Franchise 101: Charging Toward Arbitration; and Non-Compete Jumpstarted in Bankruptcy
Franchisor 101: Charging Toward Arbitration
A California federal court granted a motion to compel arbitration by retail franchisor Batteries Plus and its two executives, and dismissed a franchisee’s action alleging violations of the California Franchise Investment Law, breach of the implied covenant of good faith and fair dealing, and misrepresentation. The court also struck some of the arbitration terms in the franchise agreement because they were unconscionable.
The franchisee’s complaint alleged that Batteries Plus underestimated new franchise operating costs in its FDD, provided false and inflated revenue projections, permitted another franchisee to encroach on its territory, failed to provide support, and created a hostile work environment. After the franchisee filed suit in state court, Batteries Plus removed the action to federal court, then moved to compel arbitration and to dismiss or stay the action. The franchisee opposed this motion on the grounds that there was no valid agreement to arbitrate, that the arbitration provision was unconscionable, and that if the arbitration provision was enforceable, it did not extend to the two executive defendants.
The court held the two executives were entitled to the benefits of the arbitration provision and to move to compel arbitration, because they were agents of Batteries Plus and their alleged conduct was related to and connected with the franchise agreement. The court also agreed with Batteries Plus that the franchisee validly agreed to arbitrate his claims, and presumed that the franchisee read and understood the agreement before he signed, regardless of whether he did not have the benefit of counsel.
Recognizing that franchise agreements have some characteristics of adhesion contracts, the court determined that there was minimal procedural unconscionability. The court saw some oppression to the extent Batteries Plus drafted the agreement, had the greater bargaining power, presented the agreement on a take-it-or-leave-it basis, and first mentioned the arbitration provision at page 32 of the 57-page agreement without a table of contents. The court nevertheless found that the franchisee had ample time to review and understand the agreement.
However, the court found there was some substantive unconscionability because only Batteries Plus, not the franchisee, could seek injunctive relief in a judicial forum. The arbitration provision also imposed a restriction on punitive damages and exemplary damages, which the court found to be contrary to California law. The court severed those provisions as unconscionable.
Other unconscionability challenges to the arbitration clause, such as the Wisconsin venue provision and the class action/joinder waiver, were rejected. Mere inconvenience or additional expense would not make a forum selection clause unduly oppressive or unreasonable, and the franchisee could have reasonably anticipated arbitration in a different state given the disclosures Batteries Plus presented before the franchisee signed.
Even when arbitration is compelled, courts can play a significant role in shaping the parameters of arbitration. Franchisors should consider addressing potential unconscionability issues in their agreements with counsel to minimize the risk of courts scrutinizing overly oppressive terms. Such a proactive approach can help maintain the integrity of the franchisor’s chosen dispute resolution method.
Singh v. Batteries Plus, LLC., No. 2:24-cv-00223-KJM-DB (E.D. Cal. May 10, 2024)
Franchisee 101: Non-Compete Jumpstarted in Bankruptcy
A Michigan bankruptcy court held that a debtor-franchisee seeking to reject a franchise agreement for an auto repair center could not reject either a stand-alone confidentiality agreement with the franchisor or the non-compete and confidentiality provisions included within the franchise agreement. The court determined that these provisions were neither executory nor subject to rejection under the Bankruptcy Code. As a result, the debtor-franchisee could be prohibited from operating a competing business from its former franchised location and from using the franchisor’s intellectual property.
The franchisee sought bankruptcy court approval to reject its franchise agreement. Prior to the bankruptcy court’s ruling, the franchisee began taking steps to end its relationship with its franchisor and operate an independent business, by copying customer lists, repainting the interior of its facility, ceasing reports of sales to the franchisor, and posting a notice for its customers advising of its name change to an independent “car care” center.
The court noted a general rule that a debtor in bankruptcy may assume or reject executory contracts. For a contract to be “executory” and subject to rejection, performance by both parties must remain due to some extent. The franchise agreement was a rejectable executory contract because performance by both franchisor and franchisee remained outstanding. However, neither the non-compete and confidentiality clauses, nor the separate confidentiality agreement, could be considered executory because they lacked material continuing obligations. The franchisor had already performed by providing all trademarks, intellectual property and other proprietary confidential information to the debtor-franchisee.
The court next looked to the nature of the franchisor-creditor’s damages that would arise from the debtor’s breach of the agreements as a result of rejection of the franchise agreement, even if the provisions in question had been rejectable executory agreements. Such rejections afford the creditor a claim against the debtor’s bankruptcy estate to compensate it for the debtor’s non-performance. In this case, the franchise agreement contained a liquidated damages clause that calculated the franchisor’s recoverable damages from the debtor’s breach. Accordingly, the court determined the debtor-franchisee’s rejection could be reduced to a monetary claim in the debtor’s estate.
The non-compete and confidentiality clauses in the franchise agreement, and the separate confidentiality agreement, however, could not be reduced to a monetary claim because they provided for the franchisor-creditor’s right to seek equitable relief, i.e., a court order enjoining the debtor-franchisee from breaching those restrictions. Both equitable and monetary relief were available to the franchisor under those provisions, but the bankruptcy court found the protections of the franchisor’s intellectual property to be entirely distinct from protections surrounding ongoing royalty payments that the liquidated damages clause was designed to ensure. Thus, equitable protections could not be reduced to a claim in the debtor’s estate. This finding allowed the franchisee to reject the franchise agreement and the monetary obligations, but not the non-compete and confidentiality obligations.
Franchisees considering bankruptcy cannot eliminate every obligation of a franchise agreement. Provisions protecting intellectual property, whether or not they are contained within agreements sought to be rejected, will not necessarily be discharged. Debtor-franchisees should be mindful of potentially non-dischargeable obligations and their long-term impact on post-bankruptcy operations.
In re Empower Cent. Mich., No. 23-31281-jda (Bankr. E.D. Mich. Apr. 26, 2024)