What Law Applies? The Importance of Understanding the Interplay Between Contractual Choice-of-Law Provisions and State Franchise Laws

Vol. 14, No. 4

By

Singler & Dillon, L.L.P.

Contractual choice-of-law clauses are a relatively standard feature of most franchise agreements and are generally enforced.  But in the franchise context, determining the eventually applicable law is much more complex than just assuming your client will be subject to the law designated in the franchise agreement.  Thus, it is essential for transactional attorneys to anticipate the multiple factors that go into determining which law will apply when advising franchise clients, and for litigators to understand how to navigate the various facts and laws that can affect whether the court will enforce the parties’ contractual choice-of-law clause.

This article examines the general rules for enforcing a contractual choice-of-law provision, and the effect that state franchise laws can have on determining which law will apply.  This article uses the recent California case, 1-800-Got Junk? LLC v. Superior Court, 189 Cal.App.4th 500 (2010), review denied Jan. 12, 2011, as a case study to demonstrate the complexities surrounding a choice-of-law clause in a franchise case, including its interplay with state franchise acts.  This is an unusual but informative case in which the franchisor wound up in the unenviable position of arguing against application of its own choice-of-law provision.  I was lead counsel for the franchisee at the trial level and throughout the appeals, and also want to acknowledge my former partner, Bruce Napell, for his considerable assistance with the case.

 

I.  The General Rules for Enforcing Contractual Choice-of-Law Clauses

Conflict of Laws.  A federal court generally applies the choice-of-law rules of the state in which it sits.  However, if the case was transferred, the transferee court applies “the choice-of-law rules of the State from which the case originated.”  Piper Aircraft Co. v. Reyno, 454 U.S. 235, 243, fn. 8 (1981).  State courts generally apply their own choice-of-law rules.  Thus, whether a lawsuit is pending, or you are simply advising your client about its contract, to begin the choice-of-law analysis it is necessary to first identify which state’s conflict-of-laws rules will apply.  If it is pre-litigation, consideration also should be given to potential locations where the dispute might be resolved, so you can determine if there are any advantages or disadvantages to litigating in a particular forum.

Restatement Section 187.  Many states, including California, Ohio, Pennsylvania, Washington and Texas, follow the rules set out in section 187 of the Restatement of Law 2d (1971) 561, Conflict of Laws, and will enforce the parties’ choice-of-law clause, unless either:

  1. the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties’ choice; or
  2. application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state.

Nedlloyd Lines B.V. v. Superior Court, 834 P.2d 1148, 1151-52 (Cal. 1992); Schulke Radio Prods., Ltd. v. Midwestern Broad Co., 453 N.E.2d 683, 686 (Ohio 1983); DeSantis v. Wackenhut Corp., 793 S.W.2d 670, 677 (Tex. 1990); Schifano v. Schifano, 471 A.2d 839, 843 (1984); Erwin v. Cotter Health Centers, 161 Wash.2d 676, 694 (Wash. 2007).

Other states, like New York, follow the more limited “substantial relationship” approach, or variations thereof, which essentially omits the Restatement’s language “no other reasonable basis for the parties’ choice” from the first prong of section 187.  This approach allows a court to disregard the parties’ choice, even if they had a reasonable basis for it, if the “most significant contacts” are with another state.  Walter E. Heller & Co. v. Video Innovations, Inc., 730 F.2d 50, 52 (2d Cir. 1984); see also Manion v. Roadway Package Sys., Inc., 938 F. Supp. 512, 515 (C.D. Ill. 1996) (similarly, “[i]n Illinois, an express choice-of-law provision will be given effect, subject to two limitations: 1) there must be a sufficient relationship between the chosen forum, the parties, or the transaction; and 2) it must not offend Illinois public policy”).

Under the more expansive approach adopting the entirety of section 187, many courts have recognized that multi-state franchising itself satisfies the reasonable basis element of the test’s first prong, since it is objectively reasonable for franchisors to pick one state’s law to apply to all of their agreements.  See 1-800-Got Junk? LLC v. Superior Court, supra, at 514 (“case law has recognized it is reasonable for a franchisor to designate a single state’s law to apply to all of its franchise agreements”); see also Capital Nat. Bank of New York v. McDonald’s Corp., 625 F. Supp. 874, 880 (S.D.N.Y. 1986); Carlock v. Pillsbury Co., 719 F. Supp. 791, 808 (D. Minn. 1989); Sullivan v. Savin Business Machines Corp., 560 F. Supp. 938 (N.D. Ind. 1983).  Of course, franchisors generally choose the law of their home jurisdiction, or designate the law where the franchisee is located.  Thus, even under the more restricted substantial relationship approach, the substantial relationship prong will often be satisfied.  However, as international franchising grows, there will likely be more and more instances of foreign franchisors choosing a particular state’s law despite having no substantial relationship with that state.

The Effect of State Franchise Investment, Disclosure and Relationship Laws.  When choice-of-law provisions bump into state franchise laws, the analysis generally involves the second prong of the tests for enforceability:  whether applying the chosen law would offend a state’s strong or fundamental public policy.  This is because many of the state franchise statutes include anti-waiver provisions.  See e.g., Cal. Bus. & Prof. Code § 20010; Cal. Corp. Code § 31512; Mich. Comp. Laws § 445.1527(b); Iowa Code § 523H.4; Ind. Code § 23-2-2.7-1; 815 Ill. Comp. Stat. § 705/41; Wash. Rev. Code § 19.100.220.  Most courts interpret these anti-waiver provisions as evidence that the franchise laws establish strong public policies that cannot be avoided by a contractual choice-of-law clause.  See Wright-Moore Corp. v. Ricoh Corp., 908 F.2d 128, 132 (7th Cir. 1990) (Indiana law); Morley-Murphy Co. v. Zenith Elec. Corp., 142 F.3d 373, 381 (7th Cir.1998) (Wisconsin law); To-Am Equip. Co., Inc. v. Mitsubishi Caterpillar Forklift Am., Inc., 152 F.3d 658, 662 (7th Cir. 1998) (Illinois law); Rutter v. BX of Tri-Cities, Inc., 60 Wash. App. 743, 748, 806 P.2d 1266, 1268 (Wash. Ct. App. 1991) (Washington Law); Three M Enterprises, Inc. v. Texas D.A.R. Enterprises, Inc. 368 F.Supp.2d 450 (D. Md., 2005) (Maryland law).  Thus, where a franchisor has a dispute with a franchisee from a state with a franchise act, courts are likely either to void the choice-of-law provision entirely or, at a minimum, to apply the franchisee’s home state’s franchise act, while applying the parties’ chosen law for the remaining issues.  The Iowa Act removes the courts’ discretion, and expressly voids choice-of-law clauses.  See Iowa Code § 523H.14.

Logically, though perhaps unexpectedly, some courts will still enforce the parties’ choice-of-law, despite the anti-waiver provisions, as long as the chosen state’s law affords similar protections.  See Banek Inc. v. Yogurt Ventures U.S.A., Inc., 6 F.3d 357, 362 (6th Cir. 1993); see also Cottman Transmission Systems, Inc. v. Melody 869 F.Supp.1180 (E.D. Pa.1994); JRT, Inc. v. TCBY Sys., Inc., 52 F.3d 734, 739 (8th Cir. 1995); 1-800-Got Junk? LLC v. Superior Court, supra, at 500. 

The geographical “in this state” limitation found in most state franchise acts adds yet another layer of analysis.  Generally, franchise acts are written to apply only to franchises located in the state or conduct occurring in the state – e.g. sales or offers to sell occurring in the state.  Thus, unless there is a separate basis for application of another state’s franchise laws such as the sale or offer occurred there, franchisees in one state are not ordinarily entitled to the benefit of another state’s franchise laws, even if the parties expressly chose the second state’s law to govern their agreement.  For instance, if a Texas franchisee is in a dispute with an Illinois franchisor, and the contract contains an enforceable Illinois choice-of-law clause, the franchisee cannot use the choice-of-law clause to bring itself under the protection of the Illinois Franchise Disclosure Act (“IFDA”):  “[B]y its own terms, the IFDA applies only to franchises located within the State of Illinois.”  See Cromeens, Holloman, Sibert, Inc v. AB Volvo, 349 F.3d 376, 385 (7th Cir. 2003); see also 815 ILCS § 705/19; Peugeot Motors of America, Inc. v. Eastern Auto Distributors, Inc.  892 F.2d 355, 358 (4th Cir. 1989) (analyzing the N.Y. Franchise Motor Vehicle Dealer Act); JRT, Inc. v. TCBY Systems, Inc. 52 F.3d 734, 736 (8th Cir. 1995), Ark. Code. Ann. § 4-72-203; Forbes v. Joint Medical Products Corp., 976 F. Supp. 124, 126 (D. Conn.1997); Conn. Gen.Stat. Ann. § 42-133h.

On the other hand, a minority of cases have held that in limited circumstances choice-of-law provisions can be used to apply states’ franchise laws extraterritorially despite the geographically limiting language found in the statutes.  These cases typically rely on the parties’ right to contract.  See Infomax Office Sys., Inc. v. MBO Binder & Co. of Am., 976 F. Supp. 1247, 1255 (S.D. Iowa 1997) (determining that the IFDA can apply extraterritorially through a contractual choice-of-law clause despite its general statement that it only applies in Illinois, but holding that the express terms of section 705/19 of the IFDA did not apply in the particular case since it specifically prohibited early terminations of franchisees only of franchises located in Illinois); see also Mon-Shore Mgmt., Inc. v. Family Media, Inc., 584 F. Supp. 186, 193 (S.D.N.Y. 1984) (applying New York Franchise Relations Act to New Jersey, Pennsylvania and California franchisees based on language in New York choice-of-law clause stating “[t]his agreement shall be deemed made in the state of New York”); and Instructional Sys., Inc. v. Computer Curriculum Corp., 35 F.3d 813, 825 (3d Cir. 1994) (applying the New Jersey Franchise Protection Act to an exclusive multistate distribution agreement).

While other state franchise statutes limit themselves either to activity in the state or to franchisees located in the state, the Washington Franchise Investment Protection Act (“WFIPA”) is somewhat of an outlier.  The WFIPA includes the “in this state” limitation only in the sections governing sale, disclosure, advertising and registration.  The remaining sections of the WFIPA, including the provisions governing the franchise relationship, do not contain the “in this state” limitation and can be applied extraterritorially pursuant to a valid choice-of-law clause.

 

II. A Case Study: 1-800-Got Junk? LLC v. Superior Court

The 1-800-Got Junk? case strongly illustrates the importance of understanding the effect of a contractual choice-of-law provision before terminating a franchise.  The case involved a California 1-800-GOT-JUNK? franchisee that was terminated because its Canadian franchisor believed it was intentionally underreporting revenue.  After conducting its own investigation, the franchisee determined that the underreporting was a result of one or more of its drivers pocketing money from cash jobs, and then reporting the jobs as cancelled.  After several unsuccessful attempts at trying to get reinstated, the franchisee eventually sued its franchisor for wrongful termination.

The franchise agreement contained a Washington choice-of-law clause.  In an unusual twist, the franchisor had to argue against enforcement of its own choice-of-law provision.  It understandably wanted to avoid application of the more franchisee protective provisions of the WFIPA.  In a nutshell, the California Franchise Relations Act (“CFRA”) is less restrictive, and allows termination of a franchisee without prior notice and opportunity to cure in eleven specific circumstances, whereas the WFIPA allows it in just four.  Compare Cal.Bus. & Prof.Code § 20021 with Wash. Rev. Code § 19.100.180.  If California law applied, the franchisor had a basis to argue that the immediate termination complied with the CFRA, whereas if the WFIPA applied, the termination clearly violated its statutory restrictions. 

After more than a year of extensive litigation fighting over the choice-of-law issue in dispositive motions, the California Superior Court eventually held a bifurcated trial on the issue.  It determined that the parties’ contractual choice of Washington law was enforceable, and that the provisions of the WFIPA would apply at trial.  1-800-GOT-JUNK? sought to overturn the lower court’s ruling by writ of mandate to the California Court of Appeal.  The Court of Appeal upheld the lower court’s ruling.  The franchisor thereafter sought review before the California Supreme Court, which was summarily denied. 

1-800-GOT-JUNK? argued extensively that even if the choice of Washington law was enforced, the WFIPA could not be applied extraterritorially, since it contains language limiting its application to activities “in this state.”  It relied primarily on two U.S. District Court decisions holding that the WFIPA applies only to transactions or franchises in Washington.  See Taylor v. 1-800-Got-Junk?, LLC, 632 F. Supp. 2d 1048, 1050 (W.D. Wash. 2009) aff’d, Taylor v. 1-800-GOT-JUNK?, LLC, 387 F. App’x. 727 (9th Cir. 2010); and Red Lion Hotels Franchising, Inc. v. MAK, LLC, 707 F. Supp. 2d 1110, 1111 (E.D. Wash. 2010).  Fatal to 1-800-GOT-JUNK?’s argument was the fact that the restrictive “in this state” language is found only in certain sections of the WFIPA.  Thus, these cases could be distinguished. 

The WFIPA combines Washington’s disclosure, registration and relationship laws in a single Act.  Only sections 020, 030, 100, 110 and 170 contain specific language limiting their effects to activities occurring “in this state,” e.g., offers to sell; registration; advertising; and misrepresentations.  In contrast, section 180, which governs franchise relations, including terminations, contains no geographical limitation.  See Wash. Rev. Code § 19.100.180.  Nor can the “in this state” limitations from the other sections reasonably be read into section 180. 

Although the U.S. District Court cases on which 1-800-GOT-JUNK? relied reached the correct results on their specific facts, each unnecessarily broadened its ruling to derive a general statement regarding extraterritorial applicability of the WFIPA.  Minimal scrutiny of those cases, however, reveals that it was unnecessary for either court to analyze that issue or reach that general conclusion under the facts presented.  For example, the underlying claim in Taylor was based on WFIPA section 170 which expressly contains the “in this state” limitation; and the parties’ choice-of-law provision in Red Lion Hotels Franchising, Inc. expressly excluded application of the WFIPA. Rather than making a choice-of-law analysis as to whether the WFIPA would apply to a California franchisee through the parties’ choice-of-law provision, Red Lion merely adopted and extended Taylor’s dicta that the WFIPA cannot be applied extraterritorially.  The California Court of Appeal apparently found these two U.S. District Court cases to be unpersuasive, as it rather summarily dismissed the issue and found that the WFIPA could be applied extraterritorially in this case.  See 1-800-Got Junk? LLC v. Superior Court, supra, at 519.

The court instead focused on whether application of the parties’ choice of Washington law would run afoul of the CFRA’s anti-waiver provision.  See Cal.Bus. & Prof.Code § 20021.  It held it did not, ruling that the CFRA sets only a floor, and that the parties are free to choose any other law so long as it affords equal or greater protections to the franchisee.  Since the WFIPA affords franchisees greater protection from termination than the CFRA, California’s strong public policy of protecting franchisees from the unequal bargaining power of franchisors was not offended by its application. See 1-800-Got Junk? LLC v. Superior Court, supra, at 515-19.  The lawsuit settled at a mediation shortly after the California Supreme Court denied review. 

The 1 800 GOT JUNK? case demonstrates the complexities involved when a choice-of-law clause chooses the laws of a state that has a state franchise act, which, by its own terms, does not exclude the possibility of its application extraterritorially.  And while the result may not always be so drastic – nearly four years of protracted hard-fought litigation – the case also illustrates a situation that franchisors and franchisees alike should seek to avoid.  Indeed, if the franchisor wishes to avoid extraterritorial application of a state’s franchise laws, it would be well advised to consider language in its agreement that expressly excludes application of the chosen state’s franchise laws.  Many franchise agreements now accomplish this by expressly excluding or waiving extraterritorial application of the chosen state’s franchise laws, unless it would be independently enforced absent the choice-of-law clause.  Not only can this help clients avoid or reduce the cost of litigation, but it can also help avoid the disruption to the system that protracted litigation often creates.

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