State Regulators Circumvent Venue Clauses for Arbitration

Vol. 18 No. 1

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Franchise laws in several states prohibit the enforcement of venue selection clauses in franchise agreements. To the extent these laws purport to apply to venue selection clauses in the arbitration provisions of franchise agreements, courts have held that they are preempted by the Federal Arbitration Act, 9 U.S.C. § 1 et seq. (“FAA”), which provides that contracting parties’ arbitration provisions in interstate commerce are “valid, irrevocable and enforceable.” 9 U.S.C. § 2; Southland Corp. v. Keating, 465 U.S. 1 (1984). Nonetheless, some state regulators still require franchisors to remove out-of-state venue clauses from their arbitration provisions as a condition to approving the registration of their franchise offerings. This forces franchisors to consent to in-state arbitration under the preempted state laws or risk denial of their applications for registration. This article considers the constitutionality of regulators’ essentially forcing adherence to state statutes that are preempted by federal law.

Federal Preemption

Many franchise agreements contain provisions requiring the arbitration of disputes in a particular state, such as the home state of the franchisor. Franchisors have an interest in funneling dispute resolution to a particular jurisdiction rather than having to travel to every state where a dispute with a franchisee may arise. These contractual provisions may conflict with state franchisee protection laws, but courts have found that the FAA preempts these state laws, rendering the arbitration provisions enforceable.

Specifically, the United States Supreme Court and other federal and state courts have consistently held that Section 2 of the FAA preempts state franchise laws—and other state laws—that invalidate contract clauses mandating arbitration or the site of the arbitration. E.g., Keating, 465 U.S. 1; Bradley v. Harris Research, 275 F.3d 884 (9th Cir. 2001) (FAA preempted out-of-state venue restriction in California Franchise Investment Law); KKW Enters. v. Gloria Jean’s Gourmet Coffees Franchising Corp., 184 F.3d 42 (1st Cir. 1999) (FAA preempted out-of-state venue restriction in Rhode Island Franchise Investment Act); Doctor’s Assocs v. Hamilton, 150 F.3d 157 (2nd Cir. 1998) (FAA preempted out-of-state venue restriction in New Jersey Franchise Practices Act); Mgmt. Recruiters Int’l, Inc. v. Bloor, 129 F.3d 851, 856 (6th Cir. 1997) (validity of Washington Franchise Investment Protection Act “would be in serious doubt as a result of the preemptive effect of the FAA” if it “imposed an absolute requirement of in-state arbitration notwithstanding the parties’ agreement to arbitrate” elsewhere); Alphagraphics Franchising v. Whaler Graphics, 840 F. Supp. 708 (D. Ariz. 1993) (FAA preempted out-of-state venue restriction in Michigan Franchise Investment Law).

Outside the franchise context, courts have likewise held that state laws cannot prohibit out-of-state arbitration of disputes under the FAA. For instance, a Louisiana law rendered unenforceable clauses in construction contracts that required resolution of disputes in a forum outside Louisiana. This law was held preempted by the FAA. OPE Int’l LP v. Chet Morrison Contractors, 258 F.3d 443 (5th Cir. 2001).

State Laws Barring Out-of-State Arbitration

Many states have franchise laws that restrict a franchisor’s ability to mandate an out-of-state venue for arbitration, litigation, or other forms of dispute resolution. These state-law restrictions take various forms, examined below.

Michigan’s Franchise Investment Law declares void and unenforceable any provision in a franchise agreement or other document relating to a franchise “requiring that arbitration or litigation be conducted outside this state.” Mich. Stat. § 445.1527. Washington’s State Securities Administrator, interpreting the Washington Franchise Investment Protection Act, Wash. Rev. Code § 19.100.180, concluded “it is not in good faith, reasonable or a fair act and practice for a franchisor to require an arbitration clause in a franchise agreement that unfairly and non-negotiably sets the site of arbitration in a state other than the State of Washington.” Wash. Franchise Act Interpretive Statement FIS-04, January 1, 1991. North Dakota’s Securities Commission held that franchise agreements providing for “the arbitration of disputes at a location that is remote from the site of the franchisee’s business” are unfair, unjust, or inequitable to North Dakota franchisees under N.D. Code. § 51-19-09.

Other states, such as California and Rhode Island, prohibit requiring an out-of-state venue for any type of dispute resolution. See, e.g., Cal. Bus. & Prof. Code § 20040.5 (“A provision in a franchise agreement restricting venue to a forum outside this state is void with respect to any claim arising under or relating to a franchise agreement involving a franchise business operating within this state”); R.I. Stat. § 19-28.1-14 (“A provision in a franchise agreement restricting jurisdiction or venue to a forum outside this state . . . is void with respect to a claim otherwise enforceable under this act”).

These provisions of the laws of Michigan, Washington, North Dakota, California, and Rhode Island run afoul of the FAA, to the extent they restrict parties’ rights to select the venue for arbitration by contract.

A number of states have recognized the supremacy of federal law and have permitted arbitration of disputes outside their borders, notwithstanding their bias against out-of-state venue clauses. For example, the Illinois Franchise Disclosure Act of 1987 provides that “[a]ny provision in a franchise agreement that designates jurisdiction or venue in a forum outside of this State is void provided that a franchise agreement may provide for arbitration in a forum outside of this State.” Ill. Stat. 815 § 705/4. Similarly, the South Dakota Franchise Investment statute tracks in substance Section 2 of the FAA and adds that “any condition, stipulation, or provision requiring a franchisee to waive compliance with or relieving a person of a duty or liability imposed by or a right provided by this Act or a rule or order under this Act is void.” S.D. Code § 37-5B-21.

Considerations for Registration, Disclosure

Franchisors that are exempt from registration and disclosure under state law can mandate an out-of-state venue for arbitration, relying on the FAA, but they may still find themselves having to defend against a franchisee’s motion for removal or dismissal, or an administrative action by a state attorney general. Franchisors that are not exempt are not so lucky. They must choose between a bad option and a worse option, due to state regulators’ enforcement of their state laws during registration. If the franchisor relies on the FAA’s preemptive effect and ignores the state law’s venue restriction, it risks non-approval or delay of its registration as it responds to a comment letter, which in turn delays or prevents it from offering and selling franchises in the state. Theoretically, the franchisor could bring an administrative action against the state regulator, but no franchisor wants its registration held up for months while it incurs the cost and delay that come with challenging the constitutionality of a state regulator’s position. As a practical matter, one can see that these state law venue restrictions on arbitration have the greatest impact on small franchisors, which are not usually exempt and thus must comply with the preempted laws.

Recommendations for Franchisors

A franchisor intending to require out-of-state arbitration in the face of contradictory state laws should carefully negotiate and draft its franchise disclosure document (“FDD”) and franchise agreement to avoid giving franchisees any ground to challenge the enforceability of the contract and to ensure that the arbitration clause does not inadvertently become subject to state laws, resulting in a waiver of the right to assert FAA preemption.

First, the franchisor should ensure that its arbitration and other related provisions are consistent among the franchise agreement, the FDD, and any state addenda. For example, in Great Earth Cos. v. Simons, a federal court in New York invalidated an arbitration clause in a franchise agreement that provided for arbitration in New York because the FDD explicitly assured the franchisee that, under Michigan law, clauses requiring arbitration outside of Michigan were void even if the Michigan law was preempted by the FAA. No. 00 Civ. 0967 (NRB), 2000 U.S. Dist. LEXIS 3772 (S.D.N.Y. March 24, 2000). The court in Great Earth Cos. held that the franchisor fraudulently induced the franchisee to agree to an out-of-state arbitration provision by failing to disclose its intent to enforce the arbitration clause in its franchise agreement despite its statements in the FDD. The lesson learned: A franchisor relying on the FAA notwithstanding state laws to the contrary should verify that its FDD and any state addenda do not contradict any arbitration or venue clause in its franchise agreement.

Second, the arbitration provision in the franchise agreement should clearly specify the location for the arbitration, which will typically be the franchisor’s home state. The parties should also consider adding language to clarify that the FAA preempts any state law barring out-of-state arbitration, similar to the following:

The parties intend and agree that any state laws attempting to prohibit arbitration or void out-of-state forums for arbitration are preempted by the Federal Arbitration Act and that arbitration shall be held as provided in this section.

Third, so long as the preempted state laws remain on the books, the franchisor should be prepared to support its argument that the FAA preempts state laws barring out-of-state arbitration and enforces the parties’ right to contract for an out-of-state venue for arbitration. Moreover, the franchisor must keep in mind that even if a state regulator ultimately accepts this argument, choosing not to comply with the state law in an initial filing may delay the ability to register and offer franchises in the state while the franchisor responds to a comment letter from the state.

Recommendations for States

States should amend their franchise laws to make them consistent with the FAA. Specifically, because the FAA permits the parties to a contract (including a franchise agreement) to agree to out-of-state arbitration, state laws should not prohibit arbitration or restrict the location of arbitration, and state regulators should not prohibit the registration of franchises requiring out-of-state arbitration. States should ensure that their laws, regulations, and other requirements are consistent with the FAA or provide an exception to allow compliance with the FAA (as Illinois did with its Franchise Disclosure Act), or, simpler yet, should delete their restrictions on arbitration entirely, given that such restrictions are not likely to hold up in court.

In the meantime, given that legislative change can be slow, state regulators reviewing franchise applications should recognize the unconstitutionality of these state laws (as state attorneys general have done for years in the area of civil rights), and should stop trying to enforce them by requiring franchisors to modify their arbitration provisions as a condition to achieving registration in the state.

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