Will Your Arbitration Provision Be Enforceable?/USA

Introduction

A decision handed down in December 2006 by the full bench of the US Court of Appeals for the Ninth Circuit has caused substantial concern among franchisors that include arbitration clauses in their franchise agreements.

In Nagrampa v MailCoups, Inc the Ninth Circuit, applying California law, invalidated a specific arbitration provision in a franchise agreement on the grounds that it was procedurally and substantively unconscionable. The court held that the provision was procedurally unconscionable because the franchisor:

had overwhelming bargaining power;

drafted the contract; and

presented it to the franchisee on a take-it-or-leave-it basis.

The court further held that the provision was substantively unconscionable because, among other things, it: (i) lacked mutuality by reserving the franchisor's right to bring certain actions against the franchisee in court, while limiting the franchisee's right to bring actions against the franchisor to the arbitral forum; and (ii) contained a forum selection clause designating the franchisor's home state as the situs for arbitration that was found to be oppressive to the franchisee.

Facts

On August 24 1998 Connie Nagrampa entered into a franchise agreement with MailCoups, Inc to establish and operate a MailCoups franchise in Contra Costa, California. The franchise agreement contained a provision requiring the parties to arbitrate - in accordance with the rules of the American Arbitration Association - any dispute that arose out of, or related to, the franchise agreement. The arbitration provision further provided:

"[T]his clause shall not be construed to limit MailCoups' right to obtain any provisional remedy, including, without limitation, injunctive relief from any court of competent jurisdiction, as may be necessary in MailCoups' sole subjective judgement, to protect its service marks and proprietary information... The situs of the arbitration proceeding shall be the regional office of the American Arbitration Association, which is located in Boston, Massachusetts. The costs of arbitration shall be borne equally by MailCoups and the franchisee. Each party shall be responsible for the fees and expenses of its respective attorneys and experts."

In September 2000 Nagrampa unilaterally terminated the franchise agreement. In December 2001 MailCoups initiated arbitration proceedings claiming that at the time Nagrampa terminated the agreement, she owed MailCoups in excess of $80,000 in fees.

MailCoups initially designated Los Angeles, California as the hearing locale.

Nagrampa objected to the arbitration proceeding, asserting "serious concerns about the validity of the arbitration clause". She further objected to the venue selection, requesting that the venue for the arbitration be Contra Costa, the county in which Nagrampa operated her MailCoups franchise. Finally, she objected to the arbitration fee clause. Based on these objections, as well as the American Arbitration Association's eventual determination that the hearing would take place in Boston, Nagrampa refused to participate in the arbitration proceedings.

Instead, Nagrampa filed suit in the Superior Court of the State of California against MailCoups and the American Arbitration Association, challenging the enforceability of the arbitration provision, among other things. Nowhere in her complaint did Nagrampa seek to have the franchise agreement as a whole invalidated or declared unenforceable.

On January 14 2003 MailCoups removed the action to the US District Court for the Northern District of California, based on diversity of citizenship. MailCoups thereafter filed a motion to compel arbitration and dismiss or stay Nagrampa's action, alternatively seeking transfer of the action to the US District Court for the District of Massachusetts.

District Court Decision

The District Court for the Northern District of California glossed over the question of whether the arbitration provision was procedurally unconscionable and concluded that procedural unconscionability was not a dispositive issue for a motion to compel. The district court addressed only one issue - whether the arbitration provision was substantively unconscionable - and found that the provision was both valid and enforceable. Furthermore, because it found that the parties had agreed to arbitrate in Boston, it dismissed the action, permitting MailCoups to move in the District Court for the District of Massachusetts to compel arbitration.

Nagrampa appealed. Initially, a three-judge panel of the Ninth Circuit affirmed the district court's holding, although on different grounds. Nagrampa then sought review of the panel's decision by the full bench of the Ninth Circuit.

Ninth Circuit Decision

Proper tribunal

As an initial matter, the Ninth Circuit confronted the question of whether a court or an arbitrator should determine the validity of an agreement to arbitrate. The court held that unless the challenge is to the validity of a contract as a whole, the issue of the validity of an arbitration provision is for a court to decide. Finding that Nagrampa's challenge was specifically - and only - to the validity of the arbitration provision, the court concluded that it was the proper tribunal to decide that issue.

Unconscionability generally

The Ninth Circuit observed that, in assessing an unconscionability claim, California courts analyze the contract provisions for both procedural and substantive unconscionability. The court further noted that, in California, the prevailing view is that procedural and substantive unconscionability need not both be present to the same degree. Instead, a sliding scale is applied: the more substantively oppressive the contract term, the less evidence of procedural unconscionability is required to conclude that the term is unenforceable, and vice versa.

Procedural unconscionability

Turning first to the issue of procedural unconscionability, the Ninth Circuit observed that, under California law, the critical factor in a procedural unconscionability analysis is the manner in which the contract or the disputed clause was presented and negotiated.

Noting that California courts have long recognized that franchise agreements have some characteristics of contracts of adhesion because of the allegedly vastly superior bargaining strength of the franchisor, the court concluded that MailCoups had overwhelming bargaining power, drafted the contract and presented it to Nagrampa on a take-it-or-leave-it basis. While acknowledging that the evidence of procedural unconscionability appeared minimal, the court went on to analyze substantive unconscionability.

Substantive unconscionability

The court found that two provisions set forth in the arbitration clause exhibited a lack of mutuality supporting a finding of substantive unconscionability.

First, the court noted that the contract gave MailCoups access to a judicial forum to obtain provisional remedies to protect its intellectual property, while it restricted Nagrampa to the arbitral forum to resolve her claims. The court observed that where the party with stronger bargaining power has restricted the weaker party to the arbitral forum, but reserved for itself the ability to seek redress in either an arbitral or judicial forum, California courts have found that lack of mutuality supported a finding of substantive unconscionability.

Second, the court noted that the arbitral forum was designated as Boston, a location considerably more advantageous to MailCoups since its headquarters were in the vicinity. Under California law, 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, the forum selection provision is unconscionable.

The court thus concluded that the forum selection clause supported a finding of substantive unconscionability because the clause had no justification other than as a means of maximizing MailCoups' advantage over Nagrampa. The court found that the prohibitive costs and burden of pursuing arbitration in Boston effectively precluded Nagrampa from ever raising claims against MailCoups.

Other reasons for unenforceability

As an additional basis for finding the forum selection provision unenforceable, the court noted that the franchise agreement was entered into when Paragraph 20040(5) of the California Business and Professions Code was still considered good law and out-of-state forum selection provisions in franchise agreements were not enforceable under California law. In recognition of Paragraph 20040(5), the MailCoups offering circular contained language suggesting that the forum selection clause may be unenforceable under California law. Applying a prior decision (Laxmi), the court found no evidence that MailCoups ever indicated that it would insist on an out-of-state forum, despite contravening the California law in place at the time the contract was executed. Therefore, the court concluded that Nagrampa had no reasonable expectation that the arbitration would take place in Boston.

Finally, the court found that the forum selection clause could also be unenforceable on public policy grounds because it impeded the enforcement of unwaivable statutory rights. The court concluded that because the forum selection clause could have forced Nagrampa to forgo unwaivable public rights by imposing unreasonable costs to arbitrate her claims in Massachusetts, it was contrary to California public policy and might be unenforceable.

Sliding-scale test

Applying California's sliding-scale test for unconscionability, the court held that even though the evidence of procedural unconscionability was slight, the evidence of substantive unconscionability was strong enough to tip the scale and render the arbitration provision unconscionable and unenforceable.

Two judges on the full bench wrote vigorous dissents, in which a number of other judges joined, taking strong issue with the majority's determinations of procedural and substantive unconscionability, as well as whether the proper forum for deciding those issues was in court or in arbitration.

Comment

The Ninth Circuit's decision in Nagrampa may have a major impact on many standard arbitration provisions in franchise agreements governed by California law. Because franchisors arguably often have superior bargaining power, draft franchise agreements and present them to franchisees on a take-it-or-leave-it basis, there may be no practical way to avoid a finding of procedural unconscionability if the standard set forth by the court in Nagrampa is applied.

However, franchisors can maximize the likelihood of the enforceability of arbitration provisions by trying to address the factors that the Nagrampa court found to constitute substantive unconscionability. To avoid the impact of Nagrampa, franchisors whose arbitration clauses are likely to be assessed under California law should consider drafting arbitration provisions that provide for the same arbitral and judicial forum availability for both franchisor and franchisee.

"International Law Office"