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During the past 10 years, there has been a movement in the franchise community to adopt alternative forms of dispute resolution, mirroring the general trend in nonfranchise commercial contracts. The California Court of Appeals recently had the opportunity to review the enforceability of an arbitration provision under the California Franchise Investment Law (CFIL) in an unpublished decision, Vlahos v. International Baking Company Inc. This case involved International Baking Co.’s decision to convert its agreements with its distributors from distribution agreements to franchise agreements as a condition for its distributors retaining their pre-existing routes. Vlahos is interesting because the court examined whether International Baking Co.’s franchise agreement amounted to a contact of adhesion and the consequences flowing from an affirmative determination, namely, whether the alternate dispute resolution provisions were unconscionable. The plaintiffs, James and Nick Vlahos, had entered into a series of distribution agreements with International Baking Co. in the early 1990s pursuant to which the plaintiffs had the right to sell IBC’s Sara Lee Fresh products. IBC’s form of distribution agreement contained a renewal provision. In the fall of 1999, IBC notified plaintiffs and its other distributors that they would have to enter into new franchise agreements in order to retain their routes. IBC did not simply require its distributors to sign its then-current form of agreement; instead, IBC required that each distributor sell its distributorship back to IBC and then buy the franchise at a higher price, the justification being that the franchises would be more valuable. IBC held a series of three meetings with its distributors to discuss the transaction documents and field questions. At the third meeting, IBC distributed execution copies of the applicable sale, buyback and franchise agreements, expecting all of the distributors to sign on the spot. One IBC executive indicated to the plaintiffs that their “days would be numbered” if they did not sign the agreement. The plaintiffs signed the required agreements at that third meeting without any modifications. The franchise agreement contained an alternative dispute resolution provision, which required that the parties mediate any dispute prior to proceeding to binding arbitration. Specifically, an aggrieved party was required to initiate mediation within 10 days of learning any facts giving rise to a dispute, with the mediation to be concluded within 10 business days after the date of initiation. IBC reserved the unilateral right to institute any action or proceeding during this time pertaining to the subject matter of the dispute. The franchise agreement further provided that should the parties be unable to resolve their dispute through mediation, either party could seek relief from an arbitrator by filing a complaint within 20 days following the conclusion of the mediation process. The franchise agreement specifically provided that this 20-day period was an agreed limitations period. The dispute resolution provision also provided that no mediator, arbitrator or judge would be permitted to substitute his judgment for the judgment of IBC in instances where IBC had taken or refrained from taking any action in the exercise of its business judgment based on its assessment of the overall best interest of its franchise system. The franchise agreement also contained an express waiver of punitive damages. Approximately four years later, IBC notified the plaintiffs that their franchise agreements would be terminated due to their failure to properly account for certain credit invoices and overpayments, which was a breach that was incapable of being cured. The plaintiffs referred the termination notice to counsel, who responded by writing a letter of protest, alleging that IBC was in reality attempting to compel the plaintiffs to lose or sell their franchises. Thereafter, the plaintiffs brought suit against IBC, seeking compensatory and punitive damages, injunctive relief prejudgment interest, attorney fees and costs. Plaintiffs alleged various causes of action including breach of contract, breach of the covenant of good faith and fair dealing, fraud and violations of the CFIL. Defendant IBC did not file an answer, but instead filed a motion to compel arbitration as required by the franchise agreement, arguing that the terms of the dispute resolution provision in the franchise agreement were neither procedurally nor substantively unconscionable. The trial court ruled that the entire dispute resolution provision was unenforceable and IBC appealed from that ruling. IBC wrote a letter to the appeals court following the parties’ submission of briefs, arguing that the procedural prong of the analysis of unconscionability of an arbitration provision should be resolved by an arbitrator and not a court, relying on a case of first impression decided by the 9th U.S. Circuit Court of Appeals. At the beginning of its analysis, the appeals court stated that the doctrine of unconscionability has both procedural and substantive elements, noting that procedurally unconscionability generally takes the form of a contract of adhesion, which is a contract drafted and imposed by the party in the superior bargaining position. The court framed its analysis of the arbitration provision by stating that “(w)here an arbitration provision is part of a contract of adhesion, courts will carefully scrutinize the agreement to assure that the arbitration falls within the reasonable expectations of the weaker, or “adhering” party, and are not unduly oppressive or “unconscionable.” The appeals court stated that the case on which IBC relied as to the procedural aspect of unconscionability was of no precedential value in a California state court and was contrary to California precedent. In particular, the court noted that the California Supreme Court has held that a court, not an arbitrator, is to determine the unconscionability of an arbitration provision contained in a contract of adhesion. Accordingly, the court undertook a two-prong analysis of the arbitration provision contained in the IBC franchise agreement. The first prong of that inquiry was procedural, focusing on the manner in which the franchise agreement was negotiated, including the extent to which the conduct of the superior party, in this case IBC, was oppressive. The appeals court found as an initial matter that the trial court reasonably concluded that the franchise agreement was a contract of adhesion as the plaintiffs “had no real choice but to accept the dispute resolution (provision) in the franchise agreement because the inclusion of the provision was non-negotiable.” The court concluded its analysis of the procedural prong by stating that neither the plaintiffs’ business interest in continuing as IBC distributors nor their knowledge of the contents of the franchise agreement would preclude a finding of unconscionability. The court then turned its attention to a discussion of substantive unconscionability, describing that term as a contract of adhesion or provision contained therein that is unfairly one-sided. The trial court found that three paragraphs in the arbitration provision were substantively unconscionable. The first provision required a party to initiate a mediation proceeding within 10 days from the date a dispute arises. A party would then have 20 days from the conclusion of mediation in which to file an arbitration proceeding. The second such provision stated that a tribunal would not be permitted to substitute its business judgment for that of IBC in instances where IBC has taken, or refrained from taking, action “in the exercise of its business judgment based on its assessment of the overall best interest of the network and/or distribution program.” The trial court also found that waiver of punitive damages was unconscionable. IBC argued that the 10-day limitation to seek mediation is applicable only if a party desired to mediate a dispute. IBC argued that if a party did not seek mediation, then the applicable statutory or common law statute of limitations would apply to the filing of an arbitration proceeding. The court disagreed with this argument finding that the reasonable interpretation of the agreement was to compel a two-step process – namely, mediation followed by arbitration in accordance with the parameters set forth in the franchise agreement – noting that the franchise agreement was silent with regard to how the parties were to resolve a dispute where mediation is not sought. The court opined that while the time limitations apply equally to both parties, it is more likely that a franchisee would seek to initiate dispute resolution. By way of example, the court stated that IBC is not required to mediate and arbitrate prior to terminating a franchise, and that “(i)t is the franchisee who must seek relief from wrongful termination.” The court emphasized that the limitation periods to which a franchisee is subject are much stricter than the limitations set forth in the California Franchise Investment Law, which range from 90 days to four years. Accordingly, the court agreed with the trial court’s finding that this provision was unconscionable. The court next turned its attention to the issue of the waiver of punitive damages. IBC argued that the waiver was not unconscionable as there may be circumstances where IBC would want to seek punitive damages such as where a franchisee commits fraud. The court found that while the waiver was bilateral on its face, the provision favored IBC writing that “(t)o hold otherwise ignores the question that underlies the substantive unconscionability analysis, namely, whether the agreement is unduly one-sided at the time the agreement was formed.” The court reasoned that franchisors have greater resources than franchisees and that the franchisor is more likely to be faced with a claim for punitive damages. The court held that since IBC was the party imposing the waiver, it is reasonable to conclude that it did so with the intent that the waiver benefit itself. Finally, the court turned its attention to the business judgment provision. IBC argued that the provision applied in limited circumstances and that the provision was commercially reasonable because it allowed IBC to take action for the benefit of its franchise system as a whole. The court also found that this provision unduly favored IBC. The court reasoned that the business judgment rule would preclude an arbitrator from considering whether conduct of the franchisor was tantamount to fraud, bad faith or overreaching. In addition, the court stated that the business judgment rule was at odds with the implied covenant of good faith and fair dealing, citing a prior case that stood for the proposition that where a party to a contract has discretionary power such party is required to exercise that power in good faith and in accordance with fair dealing. While courts and industry do favor alternative dispute resolution provisions, it is incumbent on counsel for a franchisor to ensure that its ADR provision is drafted in an even-handed manner. Moreover, counsel should review applicable franchise relationship laws to determine whether the proposed ADR provision will be given effect or rendered unenforceable in whole or in part. There is a reason why franchisors tend to favor forms of alternative dispute resolution and counsel does not want to be so aggressive in drafting that it results in the defeat of the franchisor’s expectations.

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