National Franchise Law Blog

On February 1, 2012, the United States Court of Appeals, Second Circuit, decided the case of In re American Exp. Merchants' Litigation, --- F.3d ----, 2012 WL 284518 (2d Cir., Feb. 1, 2012) ("Amex 2012"). The case had been returned to the Second Circuit court from the United States Supreme Court which vacated the Second Circuit's judgment and remanded for reconsideration in light of Stolt-Nielsen S.A. v. AnimalFeeds Int'l Corp., 130 S.Ct. 1758 (2010) ("Stolt-Nielsen"). In Stoltz-Nielsen, the Supreme Court reversed the Second Circuit and held that the Federal Arbitration Act requires parties to affirmatively agree to permit class arbitration proceedings for a court to compel them. 130 S. Ct. 1758 (2010). The Stolt-Nielsen court held that absent an affirmative agreement to permit class arbitrations, neither the courts nor an arbitrator could imply an agreement to permit such a proceeding where the arbitration agreement is silent on the issue.

Shortly after the Second Circuit had issued its earlier decision in In re American Express Merchants' Litigation, 634 F.3d 187 (2d Cir.2011) (Amex 2011"), the Supreme Court addressed the issue of class-action waivers in AT & T Mobility LLC v. Concepcion, 131 S.Ct. 1740 (2011) ("Concepcion"). In Amex 2011, the Second Circuit held a class action waiver unenforceable, "because enforcement of the clause would effectively preclude any action seeking to vindicate the statutory rights asserted by the plaintiffs." Amex 2011, 554 F.3d at 304. In Concepcion, the Supreme Court held that courts must enforce arbitration agreements as written, even when the terms require individual, and not class, arbitration, explaining that requiring class-wide arbitration when the parties' contract says otherwise "interferes with fundamental attributes of arbitration and thus creates a scheme inconsistent with the FAA."

On remand, the Second Circuit Court in Amex 2011 held that neither Stolt-Nielsen nor Concepcion counseled it to alter its original analysis. Therefore, the Second Circuit held that (1) the question of the enforceability of the class action waiver provision is properly decided by the court and (2) the class action waiver therein provision was unenforceable under the Federal Arbitration Act. In re American Express Merchants' Litigation, --- F.3d ----, 2012 WL 284518 (2d Cir., Feb. 1, 2012). The Amex 2012 court reasoned that a careful reading of Stolt-Nielsen and Concepcion "demonstrates that neither one addresses the issue presented here: whether a class-action arbitration waiver clause is enforceable even if the plaintiffs are able to demonstrate that the practical effect of enforcement would be to preclude their ability to vindicate their federal statutory rights." The plaintiff therein put forth the opinion of its expert that an individual pursing its claims would have to spend in excess of $850,000, with the expectation of recovering only $38,549. The Second Circuit focused on the need to vindicate statutory rights, as opposed to common law rights, and found that the plaintiffs had met their burden of establishing that an unreasonable cost fell to plaintiffs in the absence of class action. On this basis, the court held that the plaintiffs could proceed with their class action claim in court or, at American Express's election, in arbitration.

Franchisees and franchisors alike, should be well aware of these rulings, and should be advised to thoroughly consider the pros and cons of class arbitration/litigation, and carefully and clearly draft their agreements accordingly. Prospective franchisees may be well advised to preserve their rights to class action and/or consolidated arbitration. This is accomplished not only by making sure that there is no waiver included in the franchise agreement as to class, group and/or consolidated litigation/arbitration, but also by making sure that there is an affirmative representation in the franchise agreement that class, group and consolidated arbitration/litigation is permitted in the event of a dispute between the parties. The time to have this particular dispute is not after another dispute arises, but rather at the beginning of the relationship. An attorney well versed in franchise law is a must.

According to China's Ministry of Commerce (MOC), at the end of 2010 there were more than 4,500 registered franchises in China. Recognizing the importance franchising plays in the economy, the MOC has issued a guideline vowing to increase the number of franchised outlets, expand the scale of such operations and standardize the franchise market within the next five years. According to the guideline, the MOC will revise the regulations relevant to the franchising industry and thereby standardize the market.

In addition to standardizing the industry through regulation, the guideline also reported that over the next five years relevant authorities would work to help build brands and bring brand-building efforts into line with local governments' trade development plans, including assisting companies in developing their information systems and accelerating the establishment of local logistic systems. The guideline also reported that the authorities would establish and evaluation system for brands, and would strive to improve the collection of industrial statistics and credit rating.

Franchising is nothing new in China, and is an important part of its economy. For example, in 2010, the China division of Yum! Brands, Inc. opened more than 500 new restaurants in mainland China. Yum! Brands franchises under the KFC, Pizza Hut and Taco Bell brands. KFC is the leading quick-service restaurant brand in mainland China, with over 3,400 restaurants in more than 700 cities. Pizza Hut is the leading casual dining brand in mainland China with over 550 Pizza Hut Casual Dining restaurants in over 130 cities.

With the standardized regulation and anticipated assistance from the relevant authorities in brand-building, etc., it will be important for any franchise company wishing to enter the global market to consider China as a strong and developing market.

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."

As one of the world's largest and fastest growing markets, India has become an attractive possibility for expansion by U.S. franchisors. It provides an excellent franchise opportunity for qualified franchisors. It has a middle class estimated to be over 30% of population which computes to 300,000 million people and also has the world's largest English speaking population. In the recent past, India has seen a significant development in franchising with ever increasing U.S. brands operating in India. An added advantage that India offers is a large population of well educated young people familiar with technology and software. However, in addition to having a huge population and ever growing middle class, India provides a friendly franchising climate.

The Indian Legal Climate for Franchising

Unlike the United States, there are no statutes specific to franchising which govern either the sale of franchises or the relationship between franchisees and franchisors. This means there are no formal registration requirements or pre-contractual disclosure requirements for franchisors. Does this mean that a franchisor may act in whatever manner it chooses with its prospective franchisees? It absolutely does not.

Both the common law doctrine, as well as other general statutes, can be used to ensure that a franchisor deals honestly and in good faith with its prospects and franchisees. For example, the common law doctrine of equity under Indian law requires that, where a disclosure document is provided, it must comply with the common law doctrine and be a true and genuine statement of the franchise offering. Additionally, there is a legal obligation on behalf of both the franchisor and franchisee to deal with one another in good faith.

The Indian Contract Act of 1872 (the "Contract Act") governs the contract between the parties to a Franchise Agreement. This Contract Act provides: "All agreements are contracts, if they are made by the free consent of the parties, competent to contract, for a lawful consideration with a lawful object, and not hereby expressly to be void." Both franchisees and franchisors should be diligent in consulting with international franchise legal counsel to ensure that the Franchise Agreement does not contain any provisions that render the contract void or voidable under Indian law.

An important consideration when entering into a Franchise Agreement is whether any covenant not to compete contained therein might be enforceable. Under the current state of Indian law, the answer is probably during the term of the agreement, but perhaps not once the agreement has expired. Although Section 27 of the Contract Act provides that agreements in restraint of trade is void, the Supreme Court of India has held that covenants not to compete during the term of a franchise agreement do not fall within the purview of Section 27 of the Contract Act. In Gujarat Bottling Company Limited v Coca Cola Company (AIR (1995) Supreme Court 237), the Supreme Court of India held: "Since the negative stipulation in ... the . . . Agreement is confined in its application to the period of subsistence of the agreement and the restriction imposed therein is operative only during the period the 1993 Agreement is subsisting, the said stipulation cannot be held to be in restraint of trade so as to attract the bar of Section 27 of the Contract Act." The Gujarat court also held: "There is a growing trend to regulate distribution of goods and services through franchise agreements providing for grant of franchise by the franchisor on certain terms and conditions to the franchisee. Such agreements often incorporate a condition that the franchisee shall not deal with competing goods. Such a condition restricting the right of the franchisee to deal with competing goods is for facilitating the distribution of the goods of the franchisor and it cannot be regarded as in restraint of trade." Both franchisors and prospective franchisees should be careful to review Indian Law as it develops on this issue.

Other statutes which franchisors and franchisees should be aware of and seek legal counsel on include, but are not limited to, the Consumer Protection Act, 1986 ("CPA") and the Competition Act, 2002 ("CA"). A violation of these acts could create liability to members of the consuming public in India.

A clear understanding of the provisions of the CPA, and the state of the case law thereon, is vital so that both the franchisor and franchisee understand their liabilities to each other and the consuming public. Under the CPA, consumers may recover from manufacturers and service providers for defective products and/or deficiencies in service. A consumer might file an action under the CPA against both the franchisor and the franchisee, but most franchise agreements contain indemnification clauses in favor of the franchisor, which provide that the franchisee is responsible for such claims and indemnifies the franchisor against same. International franchise legal counsel can advise both franchisors and franchisees as to their potential liabilities under the CPA to third parties and as to the effect of any indemnification clause in a franchise agreement.

The CA also should be examined, as the statute prohibits arrangements regarding production, supply, distribution, storage, acquisition or control of goods, or provision of services that cause or are likely to cause an appreciable adverse effect on competition within India. Under the CA, certain arrangements are presumed to have an appreciable adverse effect on competition, including, but not limited to any agreements which directly or indirectly determine purchase or sale prices, limit or control production, supply, markets, technical development, investment or provision of services, and/or share the market or source of production or provision of services by way of allocation of geographical areas of the market, or type of goods or services, or number of customers in the market, or in any other similar way. The CA is similar to the Sherman Antitrust and Clayton Act in the United States. As such, franchisors should have their agreements carefully reviewed by an international franchise attorney to determine if the provisions thereof include any tie-in arrangements, exclusive supply and distribution provisions, and/or resale price provisions, which would be regarded as being anti-competitive in that they would cause an appreciable adverse effect on competition in India.

Important Considerations

Before a franchisor decides to export their franchise concept to India, or any other country, they need to perform some self analysis and make sure they're fully prepared for this new venture.

Following are ten important steps to follow before going into foreign markets:

1. Have a solid franchise program in operation with successful franchisees and good franchise relations.
2. There should be a minimum of 50 franchisees in the home country. Although not a strict requirement, a minimum of 50 units indicates a level of franchisor experience.
3. Be sure that the franchise concept can be successful in other countries. Due to local customs or consumer preferences, some concepts may not be adaptable to other countries.
4. There needs to be competent franchisor staff available to implement, train, and support the new foreign licensee.
5. Make sure that all of the operating and marketing manuals are current and up to date. There should be marketing materials that can be adapted and translated for use in other countries.
6. Perform a competitive analysis of target countries to determine if the franchise will face competition. A number of competitors can signal good demand for the franchise product or services.
7. Get some advice from a consultant or advisor who has experience in international franchising and licensing. You need to rely upon experts who have prospected candidates, negotiated agreements, and have operational experience.
8. Be prepared to invest some capital in overseas visits and legal costs.
9. Before implementing your international launch, apply to register your trademarks and any intellectual property ("IP") you own.
10. Lastly, don't expect to receive a licensing fee until you've invested a good deal of time and effort in the entire sales process.

With a growing economy, franchising in India has great potential. However, both franchisors and prospective franchisees should proceed only after consulting qualified international franchise legal counsel, and after having a clear understanding of the common law and statutes which might impact not only the relationship between the franchisor and the franchisee, but also as to potential liability to the consuming public in India.