Keith Girard writes in AllBusiness that Richard Welshans and his wife Deborah are typical in many ways of enterprising individuals who choose a franchised business to build a career. After Richard was laid off from his sales job at a chemical manufacturing plant, owning a small business appealed to them.
But in the six years since they signed the franchise agreement in 2003, making them owners of a Coffee Beanery shop in trendy Annapolis, Md., their nightmarish experience has become a cautionary tale for any potential franchisee — beware the fine print.
In particular, their case highlights how many franchisors are misusing mandatory binding arbitration clauses in franchise agreements to gain the upper hand over franchisees in any legal dispute.
On its face, mandatory arbitration seems like a sensible approach to resolve disputes to avoid costly litigation. In fact, the U.S. Supreme Court threw its weight behind arbitration when it ruled in a case several years ago that “any doubt as to the scope of an arbitration provision must be resolved in favor of arbitration.”
The Federal Arbitration Act, enacted more than 80 years ago, sets the ground rules for the use of arbitration and generally pre-empts state franchise laws that address how legal disputes should be resolved. But there are loopholes, and state courts are increasingly citing them to overturn restrictive arbitration clauses in franchise agreements.
In fact, binding arbitration clauses are under assault in several states, and a bill addressing their abuse has been reintroduced in Congress this session. Known as the Arbitration Fairness Act, it would ban mandatory binding arbitration and enact other reforms.
The International Franchise Association (IFA), which represents the industry, has lobbied intensely against the measure, and was able to keep it bottled up last year. But cases like the Welshans’, which has been nationally publicized in magazines like Mother Jones, are building momentum for change.
The Annapolis couple thought a small coffee bar would be right for them and would do well in their trendy, upscale sailing town, which also doubles as the Maryland state capital. They decided on Flushing, Michigan-based Coffee Beanery. They paid $25,000 up front and proceeded to open their shop, even though the company had substantially changed the concept from a coffee bar to a full-fledged cafe with a food menu.
What the Welshans weren’t told was that most Coffee Beanery cafes closed within three years, leaving their owners deep in debt. More than 100 shops have failed during their ordeal, and they soon found out why. The franchisor piled on costs for “required equipment,” such as a surveillance system, a music system, and an obsolete, $14,000 lighting system. Other expensive equipment provided by the company, including a computerized cash register, proved to be faulty, according to Mother Jones.
Read More at AllBusiness
Had Mr. Girard contacted us for comments, we would have been pleased to offer our perspective on the issues that his piece raised. As with most things there are two sides to every story, but Mr. Girard’s reliance on a limited number of sources has left his piece woefully slanted against franchising and the International Franchise Association.
I have listed two of what we believe to be the most significant misstatements in his story below along with specific rebuttal points. In the meantime, let me briefly explain the IFA’s opposition to H.R. 1020, the so-called “Arbitration Fairness Act.” As Mr. Girard’s piece points out, arbitration can be a sensible approach to resolving complex business disputes, and franchise disputes most often involve interpreting the terms of a contract between two business partners. Successful franchising involves sustaining an ongoing business relationship between franchisor and franchisee over a period of many years. In our view, it is imperative that business disputes in franchising be resolved expeditiously and with as little cost and acrimony as possible. We support a number of tools including mediation and arbitration as valid alternatives to litigation. It is our concern that enactment of H.R. 1020 will eliminate arbitration as an alternative to litigation and result in complicated business disputes being dumped into overburdened courts, significantly threatening the franchise model. As the old saw goes, justice delayed is justice denied. Moreover, this bill would retroactively invalidate a clause in thousands and thousands of existing contracts, and we view this as an unwarranted intrusion on the basic freedom to enter into contracts and expect that these contracts will be upheld by law.
We are very concerned that this legislation, like Mr. Girard’s article, is premised on a few anecdotes as opposed to empirical evidence. There is no empirical data that I am aware of that supports any of the conclusions that his article has drawn. In fact, the Federal Trade Commission recently completed a thorough overhaul of the Franchise Rule. Regulatory proceedings took more than a decade, involving multiple public hearings and more than three hundred comments from interested parties. The Commission specifically considered whether additional regulation of contract terms was necessary, and they ultimately concluded that such additional regulation was not justified, noting that the public record failed to show a pattern of unfairness in practices or acts in franchising. In all of the submissions by all of the parties, the subject of mandatory binding arbitration in franchise contracts was hardly raised, if at all.
The story noted that this case is still pending in the courts. The Coffee Beanery has asked the US Supreme Court to consider an appeal, and the International Franchise Association has filed a friend of the court brief in support of the Coffee Beanery petition. The underlying question before the Supreme Court is whether or not there can be judicial review of arbitration decisions for grounds that are not clearly stated in Section 10 of the Federal Arbitration Act. In a recent Supreme Court decision, the Court clearly said that only Section 10 provides grounds for vacating an award, raising a valid question in our minds of whether the Sixth Circuit is correct in their ruling. We believe that this case is an important test of whether or not there is a national policy favoring arbitration, and we are concerned that a failure by the Supreme Court to reverse the Sixth Circuit’s decision will open up more and more arbitration cases to costly and lengthy judicial review. While the article implies that the judicial attacks on arbitration are compelling evidence of arbitration’s failings, another observer might conclude that arbitration is under attack by an activist judiciary in California seeking to write new laws.
Now, let me outline a couple of the most outrageous misstatements in the Girard piece and attempt to correct the record:
(1) “Many franchisors are misusing mandatory binding arbitration clauses” – We know of no empirical data that supports this conclusion. Arbitration is simply a process like litigation is a process. It is not inherently more or less fair than litigation. One of the key advantages of arbitration is that complex commercial cases such as franchise cases can be heard by neutral arbitrators who have a background in franchising or the underlying business model. In litigation, you get a judge or a jury who have no background in the business or industry in question. In theory, arbitration should be quicker and less expensive than litigation; and this has appeal to franchise systems that want to manage their exposure to litigation expenses. I should point out that there is current research showing that approximately 45 percent of franchise agreements contain an arbitration clause, while 55 percent of franchise systems do not.
(2) “The Federal Arbitration Act…generally pre-empts state franchise laws” – The FAA’s pre-emption of state laws is generally limited to saying that a state law cannot compel a dispute to be heard in a court. Otherwise, state franchise laws still apply. In the case of the Welshans’ arbitration, the arbitrator in Michigan heard the case and applied Maryland law.
David French writes: “In the case of the Welshans’ arbitration, the arbitrator in Michigan heard the case and applied Maryland law.”
This is simply wrong. Had the arbitrator applied Maryland land, she would have realized that the Maryland Courts and not her had jurisdiction to hear the case. This was the ultimate ruling by the US Federal Court, which is being appealed.
French has no data to support his claims that arbitration is a cheaper than litigation. And if the IFA has such information, then they should support the Arbitration Fairness Act.
Why?
Well, the Act simply gives the parties a choice of litigation paths to choose, after a dispute has been encountered. If the IFA has data which shows that arbitration is cheaper and more equitable than litigation, then they will do a great business selling this data to both franchisors and franchisees when a dispute takes place!
Of course, the IFA doesn’t want any changes in “mandated arbitration” in franchise contracts and will, as always, continue to influence the courts to maintain their strong position in law and public policy that continues to protect franchisors and treat “founding” franchisees merely as expendable resources for franchisors to churn an appearance of viability, as necessary. in local economies. How alarming that the FAA is determined to be supreme by the Suprme Court and to trump both state and federal law because this is very expedient in terms of protecting the “stacked deck” for the franchisors and the other special corporate interests who grow franchising and their profits in our economy.
The Arbitration Fairness Act could upset the balance of power because the “inducement” problem in the pre-sale process might overwhelm the Courts if franchisees, who feel that they have been unfairly induced to contract because material facts were withheld from them because of ineffective government regulation would have access to the courts. Sooner or later, the inducement problem (the fatal flaw of the FTC Rule) will have to be addressed by our Congress and the Courts, i.e., the problem, as described in the American Business Journal Article, 01 Jan 2003, entitled “Franchising Fraud, the continuing need for reform.”
When you read the history of The Coffee Beanery arbitration and litigation, franchisees have to ask “What is the purpose of regulation?” —-if it doesn’t protect franchisees from buying franchises that have experienced little, if any, success and a high rate of unprofitability and failure, and these facts can be hidden from the view of founding buyers by the franchisors, the sellers of the franchises.
It appeared in the Coffee Beanery Case that both the arbitrator and the Michigan Judge felt that federal regulation trumped state law and protected the franchisor because the Arbitrator was aware that the FTC Rule deems that there is no fraudulent inducement to contract unless there is a violation of the FTC Rule, and if there is a violation of the Rule that could amount to fraudulent inducement, there is NO PRIVATE RIGHT OF ACTION
We have to be grateful that the Coffee Beanery Arbitration disgrace came to the attention of the Sixth Court of Appeals and that this information is available on the Internet to members of the public. It becomes apparent that the Arbitrator felt very comfortable in IGNORING the findings of the Maryland Regulators, who did find that there was a substantive violation of Maryland franchise law, because she knew that federal law would preempt state law. (Apparently, the President recently isued an EO in which he wants the regulators to look ten years back and assess the consequence of federal law preempting state law in terms of consumer protection, etc. — but, of course, franchisees are not protected under consumer protection laws, and the FTC Rule was promulgated in 1978, 30 years ago,) .
Yes, as Michael Webster indicates! Why would the IFA want to defeat the Arbitration Fairness Act that merely gives both parties a choice of arbitration or mediation after a disagreement arises and merely removes ” mandated” arbitration from the aadhesory franchise agreement. Why? Indeed!