Franchise Agreements’ Arbitration Clause Was Unenforceable Under California Law

This posting was written by Pete Reap, Editor of CCH Business Franchise Guide.

The arbitration clause in franchise agreements between a Texas payday loan franchisor and two California payday loan franchisees was neither severable nor enforceable under California law, according to the U.S. Court of Appeals in San Francisco.

A federal district court did not err in declining to sever the unconscionable portions and refusing to enforce the entire arbitration clause (CCH Business Franchise Guide ¶13,966).

The dispute centered on the franchisees' claims that the franchisor made material misrepresentations and omissions regarding its franchises and that the franchisor's business model did not comply with California law.

The franchisees alleged violations of the California Franchise Investment Law, unfair trade practices, fraud, and breach of contract, among other things. The franchisor filed a motion to dismiss or, alternatively, to stay the action pending arbitration. After the district court held the arbitration clause unconscionable and unseverable, the franchisor appealed.

Abitrability of Claims

On appeal, the franchisor argued that, under the “crux of the complaint rule,” the question of arbitrability should be determined by an arbitrator because the franchisees’ complaint did not contain a specific challenge to the arbitration clause. However, the Ninth Circuit did not create a rule under which a plaintiff must plead a separate and distinct challenge to the arbitration clause in order to have a court determine arbitrability, the court reasoned.

In most cases in which the validity of the arbitration clause was distinct from contract claims, a court would not expect the plaintiff to raise claims against the arbitration clause in the complaint because such claims would be unrelated to the plaintiff’s principle prayer for relief.

An independent challenge to the arbitration clause would become relevant only when the plaintiff was required to oppose a motion to compel arbitration. In such a case—and in this one—the challenge to the arbitration clause would come in the pleadings resulting from a motion to compel. Thus, to determine arbitrability, it was necessary to look at the franchisees’ complaint and motion papers to determine if the franchisees’ objections to the arbitration clause were severable from the challenge to the validity of the franchise agreement as a whole.

Unconscionability of Clause

The franchisees contended that the arbitration clause was both procedurally and substantively unconscionable, because it:

(1) Was not mutually entered into;

(2) Improperly limited the franchisee’s damages;

(3) Impermissibly shortened the statute of limitations;

(4) Contained invalid place and manner restrictions;

(5) Sought to negate the franchisee’s unwaiveable rights under the California Franchise Investment Law; and

(6) Wrongly banned class and consolidated actions.

These contentions were clearly attacks on the arbitration clause alone and separate from the franchisees’ claims that the franchisor’s misrepresentations fraudulently induced them into purchasing franchises, the appellate court held. Thus, the question of arbitrability of the parties’ dispute was properly decided by the district court.

Choice of Law

California law governed the question of the unconscionability of the arbitration clause, and the district court’s decision to apply California law to determine that the arbitration clause was unconscionable was affirmed.

On appeal, the franchisor argued that Texas law should govern because the agreements contained a choice of Texas law clause. California’s choice of law rules applied to determine which state’s law governed the unconscionability issue, the appellate court observed.

It was undisputed that Texas had a substantial relationship to the parties and the transaction because the franchisor’s principle place of business was there and the agreements were executed there. However, enforcement of the arbitration clause would contravene the fundamental California public policy in favor of protecting franchisees from unfair and deceptive business practices, as established by the California Franchise Investment Law (CFIL).

Case law demonstrated California’s established public policy against arbitration clauses that forced franchisees to waive the limitations period, bar class actions, or limit punitive and consequential damages in violation of the CFIL’s anti-waiver provisions, the appellate court noted.

Under Texas law, the arbitration clause in the parties’ agreement would be enforceable. Thus, Texas law was in conflict with that of California on the issue. The question came down to which state had a materially greater interest in having its law regarding unconscionability of arbitration agreements applied in the dispute, according to the court.

Of the two, California’s interest was greater. Texas had a significant general interest in enforcing contracts executed there and by its citizens, and in protecting its franchisors from significant liabilities. However, California had a substantial, case-specific interest in protecting its resident franchisees from losing statutory protections against fraud and unfair business practices. Because the franchises were operated in California by California citizens, California would suffer a significant impairment of its public policy if the arbitration clause was enforced against its citizens.

Severability

The district court did not abuse its discretion by declining to sever the unconscionable portions of the arbitration clause and refusing to enforce the arbitration clause in its entirety, the court ruled. Four of the five paragraphs of the arbitration clause were unconscionable, or at least unenforceable, under California law.

After determining that the majority of the arbitration clause was substantively unconscionable and imposed on the franchisees without any opportunity to negotiate, the district court ruled that unconscionability “permeated” the entire arbitration clause and was “overwhelming.” This ruling was not an abuse of discretion, the appellate court held.

The September 16 decision in Bridge Capital Fund Corp. v. Fastbucks Franchise Corp. will appear in the CCH Business Franchise Guide.