Choice of Forum in Franchise Agreements Still Subject of Debate

While franchise arbitration agreements continue to receive favorable treatment under the Federal Arbitration Act, 9 U.S.C. ' 1, et seq., ("FAA") the ability of franchisors and franchisees to freely choose their forum remains under attack. As the battle continues, however, both franchise arbitration agreements and offering circulars should expressly include reference to the FAA. Here are some recent "verdicts" on the issue:

In Doctor's Associates, Inc. v. Hamilton, -- F.Supp. -- (D.Conn. May 21, 1997), a Subway franchisee argued that his franchise agreement's forum selection clause was void under the New Jersey Franchise Practices Act because it required arbitration in Bridgeport, Connecticut. The parties had, however, covenanted to the following in their franchise agreement:

The parties hereby agree that the Federal Arbitration Act shall apply to all disputes and claims arising out of or relating to the Agreement, including breach thereof, and including any alleged violations of the Racketeering Influenced and Corrupt Organizations Act (RICO), applicable state franchise disclosure or franchise relationship statutes, . . . and that the business which is the subject of this Agreement is engaged in interstate commerce.
Citing the U.S. Supreme Court's decision in Southland Corp. v. Keating, 466 U.S. 1 (1983) (holding that the FAA pre-empted California's Franchise Investment Law), the Court rejected Hamilton's challenge to the parties' arbitration agreement, including their original choice of forum.

Even where the parties do not expressly contract for the application of the Federal Arbitration Act, federal courts have continued to apply the FAA wherever interstate commerce is involved or "affected." See, Allied-Bruce Terminix Companies, Inc. v. Dobson, 513 U.S. 265 (1995) (wherein respondents, supported by 20 state attorneys general, argued unsuccessfully against federal pre-emption of Alabama Code ' 8-1-41(3) making written, predispute arbitration agreements invalid). In Doctor's Associates, Inc. v. Distajo, 107 F.3d 126 (2nd Cir. 1997), for example, several disgruntled Subway franchisees argued that the franchisor had waived its right to arbitrate by instigating eviction proceedings under the parties' lease agreement./ In support of their argument, the franchisees attempted to rely, in part, on Connecticut state cases on the issue of waiver. The franchise agreement between the parties called for the application of Connecticut law. Upholding the district court's order compelling the franchisees to arbitration, the 3rd Circuit expressly found that the Federal Arbitration Act would apply regardless of the franchise agreement's choice of law provision. Accordingly, as a result, the "strong federal policy favoring arbitration resolved any doubt as to whether waiver occurred in favor of arbitration." Id., at 130, citing Moses H. Cohen Mem'l Hosp. v. Mercury Constr., 450 U.S. 1 (1983). Notably, the court stated that:

"[E]ven the inclusion in the contract of a general choice-of-law clause does not require application of state law to arbitrable issues, unless it is clear that the parties intended state arbitration law to apply to a particular issue."
The 3rd Circuit's recent opinion follows the 1995 U.S. Supreme Court decision in Mastrobuono v. Shearson Lehman Hutton, Inc., 514 U.S. 52 (1995). In Mastrobuono, the U.S. Supreme Court rejected an attempt to exclude punitive damages from the arbitration award. The contract at issue provided that it would be governed by New York law. New York law prohibits arbitrators from awarding punitive damages under the Garrity Rule (named after Garrity v. Lyle Stuart, Inc., 40 N.Y. 2d 354 (1976)). Avoiding the application of the Garrity Rule, the Supreme Court held that the issue of whether or not the arbitrators had the authority to award punitive damages was to be decided by traditional contract interpretation. The Supreme Court then determined that the contract evidenced an intent to allow punitive awards because (1) the arbitration provision incorporated N.A.S.D. arbitration rules, and (2) neither N.A.S.D. rules nor the contract itself excluded an award of punitive damages.

Nevertheless, the FAA's preemption of state franchise laws -- and the anti-forum selection policies contained therein -- was held not to apply to the Michigan Franchise Investment Law ("MFIL") only last year in Interactive Associates, L.C. v. Interactive Electronics Corp., Civil Action No. 96-71836 (E.D. Mich. 1996). The MFIL voids any provision in the franchise agreement requiring arbitration to be conducted outside of Michigan. Interactive Electronics argued that the MFIL was preempted by the FAA, and that, as a result, the franchise agreement's forum selection clause should be honored. The franchisee responded that, unlike other state statutes that completely barred arbitration, Michigan's law was not "unfriendly" to arbitration but only determined its locale (distinguishing the MFIL from the Alabama statute considered in Allied-Bruce, supra). The district court ruled in the franchisee's favor.

The Interactive case was never certified for publication, however, and at least one earlier case interpreting the Michigan statute held otherwise. In Alphagraphics Franchising, Inc. v. Whaler Graphics, Inc., 840 F.Supp.708 (D.Ariz. 1993), the court expressly found that the FAA pre-empted the MFIL, because the MFIL placed greater restrictions on arbitration agreements than on other contracts and, thus, was preempted. The same reasoning formed the basis of the U.S. Supreme Court's decision in Doctor's Associates v. Casarotto, -- U.S. --, 116 S.Ct. 1652 (1996) holding that Montana's statute -- requiring any arbitration clause to be printed in underlined capital letters on the document's first page -- "conflicts with the FAA and is therefore displaced by the federal measure." Id. at --, 116 S.Ct. at 1653.

While the foregoing reasoning may be persuasive, drafters should note that Alphagraphics ultimately lost its argument in Whaler, supra, to its in pro per franchisees, and despite considerable legal representation, because the franchise documents had failed to disclose that arbitration would be governed by the FAA!

"Alphagraphics supplies the MFIL Notice to its franchisees in its offering circular, but does not inform them of its intention to insist on enforcement of the forum selection clause if a dispute arises. Plaintiff's preemption defense remains undisclosed. . . . Because of this omission, the Court cannot conclude that there is a meeting of the minds on the forum selection provision."
Id. at 711.

If anything can be learned from the foregoing, franchisors are well advised to include an express reference to the FAA in both their agreements and offering circulars. Without reference, "the basic purpose of the Federal Arbitration Act . . . to overcome courts' refusals to enforce agreements to arbitrate" may be of no help when faced with a disclosure agreement. Allied-Bruce, supra. Given that franchisors are required to identify out-of-state arbitration as a risk factor under the Uniform Franchise Offering Circular Guidelines (as adopted January 1, 1996), the FAA's inclusion should, at a minimum, appear at Item 17(w) in the UFOC and the corresponding section of the parties' franchise agreement.

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