Developments in California Franchise Law
Reprinted with permission of California Continuing Education of the Bar from 28 CEB Cal Bus L Rep No. 5 (Mar. 2007)
Franchises
Robin Day Glenn
Disclosure Requirements
Revised FTC franchise rule becomes effective July 1, 2007.
16 CFR pts 436 and 437
After a rulemaking that lasted nearly 12 years and entailed multiple rounds of comments, workshops, and ongoing consultation with state franchise administrators, the Federal Trade Commission finally, in January, amended its Trade Regulation Rule entitled "Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures (Rule)." The rewritten Rule separates out franchises from business opportunities (in California, "seller assisted marketing plans") and addresses the two at 16 CFR pts 436 and 437, respectively.
The new Rule was worth the wait. It becomes effective on a voluntary basis on July 1, 2007, and on a mandatory basis on July 1, 2008. The new guidelines it includes are not based on the seldom-used "FTC version" format for a disclosure document, but rather on the commonly used Uniform Franchise Offering Circular (UFOC) guidelines issued by the North American Securities Administrators Association (NASAA) in 1993. Although the FTC permitted franchisors to use the 1993 UFOC guidelines rather than the FTC version of the original Rule, only the new FTC guidelines for disclosure documents will be permitted when the amended Rule becomes mandatory in 2008. They will supersede the NASAA guidelines. States may require enhanced disclosures if they wish, but these will probably be placed in a state-specific addendum to the disclosure document. In other respects, state franchise laws will be preempted by the amended Rule only to the extent that they are inconsistent with the Rule's requirements.
Probably the most publicized feature of the amended Rule is the substitution of an easily determined 14-calendar-day waiting period between provision of a disclosure document and sale of a franchise for the previous 10-business-day waiting period. If a prospective franchisee asks for a copy earlier in the sale process, the franchisor must provide it on reasonable request, but the requirement that a franchisor provide a disclosure document to a prospect at the first face-to-face meeting has been snipped from the Rule. The requirement that a franchisor provide a signature-ready agreement to a prospect 5 business days before signing, even if the changes were made at the franchisee's request, has been dropped in favor of a prohibition on undisclosed unilateral changes to the agreement by the franchisor.
The guidelines included in the amended Rule were intelligently and thoughtfully drafted so that they simplify, clarify, and update the UFOC guidelines in nearly every respect. Disclosures regarding franchise brokers, which have become increasingly more burdensome as lead generation chains multiplied and expanded, have been eliminated. (Lead generation chains are networks consisting of affiliated but independent finders or brokers who refer prospective franchisees to franchisors for commissions when sales are made.) The litigation disclosure requirements have been amplified to mandate inclusion of certain franchisor actions against franchisees, as well as of franchisee-franchisor proceedings. If a franchisor's agreements with any of its franchisees contain provisions inhibiting the franchisees from freely providing information about their experience with the franchise to prospects, the fact that such "confidentiality clauses" exist must be disclosed. Information pertaining to promotional use of the Internet and use of electronic disclosure formats, which were not major issues when the UFOC guidelines were finalized in 1993, have been added to the disclosure requirements. The new rules for providing statistics about franchisor- and franchisee-owned outlets in Item 20 of the offering circular have been revised to demystify both the requirements and the disclosures themselves.
The amended rule provides three new "sophisticated investor" exemptions. The first exempts franchise sales that involve an initial investment of at least $1 million, not including the value of unimproved land or financing by the franchisor. The second exempts franchise sales to entities that have a $5 million net worth and at least 5 years of business experience in any field. The third exempts sales to franchisor insiders, including officers, directors, franchise sales executives and owners of an equity interest of 25 percent or more.
In addition, the rule exempts petroleum marketers and resellers covered by the Petroleum Marketing Practices Act (15 USC §§2801-2806).
COMMENT: NASAA may use the new FTC guidelines as the basis for a new set of UFOC guidelines that includes enhanced disclosure requirements. The FTC has indicated that in the future it will consider authorizing the use of such guidelines as an alternative to those stated in the revised Rule.
California, in 2005, anticipated the release of the rewritten Rule by incorporating its requirements for e-disclosure into the Corporations Commissioner's regulations (10 Cal Code Regs §§310.100.4, 310.101, 310.114.4), as described previously in this column. See 26 CEB CBLR 127 (Mar. 2005). In that regard, we were ahead of the curve.—R.D.G.
Arbitration
Ninth Circuit rules out-of-state arbitration venue "unconscionable."
Nagrampa v MailCoups, Inc. (9th Cir 2006) 469 F3d 1257
In a 7-4 decision, the Ninth Circuit Court of Appeals, ruling after a rehearing en banc, held that an arbitration clause in a franchise agreement that specified arbitration in Massachusetts was procedurally and substantively unconscionable and had to be stricken from the agreement.
Nagrampa, a California resident, entered into a franchise agreement to operate a direct mail coupon advertising business under a MailCoups franchise. The agreement included an arbitration clause requiring arbitration by the American Arbitration Association at a venue close to the franchisor's headquarters. The arbitration clause included the proviso that it did not (469 F3d at 1265):
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 judgment, to protect its Service Marks and proprietary information.
It further provided that the parties would share the costs of arbitration, other than their own attorney fees, equally.
Nagrampa lost money in the franchised business, and when she finally stopped operating, she owed MailCoups a substantial sum. MailCoups filed an arbitration proceeding against her to recover the debt, and the arbitrator determined that the venue would be Massachusetts, as required by the franchise agreement. Nagrampa declined to participate in the arbitration proceeding and an award of $160,000 was rendered against her. Meanwhile, she filed a state court lawsuit against MailCoups in California, alleging fraud and violation of various California statutes, including the Franchise Investment Law (Corp C §§31000-31516). MailCoups removed the case to federal court and moved to compel arbitration. Nagrampa argued that the arbitration clause was buried on page 25 of a 30-page contract, so that she was unaware of it, and, in addition, the offering circular contained a caveat (which at that time was mandated by a state regulation) that the arbitration clause might not be enforceable under California law. Therefore, she argued, the arbitration clause was unconscionable on the basis of surprise.
The district court held that the arbitration clause was valid and granted MailCoup's motion to dismiss the lawsuit. Nagrampa appealed and the three-judge court of appeals affirmed. See 401 F3d 1024. On rehearing en banc, the court reversed.
The opinion began by distinguishing the recent case of Buckeye Check Cashing, Inc. v Cardegna (2006) 546 US 440, 163 L Ed 2d 1038, 126 S Ct 1204, in which the U.S. Supreme Court held that challenges to the validity of an agreement as a whole must be decided by the arbi[PAGE 142]trator. In this case, the court concluded, Nagrampa was attacking only the arbitration clause, not the entire franchise agreement. Therefore, the court, not the arbitrator, must determine whether the clause was enforceable.
Next, the court noted that California courts examine contracts for procedural and substantive unconscionability on a sliding scale, so that if a court finds more procedural unconscionability it may need less substantive unconscionability, and vice versa, to invalidate a provision. Armendariz v Foundation Health Psychcare Servs., Inc. (2000) 24 C4th 83, 114, 99 CR2d 745.
The court found that the MailCoups arbitration clause was procedurally unconscionable. Nagrampa was an advertising executive with a $100,000 annual salary and no experience in operating her own business, while MailCoups' parent company was a large corporation with a net worth exceeding $200 million. This evidenced oppression flowing from an inequality of bargaining power. Further, the contract as a whole was presented on a take-it-or-leave-it basis, which made it a contract of adhesion. These facts showed the minimal amount of procedural unconscionability needed to mandate review of the second prong of the analysis, that of substantive unconscionability.
Next, the court found that the clause was substantively unconscionable. First, it lacked mutuality, because it reserved to MailCoups the right to seek a judicial forum to protect its intellectual property rights, while requiring Nagrampa to resolve all claims in an arbitral forum. Second, the forum specified was in Massachusetts, which was considerably more advantageous to MailCoups than to Nagrampa. In making this second point, the court conceded that forum selection clauses are valid and should be given effect unless enforcement would be unreasonable. However, it continued, if they have the effect of shielding the stronger party from liability to the weaker, they are unconscionable.
Further, the district court erred by failing to consider whether the arbitral cost-splitting provision, requiring Nagrampa to pay for the assertion of nonwaivable statutory rights under California's Franchise Investment Law, Unfair Competition Law (Bus & P C §§17200) and Consumer Legal Remedies Act (CC §§1750), contravened California public policy. However, it declined to resolve that issue because the district court did not consider it.
In the court's view, evidence of substantive unconscionability was overwhelming. It compensated for the slight evidence of procedural unconscionability. The arbitration clause was "so permeated by substantive unconscionability" that it simply could not be saved short of rewriting the contract. 469 F3d at 1293.
COMMENT: What, if anything, could MailCoups have done to preserve its arbitration clause in the Nagrampa franchise agreement? It could have provided prominent pre-signing notice of the arbitration clause to Nagrampa. However, the U.S. Supreme Court has held that mandating such a notice violates the Federal Arbitration Act (9 USC §§1-16), so this should not be necessary. Doctor's Assocs. v Casarotto (1996) 517 US 681, 134 L Ed 2d 902, 116 S Ct 1652. Further, the opinion does not seem to rely (much) on "surprise" as a ground for its holding. MailCoups could have omitted the proviso giving it recourse to the courts for injunctive relief to protect its marks, because the right to seek such relief is implicit anyway; or, it could have made the right mutual. But will a franchise agreement specifying out-of-state arbitration be held unconscionable in California federal courts, regardless of these other factors? Possibly. What if the franchisor is not a large corporation, like MailCoups? Will that make its arbitration clause more enforceable in California? It isn't clear. This lengthy opinion uses so many arguments to justify its decision that it provides little guidance to the practitioner.—R.D.G.
Professional Certification
First certification exam slated for August.
The State Bar Board of Governors has approved certification standards for a new legal specialization in Franchise and Distribution Law. The first biannual exam, the initial step in qualifying for certification as a specialist in this area of law, will be given at San Jose and Los Angeles locations on August 12. The deadline for registration for the exam is June 29. Applicants may register online in the Attorney Services/Legal Specialization section of the State Bar's website (http://calbar.ca.gov). The site also provides information on certification requirements and exam specifications.