Arbitration Clause in Franchise Agreement Unconscionable Under California Law

This posting was written by Peter Reap, editor of CCH Business Franchise Guide.

In a long-awaited en banc decision, the U.S. Court of Appeals in San Francisco has ruled that an arbitration provision in a franchise agreement was both procedurally and substantively unconscionable under California law and was therefore unenforceable. A federal district court ruling that the provision was valid and enforceable (Business Franchise Guide 2002-2004 New Developments Transfer Binder ¶12,559) was reversed.

The arbitration provision at issue in the agreement between the Massachusetts franchisor and the California franchisee provided in part:

35.1 Arbitration. Any controversy or claim arising out of or relating to this Agreement, or any breach thereof, including, without limitation, any claim that this Agreement or any portion thereof is invalid, illegal, or otherwise voidable or void, shall be submitted to arbitration before and in accordance with the rules of the American Arbitration Association (AAA) or successor organization.

After two years of unprofitable operation, the franchisee unilaterally terminated the parties’ agreement. The franchisor sought arbitration of its claim for more than $80,000 in unpaid fees it claimed the franchisee owed. The franchisee then brought suit against the franchisor in a California state court (later removed to federal court by the franchisor), alleging violations of California franchise law, misrepresentation, and challenging the validity of the arbitration provision.

Validity for Court, Not Arbitrator, to Determine

The appellate court reached its conclusion that the provision was unenforceable after first determining that a court, not an arbitrator, was required to decide the issue of whether the arbitration provision in the parties’ agreement was valid and enforceable. In an earlier, now-withdrawn opinion (Business Franchise Guide 2004-2005 New Developments Transfer Binder ¶13,034), a three-judge panel of the appellate court determined that the unconscionability of the arbitration provision was for an arbitrator to decide. However, considering the issue en banc, the appellate court decided that the franchisee did not seek invalidation of the parties’ agreement as a whole on the grounds of unconscionability; instead, the franchisee challenged only the arbitration provision. In light of the recent ruling of the U.S. Supreme Court in Buckeye Check Cashing, Inc. v. Cardegna (126 S. Ct. 1204, 2006), a court was required to determine the provision’s enforceability.

The franchisee’s complaint made it “abundantly clear” that the franchisee challenged only the arbitration provision, according to the appellate court. The franchisee did not allege a single ground for invalidation of the entire agreement. Although the franchisee did contend that the provision was procedurally unconscionable, based in part on the fact that the entire agreement was a contract of adhesion, the franchisee did not allege that the entire agreement was invalid or seek any relief from the agreement as a whole. Indeed, the franchisee’s four other causes of action provided relief only if the agreement between the parties was a valid and binding one, the court observed.

Unconscionability

The federal district court erred when it “sidestepped the requisite procedural unconscionability analysis” under California law, finding it “nondispositive.” Under California law, the critical factor in procedural unconscionability was the manner in which the disputed provision was presented and negotiated, according to the appellate court. In the instant dispute, the franchisee was in a substantially weaker bargaining position than the franchisor. The franchisor drafted the franchise agreement, and presented it to the franchisee on a take-it-or-leave-it basis. Although the evidence of procedural unconscionability appeared minimal, it was sufficient to require an analysis of whether, under the sliding scale approach employed under California law in a weighing of procedural and substantive unconscionability, the provision was unconscionable.

Two particulars in the arbitration provision exhibited a lack of mutuality supporting a finding of substantive unconscionability, the appellate court ruled. First, the provision gave the franchisor access to a judicial forum to obtain provisional remedies for the protection of its intellectual property, while affording the franchisee only the arbitral forum to resolve her claims. Second, the designation of Boston as the arbitral forum was a location considerably more advantageous to the franchisor than to the franchisee.

The December 4, 2006 opinion in Nagrampa v. Mailcoups, Inc., is posted at the Ninth Circuit web site:

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C2FA43604F5CB31A8825723A005ACAC0/$file/0315955.pdf?openelement">

The decision will appear in a forthcoming issue of the CCH Business Franchise Guide.