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A Cautionary Tale On Arbitration Clauses For Prospective Franchisees

By Mario Herman, Esq.

The following case demonstrates why individuals considering executing a franchise agreement in California should be cautious regarding franchise agreements that contain an arbitration clause. Learn why it’s important to utilize experienced franchise counsel.

In MJKA, Inc. v. 123 Fit Franchising, LLC, (January 4, 2011, D055867) [2011 DJDAR 194], the California Court of Appeal reversed the trial court’s order which concluded that plaintiffs were not able to arbitrate their claims with the American Arbitration Association due to their financial inability to pay the fees and costs, and therefore lifted the stay it had previously placed on the litigation. 

In 2006, the MJKA Plaintiff franchisees sued in California, alleging they had been fraudulently induced by the defendants to enter into the franchise agreements and that during the term of the franchise agreements defendant failed to provide the operational support that it had promised.  The defendant did not file a motion to compel arbitration in the California court, but did so in a Colorado court, while moving the California court to stay the lawsuit under C.C.P. 1281.4.  In opposition to the motion, the plaintiffs moved to declare the arbitration provisions unenforceable.  In January 2007, the California trial court granted the motion to stay and denied plaintiff’s motion to declare the provisions unenforceable.  In October 2007, the Colorado court ordered the parties to arbitration.  In September 2008 plaintiffs filed a motion in the California court to lift on the basis that nearly a year had passed and the plaintiffs could not afford to arbitrate the matter in Colorado.  Plaintiff’s motion was denied in November 2008, but the California court added the caveat that the motion was denied “without prejudice to the possibility of plaintiffs bringing a motion to lift the stay again in the future." Nine months later, three year after Plaintiff’s original California lawsuit had been filed, Plaintiffs filed another motion with the California court to lift the stay.  This time, the court concluded that the plaintiffs were financially unable to arbitrate their claims with the American Arbitration Association (which refused to waive the fees associated therewith).  The California court lifted the stay and found that the arbitration provisions were unconscionable and unenforceable. 

Defendant appealed, and the appellate court found that C.C.P. Sec. 1281.4 mandated a stay of litigation pending arbitration and that the trial court had no discretion to lift the stay based on a party’s financial inability to arbitrate.  The appellate court also held that once a stay is issued the trial court has only “vestigial jurisdiction,” which does not allow the trial court to thereafter find that the arbitration provision is unconscionable and unenforceable. 

Prospective franchisees in California should take note of this Court of Appeal decision, and determine if it is really wise to enter into a franchise agreement containing an arbitration clause.  The Plaintiffs in MJKA informed the California court that the costs to arbitrate in Colorado would include a $6,000 filing fee, a $2,500 case service fee, the estimated cost of $10,000-$14,000 in arbitrator's fees, and unknown facility fees.  Adding attorney’s fees and travel and accommodation fees in an estimated amount in excess of $20,000, the plaintiffs estimated the total cost to arbitrate in Colorado at $38,500-$42,500 per case.  Additionally, the plaintiffs filed declarations with the trial court emphasizing the economic losses that the plaintiffs had suffered as a result of their failed franchises. One plaintiff declared that she had "incurred at least $208,000 in personal debt because of 123 Fit, and another stated that she and her partner had invested over $253,000 in their franchise, and that she had filed the lawsuit to "try and recoup some of my lost monies." Another franchisee stated that she and her partner had "incurred approximately $300,000-$320,000 in personal debt due to [their] involvement in the Defendant 123 Fit Franchise."

Clearly, plaintiff’s made a sympathetic case regarding their financial condition and inability to proceed with arbitration for financial reasons.  However, the Court of Appeal found that the mandatory provisions of the California Arbitration Act would not allow for the lifting of the stay based on a party’s financial inability to proceed with arbitration.  Moreover, it should be noted that under the American Arbitration Association’s rules, an arbitration may suspend or terminate the arbitration proceedings if the administrative charges and/or arbitrator’s fees are not paid.

As such, prospective franchisees should consider that if something goes horribly wrong, and the franchise is not only unprofitable but also depletes the coffers, the franchisee may be without the financial means to arbitrate and left without any chance to have his/her “day in court.”

Mr. Herman based in Washington, D.C., represents franchisees domestically and internationally negotiation, mediation, arbitration, and litigation. Contact: mherman@franchise-law.com

www.franchise-law.com  
www.internationalfranchiselaw.com 
202-686-2886 (ph)

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