Is your commitment to arbitrate enforceable?

The Ninth Circuit voided the standard arbitration clause: Is this a sign of things to come or just the musings of a liberal court?

By Bill Killion
As published in: Franchise Times - March 2007

A commitment to arbitrate is the most powerful risk-allocation tool available to a franchisor. A carefully drafted arbitration provision can (1) preclude class actions, (2) guaranty that disputes will be heard in the franchisor’s own backyard, (3) allow the parties to control the qualifications of the arbitrator, (4) limit remedies, (5) control dispute-resolution procedures, (6) preserve resort to the courts for provisional relief, and (6) result in a more expeditious, and less costly, resolution of disputes.

It is not surprising therefore that arbitration provisions are common in franchisor agreements. In 1999 Professor Christopher Drahozal studied the franchise agreements of the largest franchisors and found that nearly 45 percent of the agreements contained an arbitration clause. I did my own study of the agreements of a larger group and found that 72 percent contained commitments to arbitrate. The details of the studies are published in the 2002 Franchise Law Journal.

Arbitration has not always been the darling of franchisors—or courts for that matter. Until the early 20th century, U.S. courts were reluctant to enforce commitments to arbitrator, a “judicial disposition,” according to the Supreme Court in Circuit City, “inherited from then-longstanding English Practice.” Congress enacted the Federal Arbitration Act (FAA) in 1925 to overcome this hostility to arbitration. Congress declared arbitration agreements “valid, irrevocable, and enforceable” on the same basis as any other contract. The Supreme Court found in Moses H. Cone that the FAA embodies “a liberal federal policy favoring arbitration agreements, notwithstanding any state substantive or procedural policies to the contrary.” In the years following enactment of the FAA, the Supreme Court has rejected repeatedly efforts by courts and state legislatures to restrict arbitration. The Court has held that the FAA pre-empts state anti-arbitration laws; that federal statutory claims, even antitrust and federal employment law claims, are subject to arbitration; that the FAA precludes states from singling out arbitration clauses for special treatment; that arbitration agreements limiting remedies are enforceable; and that the arbitrator decides fraud in the inducement claims, except where the fraud relates to the arbitration clause itself.

Against this backdrop comes a December 4, 2006, decision out of the Ninth Circuit Court of Appeals, Nagrampa v. MailCoups Inc. The court, in a sharply divided opinion, found that an arbitration clause in a franchise agreement was unconscionable and therefore unenforceable under California law. The problem with Nagrampa is this: If the arbitration clause in that case is unenforceable, then no arbitration commitment is safe from judicial interference. The big question is whether Nagrampa is “good law” or little more than musings of what some skeptics call the Ninth “Circus” Court of Appeals located on the “Left Coast.”

Connie Nagrampa was hardly the prototypical mom-and-pop franchisee when she first considered a MailCoups franchise. She was earning over $100,000 per year as a sales manager for ValPak, a company that competed with MailCoups in the direct marketing industry. Judge Kozinski observed in his dissent that “if Nagrampa was not sophisticated enough to sign up as a direct-mail franchisee, nobody is.” The majority nevertheless characterized Nagrampa as in “a substantially weaker bargaining position than MailCoups” because she was a first-time franchisee and “had no specialized training education or training in the field,” something apparently not offset by her actual experience in the industry.

Nagrampa’s weak bargaining position, coupled with MailCoups’ take-it-or-leave-it position on the franchise agreement, was enough for the majority to declare the commitment to arbitrate “procedurally unconscionable” and get the court to the second prong of the two-part California test for declaring the entire commitment unenforceable—“substantive unconscionability.” Here is where the decision gets particularly troublesome.

The arbitration clause in the MailCoups agreement was “plain vanilla.” It said that “any controversy ... shall be submitted to arbitration” in accordance with the American Arbitration Association rules, (2) MailCoups could seek “provisional” relief (an injunction) “to protect its Service Marks and proprietary information,” (3) the “situs” of the arbitration will be Boston, MailCoups’ home, and (4) the parties will share the costs of arbitration.

The majority opinion addresses a host of issues, but ultimately comes down to a few key points of particular interest to the franchise community. First, the majority rested its decision on a supposed lack of mutuality and the choice of Boston as the forum for the arbitration. According to the court, Nagrampa was duty-bound to submit all of her claims to arbitration, but MailCoups could ask for provisional relief. Oddly, Nagrampa offered no evidence that she could not afford to arbitrate in Boston. The majority said that under California law MailCoups had the burden of showing that the forum selection clause did not diminish Nagrampa’s rights.

The Nagrampa decision sparked a spirited debate within the franchise law bar, with some lawyers opining that the decision was a warning to all franchisors that courts will more carefully scrutinize their one-sided agreements while others passed it off as the by-product of a court out-of-step with the law. The decision is obviously significant to franchisors doing business in California. When looking beyond California, however, franchisors should be slow to do anything differently.

To begin with, the Nagrampa decision is, in many ways, a political decision. The majority decision reflects a philosophy that franchisees (just like widows, orphans, and sailors) need special protection. All seven of the judges comprising the majority are Democrat appointees (five Clinton and two Carter). Three of the four dissenters are, in turn, Republican appointees. Although the majority and minority spar over the nuances of the law, their real differences are reflected in a handful of pages. The majority proceeds on the assumption that “California courts have long recognized that franchise agreements have some characteristics of contracts of adhesion because of the ‘vastly superior bargaining strength’ of the franchisor.” In contrast, Judge Kozinski observes that “as with most paternalistic endeavors, the majority’s opinion carries the seeds of great irony. By invoking the unconscionability doctrine to protect ‘the little guy’ in this case, the majority has construed California franchise law in a way that will result in fewer opportunities for other ‘little guys’ in the future” by discouraging companies from becoming franchisors.

The MailCoups arbitration clause was far from oppressive. It did give MailCoups the limited right to seek provisional relief, but this is standard in franchise agreements. Professor Drahozal found that 76 percent of the arbitration clauses he studied contained a similar provision. The forum selection clause was also typical. In fact, Drahozal observed that 82 percent of the clauses he reviewed designated the franchisor’s home state as the location of the arbitration.

One lesson from Nagrampa is that franchisors should craft arbitration clauses so that they do not appear one-sided. The Nagrampa majority opinion voided the MailCoups agreement largely because the franchisee did not have a similar right to seek provisional relief. There is little harm in franchisors extending a similar right to franchisees, and MailCoups would probably have made the exception mutual if it had any idea that a court might void the commitment altogether.

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Franchise Times - March 2007