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Arbitration Clause Itself Goes Before Court

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By RICHARD WEATHERINGTON

Arbitration clauses are popping up almost everywhere, so it is not uncommon that when a dispute arises, the arbitration clause is often one of the first issues to be fought over.

One key question for the courts is whether the “crux of the complaint” is the arbitration clause itself or the contract as a whole, including the arbitration clause.

A California corporation and a limited liability company entered into franchise agreements with a franchisor to operate payday loan franchises in California. The franchisor was a Nevada corporation with its principal place of business in Texas.

The franchise agreements included a Texas choice of law clause, as well as an arbitration provision directing that “any and all disputes between the parties and any claim by either party that cannot be amicably settled shall be determined solely and exclusively by arbitration under the rules of the American Arbitration Association.”

The five-paragraph arbitration clause also provided that (1) the arbitrator, a Texas bar member, shall hear the dispute in Dallas County, Texas; (2) the claims subject to arbitration shall not be arbitrated on a class wide basis; (3) while the Franchisor may institute an action for temporary, preliminary, or permanent injunctive relief, the franchisee is not afforded the same remedy; (4) there is a one-year statute of limitations for all claims; and (5) the parties are limited to recovery of actual damages, and waive any right to consequential, punitive or exemplary damages.

In addition, the franchise agreement included an “Addendum” that mentioned that certain provisions of the franchise agreement might not be consistent with California law, and that “if the Franchise Agreement contains provisions that are inconsistent with the law, the law will control.”

Files Suit

In February 2008, the franchisee filed a complaint in California state court, alleging breach of the franchise agreements, fraud and deceit, negligent misrepresentation, violation of the California Franchise Investment Law, declaratory relief, and unfair trade practices under California state law.

In general, the franchisee claimed that the franchisor made numerous material misrepresentations in its Uniform Franchise Offering Circular, such as representing that it offered a unique system of training, it would provide a manual for its business system, and that it provided a system for ensuring the collection of loans.

The franchisee also claimed that certain provisions of the franchise agreement were unconscionable, but neglected to insert into the complaint the list of specific provisions being challenged on that ground.

The franchisee asked for the rescission of the franchise agreement, damages, including punitive damages, declaratory relief, costs and attorney’s fees.

In April 2008, the franchisor had the action removed to federal court based on diversity of citizenship. It then moved to dismiss, or stay the action pending arbitration.

The franchisee opposed the motion, arguing that the arbitration clause within the franchise agreement was unconscionable and unenforceable.

In addition, the franchisee argued that the arbitration provision within the franchise agreement was both procedurally and substantively unconscionable; specifically, that the agreement was not mutually entered into, it improperly limited the franchisee’s damages, it impermissibly shortened the statute of limitations, it contained invalid place and manner restrictions, it sought to negate the franchisee’s unwaivable rights under the CFIL, and it wrongly banned class and consolidated actions.

The district court agreed with the franchisee and denied the franchisor’s motion. The franchsior then appealed to the United States Court of Appeals for the Ninth Circuit and argued that the district court committed three errors:

1. it failed to rule that it was for the arbitrator to decide the threshold issue of arbitrability,

2. it was wrong in applying California rather than Texas law, and

3. it abused its discretion in refusing

to sever the portions of the

arbitration provision it held to be unconscionable under California law.

Abritrability

Although the validity of an arbitration clause can be a question for the arbitrator where the “crux of the complaint” is that the contract as a whole (including its arbitration provision) is invalid, the court determines the validity of the clause where the challenge is specifically to the validity of the agreement to arbitrate.

In other words, said the Appeals Court, when a plaintiff’s legal challenge is that a contract as a whole is unenforceable, the arbitrator decides the validity of the contract, including such things as the arbitration clause.

However, when the challenge is that an arbitration clause independently is unenforceable, that is a question to be decided by the court.

Different Sceanario

The Appeals Court said this case presented a third scenario not described in any precedents, namely, a specific challenge to the arbitration clause that was not raised as a separate claim in the complaint.

What mattered, noted the Appeals Court, was the substantive basis of the challenge.

The “crux of the complaint” matters when the complaint itself makes clear that the challenge to the arbitration clause is the same challenge that is being made to the entire contract.

The “crux of the complaint” and the language in Nagrampa, said the Appeals Court, did not create a rule whereby the plaintiff must plead a separate and distinct challenge to the arbitration clause in order to have the court determine arbitrability.

An independent challenge to the arbitration clause would become relevant only at the point the plaintiff is required to oppose a motion to compel arbitration.

In such a case, like the present one, the challenge to the validity of the arbitration provision would usually appear not in the complaint, but in the pleadings resisting a motion to compel arbitration.

Accordingly, said the Appeals Court, it looks not only to the complaint but also to the franchisee’s motion papers to determine if its objections to the arbitration clause are severable from its challenge to the validity of the franchise agreement as a whole.

Contrary to the franchisor assertions, said the Appeals Court, the franchisee’s argument was that the arbitration provision contained in the franchise agreement was both procedurally and substantively unconscionable because the arbitration agreement:

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 unwaivable rights under the CFIL, and

6. wrongly banned class and consolidated actions.

These were clearly arguments marshaled against the validity of the arbitration clause alone, and separate from the franchsee’s fraudulent inducement claims. The question of arbitrability, therefore, was properly decided by the district court.

Choice of Law

The franchisor next argued that the district court was wrong in applying California law because the franchise agreement contained a Texas choice of law clause. A federal court sitting in diversity applies the forum state’s choice of law rules. Therefore, because the lawsuit was brought in California, the Appeals Court said it must apply California’s choice of law rules to determine whether to apply California or Texas law to the unconscionability issue.

When an agreement contains a choice of law provision, California courts apply the parties’ choice of law unless the analytical approach dictates a different result. The court must first determine “whether the chosen state has a substantial relationship to the parties or their transaction, … or whether there is any other reasonable basis for the parties’ choice of law.

“If … either test is met, the court must next determine whether the chosen state’s law is contrary to a fundamental policy of California.”

If the court finds such a conflict, it “must then determine whether California has a materially greater interest than the chosen state in the determination of the particular issue.” If California possesses the materially greater interest, the court applies California law despite the choice of law clause.

The Appeals Court noted that Texas was the franchisor’s principle place of business and the place it receives royalties and franchise fees. The franchise agreements were formed in Texas and the franchisees received their training there. Accordingly, the parties did not dispute that Texas had a substantial relationship to the parties and the transaction.

At the second step of the analysis, the court asked whether application of Texas law concerning the unconscionability question would be contrary to a fundamental public policy of California.

In cases involving claims under the CFIL, California has an established public policy against arbitration clauses that force franchisees to waive the limitations period, bar class actions, or limit punitive and consequential damages in violation of the law’s anti waiver provisions.

The parties did not dispute that the arbitration clause was enforceable under Texas law, which favors arbitration agreements and has no counterpart to the CFIL, and that Texas law therefore was in conflict with California law on this issue.

Materially Greater Interest

The final question, then, was which state has the materially greater interest in having its law regarding unconscionability of arbitration agreements enforced in this case.

The Appeals Court said it agreed with the district court that California has the greater interest. In assessing which state has a materially greater interest, California courts “consider which state, in the circumstances presented, will suffer greater impairment of its policies if the other state’s law is applied.”

Although Texas certainly has a significant general interest in enforcing contracts executed there and by its citizens and protecting its franchisors from significant liabilities, California has a substantial, case specific interest in protecting its resident franchisees from losing statutory protections against fraud and unfair business practices.

Because the relevant franchises in this case were operated in California, by California citizens, California would suffer a significant impairment of its public policy if this arbitration clause were enforced against its citizens.

Unconscionability

To defeat an arbitration clause, the litigant must show both procedural and substantive unconscionability.

The Appeals Court concluded that procedural unconscionability had been established.

Next, California law holds that mandatory waivers of non waivable statutory rights granted under the CFIL are the sort of one-sided and overly harsh terms that render an arbitration provision substantively unconscionable.

In addition, class action waivers are usually considered substantively unconscionable, as are terms granting the party of greater bargaining power the right to seek injunctive relief in court while denying such relief to the weaker party, at least in the absence of a valid business justification.

The class action and injunctive relief waivers, said the Appeals Court, were accordingly substantively unconscionable.

In addition, said the Appeals Court, if the “place and manner” restrictions of a forum selection provision are “unduly oppressive,” or have the effect of shielding the stronger party from liability, then the forum selection provision is unconscionable.

Because the selection of Texas as the forum made the arbitration clause primarily a tool that the franchisor could use to evade California statutory protections for franchisees, the provision would have the effect of shielding the stronger party from liability, and was thus likely unconscionable.

In sum, said the Appeals Court, four of the five paragraphs of the arbitration clause were unconscionable, or at least unenforceable, in California.

Severability

California Civil Code provides in part that if the court as a matter of law finds the contract or any clause of the contract to have been unconscionable at the time it was made, the court may refuse to enforce the contract, or it may enforce the remainder of the contract without the unconscionable clause, or it may so limit the application of any unconscionable clause as to avoid any unconscionable result.

The California Supreme Court has construed that provision as giving “a trial court some discretion as to whether to sever or restrict the unconscionable provision or whether to refuse to enforce the entire agreement.”

Having found the major part of the arbitration provision substantively unconscionable, and imposed on the franchisees without any opportunity to negotiate, the district court determined that unconscionability “permeated” the entire arbitration agreement and was “overwhelming.”

The court then determined that the arbitration agreement as a whole should not be enforced.

The Appeals Court said it could not find this was an abuse of discretion.

The case was remanded to the district court for further proceedings.

Readers who would like a free copy of this case sent electronically should send an E-mail to cases@cnsus.org with “Franchise Arbitration” in the subject line.



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