Mandatory Franchise Dispute Arbitration Under Assault

Richard Welshans and his wife Deborah are typical in many ways of enterprising individuals who choose a franchised business to build a career. After Richard was laid off from his sales job at a chemical manufacturing plant, owning a small business appealed to them.

But in the six years since they signed the franchise agreement in 2003, making them owners of a Coffee Beanery shop in trendy Annapolis, Md., their nightmarish experience has become a cautionary tale for any potential franchisee -- beware the fine print.

In particular, their case highlights how many franchisors are misusing mandatory binding arbitration clauses in franchise agreements to gain the upper hand over franchisees in any legal dispute.

On its face, mandatory arbitration seems like a sensible approach to resolve disputes to avoid costly litigation. In fact, the U.S. Supreme Court threw its weight behind arbitration when it ruled in a case several years ago that "any doubt as to the scope of an arbitration provision must be resolved in favor of arbitration."

The Federal Arbitration Act, enacted more than 80 years ago, sets the ground rules for the use of arbitration and generally pre-empts state franchise laws that address how legal disputes should be resolved. But there are loopholes, and state courts are increasingly citing them to overturn restrictive arbitration clauses in franchise agreements.

In fact, binding arbitration clauses are under assault in several states, and a bill addressing their abuse has been reintroduced in Congress this session. Known as the Arbitration Fairness Act, it would ban mandatory binding arbitration and enact other reforms.

The International Franchise Association (IFA), which represents the industry, has lobbied intensely against the measure, and was able to keep it bottled up last year. But cases like the Welshans’, which has been nationally publicized in magazines like Mother Jones, are building momentum for change.

The Annapolis couple thought a small coffee bar would be right for them and would do well in their trendy, upscale sailing town, which also doubles as the Maryland state capital. They decided on Flushing, Michigan-based Coffee Beanery. They paid $25,000 up front and proceeded to open their shop, even though the company had substantially changed the concept from a coffee bar to a full-fledged cafe with a food menu.

What the Welshans weren’t told was that most Coffee Beanery cafes closed within three years, leaving their owners deep in debt. More than 100 shops have failed during their ordeal, and they soon found out why. The franchisor piled on costs for "required equipment," such as a surveillance system, a music system, and an obsolete, $14,000 lighting system. Other expensive equipment provided by the company, including a computerized cash register, proved to be faulty, according to Mother Jones.

The Welshans sued for fraud in federal court in Maryland, hoping to get out of the deal and get back their $130,000 investment. But under their franchise agreement they had pledged to submit disputes to binding arbitration. Coffee Beanery sued the Welshans in federal court in Michigan, and a judge ordered them to go through the process.

The franchise agreement also allowed the company to pick the arbitrator and the state in which the matter would be negotiated. Not surprisingly, the company chose Michigan, avoiding Maryland’s tough franchise law and forcing the Welshans to travel there repeatedly.

The arbitrator is supposed to be impartial, but the company’s hand-picked choice had ties to Coffee Beanery’s in-house lawyer and used the same accounting firm as the company -- even though accounting issues were part of the dispute. In two previous cases, the arbitrator had ruled in favor of the company.

Among other grievances, the Welshans learned that Coffee Beanery’s vice president was a convicted felon. The company never disclosed that fact, although it was required to do so in its offering. Even so, the Welshans lost the arbitration. To add insult to injury, the arbitrator ordered them to pay $187,000 to cover the cost of the proceeding.

The Welshans sued to overturn the arbitration award, and last August, a three-judge panel of the 6th Circuit Court of Appeals ruled in their favor. It said the arbitrator had ignored state law by disregarding the vice president’s felony conviction. The case is still being heard in court.

While the Welshan’s experience seems extraordinary, they are far from alone.

In another significant case, Federal District Court Judge Rya Zobel, sitting in Massachusetts, ruled two weeks ago that a health club franchisor known as Planet Fitness could not compel arbitration of a dispute under Maryland’s state franchise law.

Attorney Dave Ross, lead counsel for the franchisees, called the ruling "highly significant" in light of the Planet Fitness franchise agreement’s "broad arbitration provision" and the "strong federal policy in favor of arbitration."

The opinion is also noteworthy, Ross said in a statement after the ruling, "because it reaffirms a concept echoed in several Supreme Court cases that 'arbitration is a creature of agreement. [A] party cannot be forced to arbitrate that which it has not agreed to arbitrate.' This is particularly important, given the disadvantages and risks that arbitration poses for franchisees."

In a May article in Franchising World, the IFA’s in-house magazine, lawyers Joel D. Siegel and Norman M. Leon wrote that enforcing arbitration clauses is becoming increasingly "challenging," especially in California and other states with strong franchise laws.

California courts, which often lead the nation in setting legal trends, have not only overturned binding arbitration provisions, but they have also ruled against provisions that allow franchisors to pick the location for arbitration hearings. Critics say the provision allows franchisors to pick states with more favorable laws, typically where they are headquartered. And in more abusive instances, critics say franchisors use such provisions to jack up costs in an effort to financially exhaust franchisees.

Seigel and Leon noted that some of the state court rulings appear to conflict with federal law, principally the franchise act, and a number of cases are on appeal.

The upshot is that a legal showdown, perhaps before the Supreme Court, to resolve the hodge-podge of state and federal court rulings seems inevitable, which makes the bill pending in Congress all that much more significant.

Congress seems a far more reasonable venue to resolve this thorny issue. But with the IFA spending more than $2 million on campaign contributions in the past four years, there is some question as to how level the playing field is in Washington. Fortunately, a number of state attorneys general have also become involved in the issue, so there is a chance franchisees could see some relief. In the meantime, read the fine print carefully.