossly inflated prices from which the franchisor ultimately received a profit. The case was before the court on the plaintiffs’ Rule 59(e) motion to alter or amend the court’s earlier judgment in which it had dismissed the plaintiffs’ civil RICO, fraud and anti-trust claims with prejudice. The court concluded that it had manifestly erred in its earlier order dismissing the plaintiffs’ state fraudulent inducement and federal RICO claims by concluding that the disclaimers and nonreliance clauses contained in the franchisor’s contract documents “fatally undermined” the allegations of misrepresentations and omissions upon which such claims were based.

The court discussed its misplaced reliance on several cases in reaching its earlier decision. Specifically, the language from Hardees of Maumelle, Ark, Inc. v. Hardee’s Food Sys., Inc.,10 quoted by the court in its earlier decision was a finding of fact made by the court after a bench trial and was not a conclusion of law reached on a motion to dismiss. The courts reliance on Rissman v. Rissman,11 was misplaced because it involved securities transactions and was decided on summary judgment, not on a motion to dismiss. Finally, the court in Associates in Adolescent Psychiatry, S.C. v. Home Life Insurance Co.,12 considered not only the language in the contract documents in granting the defendant’s motion for summary judgment but also that the alleged representations were mere “puffery.” Upon reconsideration, the court concluded that none of the aforementioned cases holds that the contract language precluded a claim of fraud regardless of the facts alleged. Finally, the court noted that Wisconsin law was clearly contrary to the court’s earlier finding that the disclaimers and non-reliance clauses were dispositive as a matter of law. Specifically, the Wisconsin Supreme Court has adopted the position that “‘exculpatory clauses are unenforceable on public policy grounds where the alleged harm is caused intentionally or recklessly,’” as the plaintiffs had in the case at hand.

Nice questionnaire, but . ..
In Emfore Corp. v. Blimpie Assoc., Ltd.,13 the court held that the trial court erred in dismissing the franchisee’s fraud claims under the N.Y. Franchise Act,14 based on the franchisee’s responses in a franchise agreement Rider/Questionnaire to certain disclaimers and acknowledgments regarding information supplied to it by the franchisor and in not dismissing the franchisor’s affirmative defenses that were based on the franchisee’s responses. The court concluded that, on its face, the questionnaire did not violate the NYFA and that it was indeed a good tool for franchisors to identify dishonest sales personnel and avoid sales secured by fraud. The defendant franchisor could not, however, advance the questionnaire as a waiver of fraud claims because such waivers are barred by the NYFA. Reliance is a necessary element to a fraud claim under the Franchise Act and, in light of the disclaimers and acknowledgments, issues of fact remained as to the extent and reasonableness of the franchisee’s reliance on the defendants’ alleged oral misrepresentations.

In contrast to Emfore, in Edwards v. Kia Motors of America,15 the Alabama Supreme Court held that a mutual release of all existing claims executed between an automobile dealer and the manufacturer was not invalidated by the non-waiver provision of the Alabama Motor Vehicle Franchise Act.16 Specifically, the Franchise Act provides “Notwithstanding the terms, provisions, or   conditions of any dealer agreement or franchise or the terms or provisions of any waiver” any person injured by a violation of the Franchise Act can file a civil action for damages. After a review of the legislative history, the court concluded that there was no indication that the legislature intended this provision to prohibit settlement of known claims as an alternative to litigating them. Accordingly, the court held that an automobile dealer cannot bring a claim under the Franchise Act if it has “executed a mutual release agreement [with the manufacturer] in which it relinquished all existing legal claims against the manufacturer in exchange for valid consideration.”

Attorneys can no longer assume that careful drafting, even the use of collateral “anti-fraud” documents at signing, will be an effective shield against fraud claims in all courts.

Joel D. Siegel is a partner of Sonnenschein Nath & Rosenthal LLP and Norman M. Leon is a partner of DLA Piper USA LLP. Siegel can be reached at jsiegel@sonnenschein.com and Leon at norman.leon@dlapiper.com .