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Franchise Law

The Arbitration Clause as Class Action Shield

By Edward Wood Dunham

The nine-figure jury verdict in the Meineke Discount Muffler class action is a bracing reminder that franchising is full of potentially catastrophic litigation risks. The verdict will almost certainly spawn a new generation of class actions against franchisors, with particular emphasis on alleged mismanagement of franchisee advertising payments. Franchisors with an arbitration clause in their franchise agreements have an effective tool for managing these new class action risks.

The Federal Arbitration Act (FAA) creates "a body of federal substantive law of arbitrability, applicable to any arbitration agreement within the coverage of the Act," and under the prevailing interpretation of the FAA, there can be no consolidated or class action arbitration without the express consent of the parties. Absent unusual circumstances, therefore, the franchisor with an arbitration clause should be able to require each franchisee in the potential class to pursue individual claims in a separate arbitration. Since many (and perhaps most) of the putative class members may never do that, and because arbitrators typically do not issue runaway awards, strict enforcement of an arbitration clause should enable the franchisor to reduce dramatically its aggregate exposure.

In 1996, the Subway franchisor, Doctor’s Associates, Inc. (DAI), employed an arbitration clause to block a state court class action charging various improprieties in the operation of the Subway Franchise Advertising Fund (FAF), and seeking over $300 million in compensatory and punitive damages. Chief Judge Peter C. Dorsey of the United States District Court for the District of Connecticut granted DAI’s petitions to compel arbitration under FAA § 4 and enjoined the state court lawsuit in its entirety, including claims against defendants unaffiliated with DAI. DAI v. Hollingsworth, 949 F. Supp. 77 (D. Conn. 1996).

The putative class action (it was never certified) was filed in the Circuit Court of Madison County, Illinois, by lawyers who had previously sued DAI and contested the enforceability of the franchise agreement arbitration clause. In this case, to avoid arbitration, counsel omitted DAI as a defendant and named instead its owners; an affiliated corporation that provided administrative services to the Subway system; the executive director and the franchisee-trustees of FAF (which, unlike in many other systems, is operated not by the franchisor but by the franchisees, through a board they elect and a director they employ); and eight corporations that sell products to Subway franchisees, some of which had made monetary contributions to FAF. Because the parties included Illinois plaintiffs and defendants, diversity of citizenship was incomplete; there was also no possible federal question jurisdiction, so removal to federal court was not an option. However, each of the franchisee plaintiffs named as a class representative had signed a standard form franchise agreement with DAI, and every agreement provided for arbitration in Connecticut of any claim "arising out of or related to" the franchise relationship, if either DAI or the franchisee demanded arbitration in accordance with the American Arbitration Association’s Commercial Rules. Even though DAI was not a defendant, it was clear on the face of the complaint that all of the plaintiffs’ factual allegations and legal claims related directly to the franchise agreement.

DAI’s response to this class action was therefore to invoke its rights under FAA § 4 and file a separate petition to compel arbitration against all but a few of the putative class representatives in the Connecticut District Court, which has jurisdiction over the contractually designated arbitration site. For this approach to succeed, two potential subject matter jurisdiction problems had to be solved.

First, the FAA creates important substantive rights for every party to an arbitration agreement in interstate commerce, but confers no independent basis for federal subject matter jurisdiction. As mentioned above, this Subway advertising dispute involved no federal questions, and because several of the plaintiffs in the Illinois action were citizens of Florida, where DAI is incorporated and maintains its principal place of business, DAI could not petition in federal court to compel these franchisees to arbitrate. The answer (which the district court embraced) lay in Federal Rule of Civil Procedure 65(d) and the fact that the plaintiffs in the Illinois case were purporting to act on behalf of a class comprised of all Subway franchisees, including one another. Because Rule 65(d) provides that injunctions are binding not only upon the parties to the federal action but also "upon those persons in active concert or participation with them who receive actual notice of the order," DAI successfully argued that the Florida franchisees that sued in Illinois were bound by the district court order enjoining the other plaintiffs from pursuing the Illinois action.

The second, and more fundamental, jurisdictional issue was the amount that DAI was putting into controversy by each petition to compel arbitration. There is a substantial body of federal precedent discussing how to measure the amount in controversy in class actions removed from state court. Perhaps not surprisingly, given the potential adverse effect of protracted class litigation on already congested federal dockets, these decisions in general construe the amount in controversy quite narrowly, causing many of these class actions to be remanded to state court. However, this line of authority does not address petitions to compel arbitration; in that context, as the United States Court of Appeals for the Fifth Circuit recently held, the "amount in controversy is the difference ‘between winning and losing the underlying arbitration.’ " DAI took the position that if the Illinois case were enjoined, the class representatives sued in federal court were required to arbitrate, and DAI won those arbitrations, its potential liability for the immense damages claimed in the Illinois action would be extinguished. Under this theory, the amount in controversy in each of the arbitrations that DAI sought to compel—the "difference between winning and losing"—was over $14 million.

Chief Judge Dorsey concluded that DAI’s approach was "not an unreasonable method to calculate the individual amounts in controversy—the damages sought in the class action is [sic] the ‘injury to be prevented’ in the arbitration[s], and the franchisees have not provided any other basis to calculate the individual amounts in controversy." Especially "in the face of such large damage claims by the franchisees, it is impossible to conclude to a legal certainty . . . that the amount in controversy is less than the jurisdictional amount."

Hollingsworth, now on appeal to the Second Circuit, has now affirmed Hollingsworth. The case did not answer every question that might someday arise when a franchisor invokes its arbitration clause in an effort to stop class action litigation. In this day and age, however, most class actions against established franchisors will involve impressively large aggregate damage claims. If franchisor counsel is careful to distinguish the authority on removed class actions and to rely instead on decisions like Hollingsworth, determining the amount in controversy in cases under FAA § 4, the franchisor stands an excellent chance of forcing the franchisees to arbitrate. An arbitration clause may not be an invincible shield against class action litigation, but it is surely one of the strongest pieces of armor available to the franchisor.

Edward Wood Dunham is a partner in Wiggin & Dana, which has offices in New Haven, Hartford, and Stamford, Connecticut. He represented Doctor’s Associates, Inc. (DAI) in Hollingsworth .

This article is an abridged and edited version of one that originally appeared on page 141 in Franchise Law Journal, Spring 1997 (16:4).

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