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Choice of Law and Forum Clarified in Recent Franchise Cases

By Craig Tractenberg

This article on choice of law and forum provides insight into non-compete provisions in franchise agreements as regards California law. Franchisors and franchisees will find the results of these recent decisions helpful.

A recent favorable decision for a Nixon Peabody client, served as a reminder of the importance of choice of law and choice of forum clauses in franchise agreements.

The importance of these clauses in franchise agreements has been clarified as a result of two recent arbitration decisions involving Paul Green School of Rock Music Franchising ("School of Rock"). One of those decisions was recently affirmed by the U.S. Court of Appeals in Paul Green School of Rock v. Smith.

The cases involved disputes between School of Rock and two of its franchisees—Smith and the Giammarrusco’s, who collectively acted to repudiate their franchise agreements to start a competitor, Rock Nation (the "Smith" and "Rock Nation" cases respectively). The cases had similar facts. Each involved California franchisees, breach of the respective franchise agreements, and similar claims including non-payment of royalties to School of Rock. Both cases involved franchise agreements that contained arbitration and non-compete clauses. The fundamental difference between them is that the franchise agreement in Smith provided for arbitration in Pennsylvania pursuant to Pennsylvania law, while the franchise agreement of the Giammarrusco’s in Rock Nation required arbitration in California under California law.

California law, unlike Pennsylvania law, considers covenants not to compete to violate public policy—a key difference between the two states. California law generally prohibits such covenants, and California courts rarely prohibit competition, doing so only when necessary to protect trade secrets.

The Smith case was arbitrated in Pennsylvania. Ultimately, the arbitrator ruled that Smith must pay damages including attorney’s fees and future lost profits to School of Rock, and that he was bound by the non-compete clause in the franchise agreement. The arbitrator was not bound by the prohibition on restrictive covenants found in California. In contrast to Smith, School of Rock’s arbitration award in Rock Nation was lower in damages for unfair competition with no damages for future lost profits. The arbitrator also refused to uphold the non-compete clause as against California’s public policy.

These cases provide franchisors with a guide for constructing franchise agreements for use in California. However, the extent to which clauses choosing non-California law are enforceable in California franchise disputes is still not completely clear. Prior to the arbitration in Smith, Smith objected to the choice of law and forum provisions in a California court, arguing that the provisions were unconscionable. However, the court found that, since Smith’s California rights would be recognized in Pennsylvania, the provisions should be enforced. Notably, not all California cases since Smith have been similarly decided. In Bridge Fund Capital Corp. v. Fastbucks Franchise Corp., the court refused to follow Smith. The court found that the choice of forum and law provisions in the franchise agreement, which designated Texas and Texas law, were not enforceable since there was no evidence that the franchisee’s California-based rights would be recognized in Texas.

Regardless of uncertainty created by Fastbucks, Smith provides a practical guide on how to avoid California’s prohibitions of non-compete covenants, and how franchisors in California can obtain the greatest possible protection if disputes arise. Smith and Rock Nation prove that strategically choosing the governing law and forum can make all the difference in franchise dispute resolution results, and selecting non-California law in the franchise agreement will likely provide better protection to franchisors.

Craig Tractenberg is a partner in the business litigation and bankruptcy teams in the New York and Philadelphia offices of Nixon Peabody LLP. He can be reached at ctractenberg@nixonpeabody.com or 212-940-3722

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